Professional Documents
Culture Documents
Economics
2nd Edition
M Parkin
G Antrobus, P Baur, J Bruce-Brand,
M Kohler, L Neethling, B Rhodes,
A Saayman, V Schöer,
D Scholtz, K Thompson,
J Van der Merwe
Pearson Education South Africa (Pty) Ltd
Forest Drive, Pinelands, Cape Town
www.pearsoned.co.za
Authorised adaptation from the United States edition entitled ECONOMICS, 10th Edition,
ISBN: 0131394657 by PARKIN, MICHAEL, published by Pearson Education, Inc.
Copyright © 2012.
All rights reserved. No part of this book may be reproduced or transmitted in any form or by any
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Acknowledgments
Our sincere thanks to Dr Sansia Brink for her support and wise counsel, as well as to Jacqueline van
der Merwe for all her hard work in the creation and testing of questions and answers.
Michael Parkin trained as an economist at the Universities of Leicester and Essex. Currently he is
in the Department of Economics at the University of Western Ontario, Canada. Professor Parkin has held faculty
appointments at Brown University, the University of Manchester, the University of Essex and Bond University. He is
a past president of the Canadian Economics Association and has served on the editorial boards of the American
Economic Review and the Journal of Monetary Economics and as managing editor of the Canadian Journal of
Economics. His research on macroeconomics, monetary economics and international economics has resulted in
over 160 publications in journals and edited volumes, including the American Economic Review, the Journal of
Political Economy, the Review of Economic Studies, the Journal of Monetary Economics, and the Journal of Money,
Credit and Banking. He became most visible to the public with his work on inflation that discredited the use of wage
and price controls. He also spearheaded the movement toward European monetary union. Professor Parkin is an
experienced and dedicated teacher of introductory economics.
Janet Bruce-Brand has taught economics and econometrics across undergraduate and postgraduate
levels at the University of Natal and the University of KwaZulu-Natal for just over ten years. Her main area of interest
is microeconomics and she has published in the South African Journal of Economics. Janet is currently involved
in research work on an economic evaluation of emissions trading schemes for South Africa and co-authoring an
undergraduate economics textbook for South African students.
Marcel Kohler has taught economics across undergraduate, postgraduate and MBA courses at the
University of Natal and the University of KwaZulu-Natal. He is currently registered for his PhD at the University of
Stellenbosch. His research interests include the areas of economics pertaining to the international economy and
environmental resources, in particular energy. He has published articles in the South African Journal of Economics
and the Journal of Interdisciplinary Economics and contributed to chapters in economic textbooks. He does research
for the South African Presidency, the South African National Energy Research Institute and the Trade and Industrial
Policy Strategies Unit.
Leigh Neethling is a lecturer in the School of Economics at the University of Cape Town. She is responsible for
the main first-year courses in economics and has a number of years’ experience in adult education at UCT’s Graduate
School of Business. Leigh has been extensively involved in teaching and learning initiatives at the University of Cape
Town. She is registered for a PhD in Economics with a focus on the economics of higher education in South Africa.
Bruce Rhodes has taught for over fifteen years at undergraduate and postgraduate level in both micro-
and macroeconomics and is currently based at the University of KwaZulu-Natal. Dr Rhodes’s main area of
interest is environmental and experimental economics but his more recent research has been conducted in
energy poverty and health economics involving discrete choice experiments. He has published articles in
various journals including the Economic Journal, the Quarterly Journal of Economics, Biomed Central and the
Journal of Interdisciplinary Economics.
Andrea Saayman holds a PhD in Economics and is currently a professor of Economics at the North-
West University, Potchefstroom Campus where she lectures macroeconomics and econometrics. Her research
interests are in the fields of international movement of people and money and she has published more than
50 peer-reviewed articles in national and international research journals. Professor Saayman is an executive
member of the International Association for Tourism Economics (IATE) and serves on the editorial boards of
international journals Tourism Economics and International Advances in Economic Research.
Volker Schöer has extensive experience in teaching economics across undergraduate, postgraduate
and executive courses. He was involved in curriculum development and course coordination at the University of
Cape Town and the University of the Witwatersrand. Volker received his MA in Economics from the University
of Cape Town and is currently registered for his PhD at the University of the Witwatersrand. He has published
numerous articles on South African education issues, the South African labour market and trade issues,
and has consulted widely with the World Bank, Southern African governments and various South African
government institutions.
Dirk Scholtz currently teaches introductory economics at the University of Pretoria. He served on the
editorial board of the South African Journal of Economic and Management Sciences (SA JEMS) and is the
deputy director of the African Tax Institute. In 2002, he held a fellowship at Harvard University, MA, US
where he did the International Tax Programme. He has a keen interest in public economics and fiscal policy
and has lectured extensively on comparative tax policy in the African Tax Institute’s programmes.
Kirsten Thompson is the managing director of research at Plus Economics Advisory (Pty) Ltd, an
economic research and consulting house. Prior to this she was a lecturer in the Department of Economics at
the University of Pretoria. She taught courses in introductory economics, macroeconomics, public economics
and econometrics. She is a referee of the South African Journal of Economic and Management Sciences,
Southern African Business Review and the Economic Research Southern Africa Working Paper Series. Kirsten
is presently studying towards a PhD at the University of Pretoria with specialisation in the empirical analysis of
financial conditions.
Jacky van der Merwe holds a MA in Economics and has actively taught economics via lecturing,
facilitation and tutoring since 2005. Her interests lie in economic education and development economics. She
is an independent consultant and runs her own business facilitating textbook exchanges between students.
Position of Line 24
PART ONE Positive Relationships 24
INTRODUCTION 1 Negative Relationships 24
Example 24
CHAPTER 1 ◆ WHAT IS ECONOMICS? CHAPTER 2 ◆ THE ECONOMIC PROBLEM 28
UNDERSTANDING OUR CHANGING WORLD 1 (adapted by D Scholtz)
(adapted by K Thompson)
Production Possibilities and Opportunity Cost 29
Definition of Economics 2 Production Possibilities Frontier 29
Two Big Economic Questions 2 Production Efficiency 30
What, How and for Whom? 2 Trade-Off Along the PPF 30
Can the Pursuit of Self-Interest Promote the Opportunity Cost 30
Social Interest? 5 Using Resources Efficiently 31
The Economic Way of Thinking 6 The PPF and Marginal Cost 32
A Choice is a Trade-Off 6 Preferences and Marginal Benefit 32
Making a Rational Choice 7 Allocative Efficiency 33
Benefit: What You Gain 7 Economic Growth 34
Cost: What you Must Give Up 7 The Cost of Economic Growth 34
How Much? Choosing at the Margin 7 A Nation’s Economic Growth 36
Choices Respond to Incentives 8
Gains from Trade 36
Economics as Social Science and Policy Tool 8 Comparative Advantage and Absolute Advantage 36
The Economist as Social Scientist 8 Achieving the Gains From Trade 38
The Economist as Policy Advisor 10
Economic Coordination 40
APPENDIX Firms 40
Graphs in Economics 12 Markets 40
Property Rights 40
Graphing Data 12
Money 41
Scatter Diagrams 13
Circular Flows Through Markets 41
Graphs Used in Economic Models 15 Coordinating Decisions 41
Variables That Move in the Same Direction 16
READING BETWEEN THE LINES
Variables That Move in Opposite Directions 17
The Rising Opportunity Cost of Food 42
Variables That Have a Maximum or a Minimum 17
Variables That Are Unrelated 18
PART ONE WRAP-UP
The Slope of a Relationship 18
The Slope of a Straight Line 19 Understanding the Scope of Economics
The Slope of a Curved Line 19 Your Economic Revolution 48
Key Terms, Study Plan Problems and Applications and Additional Problems and Applications appear at the end of
each chapter.
Government in the Loanable Funds Market 534 READING BETWEEN THE LINES
A Government Budget Surplus 534 The Quantity Theory of Money in Zimbabwe 566
A Government Budget Deficit 535
MATHEMATICAL NOTE
The Global Loanable Funds Market 536
The Money Multiplier 568
International Capital Mobility 536
International Borrowing and Lending 537 CHAPTER 26 ◆ THE EXCHANGE RATE AND
Demand and Supply in the Global and National THE BALANCE OF PAYMENTS 573
Markets 537 (adapted by A Saayman)
READING BETWEEN THE LINES The Foreign Exchange Market 574
Crowding Out in the Global Recession 539 Trading Currencies 574
Exchange Rates 574
CHAPTER 25 ◆ MONEY, THE PRICE LEVEL AND
Questions About the South African Exchange
INFLATION 545
Rate 574
(adapted by A Saayman)
An Exchange Rate Is a Price 575
What Is Money? 546 The Demand for One Money Is the Supply of
Medium of Exchange 546 Another Money 575
Unit of Account 546 Demand in the Foreign Exchange Market 575
Store of Value 547 Demand Curve for South African Rand 576
Money in South Africa Today 547 Supply in the Foreign Exchange Market 577
Supply Curve for South African Rand 577
Depository Institutions 549
Market Equilibrium 578
Commercial Banks 549
Profit and Prudence: A Balancing Act 549 Exchange Rate Fluctuations 579
What Depository Institutions Do 549 Changes in the Demand for South African
Economic Benefits Provided by Depository Rand 579
Institutions 550 Changes in the Supply of South African Rand 580
How Depository Institutions Are Regulated 551 Changes in the Exchange Rate 581
Financial Innovation 551 Fundamentals, Expectations and Arbitrage 582
The Real Exchange Rate 583
The South African Reserve Bank 552
The Reserve Bank’s Goals and Targets 552 Exchange Rate Policy 585
The Structure of the Reserve Bank 552 Flexible Exchange Rate 585
The Reserve Bank’s Policy Tools 553 Fixed Exchange Rate 585
Crawling Peg 586
How Banks Create Money 555
Creating Deposits by Making Loans 555 Financing International Trade 588
The Money Creation Process 556 Balance of Payments Accounts 588
The Money Multiplier 557 Borrowers and Lenders 590
Debtors and Creditors 591
The Demand For Money 558
Current Account Balance 591
The Influences on Money Holding 558
Net Exports 591
The Demand for Money Curve 559
Where Is the Exchange Rate? 593
Shifts in the Demand for Money Curve 559
Interest Rate Determination 560 READING BETWEEN THE LINES
The Supply of Money 560 China and the Rand 594
The Money Market 561
Money Market Equilibrium 561 PART EIGHT WRAP-UP
The Quantity Theory of Money 563 Understanding Macroeconomic Trends
Expanding the Frontier 599
Since the subprime mortgage crisis of August 2007 tools they have just learned by analysing an article from a
moved economics from the business report to the newspaper or news website. Each article sheds additional
front page, justified fear has gripped producers, light on the questions first raised in the Chapter Opener.
consumers, financial institutions and governments. Questions about the article also appear with the end-of-
Even the idea that the market is an efficient chapter problems and applications.
mechanism for allocating scarce resources came into
question as some political leaders trumpeted the end of
capitalism and the dawn of a new economic order in Diagrams That Show the Action
which tighter regulation reigned in unfettered greed. This book has set new standards of clarity in its
Rarely do teachers of economics have such a rich diagrams.
feast on which to draw. And rarely are the principles The diagrams feature:
of economics more surely needed to provide the solid ◆ Original curves consistently shown in blue
foundation on which to think about economic events ◆ Shifted curves, equilibrium points and other
and navigate the turbulence of economic life. important features highlighted in red
Although thinking like an economist can bring ◆ Colour-blended arrows to suggest movement
a clearer perspective to and deeper understanding of ◆ Graphs paired with data tables
today’s events, students do not find the economic way ◆ Diagrams labelled with boxed notes
of thinking easy or natural. Economics: Global and ◆ Extended captions that make each diagram and its
Southern African Perspectives seeks to put clarity and caption a self-contained object for study and review.
understanding in the grasp of the student through its
Price
D0
D2
The Second Edition Revision
Simpler where possible, stripped of some technical
detail and reinforced with problem sets. These are the 0 Quantity
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1
ou are studying economics at a time of enormous change.
Much of the change is for the better. The information age with its
laptops, wireless internet connections, handheld tablets, HD and 3D
movies, smartphones, video games and a host of other gadgets and
toys, has transformed the way we work and play.
But some change is for the worse. The United States, Europe and
Japan, the world’s richest nations, have still
Definition of Economics offered for sale than people want to buy. But there is a
price at which choices to buy and sell are consistent.
A fundamental fact dominates our lives: We want
more than we can get. Our inability to get everything Economics is the social science that studies the
we want is called scarcity. Scarcity is universal. It
choices that individuals, businesses, governments
confronts all living things.
and entire societies make as they cope with
Think about the things that you want and the
scarcity that you face. You want to live a long and scarcity and the incentives that influence and
healthy life. You want to go to a good school, or reconcile those choices.
university. You want to live in a well-equipped,
spacious and comfortable home. You want the latest The subject has two parts:
smartphone and a faster internet connection for your ◆ Microeconomics
laptop or iPad. You want some sports and recreational ◆ Macroeconomics
equipment – perhaps some new running shoes, or a
new bike. And you want more time, much more than Microeconomics is the study of the choices that
is available, to go to class, do your homework, play individuals and businesses make, the way these choices
sports and games, read novels, go to the movies, listen interact in markets and the influence of governments.
to music, travel and hang out with your friends. Some examples of microeconomic questions are:
What you can afford to buy is limited by your Why are people downloading more movies and
income and by the prices you must pay. And your TV series? How would a tax on e-commerce affect
time is limited by the fact that your day has 24 hours. kalahari.com?
You want some other things that only Macroeconomics is the study of the performance of
governments provide. You want to live in a peaceful the national economy and the global economy. Some
and secure world and safe neighbourhood and enjoy examples of macroeconomic questions are: Why is the
the benefits of clean air, lakes and rivers. South African unemployment rate one of the highest in
What governments can afford is limited by the the world? Can the South African Reserve Bank make
taxes they collect. Taxes lower people’s incomes and our economy expand by cutting interest rates?
compete with the other things they want to buy.
What everyone can get – what society can get – REVIEW QUIZ
is limited by the productive resources available. These
1 List some examples of scarcity in South
resources are the gifts of nature, human labour and
Africa today.
ingenuity, and all the previously produced tools
2 Use the headlines in today’s news to provide
and equipment.
some examples of scarcity around the world.
Because we cannot get everything we want, we
3 Use today’s news to illustrate the distinction
must make choices. If you cannot afford both a laptop
between microeconomics and macroeconomics.
and an iPhone, you must choose which one to buy. If
you cannot spend tonight both studying for your next
test and going to the movies, again, you must choose Two Big Economic Questions
which one to do. If a government is unable to spend
taxes on both national defence and environmental Two big questions summarise the scope of economics:
protection, they must choose how to spend those ◆ How do choices end up determining what, how
taxes. Your choices must somehow be made consistent and for whom goods and services are produced?
with the choices of others. If you choose to buy a ◆ When do choices made in the pursuit of self-
laptop, someone else must choose to sell it. Incentives interest also promote the social interest?
reconcile choices. An incentive is a reward that
encourages an action or a penalty that discourages
What, How and for Whom?
one. Prices act as incentives. If the price of a laptop
is too high, more will be offered for sale than people Goods and services are the objects that people value
want to buy. And if the price is too low, fewer will be and produce to satisfy human wants. Goods are physical
objects such as cellphones and cars. Services are tasks How? Goods and services are produced by using
performed for people such as those at cellphone repair productive resources that economists call factors of
centres and car service centres. production. Factors of production are grouped into
four categories:
What? What we produce varies across countries ◆ Land
and changes over time. The largest part (two-thirds ◆ Labour
in fact) of what South Africa produces today is services, ◆ Capital
such as retail and wholesale trade, health care and ◆ Entrepreneurship
education. Goods are a small part of total production.
In 1946, 24 per cent of the South African economy Land The ‘gifts of nature’ that we use to produce
was engaged in the primary sector – agriculture and goods and services are called land. In economics, land
mining. That proportion has shrunk to 8 per cent is what in everyday language we call natural resources.
today. Over the same period, the contribution of It includes land in the everyday sense of the word
the secondary sector – mining, construction and together with minerals, oil, gas, coal, water, air, forests
manufacturing – has increased from 14 per cent to and fish. Our land surface and water resources are
24 per cent. In the United States today, the services renewable and some of our mineral resources can be
sector is the largest (77 per cent of total production), recycled. But the resources, such as oil and coal that
while in China it is unsurprisingly the manufacturing we use to create energy are non-renewable; they can
sector (47 per cent). Figure 1.1 shows these numbers be used only once.
and also the percentages for Brazil, Russia and India.
What determines these patterns of production? Labour The work time and work effort that people
How do choices end up determining the quantities of devote to producing goods and services is called
cellphones, cars, cellphone service, car repair service labour. Labour includes the physical and mental
and the millions of other items that are produced in efforts of all the people who work on farms
South Africa and around the world? and construction sites and in factories, shops
and offices.
The quality of labour depends on human capital,
FIGURE 1.1 What Six Countries Produce
which is the knowledge and skills that people obtain
South Africa from education, on-the-job training and work
experience. You are building your own human capital
Brazil right now as you work on your economics course,
and your human capital will continue to grow as you
Russia gain work experience.
Human capital expands over time. Today,
India 26 per cent of the population of South Africa has
completed high school and 11 per cent has a tertiary
China qualification. Figure 1.2 shows these measures of the
growth of human capital in South Africa since 2002.
United States
0% 20% 40% 60% 80% 100% Capital The tools, instruments, machines, buildings
Primary Secondary Tertiary
and other constructions that businesses use to produce
goods and services are called capital.
Primary and secondary activities are a small percentage of In everyday language, we talk about money,
production in developed countries such as the United States, stocks and bonds as being ‘capital’. These items are
and a large percentage of production in emerging economy financial capital. Financial capital plays an important
countries such as China. Most of what is produced in South role in enabling businesses to borrow the funds that
Africa is services. they use to buy capital. But because financial capital
is not used to produce goods and services, it is not a
Source of data: Central Intelligence Agency, CIA Fact book 2012.
productive resource.
Entrepreneurship The human resource that organises FIGURE 1.2 A Measure of Human Capital
labour, land and capital is called entrepreneurship.
Entrepreneurs come up with new ideas about what 100
and how to produce, make business decisions and
90
bear the risks that arise from these decisions.
Must governments change the incentives we face so We have looked at four topics and asked many
that our self-interested choices are also in the social questions that illustrate the big question: Can choices
interest? How can governments change incentives? made in the pursuit of self-interest also promote
How can we encourage the use of wind and solar the social interest? We have asked questions but not
power to replace the burning of fossil fuels that brings answered them because we have not yet explained the
climate change? economic principles needed to do so.
By working through this book, you will discover
Economic Instability The years between 1993 and the economic principles that help economists figure
2007 were a period of remarkable economic stability, out when the social interest is being served, when it
so much so that they have been called the Great is not, and what might be done when it is not being
Moderation. During those years, the US and global served. We will return to each of the unanswered
economies were on a roll. Incomes in the United questions in future chapters.
States increased by 30 per cent and incomes in China
tripled. Even the economic shockwaves of 9/11
brought only a small dip in the strong pace of US
and global economic growth.
The Economic Way of Thinking
But in August 2007, a period of financial The questions that economics tries to answer tell us
stress began. A bank in France was the first to feel about the scope of economics. But they do not tell us
the pain that soon would grip the entire global how economists think about these questions and go
financial system. about seeking answers to these questions.
Banks take in people’s deposits and get more You are now going to begin to see how
funds by borrowing from each other and from other economists go about their work.
firms. Banks use these funds to make loans. All the We are going to look at six key ideas that define
banks’ choices to borrow and lend and the choices the economic way of thinking. These ideas are:
of people and businesses to lend to and borrow ◆ A choice is a trade-off.
from banks are made in self-interest. But does this ◆ People make rational choices by comparing
lending and borrowing serve the social interest? Is benefits and costs.
there too much borrowing and lending that needs ◆ Benefit is what you gain from something.
to be controlled, or is there too little and a need to ◆ Cost is what you must give up to get something.
stimulate more? ◆ Most choices are ‘how-much’ choices made at
When the banks got into trouble, the US Federal the margin.
Reserve (the Fed) bailed them out with big loans ◆ Choices respond to incentives.
backed by taxpayers’ dollars. Did the Fed’s bailout
of troubled banks serve the social interest? Or might
the Fed’s rescue action encourage banks to repeat A Choice Is a Trade-Off
their dangerous lending in the future? Banks were not Because we face scarcity, we must make choices. And when
the only recipients of public funds. General Motors we make a choice, we select from the available alternatives.
was saved by a government bailout. GM makes its For example, you can spend Saturday night studying for
decisions in its self-interest. The government bailout your next economics test or having fun with your friends,
of GM also served the firm’s self-interest. Did the but you cannot do both of these activities at the same
bailout also serve the social interest? time. You must choose how much time to devote to each.
Whatever choice you make, you could have
REVIEW QUIZ chosen something else.
You can think about your choices as trade-offs.
1 Describe the broad facts about what, how and A trade-off is an exchange – giving up one thing to
for whom goods and services are produced. get something else.
2 Use headlines from the recent news to When you choose how to spend your Saturday
illustrate the potential for conflict between night, you face a trade-off between studying and
self-interest and the social interest. hanging out with your friends.
Key Terms
Benefit, 7 Goods and services, 2 Marginal benefit, 7 Scarcity, 2
Capital, 3 Human capital, 3 Marginal cost, 7 Self-interest, 5
Ceteris paribus, 9 Incentive, 2 Microeconomics, 2 Social interest, 5
Economic model, 9 Interest, 4 Opportunity cost, 7 Trade-off, 6
Economics, 2 Labour, 3 Preferences, 7 Wages, 4
Efficiency, 5 Land, 3 Profit, 4
Entrepreneurship, 3 Macroeconomics, 2 Rational choice, 7
Factors of production, 3 Margin, 7 Rent, 4
Economics as Social Science and Policy Tool c. If the price of antiretroviral drugs increases,
6. Which of the following statements is positive, HIV/Aids sufferers will decrease their
which is normative and which can be tested? consumption of the drugs.
a. South Africa should cut its imports.
b. China is the largest trading partner of the
United States.
Graphs in Economics
Figure A1.2 shows two examples of economic graphs. downloaded per day. Point B tells us what these
quantities were. You can ‘read’ this graph as telling
FIGURE A1.2 Two Graphs of Economic Data you that in January 2010, 8.3 million songs and
0.4 million albums a day were downloaded.
The three graphs that you have just seen tell you
Price (cents per song)
Scatter Diagrams
Quantity (millions of albums per day)
1.0
million A scatter diagram is a graph that plots the value of
gs at 99 0.8 8.3 million songs one variable against the value of another variable for
ts per song and 0.4 million
albums were
a number of different values of each variable. Such a
0.6
A downloaded graph reveals whether a relationship exists between
0.4 B two variables and describes their relationship.
The table in Figure A1.3 shows some data on two
0.2 variables: the number of tickets sold at the box office
and the number of DVDs sold for eight of the most
5 8.3 10 15 0 5 8.3 10 15 popular movies in 2009.
ntity (millions of songs per day) Quantity (millions of songs per day)
What is the relationship between these two
loads: quantity and price (b) iTunes downloads: songs and albums variables? Does a big box office success generate a
large volume of DVD sales? Or does a box office
The graph in part (a) tells us that in January 2010, 8.3 million success mean that fewer DVDs are sold?
songs per day were downloaded from the iTunes store at a We can answer these questions by making a
price of 99 cents a song. scatter diagram. We do so by graphing the data in the
The graph in part (b) tells us that in January 2010, table. In the graph in Fig. A1.3, each point shows the
8.3 million songs per day and 0.4 million albums per day number of box office tickets sold (the x variable) and
were downloaded from the iTunes store. the number of DVDs sold (the y variable) of one of
the movies. There are eight movies, so there are eight
points ‘scattered’ within the graph.
Figure A1.2(a) is a graph about iTunes song The point labelled A tells us that Star Trek sold
downloads in January 2010. The x-axis measures the 34 million tickets at the box office and 6 million
quantity of songs downloaded per day and the y-axis DVDs. The points in the graph form a pattern that
measures the price of a song. Point A tells us what the reveals that larger box office sales are associated with
quantity and price were. You can ‘read’ this graph as larger DVD sales. But the points also tell us that this
telling you that in January 2010, 8.3 million songs a association is weak. You cannot predict DVD sales
day were downloaded at a price of 99 cents per song. with any confidence by knowing only the number of
Figure A1.2(b) is a graph about iTunes song tickets sold at the box office.
and album downloads in January 2010. The x-axis Figure A1.4 shows two scatter diagrams of economic
measures the quantity of songs downloaded per variables. Part (a) shows the relationship between income
day and the y-axis measures the quantity of albums and expenditure, on average, during a ten-year period.
11
(millions)
10 Twilight 38 10
5
Ice Age: Dawn of the Dinosaurs 26 5
The Proposal 22 5
0 20 30 34 40 50 60
Box office tickets sold (millions)
The table lists the number of tickets sold at the box office For example, point A shows the point for Star Trek, which sold
and the number of DVDs sold for eight popular movies. The 34 million tickets at the box office and 6 million DVDs. The
scatter diagram reveals the relationship between these two pattern formed by the points shows that there is a tendency
variables. Each point shows the values of the two variables for large box office sales to bring greater DVD sales. But you
for a specific movie. could not predict how many DVDs a movie would sell just by
knowing its box office sales.
Each point represents income and expenditure in a The breaks are used because the lowest values of
given year. For example, point A shows that in 2006, income and expenditure exceed R200 000. If we made
income was R310 thousand and expenditure was this graph with no breaks in its axes, there would be
R300 thousand. This graph shows that as income a lot of empty space, all the points would be crowded
increases, so does expenditure and the relationship is a into the top right corner, and it would be difficult to
close one. see whether a relationship exists between these two
Figure A1.4(b) shows a scatter diagram of variables. By breaking the axes, we are able to bring
US inflation and unemployment during the the relationship into view.
2000s. Here, the points for 2000 to 2008 show no Putting a break in one or both axes is like using a
relationship between the two variables, but the high zoom lens to bring the relationship into the centre of
unemployment rate of 2009 brought a low inflation the graph and magnify it so that the relationship fills
rate that year. the graph.
You can see that a scatter diagram conveys a
wealth of information, and it does so in much less Misleading Graphs Breaks can be used to highlight
space than we have used to describe only some of its a relationship, but they can also be used to mislead –
features. But you do have to ‘read’ the graph to obtain to make a graph that lies. The most common
all this information. way of making a graph lie is to put a break in the
axis and either to stretch or compress the scale.
Breaks in the Axes The graph in Fig. A1.4(a) has For example, suppose that in Fig. A1.4(a), the
breaks in its axes, as shown by the small gaps. The y-axis that measures expenditure ran from zero to
breaks indicate that there are jumps from the origin, R350 000 while the x-axis was the same as the one
0, to the first values recorded. shown. The graph would now create the impression
5
(thousands of rand per year)
350 350 5
09 09
08 4 08
08 084
06 06
07 05 00 05
07 06 00 3
06 300 A 3 07
300 A 07
01 04 01 04
032 03
05 05
2
04 02 02
04
03 03 1
250 02 1
250 02
01 01
00 00 0 0
09 09
–1 –1
0 250 310 0
350 250
400 310 350 2 400 4 6 8 210 4 6 8 10
Income (thousands
Income (thousands of rand per year) of rand per year) Unemployment rate (per cent)
Unemployment rate (per cent)
The scatter diagram in part (a) shows the relationship This graph shows that as income rises, so does expenditure
between income and expenditure from 2000 to 2009. Point and the relationship is a close one.
A shows that in 2006, income was R310 (thousand) on the The scatter diagram in part (b) shows a weak relationship
x-axis and expenditure was R300 (thousand) on the y-axis. between unemployment and inflation in the United States
during most of the 2000s.
The patterns to look for in graphs are the four travelled in 5 hours and speed. For example, point A
cases in which: shows that we will travel 200 kilometres in 5 hours if
◆ Variables move in the same direction. our speed is 40 kilometres an hour. If we double our
◆ Variables move in opposite directions. speed to 80 kilometres an hour, we will travel 400
◆ Variables have a maximum or a minimum. kilometres in 5 hours.
◆ Variables are unrelated. Figure A1.5(b) shows the relationship between
distance sprinted and recovery time (the time it
Let us look at these four cases. takes the heart rate to return to its normal resting
rate). This relationship is an upward-sloping one
that starts out quite flat but then becomes steeper
Variables That Move in the Same Direction as we move along the curve away from the origin.
Figure A1.5 shows graphs of the relationships between The reason this curve becomes steeper is that the
two variables that move up and down together. A additional recovery time needed from sprinting
relationship between two variables that move in the an additional 100 metres increases. It takes less
same direction is called a positive relationship or a than 5 minutes to recover from sprinting 100 metres
direct relationship. A line that slopes upward shows but more than 10 minutes to recover from
such a relationship. 200 metres.
Figure A1.5 shows three types of relationships: Figure A1.5(c) shows the relationship between
one that has a straight line and two that have curved the number of problems worked on by a student and
lines. All the lines in these three graphs are called the amount of study time. This relationship is an
curves. Any line on a graph – no matter whether it is upward-sloping one that starts out quite steep and
straight or curved – is called a curve. becomes flatter as we move along the curve away from
A relationship shown by a straight line is called the origin. Study time becomes less productive as the
a linear relationship. Figure A1.5(a) shows a linear student spends more hours studying and becomes
relationship between the number of kilometres more tired.
A
200 20 10
100 10 5
(a) Positive linear relationship (b) Positive, becoming steeper (c) Positive, becoming less steep
Each part shows a positive (direct) relationship between two Part (b) shows a positive relationship such that as the two
variables. That is, as the value of the variable measured variables increase together, we move along a curve that
on the x-axis increases, so does the value of the variable becomes steeper.
measured on the y-axis. Part (c) shows a positive relationship such that as the two
Part (a) shows a linear positive relationship – as the two variables increase together, we move along a curve that
variables increase together, we move along a straight line. becomes flatter.
Variables That Move in Opposite Directions worked on by a student. Increasing leisure time
Figure A1.6 shows relationships between things that produces an increasingly large reduction in the number
move in opposite directions. A relationship between of problems worked on. This relationship is a negative
variables that move in opposite directions is called a one that starts out with a gentle slope at a small number
negative relationship or an inverse relationship. of leisure hours and becomes steeper as the number of
Figure A1.6(a) shows the relationship between leisure hours increases. This relationship is a different
the hours spent playing squash and the hours spent view of the idea shown in Fig. A1.5(c).
playing tennis when the total time available is 5 hours.
One extra hour spent playing tennis means one
hour less spent playing squash and vice versa. This Variables That Have a Maximum or
relationship is negative and linear. a Minimum
Figure A1.6(b) shows the relationship between Many relationships in economic models have a
the cost per kilometre travelled and the length of a maximum or a minimum. For example, firms try to
journey. The longer the journey, the lower the cost make the maximum possible profit and to produce
per kilometre. But as the journey length increases, even at the lowest possible cost. Figure A1.7 shows
though the cost per kilometre decreases, the fall in relationships that have a maximum or a minimum.
the cost becomes smaller the longer the journey. This Figure A1.7(a) shows the relationship between
feature of the relationship is shown by the fact that the rainfall and wheat yield. When there is no rainfall, wheat
curve slopes downward, starting out steep at a short will not grow, so the yield is zero. As the rainfall increases
journey length and then becoming flatter as the journey up to 10 days a month, the wheat yield increases. With
length increases. This relationship arises because some 10 rainy days each month, the wheat yield reaches its
of the costs are fixed, such as car insurance, and the maximum at 40 bushels a hectare (point A). Rain in
fixed costs are spread over a longer journey. excess of 10 days a month starts to lower the yield of
Figure A1.6(c) shows the relationship between the wheat. If every day is rainy, the wheat suffers from
amount of leisure time and the number of problems a lack of sunshine and the yield decreases to zero.
5 50 25
Time playing squash (hours)
2 20 10
1 10 5
(a) Negative linear relationship (b) Negative, becoming less steep (c) Negative, becoming steeper
Each part shows a negative (inverse) relationship between Part (b) shows a negative relationship such that as the journey
two variables. Part (a) shows a linear negative relationship. length increases, the travel cost decreases as we move along
The total time spent playing tennis and squash is 5 hours. a curve that becomes less steep.
As the time spent playing tennis increases, the time Part (c) shows a negative relationship such that as leisure
spent playing squash decreases, and we move along a time increases, the number of problems worked on decreases
straight line. as we move along a curve that becomes steeper.
10 10
30 30 Minimum
Minimum
cost cost
20 20 B
Increasing Decreasing
B
Increasing Decreasing 5 5
yield yield
yield yield
10 10
0 5 10 0 15 5 20 10 25 1530 20 25
0 3015 0
35 5515 7535 9555 75 95
Rainfall (days per month)
Rainfall (days per month) Speed (kilometres perSpeed
hour) (kilometres per hour)
(a) Relationship
(a) Relationship with a maximumwith a maximum (b) Relationship with
(b) Relationship
a minimum with a minimum
Part (a) shows a relationship that has a maximum point, A. Part (b) shows a relationship with a minimum point, B. The
The curve slopes upward as it rises to its maximum point, is curve slopes downward as it falls to its minimum, is flat at its
flat at its maximum, and then slopes downward. minimum, and then slopes upward.
This relationship is one that starts out sloping upward, Let us spend a little time discussing exactly what we
reaches a maximum, and then slopes downward. mean by slope and how we measure the slope of a curve.
Figure A1.7(b) shows the reverse case – a
relationship that begins sloping downward, falls to a
minimum, and then slopes upward. Most economic
costs are like this relationship. An example is the
The Slope of a Relationship
relationship between the cost per kilometre and speed We can measure the influence of one variable on
for a car trip. At low speeds, the car is creeping in a another by the slope of the relationship. The slope
traffic jam. The number of kilometres per litre is low, of a relationship is the change in the value of the
so the cost per kilometre is high. At high speeds, the variable measured on the y-axis divided by the
car is travelling faster than its efficient speed, using change in the value of the variable measured on the
a large quantity of petrol, and again the number of x-axis. We use the Greek letter ∆ (delta) to represent
kilometres per litre is low and the cost per kilometre ‘change in’. Thus ∆y means the change in the value
is high. At a speed of 55 kilometres an hour, the of the variable measured on the y-axis, and ∆x means
cost per kilometre is at its minimum (point B). This the change in the value of the variable measured on
relationship is one that starts out sloping downward, the x-axis.
reaches a minimum, and then slopes upward. Therefore the slope of the relationship is
75 75 15 15
Unrelated: Unrelated:
x constant x constant
Unrelated: Unrelated:
50 y constant
50 y constant 10 10
25 25 5 5
0 20 040 60
20 80
40 60 0 80 1 02 1
3 42 3 4
Price of bananas (cents
Price
perofkilogram)
bananas (cents per kilogram) Output of French wine
Output
(billions
of French
of litres)wine (billions of litres)
This figure shows how we can graph two variables that In part (b), the output of the vineyards of France on the x- axis
are unrelated. In part (a), a student’s grade in economics is does not vary with the rainfall in the Western Cape on the
plotted at 75 per cent on the y- axis regardless of the price of y- axis. The curve is vertical.
bananas on the x-axis. The curve is horizontal.
33 33
77 Slope
Slope==——
44 77 Slope
Slope==– –——
44
66 66
55 55
44 44
33 33
22 22
11 11
xx xx
00 11 22 33 44 55 66 77 88 00 11 22 33 44 55 66 77 88
(a)Positive
(a) Positiveslope
slope (b)
(b)Negative
Negativeslope
slope
∆y 3
To calculate the slope of a straight line, we divide the change The slope ( x ) equals 4 .
in the value of the variable measured on the y - axis (∆y) by Part (b) shows the calculation of a negative slope. When
the change in the value of the variable measured on the x increases from 2 to 6, ∆x equals 4. That increase in x
x- axis (∆x) as we move along the line. brings about a decrease in y from 6 to 3, so ∆y equals –3.
Part (a) shows the calculation of a positive slope. When ∆y –3
The slope ( ) equals 4 .
x increases from 2 to 6, x equals 4. That change in x brings ∆x
about an increase in y from 3 to 6, so y equals 3.
Now that you have found a straight line with the to 5 and y increases from 4.0 to 5.5. The change in x
same slope as the curve at point A, you can calculate is 2 (∆x is 2), and the change in y is 1.5 (∆y is 1.5).
the slope of the curve at point A by calculating the Therefore the slope is
slope of the straight line. Along the straight line, as x
∆y 1.5 3
increases from 0 to 4 (∆x is 4) ∆y increases from 2 to = =
∆x 2 4
5 (∆y is 3).
3
Therefore the slope of the straight line is So the slope of the curve across the arc BC is .
4
This calculation gives us the slope of the curve
∆y 3
= between points B and C. The actual slope calculated
∆x 4
is the slope of the straight line from B to C. This slope
3
So the slope of the curve at point A is . approximates the average slope of the curve along the
4
arc BC. In this particular example, the slope across
Slope Across an Arc An arc of a curve is a piece of a the arc BC is identical to the slope of the curve at
curve. Figure A1.11 shows the same curve as in point A, but the calculation of the slope of a curve
Fig. A1.10, but instead of calculating the slope at does not always work out so neatly. You might have
point A, we are now going to calculate the slope across fun constructing some more examples and a few
the arc from point B to point C. You can see that the counter examples.
slope of the curve at point B is greater than at point C. You now know how to make and interpret a
When we calculate the slope across an arc, we are graph. So far, we have limited our attention to graphs
calculating the average slope between two points. As of two variables. We are now going to learn how to
we move along the arc from B to C, x increases from 3 graph more than two variables.
7 7.0
3
Slope = — Slope = 1.5
—=— 3
4 2 4
6 6.0
C
5.5
A A
5 5.0 = 1.5
B
4 4.0
3 3.0
2 2.0
1 1.0
x x
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8
To calculate the slope of the curve at point A, draw the red To calculate the average slope of the curve along the arc
line that just touches the curve at A – the tangent. The slope BC, draw a straight line from point B to point C. The slope of
of this straight line is calculated by dividing the change in y the line BC is calculated by dividing the change in y by the
by the change in x along the red line. When x increases from change in x. In moving from B to C, the increase in x is
0 to 4, ∆x equals 4. That change in x is associated with an 2 (∆x equals 2) and the change in y is 1.5 (∆y equals 1.5).
increase in y from 2 to 5, so ∆y equals 3. The slope of the 3
The slope of the line BC is 1.5 divided by 2, or 4 . So the
3 3 3
red line is 4 , so the slope of the curve at point A is 4 . slope of the curve across the arc BC is 4 .
Graphing Relationships Among More To graph a relationship that involves more than
two variables, we use the ceteris paribus assumption.
Than Two Variables
We have seen that we can graph the relationship between
two variables as a point formed by the x- and y-coordinates Ceteris Paribus
in a two-dimensional graph. You might be thinking that Ceteris paribus (often shortened to cet par) means ‘if
although a two-dimensional graph is informative, most of all other relevant things remain the same’. To isolate
the things in which you are likely to be interested involve the relationship of interest in a laboratory experiment,
relationships among many variables, not just two. For a scientist holds everything constant except for the
example, the amount of ice cream consumed depends on variable whose effect is being studied. Economists
the price of ice cream and the temperature. If ice cream use the same method to graph a relationship that has
is expensive and the temperature is low, people eat much more than two variables.
less ice cream than when ice cream is inexpensive and Figure A1.12 shows an example. There, you
the temperature is high. For any given price of ice cream, can see what happens to the quantity of ice cream
the quantity consumed varies with the temperature; and consumed when the price of ice cream varies but the
for any given temperature, the quantity of ice cream temperature is held constant.
consumed varies with its price. The curve labelled 20 °C shows the relationship
Figure A1.12 shows a relationship among three between ice cream consumption and the price of
variables. The table shows the number of litres of ice cream if the temperature remains at 20 °C. The
ice cream consumed each day at two different numbers used to plot that curve are those in the
temperatures and at a number of different prices first two columns of the table. For example, if the
of ice cream. How can we graph these numbers? temperature is 20 °C, 10 litres are consumed when the
9 7 14
6
30˚C
5 20˚C 10 5 10
0 10 20 40 60
11 3 6
Ice cream consumption (litres per day)
Ice cream consumption depends on its price and the temperature is held constant. One curve holds temperature at
temperature. The table tells us how many litres of ice cream 20 ºC and the other holds it at 30 ºC.
are consumed each day at different prices and two different A change in the price of ice cream brings a movement
temperatures. For example, if the price is R8 a scoop and the along one of the curves – along the blue curve at 20 ºC and
temperature is 20 ºC, 10 litres of ice cream are consumed. along the red curve at 30 ºC.
To graph a relationship among three variables, the When the temperature rises from 20 ºC to 30 ºC, the
value of one variable is held constant. The graph shows curve that shows the relationship between consumption and
the relationship between price and consumption when price shifts rightward from the blue curve to the red curve.
price is R8 a scoop and 18 litres are consumed when temperature changes. When that event occurs, you
the price is R6 a scoop. can think of what happens in the graph as a shift
The curve labelled 30 °C shows the relationship of the curve.
between ice cream consumption and the price of ice cream When the temperature rises from 20 °C to
if the temperature remains at 30 °C. The numbers used 30 °C, the curve that shows the relationship
to plot that curve are those in the first and third columns between ice cream consumption and the price
of the table. For example, if the temperature is 30 °C, of ice cream shifts rightward from the blue curve
20 litres are consumed when the price is R8 a scoop and to the red curve.
36 litres are consumed when the price is R6 a scoop. You will encounter these ideas of movements
When the price of ice cream changes but the along and shifts of curves at many points in your
temperature is constant, you can think of what happens study of economics.
in the graph as a movement along one of the curves. At Think carefully about what you have just learned
20 °C there is a movement along the blue curve and at and make up some examples (with assumed numbers)
30 °C there is a movement along the red curve. about other relationships.
With what you have learned about graphs, you
can move forward with your study of economics.
When Other Things Change There are no graphs in this book that are more
The temperature is held constant along each of complicated than those that have been explained in
the curves in Fig. A1.12, but in reality the this appendix.
MATHEMATICAL NOTE
y1 = a + bx1 (1)
Expenditure (rand per week)
400 y = a + bx
Value of y Now the value of x increases by ∆x to x1+ ∆x
(or R400 in Fig. 2). And the value of y increases
Slope = b
300 by ∆y to y1+ ∆y(or R300 in Fig. 2).
The equation of the line now tells us that
200
y
and now divide equation (3) by ∆x to obtain
40 Positive y-axis
∆y intercept, a = 30
=b
∆x
30
So the slope of the line is b.
Slope, b = –10
20
Position of Line
The y-axis intercept determines the position of the line on 10
the graph. Figure 3 illustrates the relationship between the
y = 30 – 10x
y-axis intercept and the position of the line. In this graph, x
the y-axis measures saving and the x-axis measures income. 0 1 2
When the y-axis intercept, a, is positive, the line Figure 4 Negative relationship
Figure 4 Negative relationship
hits the y-axis at a positive value of y – as the blue
line does. Its y-axis intercept is 100. When the y-axis
intercept, a, is zero, the line hits the y-axis at the Negative Relationships
origin – as the purple line does. Its y-axis intercept is Figure 4 shows a negative relationship – the two
0. When the y-axis intercept, a, is negative, the line variables x and y move in the opposite direction. All
hits the y-axis at a negative value of y – as the red line negative relationships have a slope that is negative. In
does. Its y-axis intercept is –100. the equation of the line, the constant b is negative. In
As the equations of the three lines show, the value the example in Fig. 4, the y-axis intercept, a, is 30.
of the y-axis intercept does not influence the slope of
The slope, b, equals ∆y , which is –20 or –10.
the line. All three lines have a slope equal to 0.5. ∆x 2
The equation of the line is
Positive Relationships
y = 30 + (–10)x
Figure 1 shows a positive relationship – the two variables x or
and y move in the same direction. All positive relationships y = 30 – 10x
have a slope that is positive. In the equation of the line, the
constant b is positive. In this example, the y-axis intercept,
a, is 100. The slope b equals ∆y/∆x, which in Fig. 2 is Example
100/200 or 0.5. The equation of the line is A straight line has a y-axis intercept of 50 and a slope
of 2. What is the equation of this line?
y = 100 + 0.5x The equation of a straight line is
y = a + bx
Saving (rand per week)
Positive y-axis
intercept, a = 100 y = 100 + 0.5x
300 where a is the y-axis intercept and b is the slope.
y = 0.5x
So the equation is
200
Negative y-axis
–200
intercept, a = –100
Figure33The
Figure They-axis
y-axisintercept
intercept
REVIEW QUIZ
1 Explain how we ‘read’ the three graphs in 7 Which of the relationships in Questions 4 and 5
Figs A1.1 and A1.2. is a positive relationship and which is a negative
2 Explain what scatter diagrams show and why relationship?
we use them. 8 What are the two ways of calculating the slope of
3 Explain how we ‘read’ the three scatter diagrams a curved line?
in Figs A1.3 and A1.4. 9 How do we graph a relationship among more
4 Draw a graph to show the relationship between than two variables?
two variables that move in the same direction. 10 Explain what change will bring a movement
5 Draw a graph to show the relationship between along a curve.
two variables that move in opposite directions. 11 Explain what change will bring a shift of a curve.
6 Draw a graph to show the relationship between two
variables that have a maximum and a minimum.
Key Terms
Ceteris paribus, 21 Inverse relationship, 17 Negative relationship, 17 Scatter diagram, 13
Direct relationship, 16 Linear relationship, 16 Positive relationship, 16 Slope, 18
1. Draw a scatter diagram of the inflation rate and Use the following info byte to work out Problems 4 to 6.
the interest rate. Describe the relationship.
2. Draw a scatter diagram of the growth rate and the Mad About You Tops Box Office with Sales of $61.2 Million:
unemployment rate. Describe the relationship.
Movie Theatres Revenue
3. Draw a scatter diagram of the interest rate and the
(number) (dollars per
unemployment rate. Describe the relationship. theatre)
Mad About You 3 777 16 213
Why Me? 2 155 13 591
Silent Stalker 4 060 7 145
Lost City 2 673 5 989
4. Draw a graph of the relationship between the 8. Calculate the slope of the relationship at point A
revenue per theatre on the y-axis and the number and at point B.
of theatres on the x-axis. Describe the relationship. 9. Calculate the slope across the arc AB.
5. Calculate the slope of the relationship between
4 060 and 2 673 theatres. Use the following table to work out Problems 10 and 11.
6. Calculate the slope of the relationship between The table gives the price of a balloon ride, the temper-
2 155 and 4 060 theatres. ature, and the number of rides a day.
7. Calculate the slope of the following relationship.
Balloon rides (number per day)
y
10 Price 10 ºC 25 ºC 30 ºC
(rand per ride)
8 50 32 40 50
6 100 27 32 40
4 150 18 27 32
2
10. Draw a graph to show the relationship
x between the price and the number of rides,
0 4.0 12.0
when the temperature is 25 °C. Describe this
Use the following relationship to work out Problems relationship.
8 and 9. 11. What happens in the graph in Problem 10 if the
y temperature rises to 30 °C?
10.0
8.0
A
6.0
4.0
B
1.5
x
0 2 4 6 8 10
12. Draw a scatter diagram of the price of oil and Use the following relationship to work out Problems
the quantity of US oil produced. Describe the 19 and 20.
relationship. y
13. Draw a scatter diagram of the price of gasoline
and the quantity of gasoline refined. Describe the A
6
relationship.
14. Draw a scatter diagram of the quantity of US oil
produced and the quantity of gasoline refined. 4
W
2
hy does food cost much more today than it did a few years ago?
One reason is that we now use part of our maize crop to produce
ethanol, a clean biofuel additive to petrol or diesel. Another reason
is that drought in some parts of the world has decreased global grain
production. In this chapter, you will study an economic model – the
production possibilities frontier – and you will learn why ethanol
production and drought have increased the cost of producing
THE ECONOMIC food. This model, in its simplest form will enable you to
understand the process behind addressing the problem of
PROBLEM relative scarcity in practice. It will also provide you with the
necessary tools to determine the opportunity costs associated
with every decision regarding the use of scarce resources.
You will also learn how to assess whether it is a good idea to increase
maize production to produce fuel; how we can expand our production
possibilities; and how we gain by trading with others.
At the end of the chapter, in Reading Between the Lines, we will
apply what you have learned to understanding why biofuel production
is raising the cost of food.
Cooldrink
Cooldrink (millions of cans)
A Pizzas (millions of
15
B Possibility (millions) cans)
C Unattainable A 0 and 15
10 B 1 and 14
Attainable D
C 2 and 12
E
D 3 and 9
5
Z
E 4 and 5
PPF
F F 5 and 0
0 1 2 3 4 5
Pizzas (millions)
The table lists six production possibilities for cooldrink and pizzas. The PPF separates the attainable from the unattainable. Production
Row A tells us that if we produce no pizzas, the maximum quantity is possible at any point inside the orange area or on the frontier.
of cooldrink we can produce is 15 million cans. Points A, B, Points outside the frontier are unattainable. Points inside the frontier,
C, D, E and F in the figure represent the rows of the table. such as point Z, are inefficient because resources are wasted or
The curve passing through these points is the production misallocated. At such points, it is possible to use the available
possibilities frontier (PPF). resources to produce more of either or both goods.
E and as possibility E in the table. The figure also shows given point in time, we have a fixed amount of labour,
other production possibilities. For example, we might land, capital and entrepreneurship. By using our
stop producing pizza and move all the people who available technologies, we can employ these resources
produce it into producing cooldrink. Point A in the to produce goods and services, but are limited in
figure and possibility A in the table show this case. The what we can produce. This limit defines a boundary
quantity of cooldrink produced increases to 15 million between what we can attain and what we cannot
cans and pizza production dries up. attain. This boundary is the real world’s production
Alternatively, we might close the cooldrink factories possibilities frontier, and it defines the trade-offs
and switch all the resources into producing pizza. In this that we must make. On our real-world PPF, we can
situation, we produce 5 million pizzas. Point F in the produce more of any one good or service only if we
figure and possibility F in the table show this case. produce less of some other goods or services.
When doctors want to spend more on Aids
and cancer research, they face a trade-off: more
Production Efficiency medical research for less of some other things. When
We achieve production efficiency if we produce goods Parliament wants to spend more on education and
and services at the lowest possible cost. This outcome health care, it faces a trade-off: more education
occurs at all the points on the PPF. Producing at any and health care for less national defence or less
output level on the PPF implies the maximisation of infrastructure spending. When an environmental
production given the available resources – hence the group argues for less logging, it is suggesting a
term production efficiency. At points inside the PPF, trade-off: greater conservation of endangered wildlife
production is inefficient because we are giving up for less paper. When you want to study more, you face
more than necessary of one good to produce a given a trade-off: more study time for less leisure or sleep.
quantity of the other good. All trade-offs involve a cost – an opportunity cost.
For example, at point Z in Fig. 2.1, we produce
3 million pizzas and 5 million cans of cooldrink. But
we have enough resources to produce 3 million pizzas Opportunity Cost
Opportunity Cost
and 9 million cans of cooldrink. Our pizzas cost more The opportunity cost of an
cooldrink than necessary. We can get them for a lower action is the highest-valued
cost. Only when we produce on the PPF do we incur alternative forgone. The
the lowest possible cost of production. PPF makes this idea precise
Production is inefficient inside the PPF because and enables us to calculate
resources are either unused or misallocated or both. opportunity cost. Along
Resources are unused when they are idle but the PPF, there are only two
could be working. For example, we might leave some goods, so there is only one
of the factories idle or some workers unemployed. alternative forgone: some www.quickto.mobi/
Resources are misallocated when they are assigned quantity of the other good. PEA-COST
to tasks for which they are not the best match. For Given our current resources
example, we might assign skilled pizza chefs to work in and technology, we can
a cooldrink factory and skilled cooldrink producers to produce more pizzas only
work in a pizza shop. We could get more pizzas and more if we produce less cooldrink. The opportunity cost
cooldrink from these same workers if we reassigned them of producing an additional pizza is the cooldrink
to the tasks that more closely match their skills. we must forgo. Similarly, the opportunity cost of
producing an additional can of cooldrink is the
quantity of pizza we must forgo.
Trade-Off Along the PPF In Fig. 2.1, if we move from point C to point D,
Every choice along the PPF involves a trade-off. On we get 1 million more pizzas but 3 million fewer
the PPF in Fig. 2.1, we trade off cooldrink for pizzas. cans of cooldrink. The additional 1 million pizzas
Trade-offs arise in every imaginable real-world cost 3 million cans of cooldrink. One pizza costs
situation in which a choice must be made. At any 3 cans of cooldrink.
We can also work out the opportunity cost Similarly, people who have spent years working at
of moving in the opposite direction. In Fig. 2.1, Roman’s Pizza are good at producing pizzas, but they
if we move from point D to point C, the quantity have no idea how to produce cooldrink. So if we move
of cooldrink produced increases by 3 million cans some of these people from Roman’s Pizza to ABI, we get
and the quantity of pizzas produced decreases by a small increase in the quantity of cooldrink but a large
1 million. So if we choose point C over point D, the decrease in the quantity of pizzas. The more of either
additional 3 million cans of cooldrink cost 1 million good we try to produce, the less productive are the
pizzas. One can of cooldrink costs 1 of a pizza. additional resources we use to produce that good and
3
the larger is the opportunity cost of a unit of that good.
Opportunity Cost Is a Ratio It is the decrease in
the quantity produced of one good divided by the REVIEW QUIZ
increase in the quantity produced of another good as
we move along the production possibilities frontier. 1 How does the production possibilities frontier
Because opportunity cost is a ratio, the opportunity illustrate scarcity?
cost of producing an additional can of cooldrink is equal 2 How does the production possibilities frontier
to the inverse of the opportunity cost of producing an illustrate production efficiency?
additional pizza. Check this proposition by returning to 3 How does the production possibilities frontier
the calculations we have just worked through. When we show that every choice involves a trade-off ?
move along the PPF from C to D, the opportunity cost 4 How does the production possibilities frontier
1 illustrate opportunity cost?
of a pizza is 3 cans of cooldrink. The inverse of 3 is 3 .
If we decrease the production of pizza and increase the 5 Why is opportunity cost a ratio?
production of cooldrink by moving from D to C, the 6 Why does the PPF bow outward and what
opportunity cost of a can of cooldrink must be 13 of a does that imply about the relationship
pizza. That is exactly the number that we calculated for between opportunity cost and the quantity
the move from D to C. produced?
Increasing Opportunity Cost The opportunity cost We have seen that what we can produce is limited
of a pizza increases as the quantity of pizzas produced by the production possibilities frontier. We have also
increases. The outward-bowed shape of the PPF reflects seen that production on the PPF is efficient. But we
increasing opportunity cost. When we produce a large can produce many different quantities on the PPF.
quantity of cooldrink and a small quantity of pizza – How do we choose among them?
between points A and B in Fig. 2.1 – the frontier has How do we know which point on the PPF is the
a gentle slope. An increase in the quantity of pizzas best one?
costs a small decrease in the quantity of cooldrink – the
opportunity cost of a pizza is a small quantity of cooldrink.
When we produce a large quantity of pizzas and
Using Resources Efficiently
a small quantity of cooldrink – between points E and
F in Fig. 2.1 – the frontier is steep. A given increase We achieve production efficiency at every point on the
in the quantity of pizzas costs a large decrease in the PPF, but which point is best? The answer is the point
quantity of cooldrink, so the opportunity cost of a on the PPF at which goods and services are produced
pizza is a large quantity of cooldrink. in the quantities that provide the greatest possible
The PPF is bowed outward because resources are benefit. When goods and services are produced at
not all equally productive in all activities. People with the lowest possible cost and in the quantities that
many years of experience working for Amalgamated provide the greatest possible benefit, we have achieved
Beverage Industries (ABI) are good at producing allocative efficiency.
cooldrink but not very good at making pizzas. So if The questions that we raised when we reviewed
we move some of these people from ABI to Roman’s the four big issues in Chapter 1 are questions about
Pizza, we get a small increase in the quantity of pizzas allocative efficiency. To answer such questions, we
but a large decrease in the quantity of cooldrink. must measure and compare costs and benefits.
MC
Cooldrink (millions of cans)
A 5
Increasing
15
B opportunity cost
14 ... means increasing
of a pizza ...
marginal cost of a
C 4 pizza
12
D 3
9
2
E
5
F
0 1 2 2.5 3 4 5 0 1 2 2.5 3 4 5
Pizzas (millions) Pizzas (millions)
Marginal cost is calculated from the slope of the PPF. As the The bars in part (b) show the cost of an average pizza in
quantity of pizzas produced increases, the PPF becomes steeper each of these 1 million blocks. The red curve, MC, shows the
Marginal cost (cans of cooldrink per pizza)
MC
and the5 marginal cost of a pizza increases. The bars in part (a) marginal cost of a pizza at each point along the PPF. This curve
show the opportunity cost of pizza in blocks of 1 million pizzas. passes through the centre of each of the bars in part (b).
... means increasing
marginal cost of a
4 pizza
Preferences and Marginal Benefit
The marginal
3 benefit from a good or service is the Marginal benefit and preferences stand in sharp
benefit received from consuming one more unit of contrast to marginal cost and production possibilities.
it. This
2 benefit is subjective. It depends on people’s Preferences describe what people like and want and
preferences – people’s likes and dislikes and the the production possibilities describe the limits or
intensity of those feelings. constraints on what is feasible.
1
0 1 2 2.5 3 4 5
PART ONE Introduction Pizzas (millions)
We need a concrete way of illustrating preferences FIGURE 2.3 Preferences and the Marginal
that parallels the way we illustrate the limits to Benefit Curve
production using the PPF.
The device that we use to illustrate preferences is
that we call it a law or principle – the principle of The smaller the quantity of pizzas available, the more cooldrink
decreasing marginal benefit. people are willing to give up for an additional pizza. With
The basic reason why marginal benefit decreases 0.5 million pizzas available, people are willing to pay 5 cans
is that we like variety. The more we consume of any of cooldrink per pizza. But with 4.5 million pizzas, people are
one good or service, the more we tire of it and would willing to pay only 1 can of cooldrink per pizza. Willingness to
prefer to switch to something else. pay measures marginal benefit. A universal feature of people’s
Think about your willingness to pay for a pizza. preferences is that marginal benefit decreases.
If pizza is hard to come by and you can buy only a
few slices a year, you might be willing to pay a high
price to get an additional slice. But if pizza is all you
have eaten for the past few days, you are willing to pay Allocative Efficiency
almost nothing for another slice. At any point on the PPF, we cannot produce more
You have learned to think about cost as of one good without giving up some other good. At
opportunity cost, not as a money (rand or dollar) cost. the best point on the PPF, we cannot produce more
You can think about marginal benefit and willingness of one good without giving up some other good that
to pay in the same way. The marginal benefit, measured provides greater benefit. We are producing at the
by what you are willing to pay for something, is the point of allocative efficiency – the point on the PPF
quantity of other goods and services that you are that we prefer above all other points.
willing to forgo. Let us continue with the example of Suppose in Figure 2.4, we produce 1.5 million
cooldrink and pizza and illustrate preferences this way. pizzas. The marginal cost of a pizza is 2 cans of
Figure 2.3 illustrates preferences as the willingness cooldrink, and the marginal benefit from a pizza
to pay for pizza in terms of cooldrink. At point A, is 4 cans of cooldrink. Because someone values an
with 0.5 million pizzas available, people are willing additional pizza more highly than it costs to produce,
to pay 5 cans of cooldrink per pizza. As the quantity we can get more value from our resources by moving
of pizzas increases, the amount that people are willing some of them out of producing cooldrink and into
to pay for a pizza falls. With 4.5 million pizzas producing pizza.
available, people are willing to pay only 1 can of Now suppose we produce 3.5 million pizzas. The
cooldrink per pizza. marginal cost of a pizza is now 4 cans of cooldrink,
Let us now use the concepts of marginal cost and but the marginal benefit from a pizza is only 2 cans of
marginal benefit to describe allocative efficiency. cooldrink. Because the additional pizza costs more to
2
Economic Growth
During the past 30 years, production per person
1
in South Africa has doubled. The expansion of
MB
production possibilities is called economic growth.
Economic growth increases our standard of
0 1.5 2.5 3.5 5 living, but it does not overcome scarcity and avoid
Pizzas (millions) opportunity cost. To make our economy grow, we face
(b) Marginal benefit equals marginal cost a trade-off – the faster we make production grow, the
greater is the opportunity cost of economic growth.
The greater the quantity of pizzas produced, the smaller is
the marginal benefit (MB) from pizza – the less cooldrink
The Cost of Economic Growth
people are willing to give up to get an additional pizza.
But the greater the quantity of pizzas produced, the greater Economic growth comes from technological change
is the marginal cost (MC ) of a pizza – the more cooldrink and capital accumulation. Technological change is
people must give up to get an additional pizza. When the development of new goods and of better ways of
marginal benefit equals marginal cost, resources are being producing goods and services. Capital accumulation
used efficiently. is the growth of capital resources, including human
capital.
Pizza ovens
We can produce motor vehicles that provide us with
more transportation than was available when we had C
10
only horses and carriages. We can produce satellites
that provide global communications on a much
8
larger scale than that available with the earlier cable
technology. But if we use our resources to develop B B'
new technologies and produce capital, we must 6
decrease our production of consumption goods and
services. New technologies and new capital have an 4
opportunity cost. Let us look at this opportunity cost.
Instead of studying the PPF of pizzas and
cooldrink, we will hold the quantity of cooldrink 2
PPF0 PPF1
produced constant and examine the PPF for pizzas
and pizza ovens. Figure 2.5 shows this PPF as the blue A A'
B
Gains from Trade
People can produce for themselves all the goods and
D
Hong Kong C
services that they consume, or they can produce one
PPF in 1969 good or a few goods and trade with others. Producing
only one good or a few goods is called specialisation.
A
A US PPF We are going to learn how people gain by specialising
in 1969
in the production of the good in which they have a
0 Consumption goods (per person) comparative advantage and trading with others.
TABLE 2.2 Joe’s Production Possibilities Table 2.3(c). After the trade, Joe has 10 salads – the
30 he produces minus the 20 he sells to Liz. He also
Minutes to Quantity has the 10 smoothies that he buys from Liz. So Joe now
Item produce 1 per hour
has increased the quantities of smoothies and salads
Smoothies 10 6 that he can sell to his customers – see Table 2.3(d).
Salads 2 30
TABLE 2.3 Liz and Joe Gain from Trade
Liz’s Comparative Advantage In which of the (a) Before trade Liz Joe
two activities does Liz have a comparative advantage? Smoothies 15 5
Recall that comparative advantage is a situation in
Salads 15 5
which one person’s opportunity cost of producing a
good is lower than another person’s opportunity cost (b) Specialisation Liz Joe
of producing that same good. Liz has a comparative Smoothies 30 0
advantage in producing smoothies. Her opportunity Salads 0 30
cost of a smoothie is 1 salad, whereas Joe’s opportunity (c) Trade Liz Joe
cost of a smoothie is 5 salads.
Smoothies sell 10 buy 10
Joe’s Comparative Advantage If Liz has a Salads buy 20 sell 20
comparative advantage in producing smoothies, Joe (d) After trade Liz Joe
must have a comparative advantage in producing Smoothies 20 10
salads. Joe’s opportunity cost of a salad is 1
5
of a
Salads 20 10
smoothie, whereas Liz’s opportunity cost of a salad is
1 smoothie. (e) Gains from trade Liz Joe
Smoothies +5 +5
Salads +5 +5
Achieving the Gains from Trade
Liz and Joe run into each other one evening in a Liz has 20 smoothies – the 30 she produces minus
singles bar. After a few minutes of getting acquainted, the 10 she sells to Joe. She also has the 20 salads that
Liz tells Joe about her amazing smoothie business. she buys from Joe. Liz has increased the quantities of
Her only problem, she tells Joe, is that she would like smoothies and salads that she can sell to her customers
to produce more because potential customers leave – see Table 2.3(d). Liz and Joe both gain 5 smoothies
when her lines get too long. and 5 salads an hour – see Table 2.3(e).
Joe is hesitant to risk spoiling his chances by To illustrate her idea, Liz grabs a fresh napkin
telling Liz about his own struggling business, but he and draws the graphs in Figure 2.6. The blue PPF in
takes the risk. Joe explains to Liz that he spends 50 part (a) shows Joe’s production possibilities. Before
minutes of every hour making 5 smoothies and 10 trade, he is producing 5 smoothies and 5 salads an
minutes making 5 salads. Liz’s eyes pop. ‘Have I got a hour at point A. The blue PPF in part (b) shows Liz’s
deal for you!’ she exclaims. production possibilities. Before trade, she is producing
Here is the deal that Liz sketches on a paper napkin. 15 smoothies and 15 salads an hour at point A. Liz’s
Joe stops making smoothies and allocates all his proposal is that they each specialise in producing the
time to producing salads; Liz stops making salads good in which they have a comparative advantage. Joe
and allocates all her time to producing smoothies. produces 30 salads and no smoothies at point B on
That is, they both specialise in producing the good his PPF. Liz produces 30 smoothies and no salads at
in which they have a comparative advantage. point B on her PPF.
Together they produce 30 smoothies and 30 salads Liz and Joe then trade smoothies and salads at
1
– see Table 2.3(b). a price of 2 salads per smoothie or 2 a smoothie per
They then trade. Liz sells Joe 10 smoothies and Joe salad. Joe gets smoothies for 2 salads each, which is less
sells Liz 20 salads – the price of a smoothie is 2 salads – than the 5 salads it costs him to produce a smoothie.
25 25 25 25 Liz'sLiz's
PPFPPF Trade
Trade
lineline
JoeJoe buys
buys 10 10 C C
20 20 smoothies
smoothies 20 20 Liz Liz
buysbuys
20 20
from
from Liz Liz salads
salads from
from
JoeJoe
A A
15 15 15 15
C C
10 10 10 10
Trade
Trade
lineline
A A
5 5 5 5
Joe's
Joe's
PPFPPF
B B
0 0 5 5 10 10 15 15 20 20 25 25 30 30 0 0 5 5 10 10 15 15 20 20 25 25 30 30
Smoothies
Smoothies
(per(per
hour)
hour) Smoothies
Smoothies (per(per hour)
hour)
(a) (a)
JoeJoe (b) (b)
Liz Liz
Initially, Joe produces at point A on his PPF in part (a), and Liz specialises in making smoothies, she produces 30 smoothies
produces at point A on her PPF in part (b). Joe’s opportunity and no salads at point B on her PPF. They exchange salads
cost of producing a salad is less than Liz’s, so Joe has a for smoothies along the red ‘Trade line’.
comparative advantage in producing salads. Liz’s opportunity Liz buys salads from Joe for less than her opportunity cost
cost of producing a smoothie is less than Joe’s, so Liz has a of producing them. Joe buys smoothies from Liz for less than his
comparative advantage in producing smoothies. opportunity cost of producing them. Each goes to point C – a
If Joe specialises in making salads, he produces 30 point outside his or her PPF. With specialisation and trade, Joe and
salads and no smoothies at point B on his PPF. If Liz Liz gain 5 smoothies and 5 salads each with no extra resources.
Economics in Action
South Africa and China Gain from Trade
In Chapter 1 (see p. 5), we asked whether globalisation We could slide along our PPF producing fewer
is in the social interest. What you have just learned cars and more jackets. Similarly, China could slide along
about the gains from trade provides a big part of the its PPF producing more cars and fewer jackets. But
answer. We gain from specialisation and trade. everyone would lose. The opportunity cost of our jackets
The gains that we achieve from international trade and China’s opportunity cost of BMWs would rise.
are similar to those achieved by Joe and Liz. When South By specialising in cars and trading with China,
Africans buy clothes that are manufactured in China we get our jackets at a lower cost than that at which
and when China buys BMW 3 series manufactured in we can produce them, and China gets its cars at a
South Africa, the people of both countries gain. lower cost than that at which it can produce them.
FIGURE 2.7 Circular Flows in the Market Economy Households and firms make economic choices
and markets coordinate these choices.
Households choose the quantities of labour,
HOUSEHOLDS
Labour, land, capital, Goods and land, capital and entrepreneurial services to
entrepreneurship services
sell or rent to firms in exchange for wages, rent,
interest and profits. Households also choose how
to spend their incomes on the various types of
goods and services available.
Firms choose the quantities of factors of
production to hire and the quantities of goods
and services to produce.
FACTOR GOODS
MARKETS MARKETS Goods markets and factor markets coordinate
these choices of households and firms.
The counterclockwise red flows are real
Wages, rent, Expenditure
flows – the flow of factors of production from
interest, on goods and households to firms and the flow of goods and
profits services
services from firms to households.
The clockwise green flows are the payments for
the red flows. They are the flow of incomes from
FIRMS
firms to households and the flow of expenditure on
goods and services from households to firms.
Draft regulations for the mandatory blending of biofuels with petrol or diesel were published in
September last year.
Chief executive of Grain SA, Jannie de Villiers, said the organisation had recommended that the
government should not subsidise biofuels production from maize because it did not want the maize
food price to increase as a result of offtake for biofuels production.
In the United States, 40% of maize production goes into biofuels and as a result the international
maize price has become primarily linked to the international crude oil price.
Therefore, the government is likely to subsidise the production of soya for biodiesel and sorghum for
bioethanol, but not maize.
Source: Excerpt from ‘Maize production blossoms in SA’ http://mg.co.za/article/2012-05-18-maize-production-blossoms-in-sa by Teigue Payne
© Mail & Guardian.
Key Terms
Absolute advantage, 37 Economic growth, 34 Marginal cost, 32 Production efficiency, 30
Allocative efficiency, 31 Firm, 40 Market, 40 Production possibilities
Capital accumulation, 34 Marginal benefit, 32 Money, 41 frontier, 29
Comparative advantage, Marginal benefit curve, Opportunity cost, 30 Property rights, 40
36 33 Preferences, 32 Technological change, 34
64 and 1
Harry enjoys tennis but wants a high grade in his
economics course. The graphs show his PPF for these
54 and 2 two ‘goods’ and his MB curve from tennis.
40 and 3 cent)cent) 80
78
(per (per
22 and 4 80
75
78
in economics
75
70
0 and 5
in economics
Harry's PPF
70
Harry's PPF
Grade
60
1. a. Draw a graph of Brazil’s PPF and explain
Grade
60
how your graph illustrates scarcity.
b. If Brazil produces 40 barrels of ethanol a day, 50
production efficiency? 40
c. Why does Brazil face a trade-off on its PPF ? 2 4 6 8 10
40
Tennis (hours per week)
2. a. If Brazil increases its production of ethanol 2 4 6 8 10
from 40 barrels per day to 54 barrels per Tennis (hours per week)
additional ethanol?
per hour)
10
8
per day, what is the opportunity cost of the
points
(percentage
8
additional food?
(percentage
6
c. What is the relationship between your
6 Harry's MB
answers to parts (a) and (b)?
to pay
4 Harry's MB
3. Does Brazil face an increasing opportunity cost of
to pay
4
ethanol? What feature of Brazil’s PPF illustrates
Willingness
2
increasing opportunity cost?
Willingness
0 2 4 6 8 10
Using Resources Efficiently Tennis (hours per week)
0 2 4 6 8 10
Use the above table to work out Problems 4 and 5. Tennis (hours per week)
4. Define marginal cost and calculate Brazil’s 7. What is Harry’s marginal cost of tennis if he plays
marginal cost of producing a tonne of food when for (i) 3 hours a week; (ii) 5 hours a week; and
the quantity produced is 2.5 tonnes per day. (iii) 7 hours a week?
8. a.If Harry uses his time to achieve allocative a. Who now has a comparative advantage in
efficiency, what is his economics grade and producing jackets?
how many hours of tennis does he play? b. Can Safieka and Tessa still gain from trade?
b. Explain why Harry would be worse off c. Would Safieka and Tessa still be willing
getting a grade higher than your answer to trade 1 jacket for 15 caps? Explain
to part (a). your answer.
9. If Harry becomes a tennis superstar with big
earnings from tennis, what happens to his PPF, Economic Coordination
MB curve and his efficient time allocation? 14. For 50 years, Cuba has had a centrally planned
10. If Harry suddenly finds high grades in economics economy in which the government makes the big
easier to attain, what happens to his PPF, his MB decisions on how resources will be allocated.
curve and his efficient time allocation? a. Why would you expect Cuba’s production
possibilities (per person) to be smaller than
Economic Growth those of the United States?
11. A farm grows wheat and produces pork. The b. What are the social institutions that Cuba
marginal cost of producing each of these products might lack that help the United States to
increases as more of it is produced. achieve allocative efficiency?
a. Draw a graph that illustrates the farm’s PPF.
b. The farm adopts a new technology that Economics in the News
allows it to use fewer resources to fatten pigs. Use the following data to work out Problems 15 to 17.
Use your graph to illustrate the impact of the
new technology on the farm’s PPF. Brazil produces ethanol from sugar at a cost of 83 cents
c. With the farm using the new technology per gallon. The United States produces ethanol from
described in part (b), has the opportunity maize at a cost of $1.14 per gallon. Sugar grown on
cost of producing a tonne of wheat one hectare of land produces twice the quantity of
increased, decreased or remained the same? ethanol as the maize grown on a hectare. The United
Explain and illustrate your answer. States imports 5 per cent of the ethanol it uses and
d. Is the farm more efficient with the produces the rest itself. Since 2003, US ethanol
new technology than it was with the production has more than doubled and US maize
old one? Why? production has increased by 45 per cent.
15. a. Does Brazil or the United States have
Gains from Trade a comparative advantage in producing
12. In an hour, Safieka can produce 40 caps ethanol?
or 4 jackets and Tessa can produce 80 caps or b. Sketch the PPF for ethanol and other goods
4 jackets. and services for the United States.
a. Calculate Safieka’s opportunity cost of c. Sketch the PPF for ethanol and other goods
producing a cap. and services for Brazil.
b. Calculate Tessa’s opportunity cost of 16. a. Do you expect the opportunity cost of
producing a cap. producing ethanol in the United States to
c. Who has a comparative advantage in have increased since 2003? Explain why.
producing caps? b. Do you think the United States has achieved
d. If Safieka and Tessa specialise in producing production efficiency in its manufacture of
the good in which each of them has a ethanol? Explain why or why not.
comparative advantage, and they trade c. Do you think the United States has achieved
1 jacket for 15 caps, who gains from the allocative efficiency in its manufacture of
specialisation and trade? ethanol? Explain why or why not.
13. Suppose that Tessa buys a new machine for making 17. Sketch a figure similar to Fig. 2.6 on p. 39 to
jackets that enables her to make 20 jackets an hour. show how both the United States and Brazil can
(She can still make only 80 caps per hour.) gain from specialisation and trade.
Use this info byte to work out Problems 18 to 20. 19. a. Sketch the marginal benefit curves for tea in
South Africa before and after South Africans
Tea For Two began to appreciate the health benefits of
South Africans are switching to loose-leaf tea for its loose tea.
health benefits. Tea can be grown in South Africa, but b. Explain how the quantity of loose tea
picking tea leaves can be costly because it can only be that achieves allocative efficiency has
done by hand and not by machine. changed.
c. Does the change in preferences toward
18. a. Sketch PPFs for the production of tea and tea affect the opportunity cost of
other goods and services in India and in producing tea?
South Africa. 20. Explain why South Africa does not produce
b. Sketch marginal cost curves for the production much tea and instead imports it from India.
of tea in India and in South Africa.
Production Possibilities and Opportunity Cost 24. The table describes the preferences in Yucatan.
Use the following table to work out Problems 21 to 22. Sunscreen Willingness to pay
Suppose that Yucatan’s production possibilities are (litres per month) (kilograms of food per litre)
Food Sunscreen 25 3
(kilograms per month) (litres per month) 75 2
300 and 0 125 1
200 and 50
a. What is the marginal benefit from sunscreen
100 and 100
and how is it measured?
0 and 150
b. Draw a graph of Yucatan’s marginal benefit
from sunscreen.
21. a. Draw a graph of Yucatan’s PPF and explain
how your graph illustrates a trade-off. Economic Growth
b. If Yucatan produces 150 kilograms of food 25. Capital accumulation and technological change
per month, how much sunscreen must it bring economic growth, which means that the
produce if it achieves production efficiency? PPF keeps shifting outward: production that was
c. What is Yucatan’s opportunity cost of unattainable yesterday becomes attainable today;
producing 1 kilogram of food? production that is unattainable today will become
d. What is Yucatan’s opportunity cost of attainable tomorrow. Why does this process of
producing 1 litre of sunscreen? economic growth not mean that scarcity is being
e. What is the relationship between your defeated and will one day be gone?
answers to parts (c) and (d)?
22. What feature of a PPF illustrates increasing Gains from Trade
opportunity cost? Explain why Yucatan’s Use the following data to work out Problems 26 and 27.
opportunity cost does or does not increase.
Kim can produce 40 pies or 400 cakes an hour. Liam
Using Resources Efficiently can produce 100 pies or 200 cakes an hour.
23. In Problem 21, what is the marginal cost of a 26. a. Calculate Kim’s opportunity cost of a pie
kilogram of food in Yucatan when the quantity and Liam’s opportunity cost of a pie.
produced is 150 kilograms per day? What is special b. If each spends 30 minutes of each hour
about the marginal cost of food in Yucatan? producing pies and 30 minutes producing cakes,
how many pies and cakes does each produce?
Your Economic Revolution Over the entire world, people are embracing
new information technologies and prospering on an
Three periods in human history stand out as ones unprecedented scale.
of economic revolution. The first, the Agricultural Economics was born during the Industrial
Revolution, occurred 10 000 years ago. In what is Revolution, which began in England during the 1760s.
today Iraq, people learned to domesticate animals For the first time, people began to apply science and
and plant crops. People stopped roaming in search of create new technologies for the manufacture of textiles
food and settled in villages, towns and cities where and iron, to create steam engines and to boost the
they specialised in the activities in which they had output of farms.
a comparative advantage and developed markets in During all three economic revolutions, many
which to exchange their products. have prospered but many have been left behind. It is
Wealth increased enormously. the range of human progress that poses the greatest
You are studying economics at a time that future question for economics and the one that Adam Smith
historians will call the Information Revolution. addressed in the first work of economic science: What
causes the differences in wealth among nations?
Many people had written about economics before but breaking the process into a number of individu-
Adam Smith, but he made economics a science. ally small operations in which people specialise – by
Born in 1723 in Kirkcaldy, a small fishing town the division of labour – ten people could make a
near Edinburgh, Scotland, Smith was the only child staggering 48 000 pins a day. One draws out the
of the town’s customs officer. Lured from his profes- wire, another straightens it, a third cuts it, a fourth
sorship (he was a full professor at 28) by a wealthy points it, a fifth grinds it. Three specialists make
Scottish duke who gave him a pension of £300 a the head, and a fourth attaches it. Finally, the pin is
year – ten times the average income at that time – polished and packaged. But a large market is needed
Smith devoted ten years to writing his masterpiece: to support the division of labour: One factory
An Inquiry into the Nature and Causes of the Wealth employing ten workers would need to sell more than
of Nations, published in 1776. 15 million pins a year to stay in business!
Why, Adam Smith asked, are some nations
wealthy while others are poor? He was pondering
these questions at the height of the Industrial ‘It is not from the benevolence of the butcher, the
Revolution, and he answered by emphasising the brewer, or the baker that we expect our dinner,
role of the division of labour and free markets. To but from their regard to their own interest.’
illustrate his argument, Adam Smith described two
pin factories. In the first, one person, using the hand ADAM SMITH
tools available in the 1770s, could make 20 pins a
The Wealth of Nations
day. In the other, by using those same hand tools
3
W hy has the price of maize in southern Africa increased so
dramatically in the last few years and can the increase in maize prices
be linked to the constantly increasing petrol price?
By early 2012, the price of petrol in South Africa had increased
to above R12 per litre while only five years earlier, in early 2007, the
price of a litre of petrol was less than R6.
DEMAND AND SUPPLY But, how would the price increase of petrol
affect maize prices? This chapter enables
you to answer these and similar questions
about prices – prices that rise, prices that fall and prices that fluctuate.
You already know that economics is about the choices people make
to cope with scarcity and how those choices respond to incentives.
Prices act as incentives. You are going to see how people respond to
prices and how prices are determined by demand and supply. The
demand and supply model that you study in this chapter is the main tool
of economics. It helps answer the big economic question: What, how
and for whom are goods and services produced?
At the end of the chapter, in Reading Between the Lines, we will
apply the model to the market for maize in South Africa and explain
why its price has increased sharply over the last few years.
Let us begin our study of demand and supply, Why does a higher price reduce the quantity
starting with demand. demanded? For two reasons:
◆ Substitution effect
◆ Income effect
demanded of the good. Demand is illustrated by the curve labelled A to E correspond to the rows of the
demand curve and the demand schedule. The term demand schedule. For example, point A on the graph
quantity demanded refers to a point on a demand shows a quantity demanded of 22 000 Chomp bars a
curve – the quantity demanded at a particular price week at a price of 50c a bar.
Figure 3.1 shows the demand curve for Chomp
bars. A demand curve shows the relationship between Willingness and Ability to Pay Another way of
the quantity demanded of a good and its price when looking at the demand curve is as a willingness-and-
all other influences on consumers’ planned purchases ability-to-pay curve.
remain the same. The willingness and ability to pay is a measure of
The table in Fig. 3.1 is the demand schedule for marginal benefit.
Chomp bars. A demand schedule lists the quantities If a small quantity is available, the highest price
demanded at each price when all the other influences that someone is willing and able to pay for one more
on consumers’ planned purchases remain the same. unit is high. But as the quantity available increases,
For example, if the price of a bar is 50c, the quantity the marginal benefit of each additional unit falls and
demanded is 22 000 a week. If the price is R2.50, the the highest price that someone is willing and able to
quantity demanded is 5 000 a week. The other rows pay also falls along the demand curve.
of the table show the quantities demanded at prices of In Fig. 3.1, if only 5 000 Chomp bars are avail-
R1.00, R1.50 and R2.00. able each week, the highest price that someone is
We graph the demand schedule as a demand willing to pay for the 5 000th bar is R2.50. But if
curve with the quantity demanded on the x-axis and 22 000 Chomp bars are available each week, someone
the price on the y-axis. The points on the demand is willing to pay 50c for the last bar bought.
E
A 0.50 22
2.50
2.00 D B 1.00 15
1.50 C
C 1.50 10
B Demand for
1.00
Chomp bars
D 2.00 7
A
0.50
E 2.50 5
0 5 10 15 20 25
Quantity demanded (thousands of bars per week)
The table shows a demand schedule for Chomp bars. At a The demand curve can be read in two ways. For a given price,
price of 50c a bar, 22 000 bars a week are demanded; at the demand curve tells us the quantity that people plan to buy.
a price of R1.50 a bar, 10 000 bars a week are demanded. For example, at a price of R1.50 a bar, people plan to buy
The demand curve shows the relationship between quantity 10 000 bars a week. For a given quantity, the demand curve
demanded and price, other things remaining the same. The tells us the maximum price that consumers are willing and able
demand curve slopes downward: As the price falls, the to pay for the last bar available. For example, the maximum
quantity demanded increases. price that consumers will pay for the 15 000th bar is R1.00.
C C'
1.50 B 1.00 15 B’ 1.00 25
Demand for
B B' C 1.50 10 C’ 1.50 20
1.00 Chomp bars
(new)
Demand for '
Chomp bars
D 2.00 7 D’ 2.00 17
0.50
(original)
E 2.50 5 E’ 2.50 15
0 5 10 15 20 25 30 35
Quantity demanded (thousands of bars per week)
A change in any influence on buying plans other than the income (row C of the table) and 20 000 bars a week are
price of the good itself results in a new demand schedule demanded at the new higher income (row C’). A rise in
and a shift of the demand curve. A change in income income increases the demand for Chomp bars. The demand
changes the demand for Chomp bars. At a price of R1.50 curve shifts rightward, as shown by the shift arrow and the
a bar, 10 000 bars a week are demanded at the original resulting red curve.
Expected Future Prices If the expected future price leads to an increase in the demand for most goods,
of a good rises and if the good can be stored, the it does not lead to an increase in the demand for
opportunity cost of obtaining the good for future all goods. A normal good is one for which demand
use is lower today than it will be in the future when increases as income increases. An inferior good is one
people expect the price to be higher. for which demand decreases as income increases.
So people retime their purchases – they substitute
over time. They buy more of the good now before its Expected Future Income and Credit When
price is expected to rise (and less afterward), so the expected future income increases or credit becomes
demand for the good today increases. easier to get, demand for the good might increase
For example, suppose that a drought damages the now. For example, a salesperson gets the news that she
season’s wheat harvest. You expect the price of flour to will receive a big bonus at the end of the year, so she
rise, so you fill your pantry with enough flour to get you goes into debt and buys a new car right now, rather
through the next six months. Your current demand for than wait until she receives the bonus.
flour has increased and your future demand has decreased.
Similarly, if the expected future price of a good falls, Population Demand also depends on the size and
the opportunity cost of buying the good today is high the age structure of the population. The larger the
relative to what it is expected to be in the future. So again, population, the greater is the demand for all goods
people retime their purchases. They buy less of the good and services; the smaller the population, the smaller is
now before its price is expected to fall, so the demand for the demand for all goods and services.
the good decreases today and increases in the future. Also, the larger the proportion of the population
Computer prices are constantly falling and this fact in a given age group, the greater is the demand for the
poses a dilemma. Will you buy a new computer now, goods and services used by that age group.
in time for the start of the new semester at university,
or will you wait until the price has fallen some more? Preferences Demand depends on preferences.
Because people expect computer prices to keep falling, Preferences determine the value that people place on
the current demand for computers is less (and the each good and service. Preferences depend on such
future demand is greater) than it otherwise would be. things as the weather, information and fashion. For
example, greater health and fitness awareness has
Income Consumers’ income influences demand. shifted preferences away from eating chocolate bars, so
When income increases, consumers buy more of most the demand for Chomp bars has decreased.
goods; and when income decreases, consumers buy Table 3.1 summarises the influences on demand
less of most goods. Although an increase in income and the direction of those influences.
• The price of a Chomp bar rises • The price of a Chomp bar falls
Changes in Demand
The demand for Chomp bars
Price
curve and a shift of the demand curve.
A point on the demand curve shows the quan-
tity demanded at a given price, so a movement along Decrease in
the demand curve shows a change in the quantity quantity
demanded
demanded. The entire demand curve shows demand,
so a shift of the demand curve shows a change in
Decrease in Increase in
demand. Figure 3.3 illustrates these distinctions.
demand demand
Increase in
Movement Along the Demand Curve If the price quantity
D1
of the good changes but no other influence on buying demanded
plans changes, we illustrate the effect as a movement
along the demand curve. D0
demanded of it. In Fig. 3.3, we illustrate the effect of a rise When the price of the good changes, there is a movement along
in price as a movement up along the demand curve D0. the demand curve and a change in the quantity demanded,
shown by the blue arrows on demand curve D0. When any other
A Shift of the Demand Curve If the price of a good influence on buying plans changes, there is a shift of the demand
remains constant but some other influence on buying curve and a change in demand. An increase in demand shifts
plans changes, there is a change in demand for that the demand curve rightward (from D0 to D1). A decrease in
good. We illustrate a change in demand as a shift of the demand shifts the demand curve leftward (from D0 to D2).
demand curve. For example, if more parents organise
large children’s parties with party packs, consumers buy
more Chomps regardless of the price of a bar. That is
what a rightward shift of the demand curve shows – REVIEW QUIZ
more Chomp bars are demanded at each price. 1 Define the quantity demanded of a good
In Fig. 3.3, there is a change in demand and the or service.
demand curve shifts when any influence on buying 2 What is the law of demand and how do we
plans changes, other than the price of the good. illustrate it?
Demand increases and the demand curve shifts 3 What does the demand curve tell us about the
rightward (to the red demand curve D1) if the price price that consumers are willing to pay?
of a substitute rises, the price of a complement falls, 4 List all the influences on buying plans that
the expected future price of the good rises, income change demand, and for each influence, say
increases (for a normal good), expected future income whether it increases or decreases demand.
or credit increases, or the population increases. 5 Why does demand not change when the price
Demand decreases and the demand curve shifts left- of a good changes with no change in the other
ward (to the red demand curve D2) if the price of influences on buying plans?
2.00 D
B 1.00 6
1.50 C C 1.50 10
1.00 B
D 2.00 13
0.50 A
E 2.50 15
0 5 10 15 20 25
Quantity supplied (thousands of bars per week)
The table shows the supply schedule of Chomp bars. A supply curve can be read in two ways. For a given price,
For example, at a price of R1.00, 6 000 bars a week the supply curve tells us the quantity that producers plan to
are supplied; at a price of R2.50, 15 000 bars a week sell at that price. For example, at a price of R1.50 a bar,
are supplied. The supply curve shows the relationship producers are planning to sell 10 000 bars a week. For a
between the quantity supplied and the price, other given quantity, the supply curve tells us the minimum price at
things remaining the same. The supply curve slopes which producers are willing to sell one more bar. For example,
upward: As the price of a good increases, the quantity if 15 000 bars are produced each week, the lowest price at
supplied increases. which a producer is willing to sell the 15 000th bar is R2.50.
Prices of Related Goods Produced The prices of Technology The term ‘technology’ is used broadly
related goods that firms produce influence supply. to mean the way that factors of production are used
For example, if the price of soccer balls rises, firms to produce a good. A technology change occurs when
switch production from basket balls to soccer balls. a new method is discovered that lowers the cost of
The supply of basket balls decreases. Soccer balls and producing a good. For example, new methods used
basket balls are substitutes in production – goods that in the factories that produce computer chips have
can be produced by using the same resources. If the lowered the cost and increased the supply of chips.
price of beef rises, the supply of cowhide increases.
Beef and cowhide are complements in production – The State of Nature The state of nature includes all
goods that must be produced together. the natural forces that influence production. It includes
the state of the weather and, more broadly, the natural
Expected Future Prices If the expected future environment. Good weather can increase the supply of
price of a good rises, the return from selling the many agricultural products and bad weather can decrease
good in the future increases and is higher than it is their supply. Extreme natural events such as earthquakes,
today. So supply decreases today and increases in hurricanes and severe droughts can also influence supply.
the future. Figure 3.5 illustrates an increase in supply. When
supply increases, the supply curve shifts rightward
The Number of Suppliers The larger the number of and the quantity supplied at each price is larger. For
firms that produce a good, the greater is the supply of example, at R1.00 per bar, on the original (blue)
the good. As new firms enter an industry, the supply supply curve, the quantity supplied is 6 000 bars a
in that industry increases. As firms leave an industry, week. On the new (red) supply curve, the quantity
the supply in that industry decreases. supplied is 15 000 bars a week. Look closely at the
numbers in the table in Fig. 3.5 and check that the
quantity supplied is larger at each price.
0.50 '
D 2.00 13 D’ 2.00 25
E 2.50 15 E’ 2.50 27
0 5 10 15 20 25 30 35
Quantity supplied (thousands of bars per week)
A change in any influence on selling plans other than the the old technology (row C of the table) and 20 000 Chomp
price of the good itself results in a new supply schedule bars a week are supplied when producers use the new
and a shift of the supply curve. For example, a new, cost- technology (row C’).
saving technology for producing Chomp bars changes An advance in technology increases the supply of
the supply of Chomp bars. At a price of R1.50 a bar, Chomp bars. The supply curve shifts rightward, as shown by
10 000 bars a week are supplied when producers use the shift arrow and the resulting red curve.
• The price of a Chomp bar falls • The price of a Chomp bar rises
Changes in Supply
The supply of Chomp bars
• The price of a factor of production used to produce • The price of a factor of production used to produce
Chomp bars rises Chomp bars falls
• The price of a substitute in production rises • The price of a substitute in production falls
• The price of a complement in production falls • The price of a complement in production rises
• The expected future price of a Chomp bar rises • The expected future price of a Chomp bar falls
• The number of suppliers of bars decreases • The number of suppliers of bars increases
• A technology change decreases Chomp bar production • A technology change increases Chomp bar production
• A natural event decreases Chomp bar production • A natural event increases Chomp bar production
A Change in the Quantity Supplied Versus a FIGURE 3.6 A Change in the Quantity
Change in Supply Supplied Versus a Change in Supply
Changes in the influences on selling plans bring
Price
3.00
(rand per demanded supplied or
Surplus of Supply of
bar) (thousands (thousands surplus (+)
6 million bars Chomp bars of bars of bars
at R2.00 a bar per week) per week)
2.50
0.50 22 0 –22
2.00
1.00 15 6 –9
Equilibrium
1.50
1.50 10 10 0
1.00 Demand for
Chomp bars
2.00 7 13 +6
0.50 Shortage of
9 million bars
at R1.00 a bar
2.50 5 15 +10
0 5 10 15 20 25
Quantity (thousands of bars per week)
The table lists the quantity demanded and the quantity of 6 000 bars a week and the price falls.
supplied, as well as the shortage or surplus of bars at If the price is R1.50 a bar, 10 000 bars a week are
each price. If the price is R1.00 a bar, 15 000 bars a demanded and 10 000 bars are supplied. There is neither
week are demanded and 6 000 bars are supplied. There a shortage nor a surplus and the price does not change. The
is a shortage of 9 000 bars a week and the price rises. price at which the quantity demanded equals the quantity
If the price is R2.00 a bar, 7 000 bars a week are supplied is the equilibrium price and 10 000 bars
demanded and 13 000 bars are supplied. There is a surplus a week is the equilibrium quantity.
price and suppliers try to sell at the highest possible price, shifts rightward. The equilibrium price rises to R2.50
the price at which trade takes place is the equilibrium a Chomp bar and the quantity supplied increases to
price – the price at which the quantity demanded equals 15 000 Chomp bars a week, as highlighted in the
the quantity supplied. The price coordinates the plans figure. There is an increase in the quantity supplied but
of buyers and sellers and no one has an incentive to no change in supply – a movement along, but no shift
change it. of, the supply curve.
0 5 10 15 20 25 30 35
Quantity (thousands of bars per week)
Predicting Changes in Price and
Quantity Price Quantity Quantity Quantity
(rand demanded demanded supplied
The demand and supply model that we have just
per bar) (thousands (thousands (thousands
studied provides us with a powerful way of analysing per week) per week) per week)
influences on prices and the quantities bought and Original New
sold. According to the model, a change in price stems 0.50 22 32 0
from a change in demand, a change in supply, or a 1.00 15 25 6
change in both demand and supply. Let us look first 1.50 10 20 10
at the effects of a change in demand. 2.00 7 17 13
2.50 5 15 15
An Increase in Demand Initially, the demand for Chomp bars is the blue demand curve.
When more people receive higher incomes, the demand The equilibrium price is R1.50 a bar, and the equilibrium
for Chomp bars increases. The table in Figure 3.8 shows quantity is 10 000 bars a week. When people receive higher
the original and new demand schedules for Chomp incomes, the demand for Chomp bars increases and the
bars, as well as the supply schedule of Chomp bars. demand curve shifts rightward to become the red curve.
The increase in demand creates a shortage at the At R1.50 a bar, there is now a shortage of 10 000 bars
original price and to eliminate the shortage, the price a week. The price of a bar rises to a new equilibrium of R2.50.
must rise. As the price rises to R2.50, the quantity supplied increases
Figure 3.8 shows what happens. The figure shows – shown by the blue arrow on the supply curve – to the new
the original demand for and supply of Chomp bars. equilibrium quantity of 15 000 bars a week. Following an
The original equilibrium price is R1.50 a Chomp bar, increase in demand, the quantity supplied increases but
and the equilibrium quantity is 10 000 Chomp bars supply does not change – the supply curve does not shift.
a week. When demand increases, the demand curve
demand and supply determine the price of oil. The Global Market for Crude Oil
An Increase in Supply
a bar and the quantity demanded increases to
When Nestlé and other chocolate bar producers 15 000 bars a week, highlighted in the figure. There
switch to a new cost-saving technology, the supply of is an increase in the quantity demanded but no change
chocolate bars increases. in demand – a movement along, but no shift of, the
Figure 3.9 shows the new supply schedule (the demand curve.
same one that was shown in Fig. 3.5). What are the
new equilibrium price and quantity? The price falls to
R1.00 a bar, and the quantity increases to 15 000 bars A Decrease in Supply
a week. You can see why by looking at the quantities Start out at a price of R1.00 a bar with 15 000 bars a
demanded and supplied at the old price of R1.50 week being bought and sold. Then suppose that the
a bar. The new quantity supplied at that price is cost of labour or raw materials rises and the supply of
20 000 bars a week and there is a surplus. The price Chomp bars decreases. The decrease in supply shifts
falls. Only when the price is R1.00 a bar does the the supply curve leftward. The equilibrium price rises
quantity supplied equal the quantity demanded. to R1.50 a bar, the quantity demanded decreases and
Figure 3.9 illustrates the effect of an increase in the equilibrium quantity decreases to 10 000 bars
supply. It shows the demand curve for Chomp bars a week.
and the original and new supply curves. The initial We can now make two more predictions:
equilibrium price is R1.50 a bar and the equilibrium 1. When supply increases, the price falls and the
quantity is 10 000 bars a week. quantity increases.
When supply increases, the supply curve shifts 2. When supply decreases, the price rises and the
rightward. The equilibrium price falls to R1.00 quantity decreases.
1.50 1.00 15 6 15
1.00 1.50 10 10 20
2.50 5 15 27
0 5 10 15 20 25 30 35
Quantity (thousands of bars per week)
Initially, the supply of Chomp bars is shown by the blue At R1.50 a bar, there is now a surplus of 10 000 bars a week.
supply curve. The equilibrium price is R1.50 a bar and the The price of a Chomp bar falls to a new equilibrium of R1.00 a
equilibrium quantity is 10 000 bars a week. When the new bar. As the price falls to R1.00, the quantity demanded increases
cost-saving technology is adopted, the supply of Chomp bars – shown by the blue arrow on the demand curve – to the new
increases and the supply curve shifts rightward to become the equilibrium quantity of 15 000 bars a week. Following an
red curve. increase in supply, the quantity demanded increases but demand
does not change – the demand curve does not shift.
You have now seen what happens to the price and the both demand and supply increase. We need to know
quantity when either demand or supply changes while the magnitudes of the changes in demand and supply
the other one remains unchanged. In real markets, to predict the effects on price. In the example in
both demand and supply can change together. When Fig. 3.10(e), the price does not change. But notice
this happens, to predict the changes in price and that if demand increases by slightly more than the
quantity, we must combine the effects that you have amount shown in the figure, the price will rise. And
just seen. That is your final task in this chapter. if supply increases by slightly more than the amount
shown in the figure, the price will fall.
All the Possible Changes in Demand Decrease in Both Demand and Supply
and Supply Figure 3.10(i) shows the case in which demand
Figure 3.10 brings together and summarises the and supply both decrease. For the same reasons as
effects of all the possible changes in demand and supply. those we have just reviewed, when both demand and
With what you have learned about the effects of a supply decrease, the quantity decreases, and again the
change in either demand or supply, you can predict what direction of the price change is uncertain.
happens if both demand and supply change together. Let
us begin by reviewing what you already know. Decrease in Demand and Increase in Supply
You have seen that a decrease in demand lowers the
Change in Demand with No Change in Supply price and decreases the quantity. And you have seen
The first row of Fig. 3.10, parts (a), (b) and (c), that an increase in supply lowers the price and increases
summarises the effects of a change in demand with the quantity. Fig. 3.10(f ) combines these two changes.
no change in supply. In part (a), with no change in Both the decrease in demand and the increase in
either demand or supply, neither the price nor the supply lower the price, so the price falls. But a decrease in
quantity changes. With an increase in demand and demand decreases the quantity and an increase in supply
no change in supply in part (b), both the price and increases the quantity, so we cannot predict the direction
quantity increase. And with a decrease in demand and in which the quantity will change unless we know the
no change in supply in part (c), both the price and magnitudes of the changes in demand and supply. In the
the quantity decrease. example in Fig. 3.10(f ), the quantity does not change.
But notice that if demand decreases by slightly more
Change in Supply with No Change in Demand than the amount shown in the figure, the quantity will
The first column of Fig. 3.10, parts (a), (d) and (g), decrease; if supply increases by slightly more than the
summarises the effects of a change in supply with no amount shown in the figure, the quantity will increase.
change in demand. With an increase in supply and
no change in demand in part (d), the price falls and Increase in Demand and Decrease in Supply
quantity increases. And with a decrease in supply and Figure 3.10(h) shows the case in which demand
no change in demand in part (g), the price rises and increases and supply decreases. Now, the price rises and
the quantity decreases. again the direction of the quantity change is uncertain.
FIGURE 3.10 The Effects of All the Possible Changes in Demand and Supply
Equilibrium Demand
1.50 1.50 (new) 1.50
Demand
1.00 1.00 1.00 (original)
?
1.50 1.50 1.50
?
Demand
Demand (original)
1.00 1.00 1.00
(new)
To complete your study of demand and supply, South Africa. Try to get into the habit of using the
take a look at Reading Between the Lines on pp. 67–68, demand and supply model to understand the move-
which explains why the price of maize increased in ments in prices in your everyday life.
There is a concerted [South African] drive to promote so-called ‘biofuels’ by their supporters and
agro-fuels by their opponents. … They primarily include maize and sugarcane sourced ethanol,
blended with conventional petrol, or vegetable oils blended with diesel, in varying proportions.
[T]hese fuels are … better termed agro-fuels because they are all grown as industrial agricultural
commodities that compete directly against, food, fibre and oil crops for human consumption. Their
use threatens food security and drives up food prices.
Over the past three growing seasons South Africa has produced a surplus of maize of around 3–4 million
tonnes. This growing season looks set to repeat this. Yet bizarrely, despite three years of surplus crop, South
Africa is presently importing maize … at double the price our maize was sold. This has negatively affected
food inflation, mostly affecting the poor who rely on maize and chicken – fed on maize – as staples.
increase in supply. Thus, despite an increase in Figure 1 South Afrian maize market
is c
y-intercept
is a Slope is d
a
c
Slope is –b
Demand
Supply
Market 1 600 – 2Q* = 400 + 1Q*
equilibrium 1 200 = 3Q*
Q* = 400
P*
And
P* = 1 600 – 2(400)
Demand = 800
0 Q*
Quantity The equilibrium price is R8 a cone, and the
Figure 3 Market equilibrium equilibrium quantity is 400 cones per day.
Key Terms
Change in demand, 53 Competitive market, 50 Inferior good, 54 Quantity supplied, 56
Change in supply, 57 Complement, 53 Law of demand, 51 Relative price, 50
Change in the quantity Demand, 51 Law of supply, 56 Substitute, 53
demanded, 55 Demand curve, 52 Money price, 50 Supply, 56
Change in the quantity Equilibrium price, 60 Normal good, 54 Supply curve, 56
supplied, 59 Equilibrium quantity, 60 Quantity demanded, 51
Use the following information to work out Problems Predicting Changes in Price and Quantity
7 to 9. 12. The following events occur one at a time:
(i) The price of crude oil rises.
Dairies make low-fat milk from full-cream milk. In the (ii) The price of a car rises.
process of making low-fat milk, the dairies produce (iii) All speed limits on highways are abolished.
cream, which is made into ice cream. In the market for (iv) Robots cut car production costs.
low-fat milk, the following events occur one at a time: Which of these events will increase or decrease
(i) The wage rate of dairy workers rises. (state which occurs):
(ii) The price of cream rises. a. The demand for petrol?
(iii) The price of low-fat milk rises. b. The supply of petrol?
(iv) With the period of low rainfall extending, dairies c. The quantity of petrol demanded?
raise their expected price of low-fat milk next year. d. The quantity of petrol supplied?
(v) With advice from health-care experts, dairy 13. In Problem 11, a fire destroys some factories
farmers decide to switch from producing full- that produce chewing gum and the quantity of
cream milk to growing vegetables. chewing gum supplied decreases by 40 million
(vi) A new technology lowers the cost of producing packs a week at each price.
ice cream. a. Explain what happens in the market for
chewing gum and draw a graph to illustrate
7. Explain the effect of each event on the supply of the changes.
low-fat milk. b. If at the time the fire occurs there is an
8. Use a graph to illustrate the effect of each event. increase in the teenage population, which
9. Does any event (or events) illustrate the law of increases the quantity of chewing gum
supply? demanded by 40 million packs a week
at each price, what are the new equilib-
Market Equilibrium rium price and quantity of chewing gum?
10. ‘As more people buy computers, the demand for Illustrate these changes on your graph.
internet service increases and the price of internet 14. Cuts and Charges
service decreases. The fall in the price of internet Many airlines are charging passengers fees like $15
service decreases the supply of internet service.’ for their first piece of checked luggage, in addition
Explain what is wrong with this statement. to raising other fees and cutting domestic flights as
11. The demand and supply schedules for chewing they grapple with record-high fuel prices.
gum are a. According to the info byte, what is the influ-
Price Quantity Quantity ence on the supply of airline flights?
(rand per demanded (millions supplied (millions b. Explain how supply changes.
pack) of packs a week) of packs a week) 15. Grannies in Las Vegas
2 180 60 Las Vegas in the US has plenty of jobs for the
4 140 100 over 50s with a growing elderly population.
6 100 140 Explain how grannies have influenced:
8 60 180 a. The demand in some Las Vegas markets.
10 20 220
b. The supply in other Las Vegas markets.
a. Draw a graph of the market for gum and 16. Pump Prices Top 2009 High
mark in the equilibrium price and quantity. Crude oil price soars and pump prices may
b. Suppose that the price of chewing gum is R7 exceed the peak price of 2009.
a pack. Describe the situation in the chewing a. Does demand for petrol or the supply of petrol
gum market and explain how the price adjusts. or both change when the price of oil soars?
c. Suppose that the price of chewing gum is R3 b. Use a demand-supply graph to illustrate what
a pack. Describe the situation in the chewing happens to the equilibrium price of petrol
gum market and explain how the price adjusts. and the equilibrium quantity of petrol.
25. The demand and supply schedules for potato growers ploughed over their strawberry plants
chips are to make way for watermelons; others froze their
harvests and sold them to juice and jam makers.
Price Quantity Quantity a. Explain how the market for strawberries
(rand per bag) demanded supplied would have changed if growers had not
(millions of bags (millions of bags
ploughed in their plants but offered locals
a week) a week)
‘you pick for free’.
5 160 130 b. Describe the changes in demand and supply
6 150 140
7 140 150
in the market for strawberry jam.
8 130 160 30. Popcorn Prices on the Rise
9 120 170 Cinemas are raising the price of popcorn. Owing
10 110 180 to a huge demand for field maize, which is used
for animal feed, corn syrup and ethanol, its price
a. Draw a graph of the potato chip market and has exploded. In addition, some farmers have
mark in the equilibrium price and quantity. stopped growing popcorn maize and changed to
b. If the price is R6 a bag, is there a shortage or easier-to-grow field maize.
a surplus and how does the price adjust? Explain and illustrate graphically the events
described in the info byte in the market for:
Predicting Changes in Price and Quantity a. Popcorn
26. In Problem 25, a new dip increases the quantity b. Movie tickets
of potato chips that people want to buy by
30 000 bags per week at each price. Use the following info byte to work out Problems 31
a. How does the demand and/or supply of and 32.
chips change?
b. How does the price and quantity of chips Toshiba Loses to Sony’s Blu-ray
change? Toshiba Corp. has withdrawn from competing against
27. In Problem 25, if a virus destroys potato crops Sony Corp.’s Blu-ray technology. The move could give
and the quantity of potato chips produced rise to a high-definition home DVD market.
decreases by 40 000 bags a week at each price,
how does the supply of chips change? 31. a. How would you expect the price of a used
28. If the virus in Problem 27 hits just as the new dip Toshiba player on eBay to change? Will the
in Problem 26 comes onto the market, how does price change result from a change in demand,
the price and quantity of chips change? supply, or both and in which directions?
29. Strawberry Prices Drop Due to Late Harvest b. How would you expect the price of a Blu-ray
Shoppers bought strawberries in March for player to change?
R15 a kilogram rather than the R25 a kilogram 32. Explain how the market for Blu-ray format
they paid last year. With the price so low, some movies will change.
A
4
t what price do people stop smoking? Across the world,
governments impose large taxes – so-called sin taxes – on products
that they consider harmful like alcohol and cigarettes. The idea is that
taxes increase the price of these harmful products which, according
to the law of demand, should lead to a reduction in the quantity
demanded, ceteris paribus. But, by how much must the price be
increased for consumers to reduce their consumption of these products?
ELASTICITY The same question has been asked by the South African government that
considers cigarettes and alcohol to be two of the biggest contributors to
health care costs in South Africa.
Chapter 4 will illustrate how economists use the demand and
supply model in combination with the concept of elasticity to analyse
possible outcomes of economic policy. This chapter introduces you to a
key concept that is of tremendous importance in all areas of economics:
elasticity. Elasticity is a tool that addresses the quantitative questions
like the ones you have just considered and enables us to compare the
sensitivity of the quantity demanded to a change in price regardless of
the units in which the good is measured.
At the end of the chapter, in Reading Between the Lines, we
will return to the price of cigarettes and see whether high sin taxes
really reduce the demand for tobacco products. But we will begin by
explaining elasticity in another familiar setting: the market for pizza.
40.00 40.00
An increase An increase
in supply
S0 S1 S0 in supply S1
brings ... brings ...
30.00 30.00
... a large
fall in price ...
20.00 20.00
15.00
... a small DB
10.00 10.00 fall in ... and a
... and a small
price ... large increase
increase in quantity
5.00 in quantity
DA
0 5 10 13 15 20 25 0 5 10 15 17 20 25
Quantity (pizzas per hour) Quantity (pizzas per hour)
(a) Large price change and small quantity change (b) Small price change and large quantity change
Initially, the price is R20 a pizza and the quantity sold is 10 falls by only R5 to R15 a pizza and the quantity increases by
pizzas an hour. Then supply increases from S0 to S1. In part 7 to 17 pizzas an hour. The price change is smaller and the
Price (rand per pizza)
The price elasticity of demand is a units-free divided by the percentage change in price (5 per cent)
measure of the responsiveness of the quantity and is 4. That is,
demanded of a good to a change in its price when all %∆Q
other influences on buying plans remain the same. Price elasticity of demand =
%∆P
= 20%
5%
Calculating Price Elasticity of Demand
=4
We calculate the price elasticity of demand by using
the formula FIGURE 4.2 Calculating the Elasticity of Demand
Percentage change in
Price elasticity quantity demanded
=
by 2 pizzas an hour.
To calculate the price elasticity of demand, we The elasticity of demand is calculated by using the formula:*
express the change in price as a percentage of the
average price and the change in the quantity demanded Price elasticity Percentage change in quantity demanded
=
as a percentage of the average quantity. By using the of demand Percentage change in price
average price and average quantity, we calculate the %∆Q
=
elasticity at a point on the demand curve midway %∆P
between the original point and the new point. ∆Q/Qave
The original price is R20.50 and the new price =
∆P/Pave
is R19.50, so the price change is R1 and the average
price is R20 a pizza. Call the percentage change in the 2/10
=
price %∆P, then 1/20
=4
%∆P = ∆P/Pave × 100 = (R1/R20) × 100 = 5% This calculation measures the elasticity at an average price of
R20 a pizza and an average quantity of 10 pizzas an hour.
The original quantity demanded is 9 pizzas
*In the formula, the Greek letter delta (∆) stands for ‘change in’ and %∆ stands
and the new quantity demanded is 11 pizzas, so the
for ‘percentage change in’.
quantity change is 2 pizzas and the average quantity
demanded is 10 pizzas. Call the percentage change in
the quantity demanded %∆Q, then
Average Price and Quantity Notice that we use
%∆Q = ∆Q/Q ave × 100 = (2/10) × 100 = 20% the average price and average quantity. We do this
because it gives the most precise measurement of
The price elasticity of demand equals the percentage elasticity – at the midpoint between the original price
change in the quantity demanded (20 per cent) and the new price. If the price falls from R20.50
to R19.50, the R1 price change is 4.9 per cent of Minus Sign and Elasticity When the price of a
R20.50. The 2 pizza change in quantity is 22.2 per good rises, the quantity demanded decreases. Because
cent of 9 pizzas, the original quantity. So if we use a positive change in price brings a negative change in
these numbers, the price elasticity of demand is 22.2 the quantity demanded, the price elasticity of demand
divided by 4.9, which equals 4.5. If the price rises is a negative number. But it is the magnitude, or
from R19.50 to R20.50, the R1 price change is 5.1 absolute value, of the price elasticity of demand that
per cent of R19.50. The 2 pizza change in quantity is tells us how responsive the quantity demanded is.
18.2 per cent of 11 pizzas, the original quantity. So if So to compare price elasticities of demand, we use the
we use these numbers, the price elasticity of demand magnitude of the elasticity and ignore the minus sign.
is 18.2 divided by 5.1, which equals 3.6.
By using percentages of the average price and
average quantity, we get the same value for the Inelastic and Elastic Demand
elasticity regardless of whether the price falls from Figure 4.3 shows three demand curves that cover the
R20.50 to R19.50 or rises from R19.50 to R20.50. entire range of possible elasticities of demand. In
Fig. 4.3(a), the quantity demanded is constant regardless
Percentages and Proportions Elasticity is the of the price. If the quantity demanded remains constant
ratio of two percentage changes, so when we divide when the price changes, then the price elasticity of
one percentage change by another, the 100s cancel. A demand is zero and the good is said to have a perfectly
percentage change is a proportionate change multiplied inelastic demand. One good that has a very low price
by 100. The proportionate change in price is ∆P/Pave elasticity of demand (perhaps zero over some price range)
and the proportionate change in quantity demanded is is insulin. Insulin is of such importance to some diabetics
∆Q/Q ave. So if we divide ∆Q/Q ave by ∆P/Pave we get the that if the price rises or falls, they do not change the
same answer as we get by using percentage changes. quantity they buy. This does not mean that it can be said
that insulin is perfectly price inelastic at all prices, but
A Units-Free Measure Now that you have only over ‘some price range’. At very high prices it would
calculated a price elasticity of demand, you can see be unaffordable to all except very wealthy individuals.
why it is a units-free measure. If the percentage change in the quantity demanded
Elasticity is a units-free measure because the equals the percentage change in the price, then the
percentage change in each variable is independent of price elasticity equals 1 and the good is said to have
the units in which the variable is measured. The ratio a unit elastic demand. The demand in Fig. 4.3(b) is
of the two percentages is a number without units. an example of a unit elastic demand.
Price
Price
D1
6 6 6
D2
(a) Perfectly inelastic demand (b) Unit elastic demand (c) Perfectly elastic demand
Each demand illustrated here has a constant elasticity. The part (b) illustrates the demand for a good with a unit elasticity
demand curve in part (a) illustrates the demand for a good of demand. And the demand curve in part (c) illustrates the
that has a zero elasticity of demand. The demand curve in demand for a good with an infinite elasticity of demand.
Between the cases shown in Fig. 4.3(a) and That is, at the midpoint of a linear demand curve, the
Fig. 4.3(b) is the general case in which the percentage price elasticity of demand is one.
change in the quantity demanded is less than the At prices above the midpoint, demand is elastic.
percentage change in the price. In this case, the price For example, when the price falls from R25 to
elasticity of demand is between zero and 1 and the R15 a pizza, the quantity demanded increases from
good is said to have an inelastic demand. zero to 20 pizzas an hour. The average price is R20 a
Food and shelter are examples of goods with pizza and the average quantity is 10 pizzas. So
inelastic demand.
∆Q/Q ave
If the quantity demanded changes by an infinitely Price elasticity of demand =
∆P/Pave
large percentage in response to a tiny price change, then
the price elasticity of demand is infinity and the good = 20/10
is said to have a perfectly elastic demand. Figure 4.3(c) 10/20
shows a perfectly elastic demand. An example of a good =4
that has a very high elasticity of demand (almost infinite)
is a cooldrink from two campus vending machines That is, the price elasticity of demand at an average
located side by side. If the two vending machines offer price of R20 a pizza is 4.
the same cooldrinks for the same price, some people buy At prices below the midpoint, demand is inelastic.
from one machine and some from the other. But if one For example, when the price falls from R10 a
machine’s price is higher than the other’s, by even a small pizza to zero, the quantity demanded increases from
amount, no one buys from the machine with the higher 30 to 50 pizzas an hour.
price. Drinks from the two vending machines are The average price is now R5 and the average
perfect substitutes. The demand for a good that has a quantity is 40 pizzas an hour. So
perfect substitute is perfectly elastic. 20/40
Between the cases in Fig. 4.3(b) and Fig. 4.3(c) Price elasticity of demand =
10/5
is the general case in which the percentage change in
the quantity demanded exceeds the percentage change = 1/4
in price. In this case, the price elasticity of demand is That is, the price elasticity of demand at an average
greater than 1 and the good is said to have an elastic price of R5 a pizza is 1/4.
demand. Motor vehicles and furniture are examples of
goods that have elastic demand. FIGURE 4.4 Elasticity Along a Linear Demand
Curve
Price (rand per pizza)
In Figure 4.5(a), over the price range from R25 (a) Demand
to R12.50, demand is elastic. Over the price range
from R12.50 to zero, demand is inelastic. At a price of
R12.50, demand is unit elastic.
Total revenue (rand)
350.00 Maximum
Figure 4.5(b) shows total revenue. At a price total revenue
312.50
of R25, the quantity sold is zero, so total revenue
is zero.
At a price of zero, the quantity demanded is 250.00
50 pizzas an hour and total revenue is again zero.
A price cut in the elastic range brings an increase in 200.00
in price. A price cut in the inelastic range brings a When demand When demand
100.00 is elastic, a is inelastic, a
decrease in total revenue – the percentage increase price cut price cut
in the quantity demanded is less than the percentage increases decreases
50.00 total revenue total revenue
decrease in price. At unit elasticity, total revenue is at
a maximum.
Figure 4.5 shows how we can use this relationship 0 25 50
Quantity (pizzas per hour)
between elasticity and total revenue to estimate
elasticity using the total revenue test. The total revenue (b) Total revenue
test is a method of estimating the price elasticity of
demand by observing the change in total revenue
When demand is elastic, in the price range from R25 to
that results from a change in the price, when all other
R12.50, a decrease in price (part a) brings an increase in
influences on the quantity sold remain the same.
total revenue (part b). When demand is inelastic, in the price
◆ If a price cut increases total revenue, demand
range from R12.50 to zero, a decrease in price (part a)
is elastic.
brings a decrease in total revenue (part b). When demand is
◆ If a price cut decreases total revenue, demand
unit elastic, at a price of R12.50 (part a), total revenue is at a
is inelastic.
maximum (part b).
◆ If a price cut leaves total revenue unchanged,
demand is unit elastic.
The change in the price of a burger, a substitute Complements Now suppose that the price of pizza is
for pizza, is +R10 – the new price, R25, minus the constant and 11 pizzas an hour are bought. Then the
original price, R15. price of a cooldrink rises from R6 to R10. No other
The average price is R20 a burger. So the price of influence on buying plans changes and the quantity of
a burger rises by 50 per cent. That is, pizzas bought falls to 9 an hour.
The change in the quantity demanded is the
∆P/Pave × 100 = (+R10/R20) × 100 = +50%
opposite of what we have just calculated: The quantity
So the cross elasticity of demand for pizza with of pizzas demanded decreases by 20 per cent (–20%).
respect to the price of a burger is The change in the price of a cooldrink, a
complement of pizza, is the same as the percentage
+20% change in the price of a burger that we have just
= 0.4
+50% calculated. The price rises by 50 per cent (50%). So
Figure 4.6 illustrates the cross elasticity of demand. the cross elasticity of demand for pizza with respect to
Pizza and burgers are substitutes. Because they are the price of a cooldrink is
substitutes, when the price of a burger rises, the
–20%
demand for pizza increases. The demand curve for = –0.4
+50%
pizza shifts rightward from D0 to D1. Because a rise in
the price of a burger brings an increase in the demand Because pizza and cooldrinks are complements,
for pizza, the cross elasticity of demand for pizza with when the price of a cooldrink rises, the demand for
respect to the price of a burger is positive. Both the pizza decreases.
price and the quantity change in the same direction. The demand curve for pizza shifts leftward from
D0 to D2. Because a rise in the price of a cooldrink
brings a decrease in the demand for pizza, the cross
FIGURE 4.6 Cross Elasticity of Demand elasticity of demand for pizza with respect to the price
of a cooldrink is negative. The price and quantity
Price of pizza
A burger is a substitute for pizza. When the price of a burger Income Elasticity of Demand
rises, the demand for pizza increases and the demand curve
for pizza shifts rightward from D0 to D1. The cross elasticity of
Suppose the economy is expanding and people are
demand is positive.
enjoying rising incomes. This prosperity brings an
A cooldrink is a complement of pizza. When the price
increase in the demand for most types of goods and
of a cooldrink rises, the demand for pizza decreases and
services. But by how much will the demand for pizza
the demand curve for pizza shifts leftward from D0 to D2. The
increase? The answer depends on the income elasticity
of demand, which is a measure of the responsiveness
cross elasticity of demand is negative.
of the demand for a good or service to a change in
income, other things remaining the same.
67 per cent. The elasticity of supply is equal to 67 per Resource Substitution Possibilities Some goods
cent divided by 4.9 per cent, which equals 13.67. and services can be produced only by using unique
Figure 4.8 shows the range of elasticities of supply. or rare productive resources. These items have a low,
If the quantity supplied is fixed regardless of perhaps even a zero, elasticity of supply. Other goods
the price, the supply curve is vertical and the elasticity and services can be produced by using commonly
of supply is zero. Supply is perfectly inelastic. This available resources that could be allocated to a wide
case is shown in Fig. 4.8(a). A special intermediate variety of alternative tasks. Such items have a high
case occurs when the percentage change in price elasticity of supply.
equals the percentage change in quantity. Supply is A Van Gogh painting is an example of a good
then unit elastic. This case is shown in Fig. 4.8(b). with a verticalAnsupply curve and a Szero elasticity
An increase in SA An increase
40.00 demand brings ... 40.00
in demand
brings ...
30.00 30.00
21.00 SB
20.00 20.00
... a large D1 D1
price rise ... ... a small
price rise ...
10.00 10.00
... and a small D0 ... and a large D0
quantity increase quantity increase
0 5 10 13 15 20 25 0 5 10 15 20 25
Quantity (pizzas per hour) Quantity (pizzas per hour)
(a) Large price change and small quantity change (b) Small price change and large quantity change
Initially, the price is R20 a pizza, and the quantity sold is R21 a pizza, and the quantity increases by 10 to 20 pizzas
10 pizzas an hour. Then the demand for pizza increases. The an hour. The price change is smaller and the quantity change
Price (rand per pizza)
An increase
demand curve shifts
40.00 rightward to D1. In part (a), the price rises
in demand is larger in case (b) than in case (a). The quantity supplied is
by R10 to R30 a pizza,brings ...and the quantity increases by 3 to more responsive to a change in the price in case (b) than in
13 pizzas an hour. In part (b), the price rises by only R1 to case (a).
30.00
21.00 SB
20.00
D1
PART TWO ... How
a small
Markets Work
price rise ...
10.00
9781775785026_gsp_eco_stb_ter_eng_za.indb 86 2014/03/14 7:10 AM
Elasticity of Supply 87
Price
Price
S1
S 2A
Elasticity of
supply =
Elasticity of
supply = 0 Elasticity of
S3
supply = 1
S 2B
(a) Perfectly inelastic supply (b) Unit elastic supply (c) Perfectly elastic supply
Each supply curve illustrated here has a constant elasticity. supply. All linear supply curves that pass through the origin
The supply curve in part (a) illustrates the supply of a good illustrate supplies that are unit elastic. The supply curve in part
that has a zero elasticity of supply. The supply curve in part (c) illustrates the supply of a good with an infinite elasticity
(b) illustrates the supply of a good with a unit elasticity of of supply.
If a higher price is offered, the quantity supplied an example. When many people simultaneously make
increases. Such goods and services have an elasticity of a call, there is a big surge in the demand for telephone
supply between zero and infinity. cables, computer switching and satellite time. The
quantity supplied increases, but the price remains
Time Frame for the Supply Decision To study the constant. Long-distance carriers monitor fluctuations
influence of the amount of time elapsed since a price in demand and reroute calls to ensure that the
change, we distinguish three time frames of supply: quantity supplied equals the quantity demanded
◆ Momentary supply without changing the price.
◆ Short-run supply
◆ Long-run supply Short-Run Supply The response of the quantity
supplied to a price change when only some of the
Momentary Supply When the price of a good changes, possible adjustments to production can be made is
the immediate response of the quantity supplied is determined by short-run supply. Most goods have
determined by the momentary supply of that good. an inelastic short-run supply. To increase output in
Some goods, such as fruits and vegetables, have the short run, firms must work their labour force
a perfectly inelastic momentary supply – a vertical overtime and perhaps hire additional workers. To
supply curve. The quantities supplied depend on crop- decrease their output in the short run, firms either lay
planting decisions made earlier. In the case of oranges, off workers or reduce their hours of work. With time,
for example, planting decisions have to be made firms can make more adjustments, perhaps training
many years in advance of the crop being available. additional workers or buying additional tools and
Momentary supply is perfectly inelastic because, on other equipment.
a given day, no matter what the price of oranges, For the orange grower, if the price of oranges
producers cannot change their output. falls, some pickers can be laid off and oranges left on
They have picked, packed and shipped their the trees to rot. Or if the price of oranges rises, the
crop to market, and the quantity available for that grower can use more fertiliser and improved irrigation
day is fixed. to increase the yields of their existing trees.
In contrast, some goods have a perfectly elastic But an orange grower cannot change the number
momentary supply. Long-distance phone calls are of trees producing oranges in the short run.
Long-Run Supply The response of the quantity supplied For the orange grower, the long run is the time
to a price change after all the technologically possible it takes new tree plantings to grow to full maturity –
ways of adjusting supply have been exploited is about 15 years. In some cases, the long-run adjustment
determined by long-run supply. For most goods occurs only after a completely new production plant
and services, long-run supply is elastic and perhaps has been built and workers have been trained to operate
perfectly elastic. it – typically a process that might take several years.
REVIEW QUIZ
1 Why do we need a units-free measure of the 4 Provide examples of goods or services whose elas-
responsiveness of the quantity supplied of a ticities of supply are (a) zero, (b) greater than zero
good or service to a change in its price? but less than infinity and (c) infinity.
2 Define the elasticity of supply and show how 5 How does the time frame over which a supply
it is calculated. decision is made influence the elasticity of supply?
3 What are the main influences on the elasticity of Explain your answer.
supply that make the supply of some goods elastic
and the supply of other goods inelastic?
You have now learned about the elasticities of competitive markets. But first study Reading Between
demand and supply. Table 4.1 summarises all the the Lines on pp. 89–91, which puts the elasticity of
elasticities that you have come across in this chapter. demand to work and looks at price elasticities of
In the next chapter, we study the efficiency of demand for cigarettes.
*In each description, the directions of change may be reversed. For example, in this case, the smallest possible decrease in price causes an infinitely large increase in
the quantity demanded.
Smokers Cough Up
http://www.FM.co.za
by Jacqui Pile
24 October 2008
In 2007, British American Tobacco (BAT) dispensed £17bn (or about R289bn), six times as much
as its operating profit, to governments around the world.
The ability of vice stocks to withstand high tax burdens makes them an ideal target for tax collectors.
Authorities have long tried to tax particular products – which consumers buy regardless of how
expensive they are – to earn extra revenue.
Governments justify the high taxes on sin stock, saying they help offset their negative social and
economic impact. For example, half of the 11 577 road accidents in South Africa between April
2007 and March 2008 were the result of alcohol abuse – for which government must pick up the
bill; while smokers tend to clog up the health system.
In 2007, the South African government earned R18bn in excise duties on tobacco products and
alcoholic beverages, about 3.2 per cent of total tax revenues. Of the sin tax, cigarettes are the most
lucrative for governments, followed by beer and spirits.
Strictly speaking it is not the sellers of sin products that foot the tax bill, it’s consumers. About 52 per
cent of the amount smokers fork out for a pack of 20 cigarettes goes to the taxman. But sin taxes also
tend to be regressive, since consumers of alcohol and cigarettes are more likely to be poor. …
Affordability is the biggest deterrent to smoking, and the biggest incentive for smokers to quit.
◆ But it would be unfair to claim that governments ◆ Demand curve D2 on the other hand shows the
only tax addictive products in order to collect as demand for cigarettes of first-time smokers who
much revenue as they can. The objective of the sin are not yet addicted. Assuming that P1 + t is
tax is to reduce the consumption of these products. the market price, the demand for cigarettes
◆ Figure 2 shows that the imposition of a sin tax of first-time smokers is relatively more elastic
can reduce the consumption of products like compared to regular smokers. Thus, the price
cigarettes in the long run when we look at the increase from P1 to P1 + t results in significantly
consumption behaviour of first-time smokers. fewer first-time smokers buying more cigarettes.
◆ Demand curve D1 shows the demand for This is shown by the fall in the quantity
cigarettes of regular smokers who are already demanded from Q1 to Q 3.
addicted to smoking. Their price elasticity is ◆ In conclusion, in the short run a sin tax does not
relatively inelastic and even a significant increase seem to reduce the consumption of an addictive
in the price of cigarettes will not lead them to product significantly, but might reduce the
reduce their consumption significantly. number of consumers in the long run.
Tax revenue
Price (rand)
Price (rand)
S2 S2
P1+t S1 P1+t S1
P1 P1
D2
D1 D1
0 Q2 Q1 0 Q3 Q2 Q1
Quantity of cigarettes Quantity of cigarettes
Figure 1 Impact of sin tax on cigarette market Figure 2 Impact of sin tax on cigarette market including
first-time smokers
B 20 100
Or you could use the Marshall Method using
the P-axis (y-axis). Again remember it is calculated by
C 10 150 taking area below divided by area above.
0 200
20 – 0 = 1
So –––––––
40 – 20
Using the formula:
P 1 P 1 10 5 1
eD = × c) eD at C: × = × =
Q slope Q slope 150 1 3
Or you could use the Marshall Method using
we are going to calculate elasticity at A. the P-axis (y-axis). Again remember it is calculated by
taking area below divided by area above.
Now, when you approach this problem, using the
formula, it is always easier to do the calculation in steps. 10 – 0 = –––
So ––––––– 10 = ––
1
40 – 10 30 3
From this you can see that either the formula or the Price Quantity TR
Marshall Method is equally accurate at calculating point
elasticity. The difference between using the Marshall A 250 0 0
Method or the formula to calculate point elasticity is B 225 50 11 250
determined by the graphs touching the axis or not.
C 200 100 20 000
An important part of this calculation, is deter-
mining what the values of elasticity would mean to D 175 150 26 250
somebody who is working in sales.
E 150 200 30 000
A good interpretation for understanding price-
elasticity coefficients: F 125 250 31 250
At point A on the demand curve the value of G 100 300 30 000
elasticity is greater than 1. From this I can tell that
the consumers are relatively elastic or price sensi- H 75 350 26 250
tive towards the product. At point C on the demand I 50 400 20 000
curve, the value of elasticity is smaller than 1, thus I
can tell that the consumers can be regarded as inelastic J 25 450 11 250
or relative insensitive to the price of the product. K 0 500 0
The relationship between total revenue and elas-
ticity is a very important one. Always remember that Using the formula again:
total revenue will be maximised where eD = 1.
The calculation for total revenue would be P 1
eD = ×
TR = P × Q so, using the table Q slope
A 30 50 1 500
Step 1: Calculate the Slope
B 20 100 2 000 The slope of this demand curve is calculated as
C 10 150 1 500
Step 3: Put in the Data Now calculate the elasticities at each of the other
points along this slope.
Now place the data into the rest of the formula to
calculate the elasticity at F. Price Quantity TR Elasticity
A 250 0 0
The elasticity coefficient at point F is
B 225 50 11 250 9
P 1 125 2
eD at F: × = × = 1. C 200 100 20 000 4
Q slope 250 1
D 175 150 26 250 2.3
E 150 200 30 000 1.5
Calculate the total revenue for each of the points and
take note of what happens. F 125 250 31 250 1
G 100 300 30 000 0.7
Price Quantity TR H 75 350 26 250 0.4
A 250 0 0 I 50 400 20 000 0.3
%∆QuantityDemanded
TR 20 000 TR 20 000 ––––––––––––––––
%∆Income
TR 11 250 TR 11 250
Interpreting the relative % change in Quantity
over the relative % change in the Income depends on
TR 0 the coefficient and the sign of this calculation. If the
TR 0
Q (quantity)
sign of the coefficient is positive then both the income
Figure 1 Total revenue and the quantity demanded will increase.
Notice that the total revenue at point F is highest. Positive income elasticity shows that consumers regard
This correlates to the point where elasticity is perfectly these products as normal. In other words, the product
equal to 1. is normal if the consumer’s income increases and the
consumer would buy more of that product. If the Doughnuts and coffee seem to sell well, yet
coefficient is both positive and greater than 1 then the customers would be ready to pay more for the
it is also a luxury product. If there is a positive income product even if you raise the price. This is because
elasticity coefficient smaller than 1 then that product the price elasticity is less than 1. Also, you notice
is a necessity. A negative income elasticity implies that doughnuts and coffee seem to be strong comple-
that the product is inferior. This does not mean that ments shown by the negative sign for cross-price
the product itself is an inferior product compared elasticity, and because the income elasticity is positive,
to other products. It would rather show that the item is interpreted as a necessity by the consumers.
consumers would rather buy something else as Yet, you still have room to increase the price of
their incomes increase. these items.
Key Terms
Cross elasticity of demand, 82 Income elasticity of Perfectly elastic demand, 79 Total revenue, 80
Elastic demand, 79 demand, 83 Perfectly inelastic demand, 78 Total revenue test, 80
Elasticity of supply, 85 Inelastic demand, 79 Price elasticity of demand, 77 Unit elastic demand, 78
Price Elasticity of Demand Calculate the elasticity of demand when the price
1. Rain spoils the strawberry harvest, the price rises rises from R4 to R6 a pen. Over what price range
from R40 to R60 a box, and the quantity demanded is the demand for pens elastic?
decreases from 1 000 to 600 boxes a week. 5. In 2003, when music downloading first took off,
a. Calculate the price elasticity of demand over Universal Music slashed the average price of a CD
this price range. from $21 to $15 in the US. The company expected
b. Describe the demand for strawberries. the price cut to boost the quantity of CDs sold by
2. If the quantity of dental services demanded 30 per cent, other things remaining the same.
increases by 10 per cent when the price of dental a. What was Universal Music’s estimate of the
services falls by 10 per cent, is the demand for price elasticity of demand for CDs in the US?
dental services inelastic, elastic or unit elastic? b. If you were making the pricing decision at
3. The demand schedule for hotel rooms is Universal Music, what would be your pricing
decision? Explain your decision.
Price Quantity demanded 6. The demand for illegal drugs is inelastic. Much
of the expenditure on illegal drugs comes from
(rand per night) (millions of rooms per night)
crime. Assuming these statements to be correct,
200 100
a. How will a successful campaign that decreases
250 80 the supply of drugs influence the price of
400 50 illegal drugs and the amount spent on them?
500 40 b. What will happen to the amount of crime?
800 25 c. What is the most effective way of decreasing
the quantity of illegal drugs bought and
a. What happens to total revenue when the decreasing the amount of drug-related crime?
price falls from R400 to R250 a night and 7. In countries with few alternative transport options,
from R250 to R200 a night? drivers are least sensitive to changes in the price of
b. Is the demand for hotel rooms elastic, petrol. For example, if the price of petrol rose from
inelastic or unit elastic? R10 to R12 per litre and stayed there for a year,
4. The figure shows the demand for pens. petrol consumption would fall only about 5 per cent.
a. Calculate the price elasticity of demand for
petrol. Is the demand for petrol elastic, unit
Price (rand per pen)
12 elastic, or inelastic?
10
b. Explain how the price rise from R10 to
R12 per litre changes the total revenue from
8 petrol sales.
6 8. During the recent recession, sales of government
loaves of bread rose as consumers realised that
4
government loaves and other lower-cost foods can
2 be substituted for costlier cuts of meat as a way of
D controlling their already stretched food budgets.
0 20 40 60 80 100 120 a. Is a government loaf a normal good or
Pens per day
inferior good? Explain.
5
very time you decide to buy something, whether it is an everyday
biscuit or a Valentine’s Day rose, you express your view about how scarce
resources should be used and you make choices in your self-interest. A
baker one block away and a rose grower 1 000 kilometres away make
their self-interested choices about what to produce. Markets coordinate these
self-interested choices. But do markets do a good job? Do they allocate
resources between biscuits and roses, and everything else, efficiently?
The market economy generates huge
Highway space is allocated in this way too: The first to Theft, the taking of the property of others
arrive at the on-ramp gets the road space. If too many without their consent, also plays a large role. Both
vehicles enter the highway, the speed slows and people large-scale organised crime and small-scale petty crime
wait in line for some space to become available. collectively allocate billions of rand worth of resources
First-come, first-served works best when, as in the annually.
above examples, a scarce resource can serve just one But force can play a crucial positive role in
user at a time in a sequence. By serving the user who allocating resources. It provides the state (or govern-
arrives first, this method minimises the time spent ment) with an effective method of transferring wealth
waiting for the resource to become free. from the rich to the poor, and it provides the legal
framework in which voluntary exchange in markets
takes place.
Lottery A legal system is the foundation on which our
Lotteries allocate resources to those who pick the market economy functions. Without courts to enforce
winning number, draw the lucky cards, or come up contracts, it would not be possible to do business.
lucky on some other gaming system. State lotteries But the courts could not enforce contracts without
and casinos reallocate millions of rand worth of goods the ability to apply force if necessary. The state
and services every year. provides the ultimate force that enables the courts to
But lotteries are more widespread than jack- do their work.
pots and roulette wheels in casinos. They are used More broadly, the force of the state is essential to
to allocate landing slots to airlines at some airports, uphold the principle of the rule of law. This principle
seats at events like World Cup soccer matches and is the bedrock of civilised economic (and social and
the Olympics, and have been used to allocate fishing political) life. With the rule of law upheld, people can
rights and the electro-magnetic spectrum used by go about their daily economic lives with the assurance
cellphones. that their property will be protected – that they can
Lotteries work best when there is no effective sue for violations against their property (and be sued
way to distinguish among potential users of a scarce if they violate the property of others).
resource. Free from the burden of protecting their property
and confident in the knowledge that those with whom
they trade will honour their agreements, people can get
Personal Characteristics on with focusing on the activity in which they have a
When resources are allocated on the basis of personal comparative advantage and trading for mutual gain.
characteristics, people with the ‘right’ characteristics
get the resources. Some of the resources that matter
REVIEW QUIZ
most to you are allocated in this way. For example,
you will choose a marriage partner on the basis of 1 Why do we need methods of allocating scarce
personal characteristics. But this method can also be resources?
used in unacceptable ways. Allocating the best jobs 2 Describe the alternative methods of allocating
to certain males and discriminating against visible scarce resources.
minorities and women is an example. 3 Provide an example of each allocation method
that illustrates when it works well.
4 Provide an example of each allocation method
Force that illustrates when it works badly.
Force plays a crucial role, for both good and ill, in
allocating scarce resources. Let us start with the ill. In the next sections, we are going to see how
War, the use of military force by one nation a market can achieve an efficient use of resources,
against another, has played an enormous role histori- examine the obstacles to efficiency and see how some-
cally in allocating resources. The economic supremacy times an alternative method might improve on the
of European settlers in the Americas and Australia market. After looking at efficiency, we will turn our
owes much to the use of this method. attention to the more difficult issue of fairness.
Benefit, Cost and Surplus biscuit. In Fig. 5.1(b), Nick is willing to pay R1 for
the 10th biscuit and R1 is his marginal benefit from
Resources are allocated efficiently and in the social that biscuit. But at what quantity is the market willing
interest when they are used in the ways that people to pay R1 for the marginal biscuit? The answer is
value most highly. You saw in Chapter 2 that this provided by the market demand curve.
outcome occurs when the quantities produced are
at the point on the PPF at which marginal benefit
equals marginal cost (see pp. 31–34). We are now
Individual Demand and Market Demand
going to see whether competitive markets produce The relationship between the price of a good and the
the efficient quantities. quantity demanded by one person is called individual
We begin on the demand side of a market. demand. And the relationship between the price of
a good and the quantity demanded by all buyers is
called market demand.
Demand, Willingness to Pay and Value
In everyday life, we talk about ‘getting value for money’. The market demand curve is the horizontal sum
When we use this expression, we are distinguishing
of the individual demand curves and is formed
between value and price. Value is what we get and the
by adding the quantities demanded by all the
price is what we pay.
The value of one more unit of a good or service is individuals at each price.
its marginal benefit. We measure marginal benefit by
the maximum price that is willingly paid for another unit Figure 5.1(c) illustrates the market demand for
of the good or service. But willingness to pay determines biscuits if Busi and Nick are the only people in the
demand. A demand curve is a marginal benefit curve. market. Busi’s demand curve in part (a) and Nick’s
In Figure 5.1(a), Busi is willing to pay R1 for the demand curve in part (b) sum horizontally to the
30th biscuit and R1 is her marginal benefit from that market demand curve in part (c).
FIGURE 5.1 Individual Demand Market Demand and Marginal Social Benefit
Price (rand per biscuit)
30 biscuits 30 + 10 = 40 biscuits
0.50 0.50 10 biscuits 0.50
Busi's D = MB Nick's D = MB Market D = MSB
0 10 20 30 40 50 0 10 20 30 40 50 0 10 20 30 40 50 60 70
Quantity (biscuits per month) Quantity (biscuits per month) Quantity (biscuits per month)
At a price of R1 a biscuit, the quantity demanded by Busi is demand curve in part (a) and Nick’s demand curve in part (b)
30 biscuits and the quantity demanded by Nick is 10 biscuits, sum horizontally to the market demand curve in part (c). The
so the quantity demanded by the market is 40 biscuits. Busi’s market demand curve is the marginal social benefit (MSB) curve.
At a price of R1 a biscuit, Busi demands Busi’s consumer surplus is the sum of the
30 biscuits and Nick demands 10 biscuits, so surpluses on all of the biscuits she buys. This sum
the market quantity demanded at R1 a biscuit is is the area of the green triangle – the area below
40 biscuits. the demand curve and above the market price
For Busi and Nick, their demand curves are line. The area of this triangle is equal to its base
their marginal benefit curves. For society, the market (30 biscuits) multiplied by its height (R1.50)
demand curve is the marginal benefit curve. We call divided by 2, which is R22.50. The area of the
the marginal benefit to the entire society marginal blue rectangle in Fig. 5.2(a) shows what Busi pays
social benefit. So the market demand curve is also the for 30 biscuits.
marginal social benefit (MSB) curve. Figure 5.2(b) shows Nick’s consumer surplus,
and part (c) shows the consumer surplus for the
market. The consumer surplus for the market
Consumer Surplus is the sum of the consumer surpluses of Busi
We do not always have to pay as much as we are and Nick.
willing to pay. We get a bargain. When people buy All goods and services have decreasing marginal
something for less than it is worth to them, they benefit. People receive more benefit from their
receive a consumer surplus. Consumer surplus is consumption than the amount they pay.
the excess of the benefit received from a good over
the amount paid for it. We can calculate consumer
surplus as the marginal benefit (or value) of a good
Supply and Marginal Cost
minus its price, summed over the quantity bought. We are now going to see how market supply reflects
Figure 5.2(a) shows Busi’s consumer surplus marginal cost. The connection between supply and
from biscuits when the price is R1 a biscuit. At this cost closely parallels the related ideas about demand
price, she buys 30 biscuits a month because the 30th and benefit that you have just studied. Firms are
biscuit is worth exactly R1 to her. But Busi is willing in business to make a profit. To do so, they must
to pay R2 for the 10th biscuit, so her marginal benefit sell their output for a price that exceeds the cost
from this biscuit is R1 more than she pays for it – she of production. Let us investigate the relationship
receives a surplus of R1 on the 10th biscuit. between cost and price.
0 10 20 30 40 50 0 10 20 30 40 50 0 10 20 30 40 50 60 70
Quantity (biscuits per month) Quantity (biscuits per month) Quantity (biscuits per month)
(a) Busi's consumer surplus (b) Nick's consumer surplus (c) Market consumer surplus
Busi is willing to pay R2 for her 10th biscuit in part (a). The green triangle in part (b) shows Nick’s consumer surplus
At a market price of R1 a biscuit, Busi receives a surplus of on the 10 biscuits that he buys at R1 a biscuit. The green
R1 on the 10th biscuit. The green triangle shows her area in part (c) shows the consumer surplus for the market.
consumer surplus on the 30 biscuits she buys at R1 a biscuit. The blue rectangles show the amounts spent on biscuits.
Supply, Cost and Minimum Supply Price good and the quantity supplied by all producers is
Firms make a profit when they receive more from the called market supply.
sale of a good or service than the cost of producing it.
Just as consumers distinguish between value and price, The market supply curve is the horizontal sum of the
so producers distinguish between cost and price. Cost individual supply curves and is formed by adding the
is what a firm gives up when it produces a good or
quantities supplied by all the producers at each price.
service and price is what a firm receives when it sells
the good or service.
The cost of producing one more unit of a good Figure 5.3(c) illustrates the market supply
or service is its marginal cost. Marginal cost is the of biscuits if Matthew and Sabrina are the only
minimum price that producers must receive to induce producers. Matthew’s supply curve in part (a) and
them to offer one more unit of a good or service Sabrina’s supply curve in part (b) sum horizontally
for sale. But the minimum supply-price determines to the market supply curve in part (c).
supply. A supply curve is a marginal cost curve. At a price of R15 a packet of biscuits, Matthew
In Figure 5.3(a), Matthew is willing to produce supplies 100 packets of biscuits and Sabrina supplies
the 100th packet of biscuits for R15, his marginal cost 50 packets of biscuits, so the quantity supplied by
of that packet of biscuits. In Fig. 5.3(b), Sabrina is the market at R15 a packet of biscuits is 150 packets
willing to produce the 50th packet of biscuits for R15, of biscuits.
her marginal cost of that packet of biscuits. For Matthew and Sabrina, their supply curves are
What quantity is this market willing to produce their marginal cost curves. For society, the market supply
for R15 a packet of biscuits? The answer is provided curve is the marginal cost curve. We call the society’s
by the market supply curve. marginal cost marginal social cost. So the market supply
curve is also the marginal social cost (MSC) curve.
Individual Supply and Market Supply
The relationship between the price of a good and the
Producer Surplus
quantity supplied by one producer is called individual When price exceeds marginal cost, the firm receives
supply. And the relationship between the price of a a producer surplus. Producer surplus is the excess of
FIGURE 5.3 Individual Supply Market Supply and Marginal Social Cost
Price (rand per packet of biscuits)
0 50 100 150 200 250 0 50 100 150 200 250 0 50 150 250 350
Quantity (packets of biscuits per month) Quantity (packets of biscuits per month) Quantity (packets of biscuits per month)
At a price of R15 a packet of biscuits, the quantity supplied supply curve in part (a) and Sabrina’s supply curve in part (b)
by Matthew is 100 packets of biscuits and the quantity sum horizontally to the market supply curve in part (c). The
supplied by Sabrina is 50 packets of biscuits, so the quantity market supply curve is the marginal social cost (MSC ) curve.
supplied by the market is 150 packets of biscuits. Matthew’s
the amount received from the sale of a good or service The area of the blue triangle in Fig. 5.4(b)
over the cost of producing it. It is calculated as the shows Sabrina’s producer surplus and the blue area
price received minus the marginal cost (or minimum in Fig. 5.4(c) shows the producer surplus for the
supply-price), summed over the quantity sold. market.
Figure 5.4(a) shows Matthew’s producer The producer surplus for the market is the sum of
surplus from biscuits when the price is R15 a packet the producer surpluses of Matthew and Sabrina.
of biscuits. At this price, he sells 100 packets of biscuits Consumer surplus and producer surplus can be
a month because the 100th packet of biscuits costs him used to measure the efficiency of a market. Let us see
R15 to produce. But Matthew is willing to produce the how we can use these concepts to study the efficiency
50th packet of biscuits for his marginal cost, which is of a competitive market.
R10, so he receives a surplus of R5 on this packet
of biscuits.
Matthew’s producer surplus REVIEW QUIZ
Producer Surplus is the sum of the surpluses on the
1 What is the relationship between the marginal
packets of biscuits he sells. This
benefit, value and demand?
sum is the area of the blue triangle –
2 What is the relationship between individual
the area below the market price
demand and market demand?
and above the supply curve.
3 What is consumer surplus? How is it
The area of this triangle is equal
measured?
to its base (100) multiplied by its
4 What is the relationship between the
height (R10) divided by 2, which
marginal cost, minimum supply-price
www.quickto.mobi/
is R500.
and supply?
PEA-SURPLUS
The red area below the supply
5 What is the relationship between individual
curve in Fig. 5.4(a) shows what
supply and market supply?
it costs Matthew to produce
6 What is producer surplus? How is it measured?
100 packets of biscuits.
Matthew's surplus
10.00 from the 50th 10.00 10.00
packet of biscuits
5.00 5.00 5.00
0 50 100 150 200 250 0 50 100 150 200 250 0 50 150 250 350
Quantity (packets of biscuits per month) Quantity (packets of biscuits per month) Quantity (packets of biscuits per month)
(a) Matthews's producer surplus (b) Sabrina's producer surplus (c) Market producer surplus
Matthew is willing to produce the 50th packet of biscuits for triangle in part (b) shows Sabrina’s producer surplus on the
R10 in part (a). At a market price of R15 a packet of biscuits, 50 packets of biscuits that she sells at R15 each. The blue
Matthew gets a surplus of R5 on the 50th packet of biscuits. area in part (c) shows producer surplus for the market. The red
The blue triangle shows his producer surplus on the areas show the cost of producing the packets of biscuits sold.
100 packets of biscuits he sells at R15 each. The blue
Is the Competitive Market Efficient? is maximised. Buyers and sellers acting in their self-
interest end up promoting the social interest.
Figure 5.5(a) shows the market for biscuits. The market
forces that you studied in Chapter 3 (pp. 60–61) pull
FIGURE 5.5 An Efficient Market for Biscuits
the biscuit market to its equilibrium price of R15 a
packet of biscuits and equilibrium quantity of 10 000 S
You have seen that the market demand curve for a good
or service tells us the marginal social benefit from it. You 10
S = MSC
Marginal social benefit and marginal social cost
25
Figure 5.5 illustrates the efficiency of competitive
MSC
equilibrium. The demand curve and the supply curve equals
intersect in part (a) and marginal social benefit equals 20 MSB
(underproduction) or too much is produced (overpro- Overproduction In Fig. 5.6(b), the quantity of
duction). We will describe these two market failure biscuits15produced is 15 000 a day. At this quantity,
outcomes and then see why they arise. consumers are willing to pay only R10 for a packet
of biscuits that costs R20 to produce. By producing
10
Underproduction In Figure 5.6(a), the quantity of the 15 000th packet of biscuits, R10 of resources
biscuits produced is 5 000 packets a day. At this quan- are wasted. Again, the grey triangle shows the dead-
tity, consumers are willing to pay R20 for a packet of weight loss,
5 which reduces the total surplus to less
biscuits that costs only R10 to produce. By producing than its maximum. D
only 5 000 packets of biscuits a day, total surplus is Inefficient production creates a deadweight loss
0 5 10 15 20 25
smaller than its maximum possible level. The quantity that is borne byQuantity
the entire society:
(thousands It isofabiscuits
of packets socialperloss.
day)
(a) Underproduction
S
Price (rand per packet of biscuits)
25 25
Deadweight
loss
20 20
Deadweight
15 15
loss
10 10
5 5
D D
0 5 10 15 20 25 0 5 10 15 20 25
Quantity (thousands of packets of biscuits per day) Quantity (thousands of packets of biscuits per day)
If 5 000 packets of biscuits a day are produced, in part (a), total If 15 000 packets of biscuits a day are produced, in part (b),
surplus (the sum of the green and blue areas) is smaller than its total surplus is also smaller than its maximum by the amount
S triangle).
Price (rand per packet of biscuits)
maximum by the amount of the deadweight loss (the grey of the deadweight loss. At all quantities in excess of 10 000
25
At all quantities below 10 000 packets of biscuits a day, the packets of biscuits a day, the cost of one more packet of
benefit from one more packet of biscuits exceeds its cost. biscuits exceeds its benefit.
20
Deadweight
15
loss
Sources of Market Failure ◆ Externalities
Obstacles
10 to efficiency that bring market failure and ◆ Public goods and common resources
create deadweight losses are: ◆ Monopoly
◆ Price 5
and quantity regulations ◆ High transactions costs
◆ Taxes and subsidies
D
0 5 10 15 20 25
Quantity (thousands of packets of biscuits per day)
Price and Quantity Regulations Price regulations self-interested goal. To achieve its goal, a monopoly
that put a cap on the rent a landlord is permitted produces too little and charges too high a price. This
to charge and laws that require employers to pay a leads to underproduction.
minimum wage sometimes block the price adjust-
ments that balance the quantity demanded and the High Transactions Costs When you go to a coffee
quantity supplied and lead to underproduction. shop, you pay for more than the coffee. You pay your
Quantity regulations that limit the amount that a farm share of the cost of the time taken to make the various
is permitted to produce also lead to underproduction. coffees, the espresso maker, and the decor. When you
buy your first home, you will pay for more than the
Taxes and Subsidies Taxes increase the prices paid by flat or house. You will buy the services of a real estate
buyers and lower the prices received by sellers. So taxes agent and a lawyer. Economists call the costs of the
decrease the quantity produced and lead to underpro- services that enable a market to bring buyers and
duction. Subsidies, which are payments by the govern- sellers together transactions costs.
ment to producers, decrease the prices paid by buyers and It is costly to operate any market so to use market
increase the prices received by sellers. So subsidies increase price to allocate resources, it must be worth bearing
the quantity produced and lead to overproduction. the transactions costs. Some markets are too costly
to operate. For example, it is too costly to operate a
Externalities An externality is a cost or a benefit that market in time slots on a local tennis court. Instead of
affects someone other than the seller or the buyer. a market, the court uses first-come, first-served: You
An external cost arises when an electric utility burns hang around until the court becomes vacant and ‘pay’
coal and emits carbon dioxide. The utility does not with your waiting time. When transactions costs are
consider the cost of climate change when it decides high, the market might underproduce.
how much power to produce. The result is overpro- You now know the conditions under which
duction. An external benefit arises when a home-owner resource allocation is efficient. You have seen how a
installs a smoke detector and decreases her neighbour’s competitive market can be efficient, and you have seen
fire risk. She does not consider the benefit to her some obstacles to efficiency. Can alternative allocation
neighbour when she decides how many detectors to methods improve on the market?
install. The result is underproduction.
a ‘market’ price. But someone would need to ensure Philosophers have tried for centuries to answer this
that trades were honoured. At a busy ATM, first- question. Economists have offered their answers too.
come, first-served is the most efficient arrangement. But before we look at the proposed answers, you should
There is no one efficient mechanism that allocates know that there is no universally agreed upon answer.
all resources efficiently. But markets, when supple- Economists agree about efficiency. That is, they
mented by other mechanisms such as majority rule, agree that it makes sense to make the economic pie
command systems, and first-come, first-served, do an as large as possible and to produce it at the lowest
amazingly good job. possible cost. But they do not agree about equity.
That is, they do not agree about what are fair shares of
the economic pie for all the people who make it. The
REVIEW QUIZ reason is that ideas about fairness are not exclusively
1 Do competitive markets use resources efficiently? economic ideas. They touch on politics, ethics and
Explain why or why not. religion. Nevertheless, economists have thought about
2 What is deadweight loss and under what these issues and have a contribution to make. Let us
conditions does it occur? examine the views of economists on this topic.
3 What are the obstacles to achieving an efficient To think about fairness, think of economic life as
allocation of resources in the market economy? a game – a serious game. All ideas about fairness can
be divided into two broad groups. They are:
◆ It is not fair if the result is not fair.
Is an efficient allocation of resources also a fair ◆ It is not fair if the rules are not fair.
allocation? Does the competitive market provide
people with fair incomes for their work? Do people
always pay a fair price for the things they buy? Might It is Not Fair If the Result Is Not Fair
we need the government to step into some competi-
The earliest efforts to establish a principle of fairness
tive markets to prevent the price from rising too high
were based on the view that the result is what matters.
or falling too low? Let us now study these questions.
The general idea was that it is unfair if people’s incomes
are too unequal. For example, it is unfair that a bank
president earns millions of rand a year while a bank
Is the Competitive Market Fair? teller earns only thousands of rand. It is unfair that a
store owner makes a larger profit and her customers pay
When a natural disaster strikes, such as a severe winter
higher prices in the aftermath of a winter storm.
storm or a cyclone, the prices of many essential items
During the nineteenth century, economists
go up. The reason prices rise is that the demand and
thought they had made the incredible discovery:
willingness to pay for these items has increased, but
Efficiency requires equality of incomes. To make the
the supply has not changed. So the higher prices
economic pie as large as possible, it must be cut into
achieve an efficient allocation of scarce resources.
equal pieces, one for each person. This idea turns out
News reports of these price hikes almost never talk
to be wrong. But there is a lesson in the reason that it
about efficiency. Instead, they talk about equity or
is wrong, so this idea is worth a closer look.
fairness. The claim that is often made is that it is
unfair for profit-seeking dealers to cheat the victims of
Utilitarianism The nineteenth-century idea that
natural disaster.
only equality brings efficiency is called utilitarianism.
Similarly, when low-skilled people work for a
Utilitarianism is a principle that states that we should
wage that is below what most would regard as a ‘living
strive to achieve ‘the greatest happiness for the greatest
wage’, the media and politicians talk of employers
number’. The people who developed this idea were
taking unfair advantage of their workers.
known as utilitarians. They included the most eminent
How do we decide whether something is fair
thinkers, such as Jeremy Bentham and John Stuart Mill.
or unfair? You know when you think something is
Utilitarians argued that to achieve ‘the greatest
unfair, but how do you know? What are the principles
happiness for the greatest number’, income must be
of fairness?
transferred from the rich to the poor up to the point
of complete equality – to the point at which there are If a second rand is transferred, the same thing
no rich and no poor. happens: Tom gains more than Jerry loses. And
They reasoned in the following way: First, the same is true for every rand transferred until they
everyone has the same basic wants and a similar both reach point C. At point C, Tom and Jerry have
capacity to enjoy life. Second, the greater a person’s R25 000 each and a marginal benefit of 2 units. Now
income, the smaller is the marginal benefit of a dollar. they are sharing the economic pie in the most efficient
The millionth dollar spent by a rich person brings way. It brings the greatest happiness to Tom and Jerry.
a smaller marginal benefit to that person than the
marginal benefit that the thousandth dollar spent The Big Trade-Off One big problem with the
brings to a poorer person. So by transferring a dollar utilitarian ideal of complete equality is that it ignores
from the millionaire to the poorer person, more is the costs of making income transfers. Recognising
gained than is lost. The two people added together are the costs of making income transfers leads to what is
better off. called the big trade-off, which is a trade-off between
Figure 5.7 illustrates this utilitarian idea. Tom efficiency and fairness.
and Jerry have the same marginal benefit curve, MB. The big trade-off is based on the following facts.
(Marginal benefit is measured on the same scale Income can be transferred from people with high
of 1 to 3 for both Tom and Jerry.) Tom is at point A. incomes to people with low incomes only by taxing
He earns R5 000 a year, and his marginal benefit the high incomes.
from a rand is 3 units. Jerry is at point B. He earns Taxing people’s income from employment makes
R45 000 a year, and his marginal benefit from a rand them work less. It results in the quantity of labour being
is 1 unit. If a rand is transferred from Jerry to Tom, less than the efficient quantity. Taxing people’s income
Jerry loses 1 unit of marginal benefit and Tom gains from capital makes them save less. It results in the
3 units. So together, Tom and Jerry are better off – quantity of capital being less than the efficient quantity.
they are sharing the economic pie more efficiently. With smaller quantities of both labour and capital,
the quantity of goods and services produced is less
FIGURE 5.7 Utilitarian Fairness than the efficient quantity. The economic pie shrinks.
The trade-off is between the size of the economic
pie and the degree of equality with which it is shared.
Marginal benefit (units)
Low-income workers get fired and must seek other, The first rule says that everything that is valuable
perhaps even lower-paid, work. must be owned by individuals and that the state must
Today, because of the big trade-off, no one says ensure that theft is prevented. The second rule says that the
that fairness requires equality of incomes. only legitimate way a person can acquire property is to buy
it in exchange for something else that the person owns.
Make the Poorest as Well Off as Possible A new If these rules, which are the only fair rules, are followed,
solution to the big trade-off problem was proposed by then the result is fair. It does not matter how unequally the
philosopher John Rawls in a classic book entitled A economic pie is shared, provided that the pie is made by
Theory of Justice, published in 1971. Rawls says that, people, each one of whom voluntarily provides services in
taking all the costs of income transfers into account, exchange for the share of the pie offered in compensation.
the fair distribution of the economic pie is the one These rules satisfy the symmetry principle. If
that makes the poorest person as well off as possible. these rules are not followed, the symmetry principle is
The incomes of rich people should be taxed and broken. You can see these facts by imagining a world
after paying the costs of administering the tax and transfer in which the laws are not followed.
system, what is left should be transferred to the poor. But First, suppose that some resources or goods are not
the taxes must not be so high that they make the economic owned. They are common property. Then everyone is
pie shrink to the point at which the poorest person ends free to participate in a grab to use them. The strongest
up with a smaller piece. A bigger share of a smaller pie will prevail. But when the strongest prevails, the
can be less than a smaller share of a bigger pie. The goal is strongest effectively owns the resources or goods in
to make the piece enjoyed by the poorest person as big as question and prevents others from enjoying them.
possible. Most likely, this piece will not be an equal share. Second, suppose that we do not insist on voluntary
The ‘fair results’ idea requires a change in the exchange for transferring ownership of resources from
results after the game is over. Some economists say one person to another. The alternative is involuntary
that these changes are themselves unfair and propose a transfer. In simple language, the alternative is theft.
different way of thinking about fairness. Both of these situations violate the symmetry
principle. Only the strong acquire what they want.
The weak end up with only the resources and goods
It is Not Fair If the Rules Are Not Fair that the strong do not want.
The idea that it is not fair if the rules are not fair is based In a majority-rule political system, the strong are
on a fundamental principle that seems to be hardwired those in the majority or those with enough resources
into the human brain: the symmetry principle. The to influence opinion and achieve a majority.
symmetry principle is the requirement that people in In contrast, if the two rules of fairness are followed,
similar situations be treated similarly. It is the moral prin- everyone, strong and weak, is treated in a similar
ciple that lies at the centre of all the major religions and way. All individuals are free to use their resources and
that says, in some form or other, ‘Behave toward other human skills to create things that are valued by them-
people in the way you expect them to behave toward you.’ selves and others and to exchange the fruits of their
In economic life, this principle translates into efforts with all others. This set of arrangements is the
equality of opportunity. But equality of opportunity to only one that obeys the symmetry principle.
do what? This question is answered by the philosopher
Robert Nozick in a book entitled Anarchy, State, and Fairness and Efficiency If private property rights
Utopia, published in 1974. are enforced and if voluntary exchange takes place
Nozick argues that the idea of fairness as an in a competitive market, resources will be allocated
outcome or result cannot work and that fairness must efficiently if there are no:
be based on the fairness of the rules. He suggests that 1. Price and quantity regulations
fairness obeys two rules: 2. Taxes and subsidies
1. The state must enforce laws that establish and 3. Externalities
protect private property. 4. Public goods and common resources
2. Private property may be transferred from one 5. Monopolies
person to another only by voluntary exchange. 6. High transactions costs
And according to the Nozick rules, the resulting Lottery Water goes to those in luck.
distribution of income and wealth will be fair. Let us
study an example to check the claim that if resources Personal characteristics Water goes to those with the
are allocated efficiently, they are also allocated fairly. ‘right’ characteristics. Perhaps the old, the young or
pregnant women get the water.
Case Study: A Water Shortage in a Except by chance, none of these methods delivers
Natural Disaster an allocation of water that is either fair or efficient. It
An earthquake has broken the pipes that deliver is unfair in the rules view because the distribution
drinking water to a city. Bottled water is available, but involves involuntary transfers of resources among citi-
there is no tap water. What is the fair way to allocate zens. It is unfair in the results view because the poorest
the bottled water? do not end up being made as well off as possible.
The allocation is inefficient for two reasons. First,
Market Price Suppose that if the water is allocated resources have been used to operate the allocation scheme.
by market price, the price jumps to R80 a bottle – Second, some people are willing to pay for more water
five times its normal price. At this price, the people than the quantity they have been allocated and others have
who own water can make a large profit by selling it. been allocated more water than they are willing to pay for.
People who are willing and able to pay R80 a bottle The second source of inefficiency can be overcome
get the water. And because most people cannot afford if, after the non-market allocation, people are permitted
the R80 price, they end up either without water or to trade water at its market price. Those who value
consuming just a few drops a day. the water they have at less than the market price sell,
You can see that the water is being used efficiently. and people who are willing to pay the market price
There is a fixed amount available, some people are willing to obtain more water buy. Those who value the water
to pay R80 to get a bottle, and the water goes to those most highly are the ones who consume it.
people. The people who own and sell water receive a
large producer surplus and total surplus is maximised. Market Price with Taxes Another approach is to
In the rules view, the outcome is fair. No one allocate the scarce water using the market price but
is denied the water they are willing to pay for. In then to alter the redistribution of buying power by
the results view, the outcome would most likely be taxing the sellers and providing benefits to the poor.
regarded as unfair. The lucky owners of water make a Suppose water owners are taxed on each bottle sold
lot of money, and the poorest end up the thirstiest. and the revenue from these taxes is given to the poorest
people. People are then free, starting from this new distri-
Non-Market Methods Suppose that by a majority bution of buying power, to trade water at the market price.
vote, the citizens decide that the government will Because the owners of water are taxed on what
buy all the water, pay for it with a tax, and use one of they sell, they have a weaker incentive to offer water
the non-market methods to allocate the water to the for sale and the supply decreases. The equilibrium
citizens. The possibilities now are: price rises to more than R80 a bottle. There is now
a deadweight loss in the market for water – similar
Command Someone decides who is the most to the loss that arises from underproduction on
deserving and needy. Perhaps everyone is given an p. 108. (We study the effects of a tax and show its
equal share. Or perhaps government officials and their inefficiency in Chapter 6 on pp. 127–132.)
families end up with most of the water. So the tax is inefficient. In the rules view, the tax
is also unfair because it forces the owners of water
Contest Bottles of water are prizes that go to those to make a transfer to others. In the results view, the
who are best at a particular contest. outcome might be regarded as being fair.
This brief case study illustrates the complexity of
First-come, first-served Water goes to the first off the ideas about fairness. Economists have a clear criterion
mark or to those who place the lowest value on their of efficiency but no comparably clear criterion of
time and can afford to wait in line. fairness. Most economists regard Nozick as being too
extreme and want a fair tax system, but there is no You have now studied efficiency and equity
consensus about what a fair tax system looks like. (fairness), the two biggest issues that run through the
whole of economics. Reading Between the Lines on
pp. 114–115 looks at an example of an efficient
REVIEW QUIZ
market in an economy today. At many points
1 What are the two big approaches to thinking throughout this book – and in your life – you will
about fairness? return to and use the ideas you have learned in this
2 What is the utilitarian idea of fairness and what chapter. In the next chapter we study some sources of
is wrong with it? inefficiency and unfairness.
3 Explain the big trade-off. What idea of fairness
has been developed to deal with it?
4 What is the idea of fairness based on fair rules?
programmes on farms and put day labourers on temporary leave. ‘Small-scale farmers who fund their
operations through bank loans will begin defaulting on payments and that will impact their ability to get
funding for next season’, said Philip Mbithi, Chief Executive of the Fresh Produce Exporters Association
of Kenya. On 21 April, 1 000 tonnes of flowers were flown to Spain and transported by road to Paris
and Amsterdam. ‘This cuts 60% off our profit margin, but it is better than nothing’, said Mr Mbithi.
Source: International Trade Centre Information Note 14.05.10 ‘The Impact of European Airspace Closures on African Horticultural Exports’
Prepared by the ITC’s Market News Service in consultation with horticultural experts.
5.00 5.00
Volcano eruption decreases
both supply and demand but
Auction finds
auction finds new equilibrium
equilibrium and
4.00 4.00 and efficient quantity and price
efficient quantity
and price S0 = MSC0 S1 = MSC1
S0
3.00 3.00
2.00 2.00
1.00 1.00
D0 = MSB0 D0
D1 = MSB 1
0 10 20 30 40 0 10 16 20 30 40
Quantity (millions of flowers per day) Quantity (millions of flowers per day)
Figure 1 Aalsmeer flower market: Normal day Figure 2 Aalsmeer flower market: 19 April 2010
Key Terms
Big trade-off, 111 Deadweight loss, 108 Symmetry principle, 112 Utilitarianism, 110
Command system, 101 Market failure, 108 Total surplus, 107
Consumer surplus, 104 Producer surplus, 105 Transactions costs, 109
9. What method is used to allocate goods on eBay? e. Is the competitive market for cellphones
How does the allocation method used by eBay efficient?
auctions influence consumer surplus? 12. The table gives the demand and supply schedules
10. a. Can an eBay auction give the seller for sunscreen.
a surplus? Sunscreen factories are required to limit produc-
b. On a graph show the consumer surplus and tion to 100 bottles a day.
producer surplus from an eBay auction.
Price Quantity Quantity
Is the Competitive Market Efficient? (rand per demanded supplied
11. The figure illustrates the competitive market bottle)
(bottles per day)
for cellphones.
0 400 0
5 300 100
Price (rand per cellphone)
18. Which owner has the largest producer surplus Economics in the News
when the price of a ride is R17.50? Explain. 24. After you have studied Reading Between the Lines
19. What is the marginal social cost of 45 rides a day? on pp. 114–115 answer the following questions.
20. Construct the market supply schedule of jet- a. What is the method used to allocate the
ski rides. world’s cut flowers?
b. Who benefits from this method of resource
Use the following table to work out Problems 21 and 22. allocation: buyers, sellers or both? Explain
The table gives the demand and supply schedules for your answer using the ideas of marginal
sandwiches. social benefit, marginal social cost, consumer
surplus and producer surplus.
Price Quantity demanded Quantity supplied c. On 19 April 2010, when the equilibrium
(rand per quantity of cut flowers decreased by 20 per
(sandwiches per hour)
sandwich) cent, why was the outcome still efficient?
0 300 0 Why was there not underproduction and a
1 250 50 deadweight loss?
2 200 100 d. If the government of Holland placed a
3 150 150 limit of 15 million a day on the quantity
4 100 200
of flowers traded at Aalsmeer, would there
5 50 250
6 0 300 be underproduction and a deadweight loss
created? Explain your answer.
21. a. What is the maximum price that consumers Use the following information to work out Problems
are willing to pay for the 200th sandwich? 25 and 26.
b. What is the minimum price that producers
are willing to accept for the 200th sandwich? Only 1 per cent of the world supply of water is fit for
c. If 200 sandwiches a day are available, what is human consumption. Some places have more water
the total surplus? than they can use; some could use much more than
they have. The 1 per cent available would be sufficient
Is the Competitive Market Efficient? if only it were in the right place.
22. a. If the sandwich market is efficient, what is
the consumer surplus, what is the producer 25. a. What is the major problem in achieving an
surplus and what is the total surplus? efficient use of the world’s water?
b. If the demand for sandwiches increases and b. If there were a global market in water, like
sandwich makers produce the efficient quan- there is in oil, how do you think the market
tity, what happens to producer surplus and would be organised?
deadweight loss? c. Would a free world market in water
achieve an efficient use of the world’s water
Is the Competitive Market Fair? resources? Explain why or why not.
23. The winner of the men’s and women’s tennis 26. Would a free world market in water achieve a fair
singles at the South African Open is paid twice as use of the world’s water resources? Explain why
much as the runner-up, but it takes two players or why not and be clear about the concept of fair-
to have a singles final. Is the compensation ness that you are using.
arrangement fair?
R
6
ampant hyperinflation has brought on a crisis of unparalleled
proportions in Zimbabwe. Zimbabweans are suffering and poverty levels
have reached epidemic proportions as consumers simply cannot afford the
cost of essential food items and services such as health, water and electricity.
Almost every day a new machine is invented that replaces some
workers and increases productivity. Take a look at all the appliances
available for use in the modern-day household. To what extent have
MARKETS these replaced the need to employ domestic workers? Similarly, modern
machinery has to a large extent replaced low-skilled workers on many
commercial farms. Can we protect low-skilled workers with minimum
wage laws that enable people to earn a living wage?
Almost everything we buy is taxed. Alcoholic beverages are one of
the most heavily taxed items. How much of the tax on alcohol products is
paid by the buyer and how much by the seller? Do taxes help or hinder
the market in its attempt to move resources to where they are valued most
highly? Taxes put the hand of government in almost every pocket and
market. You probably think that you pay more than your fair share of taxes.
But who actually pays and who benefits when a tax is cut: buyers or sellers?
In the 2007/2008 growing season, ideal conditions brought
record yields and South African maize production soared almost 80 per
cent to 12.70 million, its biggest crop in 13 years. But in the previous
two growing seasons an extended drought slashed maize production
raising doubts over the country’s ability to convert excess maize
into biofuel. How do farm prices and revenues react to such output
fluctuations and how do subsidies and production quotas affect farmers?
Trading drugs and purchasing concert and football of social services (including housing to meet expecta-
tickets on the black market are illegal activities. How tions of previously disadvantaged citizens) is an all too
do laws that make trading in a good or service illegal, familiar social gripe.
affect its price and the quantity bought and sold?
In this chapter, we use the theory of demand
The Market Before and After 1994
and supply (Chapter 3) and the concepts of elasticity
(Chapter 4) and efficiency (developed in Chapter 5) Figure 6.1 shows the market for housing in Cape
to answer questions like those that we have just Town. The demand curve for housing is D. There is
posed. In Reading Between the Lines at the end of the a short-run supply curve, labelled SS, and a long-run
chapter, we explore how price controls imposed by the supply curve, labelled LS.
Zimbabwean government, in an attempt to forcibly
control runaway inflation, backfired. Short-Run Supply The short-run supply curve
shows the change in the quantity of housing supplied
as the rent changes while the number of houses and
apartment buildings remains constant. The short-run
A Housing Market with a Rent Ceiling supply response arises from changes in the intensity
To see how a housing market works, let us take for with which existing buildings are used. The higher
example, the city of Cape Town. Cape Town is argu- the rent, the greater is the incentive for families with
ably one of the most beautiful places on earth. From homes to rent out some of the rooms that they previ-
Table Mountain, towering above the city, to the ously used themselves to help alleviate the housing
Victoria & Alfred Waterfront, the surroundings can shortage created by the influx of people from rural
take your breath away. But this great South African areas into the city.
city like others, is still struggling to provide housing
for all its citizens especially since the huge influx of Long-Run Supply The long-run supply curve shows
hundreds of thousands of people from rural parts of how the quantity of housing supplied responds to
the country after the election of a democratic govern- a change in price after enough time has elapsed for
ment in 1994. Cape Town – as a major metropolis new apartment buildings and houses to be erected
in South Africa – is expected to be a provider of under the government’s proposed scheme to eradicate
public housing. the housing shortage. In Figure 6.1, the long-run
The then mayor, Nomaindia Mfeketo of the supply curve is perfectly elastic. The marginal cost
African National Congress (ANC), acknowledged in of building is the same regardless of the number of
December 2005, that the city needed about houses and apartments in existence. So, long-run
R750 million (US$121 million) a year over the supply is perfectly elastic at a rent equal to marginal
next five years to eradicate its housing backlog. Cape cost. (Note, in South Africa’s case, where the govern-
Town needs to build somewhere between 20 000 ment has committed itself to subsidise the building of
and 30 000 houses a year. In 2003–2004 it built houses until the shortage has been eradicated, it will
342 houses. In 2004–2005 about 2 000 were built. not be necessary for the rent to exceed the marginal
At the same time 16 000 poor people come to Cape cost of building for developers to have an incentive
Town each year to live in shacks. While South Africa’s to keep on building, provided the government keeps
cities were recognised as a separate order of govern- on paying.)
ment in the 1996 constitution, they are dependent to
a limited extent on the national government for their Equilibrium The equilibrium rent and quantity are
revenues.1 Waiting lists for public housing are length- determined by demand and short-run supply. In
ening and vast shack settlements proliferate at the Fig 6.1 before 1994, the equilibrium rent is R1 600 a
edges of the country’s towns and cities. Non-delivery month and the quantity is 100 000 units of housing.
Figure 6.1(a) shows the situation immediately after the
1 Adapted from Donwald Pressly, ‘From shantytowns to modern dwellings end of apartheid. With the large influx of people into
South Africa’s cities face housing shortage’, Forum of Federations, Vol.5 South Africa’s cities (from the rural areas) in search of
No.2, March/ April 2006, www.ForumFed.org. Note that although this
article was written in 2006, the situation remains the same. jobs and a better future, demand for available housing
increases, hence shifting the demand curve D right- More apartments and houses are built and the short-
ward to DA. The short-run supply curve remains at SS. run supply curve shifts gradually rightward.
If the rent remains at R1 600 a month, only 100 000 Figure 6.1(b) shows the long-run adjustment. As
units of housing remain available. But with only more housing is built, the short-run supply curve shifts
100 000 units of housing available, the maximum rent gradually rightward and intersects the new demand
that someone is willing to pay for the last available curve at lower rents and larger quantities. The market
accommodation is R2 400 a month. So rents rise. equilibrium follows the arrows down the new demand
In Fig. 6.1(a), the rent rises to R2 000 a month. curve. The building boom comes to an end when there
As the rent rises, the quantity of housing demanded is no further profit in building new flats and houses.
decreases and the quantity supplied increases to 120 000 The process ends when the rent is back at R1 600 a
units. These changes occur because people economise month, and 200 000 units of housing are available.
on their use of space and make spare rooms, attics and We have just seen how a housing market
basements available to others. The higher rent allocates responds to an increase in demand. And we have seen
the scarce housing to the people who value it most that a key part of the adjustment process is a rise in
2 400 2 400 SS
SS
1 600 LS 1 600 LS
1 200 DA DA
1 200
D
D
Part (a) shows that before 1994, 100 000 housing units apartments and houses. As the building proceeds,
were rented at R1 600 a month. After 1994, the demand the short-run supply curve shifts rightward (part b). The
Rent (rand per unit per month)
curve shifts from D to DA. The rent rises to R2 000 a month rent gradually falls to R1 600 a month and the quantity
SS
and2 the
400quantity of housing increases to 120 000 units. of housing increases to 200 000 units – as the arrowed
With rent at R2 000 a month, there is profit in building new line shows.
2 000 SSA
1 600 LS
1 200 DA
PART TWO How Markets Work
to housing markets, it is called a rent ceiling. How But the story does not end here. Somehow,
does a rent ceiling affect the housing market? the 100 000 units of available housing must be
The effect of a price (rent) ceiling depends on allocated among people who demand 200 000 units.
whether it is imposed at a level that is above or below How is this allocation achieved? When a rent ceiling
the equilibrium price (rent). A price ceiling set above the creates a housing shortage, two developments occur.
equilibrium price has no effect. The reason is that the They are:
price ceiling does not constrain the market forces. The ◆ Search activity
force of the law and market forces are not in conflict. But ◆ Black markets
a price ceiling below the equilibrium price has powerful
effects on a market. The reason is that the price ceiling
attempts to prevent the price from regulating the quanti- Search Activity
ties demanded and supplied. The force of the law and The time spent looking for someone with whom to do
market forces are in conflict, and one (or both) of these business is called search activity. We spend some time
forces must yield to some degree. Let us study the effects in search activity almost every time we buy some-
of a price ceiling that is set below the equilibrium price thing. You want the latest hot CD and you know four
by returning to Cape Town. What would have happened stores that stock it. But which store has the best deal?
in Cape Town if a rent ceiling of R1 600 a month – the You need to spend a few minutes on the telephone
rent before 1994 – had been imposed after the influx of finding out. In some markets, we spend a lot of time
people into South Africa’s cities? searching. An example is the housing market in which
Figure 6.2 enables us to answer this question. we spend a lot of time checking the alternatives avail-
A rent that exceeds R1 600 a month is in the grey- able before making a choice.
shaded illegal region in the figure. At a rent of R1 600 But when a price is regulated and there is a
a month, the quantity of housing supplied is 100 000 shortage, search activity increases. In the case of a
units and the quantity demanded is 200 000 units. So rent-controlled housing market, frustrated would-be
there is a shortage of 100 000 units of housing. renters scan the newspapers, not only for housing ads
but also for death notices! Any information about
FIGURE 6.2 A Rent Ceiling newly available housing is useful. And they race to
be first on the scene when news of a possible supplier
Rent (rand per unit per month)
A rent above R1 600 a month is illegal (in the grey-shaded Black Markets
illegal region). At a rent of R1 600 a month, the quantity of
A black market is an illegal parallel market in which
housing supplied after 1994 is 100 000 units. Someone
the price exceeds the legally imposed price ceiling.
is willing to pay R2 400 a month for the 100 000th unit.
Black markets or parallel markets occur in rent-
Frustrated renters spend time searching for housing and they
controlled housing, and often in ticket sales for big
make deals with landlords in a black market.
sporting events and rock concerts. In Zimbabwe,
booming parallel markets exist for all types of goods FIGURE 6.3 The Inefficiency of a Rent Ceiling
and services since the introduction of widespread
price controls by the Mugabe government, in an
black market rent is equal to the maximum price Quantity (thousands of units per month)
that renters are willing to pay. A rent ceiling of R1 600 a month decreases the quantity of
With strict enforcement of the rent ceiling in housing supplied to 100 000 units. Producer surplus shrinks,
the Cape Town example shown in Figure 6.2, the and a deadweight loss arises. If people use no resources
quantity of housing available remains at 100 000 units. in search activity, consumer surplus is the green triangle
A small number of people offer housing for rent at plus the red rectangle. But if people use resources in search
R2 400 a month – the highest rent that someone activity equal to the amount shown by the red rectangle, the
is willing to pay – and the government detects and consumer surplus shrinks to the green triangle.
punishes some of these black market traders.
FIGURE 6.4 Minimum Wage and Unemployment FIGURE 6.5 The Inefficiency of a Minimum Wage
Wage rate (rand per hour)
Firms'
Wage rate (rand per hour)
12 14
surplus
S
Unemployment SS Potential
12 loss from
job search
10 10
A B Minimum Minimum
wage wage
8
8 Illegal 6
region Deadweight
loss
4
6 Workers' D
2
surplus
DA
0 20 21 22 23 0 19 20 21 22 23 24
Quantity (millions of hours per year) Quantity (millions of hours per year)
A wage below R10 an hour is illegal (in the grey-shaded A minimum wage shrinks the firms’ surplus (blue triangle) and
illegal region). At the minimum wage of R10 an hour, workers’ surplus (green triangle) and creates a deadweight
20 million hours are hired but 22 million hours are available. loss (grey triangle). If people use extra resources in job
Unemployment – AB – of 2 million hours a year is created. search, the red area shows the potential loss from job search.
At this level of employment, unemployed people incur. Also those who find jobs are not always the
have a big incentive to spend time and effort looking least well off. When the wage rate does not allocate
for work. The red rectangle shows the potential loss labour, other mechanisms determine who finds a job.
from this extra job search. This loss arises because One such mechanism is discrimination, which is yet
someone who finds a job earns R10 an hour (read off another source of unfairness.
from the demand curve) but would have been willing The minimum wage imposes an unfair rule because it
to work for R6 an hour (read off from the supply blocks voluntary exchange. Firms are willing to hire more
curve), so everyone who is unemployed has an incen- labour and people are willing to work more, but they
tive to search hard and use resources that are worth are not permitted by the minimum wage law to do so.
the R4-an-hour surplus to find a job.
REVIEW QUIZ
Is the Minimum Wage Fair? 1 What is a minimum wage and what are its
effects if it is set above the equilibrium wage?
The minimum wage is unfair on both views of fairness: 2 What are the effects of a minimum wage set
It delivers an unfair result and imposes an unfair rule. below the equilibrium wage?
The result is unfair because only those people who 3 Explain how scarce jobs are allocated when a
have jobs and keep them benefit from the minimum minimum wage is in place.
wage. The unemployed end up worse off than they 4 Explain why a minimum wage creates an inef-
would be with no minimum wage. Some of those ficient allocation of labour resources.
who search for jobs and find them end up worse off 5 Explain why a minimum wage is unfair.
because of the increased cost of the job search they
Equivalence of Tax on Buyers and Sellers 325 million packs a year. Buyers pay R16 a pack, of
You can see that the tax on buyers in Fig. 6.7 has the which R3 is tax. Sellers receive from buyers R13, but
same effects as the tax on sellers in Fig. 6.6. In both cases, must pay a R3 tax, so they net R10 a pack.)
the equilibrium quantity decreases to 325 million packs a The key point is that when a transaction is
year, the price paid by buyers rises to R16 a pack and the taxed, there are two prices: the price paid by buyers,
price received by sellers falls to R10 a pack. Buyers pay which includes the tax; and the price received by
R4 of the R6 tax and sellers pay the other R2 of the tax. sellers, which excludes the tax. Buyers respond only
to the price that includes the tax, because that is the
Can We Share the Burden Equally? Suppose that price they pay. Sellers respond only to the price that
the finance minister wants the burden of the cigarette excludes the tax, because that is the price they receive.
tax to fall equally on buyers and sellers and declares A tax is like a wedge between the buying price
that a R3 tax be imposed on each. Is the burden of the and the selling price. It is the size of the wedge,
tax then shared equally? not the side of the market on which the tax is
You can see that it is not. The tax is still R6 a imposed by the government, that determines the
pack. And you have seen that the tax has the same effects of the tax.
effect regardless of whether it is imposed on sellers or
buyers. So imposing half the tax on one and half on Value-Added Tax Value-added tax is an example of
the other is like an average of the two cases you have a tax that the government imposes equally on both
examined. (Draw the demand-supply graph and work buyers and sellers. But the principles you have just
out what happens in this case. The demand curve learned apply to this tax too. The market for goods,
shifts downward by R3 and the supply curve shifts not the government, decides how the burden of the
upward by R3. The new equilibrium quantity is still value-added tax is divided by firms and consumers.
12 12
Price with no tax Price with no tax R6.00 tax
10 10
8 8
Price received
by sellers
4 4 D
Price received
D – tax on buyers
by sellers
D
0 275 300 325 350 375 400 425 450 0 250 275 300 325 350 375 400 425
Quantity (millions of packs per year) Quantity (millions of packs per year)
With no tax, 350 million packs a year are bought and sold With no tax, 350 million packs a year are bought and
at R12 a pack. A tax on sellers of R6 a pack shifts the supply sold at R12 a pack. A tax on buyers of R6 a pack shifts the
curve leftward to S + tax on sellers. The equilibrium quantity demand curve leftward to D – tax on buyers. The equilibrium
decreases to 325 million packs a year, the price paid by quantity decreases to 325 million packs a year, the price
buyers rises to R16 a pack and the price received by sellers paid by buyers rises to R16 a pack and the price received by
falls to R10 a pack. The tax raises the price paid by buyers sellers falls to R10 a pack. The tax raises the price paid by
by less than the tax and lowers the price received by sellers, buyers by less than the tax and lowers the price received by
so buyers and sellers share the burden of the tax. sellers, so buyers and sellers share the burden of the tax.
In the cigarette tax examples (where an excise tax sacrifice all other goods and services rather than not
was introduced), the buyers bear twice the burden of consume the insulin dose that provides good health.
the tax borne by sellers. In special cases, either buyers or The supply curve of insulin is S. With no tax, the
sellers bear the entire burden. The division of the burden price is R20 a dose and the quantity is 100 000 doses
of a tax between buyers and sellers depends on the price a day.
elasticities of demand and supply, as you will now see. If insulin is taxed at R2 a dose, we must add the
tax to the minimum price at which drug companies are
willing to sell insulin. The result is the new supply curve S
Tax Division and Price Elasticity of Demand + tax. The price rises to R22 a dose, but the quantity does
A knowledge of elasticity (as studied in Chapter Four) not change. Buyers pay the entire sales tax of R2 a dose.
proves extremely useful in the context of market
inefficiencies and fiscal policy. In order to see how Perfectly Price Elastic Demand Figure S + tax 6.8(b) shows
S + tax S + tax
S
22
S 10 D
Buyers pay
entire tax
Sellers
pay
entire
20 tax
9
D
0 100 0 1 4
Quantity (thousands of doses per day) Quantity (thousands of marker pens per week)
(a) Perfectly price inelastic demand (b) Perfectly price elastic demand
Part (a) shows the market for insulin, where demand is Part (b) shows the market for pink pens, in which demand is
perfectly price inelastic. With no
S + tax,
tax the price is R20 a dose perfectly price elastic. With no tax, the price of a pen is R10
Price (rand per pen)
and the quantity is 100 000 doses a day. A tax S of R2 a and the quantity is 4 000 pens a week. A tax of R1 a pink
dose shifts the supply curve to S + tax. The price rises to R22 pen shifts the supply curve to S + tax. The price remains at
10 D
a dose, but the quantity bought does not change. Buyers pay R10 a pen, and the quantity of pink pens sold decreases to
the entire tax. 1 000 a week. Sellers pay the entire tax.
Sellers
pay
entire
tax
9 PART TWO How Markets Work
the amount received by sellers by the full amount of the Suppose this spring water is taxed at 50c a bottle.
tax. Sellers pay the entire tax of R1 a pink pen. The supply curve does not change because the spring
We have seen that when demand is perfectly price owners still produce 100 000 bottles a week even
inelastic, buyers pay the entire tax and when demand though the price they receive falls. But buyers are
is perfectly price elastic, sellers pay the entire tax. In the willing to buy the 100 000 bottles only if the price is
usual case, demand is neither perfectly price inelastic nor R5 a bottle. So the price remains at R5 a bottle. The
perfectly price elastic and the tax is split between buyers tax reduces the price received by sellers to R4.50 a
and sellers. But the division depends on the price elasticity bottle and sellers pay the entire tax.
of demand. The more price inelastic the demand, the
larger is the amount of the tax paid by buyers. Perfectly Price Elastic Supply Figure 6.9(b) shows
the market for sand from which computer-chip makers
Tax Division and Price Elasticity of Supply The extract silicon. Supply of this sand is perfectly price
S
11 S + tax
5.00
Buyers pay
entire tax
Sellers pay
entire tax
10 S
4.50
D D
0 100 0 3 5
Quantity (thousands of bottles per week) Quantity (thousands of kilograms per week)
(a) Perfectly price inelastic supply (b) Perfectly price elastic supply
Part (a) shows the market for water from a mineral spring. Supply Part (b) shows the market for sand. Supply is perfectly price
is perfectly price inelastic. With no tax, the price is R5 a bottle. elastic. With no tax, the price is R10 a kilogram. A tax of R1 a
Price (rand per kilogram)
With a tax of 50c a bottle, the price remains at R5 a bottle. The kilogram increases the minimum supply-price to R11 a kilogram.
number of bottles bought remains the same, but the price received The supply curve shifts to S + tax. The price increases to R11
by sellers
11 decreases to R4.50 a bottle. Sellers pay Sthe entire tax.
+ tax a kilogram. Buyers pay the entire tax.
Buyers pay
entire tax
We have seen that when supply is perfectly price Figure 6.10 shows the inefficiency of a tax on CD
inelastic, sellers pay the entire tax and when supply players. With a tax, both consumer surplus and
is perfectly price elastic, buyers pay the entire tax. producer surplus shrink. Part of each surplus goes to
In the usual case, supply is neither perfectly price the government in tax revenue – the purple rectangle.
inelastic nor perfectly elastic and the tax is split And part becomes a deadweight loss – the grey triangle.
between buyers and sellers. But how the tax is split In the extreme cases of perfectly price inelastic demand
depends on the price elasticity of supply. The more and perfectly price inelastic supply, a tax does not
price elastic the supply, the larger is the amount of change the quantity bought and sold and there is no
the tax paid by buyers. deadweight loss. The more price inelastic either demand
or supply is, the smaller is the decrease in quantity and
the smaller is the deadweight loss. When demand or
Taxes in Practice supply is perfectly price inelastic, the quantity remains
Supply and demand are rarely perfectly price elastic constant and no deadweight loss arises.
or perfectly inelastic. But some items tend toward one
of the extremes. For example, alcohol, tobacco and FIGURE 6.10 Taxes and Efficiency
fuel have low price elasticities of demand and rela-
tively high price elasticities of supply. So the burden Price (rand per CD player) 1 300
Consumer S + tax
of these taxes falls more heavily on buyers than on surplus
S
sellers. Labour has a low price elasticity of supply and Tax
a relatively high price elasticity of demand. So any revenue
attempt by the government to introduce a social secu-
rity tax with the desire to split the tax equally between 1 050 Deadweight
loss
workers and employers would fail, since the burden of 1 000
such a tax would fall mainly on workers. 950
The most heavily taxed items are those that
have either a low price elasticity of demand or a low
price elasticity of supply. For these items, the equi-
librium quantity does not decrease much when a tax Producer
750 D
surplus
is imposed. So the government collects a large tax
revenue and the deadweight loss from the tax is small. 0 1 2 3 4 5 6 7 8 9 10
It is unusual to tax an item heavily if neither its Quantity (thousands of CD players per week)
demand nor its supply is price inelastic. With an elastic
With no tax on CD players, 5 000 a week are bought and
supply and demand, a tax brings a large decrease in the
sold at R1 000 each. With a tax of R100 a CD player, the
equilibrium quantity and a small tax revenue.
buyers’ price rises to R1 050 a player, the sellers’ price falls
to R950 a player and the quantity decreases to 4 000 CD
Taxes and Efficiency players a week. Consumer surplus shrinks to the green triangle
and the producer surplus shrinks to the blue triangle. Part of the
You have seen that a tax places a wedge between the
loss of total surplus (the sum of consumer surplus and producer
price that buyers pay and the price that sellers receive.
surplus) goes to the government as tax revenue, the purple
The price that buyers pay is also the buyers’ willing-
rectangle, and a deadweight loss arises, the grey triangle.
ness to pay, which measures marginal benefit. And the
price that sellers receive is also the sellers’ minimum
supply-price, which equals marginal cost.
Taxes and Fairness
So because a tax places a wedge between the
buyers’ price and the sellers’ price, it also puts a wedge We have examined the incidence and the efficiency of
between marginal benefit and marginal cost and taxes. But when political leaders debate tax issues, it
creates inefficiency. With a higher buyers’ price and is fairness, not incidence and efficiency, that gets the
a lower sellers’ price, the tax decreases the quantity most attention. No easy answers are available to the
produced and consumed and a deadweight loss arises. questions about the fairness of taxes.
400
R2
200 R6 billion
billion
D
0 5 10 15 20 25
Subsidies and Quotas
Quantity (millions of tonnes per year)
133
(a) Poor harvest: revenue increases
800 800
600 600
R3 billion
400 400
R4 billion
R2
200 R6 billion 200
billion
D R4 billion R1
D
billion
0 5 10 15 20 25 0 5 10 15 20 25
Quantity (millions of tonnes per year) Quantity (millions of tonnes per year)
(a) Poor harvest: revenue increases (b) Bumper harvest: revenue decreases
The demand curve is D. In normal times, the supply curve is R2 billion decrease from the smaller quantity (blue area).
MS0 and 20 million tonnes are sold for R400 a tonne. A bumper harvest increases the quantity supplied. The supply
Price (rand per tonne)
MS0
A poor harvest decreases the quantity supplied. MS2supply
The curve shifts to MS2 (part b). The price falls to R200 a tonne
curve shifts to MS1 (part a). The price rises to R600 a tonne and farm revenue falls by R3 billion – the R1 billion increase
and800
farm revenue increases by R1 billion – the R3 billion from the larger quantity (purple area) minus the R4 billion
increase from the higher price (green area) minus the decrease from the lower price (blue area).
600
Quota Illegal
Price (rand per tonne)
1 600 600
Cost S
rises
1 500 500
S – subsidy
400 Price
1 400
rises
1 300 300
R200 subsidy Cost
Price falls
1 200 falls 200
D
Quantity Quantity
1 000 increases 100
decreases
D
With no subsidy, 40 million tonnes a year are produced at With no quota, 60 million tonnes a year are produced at
R1 400 a tonne. A subsidy of R200 a tonne shifts the supply R300 a tonne. A quota of 40 million tonnes a year restricts
curve rightward to S – subsidy. The equilibrium quantity total production to that amount. The equilibrium quantity
increases to 60 million tonnes a year, the price falls to R1 300 decreases to 40 million tonnes a year, the price rises to R500
a tonne and the price plus subsidy received by farmers rises to a tonne and the farmers’ marginal cost falls to R200 a tonne.
R1 500 a tonne. In the new equilibrium, marginal cost (on the In the new equilibrium, marginal cost (on the supply curve)
supply curve) exceeds marginal benefit (on the demand curve) is less than marginal benefit (on the demand curve) and a
and a deadweight loss arises from overproduction. deadweight loss arises from underproduction.
To implement the quota, each grower is assigned Governments intervene in some markets by
a production limit and the total of the production making it illegal to trade in a good. Let us now see
limits equals 40 million. Production that in total how these markets work.
exceeds 40 million tonnes is illegal, so we have shaded
the illegal region above the quota. Growers are no Markets for Illegal Goods
longer permitted to produce the equilibrium quan-
tity because it is in the illegal region. As in the case The markets for many goods and services are regu-
of price ceilings and price floors, market forces and lated and buying and selling some goods is illegal. The
political forces are in conflict. best-known examples of such goods are drugs, such as
When the government sets a production quota, marijuana, cocaine, ecstasy and heroin.
it does not regulate the price. Market forces deter- Despite the fact that these drugs are illegal, trade
mine it. In the example in Fig. 6.13, with production in them is a multimillion-rand business. This trade
limited to 40 million tonnes a year, the market price can be understood by using the same economic model
rises to R500. and principles that explain trade in legal goods. To
The quota not only raises the price, but also study the market for illegal goods, we are first going to
lowers the marginal cost of producing the quota examine the prices and quantities that would prevail
because the sugar growers slide down their supply if these goods were not illegal. Next, we will see how
(and marginal cost) curves. prohibition works. Then we will see how a tax might
A production quota is inefficient because it be used to limit the consumption of these goods.
results in underproduction. At the quota quan-
tity, marginal benefit is equal to the market price
A Free Market for a Drug
and marginal cost is less than the market price, so
marginal benefit exceeds marginal cost. Figure 6.14 shows the market for a drug. The demand
Because of these effects of a quota, such arrange- curve, D, shows that, other things remaining the same,
ments are often popular with producers and in the lower the price of the drug, the larger is the quantity
some cases, producers, not governments, attempt of the drug demanded. The supply curve, S, shows that,
to implement them. But it is hard for quotas to other things remaining the same, the lower the price
work when they are voluntary. The reason is that of the drug, the smaller is the quantity supplied. If the
each producer has an incentive to cheat and produce drug were not illegal, the quantity bought and sold
a little bit more than the allotted quota. You can see would be Q C and the price would be PC.
why by comparing the market price and marginal
cost. If one producer could get away with a tiny
A Market for an Illegal Drug
increase in production, her or his profit would
increase. But if all producers cheat by producing When a good is illegal, the cost of trading in the good
above the quota, the market moves back toward increases. By how much the cost increases and who
the unregulated equilibrium and the gain for incurs the cost depend on the penalties for violating
producers disappears. the law and the effectiveness with which the law is
enforced. The larger the penalties and the more effec-
tive the policing, the higher are the costs. Penalties
REVIEW QUIZ might be imposed on sellers, buyers or both.
1 Summarise the effects of a production
quota on the market price and the Penalties on Sellers Drug dealers in South Africa
quantity produced. face large penalties if their activities are detected. For
2 Explain why a production quota is example, a cocaine dealer could pay a R200 000 fine and
inefficient. serve a 20-year prison term. A heroin dealer could pay a
3 Summarise the effects of a subsidy on the R500 000 fine and serve a maximum of a 25-year prison
market price and the quantity produced. term. These penalties are part of the cost of supplying
4 Explain why a subsidy is inefficient. illegal drugs and they bring a decrease in supply – a
leftward shift in the supply curve. To determine the new
supply curve, we add the cost of breaking the law to the shifts to D – CBL. If penalties were imposed only on
minimum price that drug dealers are willing to accept. In buyers, the market equilibrium would move from
Figure 6.14, the cost of breaking the law by selling drugs point E to point G.
(CBL) is added to the minimum price that dealers will
accept and the supply curve shifts leftward to S + CBL. Penalties on Both Sellers and Buyers If penal-
If penalties were imposed only on sellers, the market ties are imposed on both sellers and buyers, both
equilibrium would move from point E to point F. supply and demand decrease and both the supply
curve and the demand curve shift. In Fig. 6.14 the
Penalties on Buyers In South Africa, it is illegal to costs of breaking the law are the same for both buyers
possess drugs such as marijuana, cocaine, ecstasy and and sellers, so both curves shift leftward by the same
heroin. For example, possession of cocaine can bring amount. The market equilibrium moves to point H.
a prison term of 12 years and possession of heroin can The market price remains at the competitive market
bring a prison term up to a maximum of 15 years. price PC, but the quantity bought decreases to Q P. The
Penalties fall on buyers and the cost of breaking the buyer pays PC plus the cost of breaking the law, which
law must be subtracted from the value of the good to equals PB. And the seller receives PC minus the cost of
determine the maximum price buyers are willing to breaking the law, which equals PS.
pay for the drugs. Demand decreases and the demand The larger the penalties and the greater the
curve shifts leftward. In Fig. 6.14, the demand curve degree of law enforcement, the larger is the decrease
in demand and/or supply. If the penalties are heavier
FIGURE 6.14 A Market for an Illegal Good on sellers, the supply curve shifts further than the
demand curve and the market price rises above PC. If
the penalties are heavier on buyers, the demand curve
Price
Parallel markets are booming, businesses and industries are buckling and consumers are paying the
price as the Zimbabwean government’s attempts to forcibly control runaway inflation backfire. In the
face of soaring hyperinflation, President Robert Mugabe’s government ordered a 50 per cent cut in
the prices of basic commodities last week. Defiance of the order was seen as a move to topple Mugabe
and businesses were raided and threatened with closure.
John Robertson, an economist based in the capital, Harare, told the Integrated Regional Information
Networks (IRIN): ‘Consumers are getting the worst end of it. While they had every reason to be
happy when the government ordered price slashes, that happiness is fast waning, because the attempt
to militantly control prices is boomeranging.’
The government set up a taskforce to monitor and enforce compliance but a mid-June salary increase
for civil servants, which topped 600 per cent, sent the prices of basic commodities, clothing and
transport fares shooting up.
the market supply curve for bread SSA, would Maximum black
SSA
establish an equilibrium price of Zim$20 million 24 market price
per loaf of bread and a quantity of 70 000 loaves Illegal
region
would be traded per day.
◆ At a price of Zim$16 million per loaf of bread, the 20
Key Terms
Black market, 122 Price ceiling, 121 Rent ceiling, 122 Tax incidence, 127
Minimum wage, 125 Price floor, 125 Search activity, 122
Price cap, 121 Production quota, 134 Subsidy, 133
A Housing Market with a Rent Ceiling A Labour Market with a Minimum Wage
Use the following graph of the market for rental Use the following data to work out Problems 6 to 8.
housing in Townsville to work out Problems 1 and 2. The table gives the wage rate, demand and quantity
schedules of teenage labour.
Rent (rand per month)
S
6 000 Wage rate Quantity Quantity
(rand per hour) demanded supplied
4 500 hours per month
4 3 000 1 000
3 000
5 2 500 1 500
6 2 000 2 000
1 500
D 7 1 500 2 500
8 1 000 3 000
0 10 20 30 40
Quantity (thousands)
6. Calculate the equilibrium wage rate, the
1. a. What is the equilibrium rent and number of hours worked and the quantity
equilibrium quantity of rental housing? of unemployment.
b. If a rent ceiling is set at R6 000 a month, 7. If a minimum wage for teenagers is set at R5 an
what is the quantity of housing rented and hour, how many hours do they work and how
what is the shortage of housing? many hours of teenage labour are unemployed?
2. If a rent ceiling is set at R3 000 a month, what 8. If a minimum wage for teenagers is set at
is the quantity of housing rented, the shortage of R7 an hour,
housing and the maximum price that someone is a. How many hours do teenagers work and
willing to pay. how many hours are unemployed?
b. Demand for teenage labour increases by
Capping Gasoline Prices 500 hours a month. What is the wage rate
Sometimes people think that putting a price cap paid to teenagers and how many hours of
(or price ceiling) on petrol would be a good idea. teenage labour are unemployed?
However, this may cause more problems because it
would hide the true situation. Suppose that a price Use the following info byte to work out Problems 9 to 10.
ceiling is set below the equilibrium price of petrol.
3. How does the price cap influence the quantity of Oil-rich countries in the Gulf rely on millions of immi-
petrol supplied and the quantity demanded? grant workers, often from India. India is pressurising the
4. How does the price cap influence the maximum Gulf states to pay them minimum wages, at the very least.
price that someone is willing to pay for the last Suppose the Gulf countries paid a minimum wage
litre of petrol available on a black market? above the equilibrium wage to Indian workers.
5. Draw a graph to illustrate the effects of a price 9. How would the market for labour be affected in
ceiling set below the equilibrium price in the the Gulf countries? Draw a supply and demand
market for petrol. graph to illustrate your answer.
10. How would the market for labour be affected 13. Calculate the price, the marginal cost of
in India? Draw a supply and demand graph to producing an avocado and the quantity produced
illustrate your answer. if the government sets a production quota of
2 000 avocados per week.
Taxes 14. Calculate the price, the marginal cost of avocados
11. The table gives the demand and supply schedules and the quantity produced if the government
for chewing gum. introduces a subsidy of R0.30 an avocado.
90 1 7
60
7
C omputer laptops, cellphones and branded sports clothing are just
three of many items we as consumers might buy that are not produced
in South Africa. In fact, most of the goods that we buy are produced
abroad, often in Asia, and transported here in container ships and
cargo jets. And it is not just goods produced abroad that you buy – it is
services too. When you make a technical support call,
SS
SASA SS
SASA
Quantity
Quantity Quantity
Quantity
produced
produced bought
bought
Notrade
No trade decreases
decreases increases
increases
equilibrium
equilibrium
100
100 100
100
Pricewith
Price with
notrade
no trade
80
80 80
80
Price
Price World
World
falls
falls price
price
50
50 50
50
Quantity
Quantity
boughtequals
bought equals DD
SASA
Quantity
Quantity DD
SA
SA
quantity
quantity imported
imported
produced
produced Quantity
Quantity Quantity
Quantity
produced
produced bought
bought
00 20
20 40
40 60
60 00 20
20 40
40 60
60
Quantity(millions
Quantity (millionsofofT-shirts
T-shirtsper
peryear)
year) Quantity
Quantity(millions
(millionsofofT-shirts
T-shirtsper
peryear)
year)
(a)Equilibrium
(a) Equilibriumwith
withno
nointernational
internationaltrade
trade (b)
(b)Equilibrium
Equilibriumininaamarket
marketwith
withimports
imports
Part (a) shows the SA market for T-shirts with no international Part (b) shows the SA market for T-shirts with international
trade. The SA domestic demand curve DSA and SA domestic trade. World demand and world supply determine the world
supply curve SSA determine the price of a T-shirt at R80 and price, which is R50 per T-shirt. The price in the SA market falls
the quantity of T-shirts produced and bought in South Africa at to R50 a shirt. SA purchases of T-shirts increase to 60 million
40 million a year. a year, and SA production of T-shirts decreases to 20 million
a year. South Africa imports 40 million T-shirts a year.
150
150 150
150
No
Notrade
trade
equilibrium
equilibrium World
World
Price
Price price
price
Pricewith
Price with rises
rises
notrade
no trade
100
100 100
100
50
50 50
50
Quantity
Quantitybought
bought Quantity
Quantity
equals
equalsquantity
quantity exported
exported DD
SASA
DD
SASA
produced
produced Quantity
Quantity Quantity
Quantity
bought
bought produced
produced
00 200
200 400
400 600
600 800
800 00 200
200 400
400 600 700
600 700 800
800
Quantity
Quantity(1000s
(1000sofofbottles
bottlesofofwine
wineper
peryear)
year) Quantity
Quantity(1000s
(1000sofofbottles
bottlesofofwine
wineper
peryear)
year)
(a)
(a)Equilibrium
Equilibriumwithout
withoutinternational
internationaltrade
trade (b)
(b)Equilibrium
Equilibriumininaamarket
marketwith
withexports
exports
In part (a), the SA market with no international trade, the SA In part (b), the SA market with international trade, world
domestic demand curve DSA and the SA domestic supply demand and world supply determine the world price, which
curve SSA determine the price of wine at R100 per bottle and is R150 per bottle. The price in the SA market rises. SA wine
400 000 bottles are produced and bought each year. production increases to 700 000 bottles a year, and SA
purchases of wine decrease to 200 000 bottles a year. South
Africa exports 500 000 bottles of wine a year.
Consumer
Consumer
150
150 150
150 surplus
surplus
Consumer
Consumer
surplus
surplus expands
expands
SSA
SSA SSA
SSA
Equilibrium
Equilibriumwith
withnono
Increase
Increaseinin
international
internationaltrade
trade
total
totalsurplus
surplus
100
100 100
100 AA
80
80 80
80
World
World
BB DD price
price
50
50 50
50
CC
DD
SASA DD
SASA
Producer
Producer Producer
Producer
surplus
surplus surplus
surplus
shrinks
shrinks
00 20
20 40
40 60
60 00 20
20 40
40 60
60
Quantity
Quantity(millions
(millionsofofT-shirts
T-shirtsper
peryear)
year) Quantity
Quantity(millions
(millionsofofT-shirts
T-shirtsper
peryear)
year)
(a)
(a)Consumer
Consumersurplus
surplusand
andproducer
producersurplus
surpluswith
withno
no (b)
(b)Gains
Gainsand
andlosses
lossesfrom
fromimports
imports
international
internationaltrade
trade
In part (a), with no international trade, the green area shows the to the area A + B + D. Producer surplus shrinks to area C.
consumer surplus and the blue area shows the producer surplus. Area B is a transfer of surplus from producers to consumers.
In part (b), with international trade, the price falls to the world Area D is an increase in total surplus – the gain from imports.
price of R50 a T-shirt. Consumer surplus expands from area A
Gains and Losses from Exports surplus, the area D, is a net gain. This increase in total
surplus results from the higher price and increased
We measure the gains and losses from exports just like
production and is the gain from exports.
we measured those from imports, by their effect on
consumer surplus, producer surplus and total surplus.
Figure 7.4(a) shows the situation with no inter- Gains for All
national trade. Domestic demand, DSA, and domestic
You have seen that both imports and exports bring
supply, SSA, determine the price and quantity, the
gains. Because one country’s exports are other coun-
consumer surplus and the producer surplus.
tries’ imports, international trade brings gain for all
Figure 7.4(b) shows how the consumer surplus
countries. International trade is a win-win game.
and producer surplus change when the good is
exported. The price rises to the world price. The quan-
tity bought decreases to the quantity demanded at the REVIEW QUIZ
world price and the consumer surplus shrinks to the 1 How is the gain from imports distributed
green area A. The quantity produced increases to the between consumers and domestic producers?
quantity supplied at the world price and the producer 2 How is the gain from exports distributed
surplus expands to the blue area B + C + D. between consumers and domestic producers?
Part of the gain in producer surplus, the area B, is 3 Why is the net gain from international trade
a loss in consumer surplus – a redistribution of the total positive?
surplus. But the other part of the increase in producer
150
150 Equilibrium
Equilibrium
with
withnono 150
150
international
international
trade
trade
BB DD World
World
price
price
100
100 100
100
CC
Producer
Producer
5050 5050 surplus
surplus
expands
expands
Producer
Producer DSA
DSA
DSA
DSA
surplus
surplus
00 200
200 400
400 600
600 800
800 00 200
200 400
400 600 700
600 700 800
800
Quantity
Quantity(1000s
(1000s
of of
bottles
bottles
of of
wine
wine
perper
year)
year) Quantity
Quantity(1000s
(1000s
of of
bottles
bottles
of of
wine
wine
perper
year)
year)
(a)(a)
Consumer
Consumer surplus
surplus
and
and
producer
producer
surplus
surplus
with
with
nono (b)(b)
Gains
Gains
and
and
losses
losses
from
from
exports
exports
international
international
trade
trade
In part (a), the SA market with no international trade, the Consumer surplus shrinks to area A. Producer surplus expands
green area shows the consumer surplus and the blue area from area C to the area B + C + D. Area B is a transfer of
shows the producer surplus. In part (b), the SA market with surplus from consumers to producers. Area D is an increase in
international trade, the price rises to the world price. total surplus – the gain from exports.
150
150 150
150
SSA
SSA SSA
SSA
Tariff
Tariff
100
100 100
100 revenue
revenue
Worldprice
World price
80
80 plustariff
plus tariff
World
World 70
70
price
price Tariff
Tariff
50
50 50
50
Imports
Imports Imports
Imports DD
SASA
withfree
with free DD
SASA withtariff
with tariff
trade
trade
World
World
price
price
00 20
20 40
40 60
60 00 20
20 35
35 45
45 60
60
Quantity(millions
Quantity (millionsofofT-shirts
T-shirtsper
peryear)
year) Quantity(millions
Quantity (millionsofofT-shirts
T-shirtsper
peryear)
year)
(a)Free
(a) Freetrade
trade (b)Market
(b) Marketwith
withtariff
tariff
The world price of a T-shirt is R50. With free trade in part (a), With a tariff of R20 per T-shirt in part (b), the price in the SA
South Africans buy 60 million T-shirts a year. SA clothing market rises to R70 a T-shirt. SA production increases, SA
manufacturers produce 20 million T-shirts a year and South purchases decrease and the quantity imported decreases.
Africa imports 40 million a year. The SA government collects tariff revenue of R20 on each
T-shirt imported, which is shown by the purple rectangle.
The following changes occur in the market for Decrease in Purchases The higher price of a T-shirt
T-shirts: brings a decrease in the quantity demanded along the
◆ The price of a T-shirt in South Africa rises by R20. demand curve.
◆ The quantity of T-shirts bought in South Africa Figure 7.5(b) shows the decrease from 60 million
decreases. T-shirts a year at R50 a shirt to 45 million a year at
◆ The quantity of T-shirts produced in South R70 a shirt.
Africa increases.
◆ The quantity of T-shirts imported into South Increase in Domestic Production The higher price
Africa decreases. of a T-shirt stimulates domestic production and SA
◆ The SA government collects tariff revenue. clothing manufacturers increase the quantity supplied
along the supply curve.
Rise in Price of a T-shirt To buy a T-shirt, South Figure 7.5(b) shows the increase from 20 million
Africans must pay the world price plus the tariff, T-shirts at R50 a shirt to 35 million a year at R70
so the price of a T-shirt rises by the R20 tariff to a shirt.
R70. Figure 7.5(b) shows the new domestic price
line, which lies R20 above the world price line. Decrease in Imports T-shirt imports decrease by
The price rises by the full amount of the tariff. 30 million, from 40 million to 10 million a year.
The buyer pays the entire tariff because supply Both the decrease in purchases and the increase in
from the rest of the world is perfectly elastic (see domestic production contribute to this decrease
Chapter 6, p. 130). in imports.
SA Tariffs: 1960–2004
12 12 25 25 Surcharges
Surcharges
Percentage (%)
Percentage (%)
Percentage (%)
Percentage (%)
Scheduled
Scheduled
IncludingIncluding
10 10 surcharges
surcharges
20 20
8 8
15 15
6 6
10 10
4 4 Excluding
Excluding
surcharges
surcharges
5 5
2 2
0 0 0 0
1990
1994
1998
1990
2000
1994
2004
1998
1990
2000
1994
2004
1998
1990
2000
1994
2004
1998
1990
2000
1994
2004
1998
1990
2000
1994
2004
1998
1990
2000
1994
2004
1998
1990
2000
1994
2004
1998
2000
2004
1960 1965
19601970
19651975
19701980
19751985
19801990
19851995
1990 2000
1995 2000
Year Year
All All Agriculture
Agriculture
Mining Mining
Manufacturing
Manufacturing
(a) Ratio
(a)of
Ratio
dutyofcollected
duty collected
to merchandise
to merchandise
importsimports (b) Average
(b) Average
tariffs using
tariffsscheduled
using scheduled
rates rates
South Africa was one of the first countries to adopt import the need to diversify into non-gold exports through export
substitution as a vehicle for industrialisation. Protection was promotion methods. This ultimately initiated a shift in trade policy
used to encourage the substitution of imports of goods by in the early 1970s towards a more open trade regime but it
domestic manufacturers. By the 1970s, South Africa remained was not until the 1990s that South Africa’s new democratically
highly dependent on gold as a source of foreign exchange elected government’s participation in the GATT Uruguay round
and concerns regarding this dependency led to the Reynders brought about a substantial reduction in tariff rates with the
Commission of Inquiry in 1972. The commission emphasised country’s offer to the WTO to reform it is trade policy regime.
Tariff Revenue The government’s tariff revenue is SA Producers of the Good Gain Because the price of
R200 million – R20 per shirt on 10 million imported an imported T-shirt rises by the amount of the tariff,
shirts – shown by the purple rectangle. SA T-shirt producers are now able to sell their T-shirts
for the world price plus the tariff. At the higher price,
Winners, Losers and the Social Loss from a the quantity of T-shirts supplied by SA producers
Tariff A tariff on an imported good creates winners increases. The combination of a higher price and
and losers and a social loss. When the SA government larger quantity produced increases producer surplus –
imposes a tariff on an imported good: the gain to SA producers from the tariff.
◆ SA consumers of the good lose.
◆ SA producers of the good gain. SA Consumers Lose More Than SA Producers Gain
◆ SA consumers lose more than SA producers gain. Consumer surplus decreases for four reasons: Some
◆ Society loses: a deadweight loss arises. becomes producer surplus, some is lost in a higher cost of
production (domestic producers have higher costs than
SA Consumers of the Good Lose Because the price foreign producers), some is lost because imports decrease
of a T-shirt in South Africa rises, the quantity of and some goes to the government as tariff revenue.
T-shirts demanded decreases. The combination of a Figure 7.6 shows these sources of lost consumer surplus.
higher price and smaller quantity bought decreases Figure 7.6(a) shows the consumer surplus and
consumer surplus – the loss to SA consumers that producer surplus with free international trade in
arises from a tariff. T-shirts.
150
150 Consumer
Consumer 150
150
Consumer
Consumer
surplus
surplus surplus
surplus
shrinks
shrinks
SSA
SSA SSA
SSA
Gainfrom
Gain from Deadweight
Deadweight
freetrade
free trade loss
lossfrom
fromtariff
tariff
100
100 100
100
World
Worldprice
price
plus
plustariff
tariff
World
World 70
70
price
price Tariff
Tariff
BB CC DD EE
50
50 50
50
Imports
Imports AA DD
Imports
Imports Tariff
Tariff SASA
Producer
Producer withfree
with free DD
SASA
trade
trade with
withtariff
tariff revenue
revenue
surplus
surplus Producer
Producer World
World
surplus
surplus price
price
expands
expands
00 20
20 40
40 60
60 00 20
20 40
40 60
60
Quantity(millions
Quantity (millionsofofT-shirts
T-shirtsper
peryear)
year) Quantity
Quantity(millions
(millionsofofT-shirts
T-shirtsper
peryear)
year)
(a)
(a)Free
Freetrade
trade (b)
(b)Market
Marketwith
withtariff
tariff
The world price of a T-shirt is R50. In part (a), with free trade, Consumer surplus shrinks by the areas B, C, D and E.
South Africa imports 40 million T-shirts. Consumer surplus, Producer surplus expands by area B. The government’s tariff
producer surplus and the gains from free trade are as large as revenue is area D and the tariff creates a deadweight loss
possible. equal to the area C + E.
In part (b), a tariff of R20 per T-shirt raises the SA price of
a T-shirt to R70. The quantity imported decreases.
Society Loses: A Deadweight Loss Arises Some of the Quantity (millions of T-shirts per year)
loss of consumer surplus is transferred to producers (a) Free trade (b) Market w
The Effects of an Import Quota The effects of an Winners, Losers and the Social Loss from an
import quota are similar to those of a tariff. The price Import Quota An import quota creates winners and
rises, the quantity bought decreases, and the quantity losers that are similar to those of a tariff but with an
produced in South Africa increases. Figure 7.7 illus- interesting difference.
trates the effects. When the government imposes an import quota:
Figure 7.7(a) shows the situation with free inter- ◆ SA consumers of the good lose.
national trade. Figure 7.7(b) shows what happens with ◆ SA producers of the good gain.
an import quota of 10 million T-shirts a year. The SA ◆ Importers of the good gain.
supply curve of T-shirts becomes the domestic supply ◆ Society loses: a deadweight loss arises.
curve, SSA, plus the quantity that the import quota
permits. So the supply curve becomes SSA + quota. The Figure 7.8 shows these gains and losses from
price of a T-shirt rises to R70, the quantity of T-shirts a quota. By comparing Fig. 7.8(b) with a quota
bought in South Africa decreases to 45 million a year, and Fig. 7.8(a) with free trade, you can see how an
the quantity of T-shirts produced in South Africa import quota of 10 million T-shirts a year changes the
increases to 35 million a year and the quantity of consumer and producer surpluses.
T-shirts imported into South Africa decreases to the Consumer surplus – the green area – shrinks.
quota quantity of 10 million a year. All the effects of This decrease is the loss to consumers from the import
this quota are identical to the effects of a R20 per shirt quota. The decrease in consumer surplus is made up
tariff, as you can check in Fig. 7.5(b). of four parts. First, some of the consumer surplus is
150
150 150
150 Consumer
Consumer
Consumer
Consumer surplus
surplus
surplus
surplus shrinks
shrinks
SSA
SSA SSA
SSA
Deadweight
Deadweightloss
loss
from
fromquota
quota
Gain
Gainfromfrom
SSA + +quota
SSA quota
100
100 free
freetrade
trade 100
100
World
World 7070 World
World
price
price DD price
price
BB CC DD E E
5050 5050
Imports
Imports AA Imports
Imports Importers’
Importers’ DSA
DSA
Producer
Producer
with
withfree
free DSA
DSA
surplus
surplus with
withquota
quota profit
profit
trade
trade Producer
Producer
surplus
surplus
expands
expands
The world price of a T-shirt is R50. In part (a), with free trade, In part (b), the import quota raises the price of a T-shirt to R70.
South Africa produces 20 million T-shirts a year and imports The quantity imported decreases. Consumer surplus shrinks by
40 million T-shirts. Consumer surplus, producer surplus and the the areas B, C, D and E. Producer surplus expands by area B.
gain from free international trade (darker green area) are as Importers’ profit is the two areas D and the quota creates a
large as possible. deadweight loss equal to C + E.
But there is a broader range of issues in the domestic firms out of business. When the domestic
free trade versus protection debate. Let us review firms have gone, the foreign firm takes advantage
these issues. of its monopoly position and charges a higher
Two classical arguments for restricting interna- price for its product. Dumping is illegal under
tional trade are: the rules of the WTO and is usually regarded as a
◆ The infant-industry argument justification for temporary tariffs, which are called
◆ The dumping argument countervailing duties.
But there are powerful reasons to resist the
dumping argument for protection. First, it is virtu-
The Infant-Industry Argument ally impossible to detect dumping because it is hard
The infant-industry argument for protection is that to determine a firm’s costs. As a result, the test for
it is necessary to protect a new industry to enable it dumping is whether a firm’s export price is below its
to grow into a mature industry that can compete in domestic price. But this test is a weak one because
world markets. The argument is based on the idea that it can be rational for a firm to charge a low price in
comparative advantage changes or is dynamic and a market in which the quantity demanded is highly
that on-the-job experience – learning-by-doing – is an sensitive to price and a higher price in a market in
important source of changes in comparative advantage. which demand is less price-sensitive.
The fact that learning-by-doing can change comparative Second, it is hard to think of a good that is
advantage does not justify protecting an infant industry. produced by a global monopoly. So even if all the
First, the infant-industry argument is not valid if domestic firms in some industry were driven out of
the benefits of learning-by-doing accrue only to the business, it would always be possible to find alterna-
firms in the infant industry. The reason is that these tive foreign sources of supply and to buy the good at a
firms will anticipate and reap the benefits of learning- price determined in a competitive market.
by-doing without the additional incentive of protec- Third, if a good or service were a truly global
tion from foreign competition. monopoly, the best way of dealing with it would be by
For example, there are huge productivity gains regulation – just as in the case of domestic monopo-
from learning-by-doing in the manufacture of aircraft, lies (see Chapter 13, pp. 294–297). Such regulation
but these gains benefit Boeing and other aircraft would require international cooperation.
producers. Because the people making the decisions are The two arguments for protection that we have
the ones who benefit, they take the future gains into just examined have an element of credibility. The
account when they decide on the scale of their activi- counterarguments are in general stronger, however, so
ties. No benefits accrue to firms in other industries these arguments do not make the case for protection.
or other parts of the economy, so there is no need for But they are not the only arguments that you might
government assistance to achieve an efficient outcome. encounter. There are many other new arguments
Second, even if the case is made for protecting against globalisation and for protection.
an infant industry, it is more efficient to do so by
giving the firms in the industry a subsidy, which is The most common ones are that protection:
financed out of taxes. Such a subsidy would encourage ◆ Saves jobs
the industry to mature and to compete with effi- ◆ Allows us to compete with cheap foreign labour
cient world producers and keep the price faced by ◆ Penalises lax environmental standards
consumers at the world price. ◆ Prevents rich countries from exploiting devel-
oping countries
The Dumping Argument
Dumping occurs when a foreign firm sells its exports at Saves Jobs
a lower price than its cost of production. First, free trade does cost some jobs, but it also creates
Dumping might be used by a firm that wants other jobs. It brings about a global rationalisation of
to gain a global monopoly. In this case, the foreign labour and allocates labour resources to their highest-
firm sells its output at a price below its cost to drive valued activities. International trade in textiles has cost
thousands of jobs in South Africa and in the United Although high-wage SA workers are more
States as textile mills and other factories closed. But productive, on average, than low-wage workers in
thousands of jobs have been created in other countries Lesotho, there are differences across industries. SA
as textile mills opened. And thousands of SA workers labour is relatively more productive in some activities
got better-paying jobs than textile workers because than in others. For example, the productivity of SA
SA export industries expanded and created new jobs. workers in producing non-ferrous metals, transport
More jobs have been created than destroyed. equipment and professional and scientific equip-
Although protection does save particular jobs, it ment is relatively higher than their productivity in
does so at a high cost. Recent estimates by Lawrence & the production of wearing apparel, food products
Edwards (2008) ‘A New Trade Plan’, Mail & Guardian, and beverages. The activities in which SA workers are
20 May 2008 suggest that on average South African relatively more productive than their counterparts in
manufacturing workers earn R95 000 a year. Yet Lesotho are those in which South Africa has a compar-
consumers, many of whom are poor, spend almost ative advantage.
R1.5 million for each job that the tariffs on manu- By engaging in free trade, increasing our produc-
factured goods save. This research shows that if the tion and exports of the goods and services in which
effect of protection on agriculture, mining and services we have a comparative advantage, and decreasing our
are included, South African consumers forgo welfare production and increasing our imports of the goods
benefits that are almost three times the average wage of and services in which our trading partners have a
each job saved. The costs paid by SA consumers comparative advantage, we can make ourselves and
for a job saved in Tobacco (R664 000), Footwear the citizens of other countries better off.
(R162 000), Motor vehicles (R89 000) and Clothing
((R78 000) are particularly high.
Imports do not only destroy jobs. They create Penalises Lax Environmental Standards
jobs for retailers that sell imported goods and for Another argument for protection is that many poorer
firms that service those goods. Imports also create jobs countries, such as Bangladesh and Lesotho, do not
by creating income in the rest of the world, some of have the same environmental policies that SA or
which is spent on SA-made goods and services. richer countries have and, because poor countries
are willing to pollute and rich countries are not, rich
countries cannot compete with poor ones without
Allows Us to Compete with Cheap Foreign tariffs. So if poorer countries want free trade with the
Labour richer and ‘greener’ countries, they must raise their
With the removal of tariffs on trade between environmental standards.
South Africa and Botswana, Lesotho, Namibia and This argument for protection is weak. First, a
Swaziland, under the Southern African Customs poor country cannot afford to be as concerned about
Union Agreement, commentators predicted that its environmental standard as a rich country can.
jobs would rush across SA’s borders into these neigh- Today, some of the worst pollution of air and water is
bouring countries. found in Beijing, Mexico City and cities in the former
Let us see what is wrong with this view. communist countries of Eastern Europe. But only a
The labour cost of a unit of output equals the wage few decades ago, London and Los Angeles topped the
rate divided by labour productivity. For example, if pollution league chart. The best hope for cleaner air
a SA metal worker earns R30 an hour and produces in Beijing and Mexico City is rapid income growth.
10 units of output an hour, the average labour cost of And free trade contributes to that growth. As incomes
a unit of output is R3. If a metal worker in Lesotho in developing countries grow, they will have the means
earns R20 an hour and produces 5 units of output to match their desires to improve their environment.
an hour, the average labour cost of a unit of output Second, a poor country may have a comparative
is R4. Other things remaining the same, the higher a advantage at doing ‘dirty’ work, which helps it to raise
worker’s productivity, the higher is the worker’s wage its income and at the same time enables the global
rate. High-wage workers have high productivity; low- economy to achieve higher environmental standards
wage workers have low productivity. than would otherwise be possible.
Rent Seeking Rent seeking is the major reason Some compensation does take place. When
why international trade is restricted. Rent seeking is Cabinet approved the South African Customs Union
lobbying for special treatment by the government to (SACU) with Botswana, Lesotho, Swaziland and
create economic profit or to divert consumer surplus Namibia, it set up a worker compensation fund to
or producer surplus away from others. Free trade support and retrain workers who lost their jobs as a
increases consumption possibilities on average, but not result of the new trade agreement. During SACU’s
everyone shares in the gain and some people even lose. first years, a few workers applied for benefits under
Free trade brings benefits to some and imposes costs this scheme. The losers from international trade are
on others, with total benefits exceeding total costs. also compensated indirectly through the normal
The uneven distribution of costs and benefits is the unemployment compensation arrangements. But
principal obstacle to achieving more liberal interna- only limited attempts are made to compensate those
tional trade. who lose.
Returning to the example of trade in T-shirts and The main reason why full compensation is not
aeroplanes, the benefits from free trade accrue to all attempted is that the costs of identifying all the
the producers of aeroplanes and to those producers losers and estimating the value of their losses would
of T-shirts that do not bear the costs of adjusting to be enormous. Also, it would never be clear whether
a smaller garment industry. These costs are transition a person who has fallen on hard times is suffering
costs, not permanent costs. The costs of moving to because of free trade or for other reasons that might
free trade are borne by the clothing manufacturers be largely under her or his control. Furthermore,
and their employees who must become producers of some people who look like losers at one point in time
other goods and services in which South Africa has a might, in fact, end up gaining. The young textile
comparative advantage. worker who loses his job in Pietermaritzburg and
The number of winners from free trade is large, becomes a motor vehicle assembly worker in Port
but because the gains are spread thinly over a large Elizabeth might resent the loss of work and the need
number of people, the gain per person is small. The to move.
winners could organise and become a political force But a year later, looking back on events, he
lobbying for free trade. But political activity is costly. counts himself fortunate.
It uses time and other scarce resources and the gains Because we do not, in general, compensate the
per person are too small to make the cost of political losers from free international trade, protectionism
activity worth bearing. is a popular and permanent feature of our national
In contrast, the number of losers from free trade is economic and political life.
small, but the loss per person is large. Because the loss
per person is large, the people who lose are willing to REVIEW QUIZ
incur considerable expense to lobby against free trade.
1 What are the infant industry and dumping
Both the winners and losers weigh benefits and
arguments for protection? Are they correct?
costs. Those who gain from free trade weigh the
2 Can protection save jobs and the environment
benefits it brings against the cost of achieving it.
and prevent workers in developing countries
Those who lose from free trade and gain from
from being exploited?
protection weigh the benefit of protection against
3 What is offshore outsourcing? Who benefits
the cost of maintaining it. The protectionists under-
from it and who loses?
take a larger amount of political lobbying than the
4 What are the main reasons for imposing a tariff ?
free traders.
5 Why do the winners from free trade not win
the political argument?
Compensating Losers
If, in total, the gains from free international trade We end this chapter on global markets in action in
exceed the losses, why do those who gain not compen- Reading Between the Lines on pp. 159–160, where we
sate those who lose so that everyone is in favour of apply what you have learned by looking at the effects of
free trade? a SA quota on imports of textiles from China.
Johannesburg – Minister of Trade and Industry Mandisi Mpahlwa has yet to say whether government
will be lifting or extending the heavily criticised quotas on textile imports from China. Introduced
by government on 1 January 2007, the quotas were imposed in the hope they would revive the
local clothing manufacturing industry. The Southern African Clothing and Textile Workers Union
estimated in 2007 that the sector shed 60 000 jobs between 2003 and 2005. However, clothing
companies have complained that the quotas have had the opposite effect on economic growth and job
creation. Hemporium, a small business that has been making garments and accessories in SA out of
imported hemp fabric since 1996, is one of the businesses that have spoken out against the quotas as
they resulted in the company not having access to production material. Hemporium provides busi-
ness for a dye-house, a cutting and grading business, a bag manufacturing factory, a printing and
embroidery factory, a hat manufacturer and several other cut, make and trim (CMT) operations. It
employs 12 full-time staff. The company produces all its goods locally but hemp, its key raw mate-
rial input, is not grown legally in South Africa. Instead, Hemporium has been importing hemp knits
from China. However, this was brought to a halt
when quotas were introduced and hemp knits
were included in the new system. ‘The quotas did ESSENCE OF THE STORY
not save any jobs in the hemp sector because the
◆ In 2009, South Africa was expected to lift
big guys just moved their business to Bangladesh
quotas on textile imports from China.
and China’, says Hemporium’s marketing director,
◆ Introduced by the South African government
Tony Budden. With no access to fabric in SA, the
in 2007, the quotas were imposed in the hope
company had to pay for a range of T-shirts to be
they would revive the local clothing manufac-
made up in China and fork out an extra 40% in
turing industry.
taxes for bringing completed garments into South
◆ The Southern African Clothing and Textile
Africa. ‘Making these 2 000 T-shirts would have
Workers Union estimated that the sector shed
been good business for someone locally,’ says
60 000 jobs between 2003 and 2005.
Budden. – Fin24.com
◆ Clothing companies complained that the
quotas have had the opposite effect on South
Source: © Copyright Fin24. Reproduced by permission. Africa’s economic growth and job creation.
Further reproduction prohibited. ◆ With no access to Chinese fabric in South
Africa, local clothing manufacturers had to
pay an extra 40 per cent in taxes for bringing
completed Chinese garments into South Africa
effectively denying them the opportunity to
make up the garments locally.
120 120
South Africa
produces here
South Africa
100 produces and 100
consumes here
SA trade line
80 80
60 60
Expansion of
consumption
40 China produces 40 possibilities
and consumes here PPF of
South Africa China's trade line
20 PPF of 20 China
China
produces here
TABLE 1 Production possibilities and trading possibilities for China and South Africa
Other goods and services
Hemp outfits Production possibilities Trading possibilities
South Africa China South Africa China
0 100 20 100 30
20 80 10 85 15
40 60 0 70 0
100 0
In other words the relative price is determined by to produce the same type of computer. Also, South
converting the goods we are producing into some- Africa takes 1 hour to make a bottle of pineapple beer
thing that we are sacrificing. So if South Africa decides and China takes 3 hours to make the same quantity of
to produce pineapple beer then it will have to sacrifice pineapple beer. Is trade possible? Let us see.
computers, and if China produces computers, it will
have to sacrifice pineapple beer. Step 1: Who Has the Absolute Advantage and
Using our table, the opportunity cost can be in What?
seen as a ratio, in other words computers/pineapple Using this information, it is clear that South Africa has
beer or pineapple beer/computers. Remember to the absolute advantage in the production of pineapple
keep all values in labour hours per unit that we are beer and computers. From this table we can easily
producing. determine absolute advantages (remember that at this
So let us start with the ratio of computers/pine- stage we still do not have a price). South Africa has the
apple beer for South Africa. It costs South Africa absolute advantage in producing computers, because
2 units of sacrifice, and China 0.3 units of sacrifice. they only need 1 hour to make a computer. China, in
Thus China will produce and sell computers to South this example, needs 2 hours to make a computer. Also,
Africa. Using the ratio of pineapple beer/computers, South Africa has the absolute advantage of producing
it is obvious that the cost of the sacrifice is 0.5 units pineapple beer as South Africans only need 1 hour for
for South Africa and the cost of the sacrifice for China the production of pineapple beer, but China needs
is 3 units. 3 hours to make the same quantity of pineapple beer.
It is thus hard to determine direction of trade at this
Step 3: Determine the Direction of Trade stage, so let us go to Step 2.
So, we can see that China is much cheaper at
producing computers than South Africa as it Step 2: Calculate the Relative Price
has less of a sacrifice cost associated with producing Let us continue with our example: 2 countries and
computers. And South Africa will sacrifice less 2 products.
producing and selling pineapple beer. Thus
South Africa will produce and sell pineapple South Africa China
beer to China. We now have a direction of trade. Computers 1 hour 2 hours
South Africa sells pineapple beer to China and
China will sell computers to South Africa. Each Pineapple beer 1 hour 3 hours
country has an absolute advantage and trade
is possible. Computers/ 1 2
Pineapple beer (1) (0.67)
1 3
David Ricardo – Comparative Advantage Pineapple beer/ 1 3
Computers (1) (1.5)
But what happens when one country has the absolute 1 2
advantage in producing both goods? Well, according
to Adam Smith, trade is not possible, but David Using the data showing labour needed to produce
Ricardo disagreed. He believed that the relative price the computers and the pineapple beer for South
will determine the direction of trade. Africa and China; we can determine the relative price
Let us set up our example again. for both products for both countries. Using the data
provided in the tables, it costs South Africa 1 unit of
South Africa China sacrifice and China 0.67 units of sacrifice. Thus China
Computers 1 hour 2 hours
will produce and sell computers to South Africa.
Using the ratio of pineapple beer/computers, it is
Pineapple beer 1 hour 3 hours obvious that the cost of the sacrifice is 1 unit again for
South Africa and the cost of the sacrifice for China
Here we can see that South Africa takes 1 hour is 1.5 units. Thus South Africa will produce and sell
to produce a computer and China requires 2 hours pineapple beer to China.
Step 3: Determine the Direction of Trade In order to answer this question, let us go
So, we can see that it is much cheaper (in terms of through the rest of the steps.
sacrifice) to produce a computer in China than it
would be to produce a computer in South Africa, Step 2: Calculate the Relative Price
as China has less of a sacrifice cost associated with
producing computers. And South Africa will sacrifice Korea US
less producing and selling pineapple beer to China. Cars 3 hours 2 hours
Thus, for direction of trade, China will sell Bikinis 4 hours 1 hour
computers to South Africa and South Africa sells
pineapple beer to China.
3 2
But what would happen if we did not get the Cars/Bikinis (0.75) (2)
4 1
information in labour hours, but in output instead?
4 1
Bikinis/Cars (1.33) (0.5)
3 2
A New Example
Let us set up a new example. Using the labour hours needed to produce the
cars and the bikinis for the US and Korea;
Korea US we can determine the relative price for both prod-
Cars 8 units in 24 hours 8 units in 16 hours ucts for both countries. Using the ratio of the two
Bikinis 24 units in 6 hours 24 units in 24 hours products for the two countries, we can see that Korea
(0.75) produces cars cheaper than the US (0.5),
Here we can see that Korea and the US are and the US produces bikinis (0.5) cheaper than
preparing for trade. In this example we are given Korea (1.33).
quantities, and because each country is so different,
let us convert everything to labour hours. Step 3: Determine the Direction of Trade
So, we can see that it is much cheaper (in terms of
Korea US
sacrifice) to produce a car in Korea than in the US.
Cars 3 hours 2 hours Thus Korea will export cars to the US. The US will
Bikinis 4 hours 1 hour sacrifice less producing and selling bikinis to Korea.
Thus, trade is possible. Who would have guessed that
Reading this, we can see that Korea takes 3 hours the US would export bikinis?
to produce a car and the US only needs 2 hours to
produce the same type of car. Korea takes 4 hours to
make a bikini and in the US it takes 1 hour to make Consider This Issue Further
the same type of bikini. Consider how dangerous it could be to disrupt trade
flows between countries. There are many ways of
Step 1: Who Has the Absolute Advantage and disrupting trade, everything from tariffs and quotas
in What? to extreme cases of trade sanctions. Consider this
From this we can see that the US has the absolute issue. Could you give examples of why it would be
advantage in both the production of cars and the dangerous to disrupt trade flows?
production of bikinis. So is trade possible?
Key Terms
Dumping, 154 Import quota, 151 Offshore outsourcing, 156 Rent seeking, 158
Exports, 143 Imports,143 Offshoring, 156 Tariff, 147
General Agreement on Infant-industry argument, Outsourcing, 156 World Trade Organization
Tariffs and Trade (GATT), 154 (WTO), 149
149
The demand schedule is the wholesalers’ demand and 4. Describe Brazil’s comparative advantage in
the supply schedule is the SA rose growers’ supply. producing oil and explain why its comparative
advantage has changed.
Price Quantity demanded Quantity supplied 5. a. Draw a graph to illustrate the Brazilian
(rand) (millions of (millions of market for oil and explain why Brazil was an
containers per year) containers per year) importer of oil until a few years ago.
1 000 15 0 b. Draw a graph to illustrate the Brazilian
1 250 12 2 market for oil and explain why Brazil may
1 500 9 4 become an exporter of oil in the near future.
1 750 6 6 6. IT Workers Need Communication Skills
2 000 3 8
2 250 0 10
Thousands of Indian workers are employed by the
world’s tech firms and call centres possess great
technical knowledge, but their interpersonal and
Wholesalers can buy roses at auction in Aalsmeer, communication skills lag far behind. This is an
Holland, for R1 250 per container. area where Mumbai’s finishing schools can assist.
1. a. Without international trade, what would a. What comparative advantages does this
be the price of a container of roses and how information identify?
many containers of roses a year would be b. Using the information what services do you
bought and sold in South Africa? predict Mumbai (India) exports and what
b. At the price in your answer to part (a), does services do you predict it imports?
South Africa or the rest of the world have a
comparative advantage in producing roses? Winners, Losers and the Net Gain from Trade
2. If SA wholesalers buy roses at the lowest possible 7. In Problem 6, who will gain and who will lose from
price, how many do they buy from SA growers the trade in services that the information predicts?
and how many do they import? 8. Use the information on the SA wholesale market
3. Draw a graph to illustrate the SA wholesale for roses in Problem 1 to:
market for roses. Show the equilibrium in that a. Explain who gains and who loses from free
market with no international trade and the international trade in roses compared to a
equilibrium with free trade. Mark the quantity situation in which South Africans buy only
of roses produced in South Africa, the quantity roses grown in South Africa.
imported and the total quantity bought. b. Draw a graph to illustrate the gains and
losses from free trade.
International Trade Restrictions 17. Explain who gains and who loses from the lower
Use the following info byte to work out Problems 9 tariff on imported cars.
and 10. 18. Draw a graph to show how the price of a car,
the quantity of cars bought, the quantity of cars
Steel Tariffs Backfire produced in Australia, and the quantity of cars
If South Africa were to set aside free-trade principles imported into Australia changed.
and impose heavy tariffs on imported steel to help out
struggling local steel producers, market commentators Use the following info byte to work out Problems 19
may say the tariffs may have cost more jobs than they and 20.
saved, by driving up costs for car manufacturers and
other steel users. The Poor Lose Out
9. a. Explain how a high tariff on steel imports As world stocks of food dwindle during the global
can help domestic steel producers. economic recession, some countries place export
b. Explain how a high tariff on steel imports restrictions on food to protect their own supplies. This
can harm steel users. in turn drives up prices, and affects poor countries
10. Draw a graph of the SA market for steel to show that depend on imports for much of their food.
how a high tariff on steel imports: 19. a. What are the benefits to a country from
i. Helps SA steel producers. importing food?
ii. Harms SA steel users. b. What costs might arise from relying on
iii. Creates a deadweight loss. imported food?
20. If a country restricts food exports, what effect
Use the information on the SA wholesale market for does this restriction have in that country on the
roses in Problem 1 to work out Problems 11 to 16. price of food, the quantity of food it produces,
11. If South Africa puts a tariff of R250 per container the quantity of food it consumes and the quan-
on imports of roses, what happens to the SA price tity of food it exports?
of roses, the quantity of roses bought, the quantity
produced in South Africa and the quantity imported? The Case Against Protection
12. Who gains and who loses from this tariff? 21. Suppose that SA regulators ordered the recall
13. Draw a graph to illustrate the gains and losses from of more than 450 000 faulty tires. The Chinese
the tariff and on the graph identify the gains and producer of the tires disputes the allegations and
losses, the tariff revenue and the deadweight loss. hints that the recall might be an effort by foreign
14. If South Africa puts an import quota on roses of competitors to hamper Chinese exports to South
5 million containers, what happens to the SA price Africa. Increasing scrutiny of Chinese-made
of roses, the quantity of roses bought, the quantity goods has become a source of new trade frictions
produced in South Africa and the quantity imported? between the South Africa and China and fuelled
15. Who gains and who loses from this quota? worries among regulators, corporations and
16. Draw a graph to illustrate the gains and losses consumers about the risks associated with many
from the import quota and on the graph identify products imported from China.
the gains and losses, the importers’ profit and the a. What does the information imply about the
deadweight loss. comparative advantage of producing tyres in
South Africa and China?
Use the following info byte to work out Problems 17 b. Could product quality be a valid argument
and 18. against free trade?
c. How would the product-quality argu-
Car Prices Down in Oz ment against free trade be open to abuse by
In 2000, Australia cut its car tariff to 15 per cent and domestic producers of the imported good?
on January 1, 2005, it cut the tariff to 10 per cent. As
a result, cars have become easy to afford.
30. Explain how the tariff on textiles will change the footwear industry job costs R162 000 per year
price that SA buyers pay for textiles, the quantity and saving a job in the manufacturing of motor
of textiles imported and the quantity of textiles vehicles costs R89 000.
produced in South Africa. a. What are the arguments for saving the jobs
31. Explain how the SA and Chinese gains from mentioned in this information?
trade will change. Who in South Africa will lose b. Explain why these arguments are faulty.
and who will gain? c. Is there any merit to saving these jobs?
Use the following information to work out Problems Economics in the News
34 and 35. 35. After you have studied Reading Between the Lines
on pp. 159–160, answer the following questions.
With free trade between Australia and the United States, a. What events put SA textile producers under
Australia would export beef to the United States. But the pressure and caused some to go out of
United States imposes an import quota on Australian beef. business?
32. Explain how this quota influences the price b. Explain how a quota on textile imports
that US consumers pay for beef, the quantity of changes domestic production, consumption
beef produced in Australia and the US and the and imports of textiles.
Australian gains from trade. c. Illustrate your answer to part (b) with an
33. Explain who in United States gains from the appropriate graphical analysis.
quota on beef imports and who loses. d. Explain how a quota on textile imports
changes consumer surplus and producer
The Case Against Protection surplus.
34. Trading Up e. Explain the four sources of loss of consumer
The cost of protecting jobs in uncompetitive surplus that result from a quota on textile
sectors through tariffs is high: Saving a job in the imports.
tobacco industry costs South African consumers f. Illustrate your answer to part (e) with an
R664 000 in higher prices a year; saving a appropriate graphical analysis.
8
Y ou want Ke$ha’s album Animal. Will you buy the CD version from a
high street store for R150 or will you download it from the iTunes store
for R100? Some people choose a physical CD, others a download.
What determines our choices as buyers of recorded music? Also, how
much better off are we because we can download an album for less
than R100 and some songs for less than R10?
Lerato can afford all the points on the budget line and
Consumption Choices inside it. Points outside the line are unaffordable.
The choices that you make as a buyer of goods and
services – your consumption choices – are influenced FIGURE 8.1 Lerato’s Budget Line
by many factors. We can summarise them under two
broad headings:
8 B
Unaffordable
Consumption Possibilities
6 C
Your consumption possibilities are all the things that
you can afford to buy. You can afford many different
4 D
combinations of goods and services, but they are all Affordable
line shows what is possible; preferences determine the level of consumption – more consumption gener-
which possibility is chosen. We will now describe a ally gives more total utility.
consumer’s preferences. To illustrate the concept of
total utility, think about Lerato’s Total Utility
choices. We tell Lerato that we
Preferences want to measure her utility from
Lerato’s income and the prices that she faces limit her chocolate and cooldrink. We
consumption choices, but she still has lots of choice. can use any scale that we wish to
The choice that she makes depends on her preferences measure her total utility and we
– a description of her likes and dislikes. give her two starting points: (1) We
You saw one way that economists use to describe will call the total utility from no
preferences in Chapter 2 (p. 33), the concept of chocolate and no cooldrink zero www.quickto.mobi/
marginal benefit and the marginal benefit curve. But utility; and (2) We will call the total PEA-UTILITY
you also saw in Chapter 5 (p. 103) that a marginal utility she gets from eating 1 choco-
benefit curve is also a demand curve. The goal of a late bar a month 50 units.
theory of consumer choice is to derive the demand We then ask Lerato to tell us,
curve from a deeper account of how consumers make using the same scale, how much she would like
their buying plans. That is, we want to explain what 2 chocolate bars, and more, up to 10 chocolate bars a
determines demand and marginal benefit. month. We also ask her to tell us, on the same scale,
To achieve this goal, we need a deeper way of how much she would like 1 can of cooldrink a month,
describing preferences. One approach to this problem 2 cans, and more, up to 10 cans a month.
uses the idea of utility, and defines utility as the benefit In Table 8.1, the columns headed ‘Total utility’
or satisfaction that a person gets from the consump- show Lerato’s answers. Looking at those numbers, you
tion of goods and services. can say a lot about how much Lerato likes cooldrink
We distinguish two utility concepts: and chocolate. She says that 1 can of cooldrink gives
◆ Total utility her 75 units of utility – 50 per cent more than the
◆ Marginal utility utility that she gets from eating 1 chocolate bar.
You can also see that her total utility from cool-
Total Utility The total benefit that a person gets drink climbs more slowly than her total utility from
from the consumption of all the different goods and chocolate. This difference turns on the second utility
services is called total utility. Total utility depends on concept: marginal utility.
0 0 0 0
1 50 50 1 75 75
2 90 40 2 123 48
3 122 32 3 159 36
4 150 28 4 183 24
5 176 26 5 205 22
6 200 24 6 225 20
7 222 22 7 238 13
8 242 20 8 248 10
9 259 17 9 255 7
10 275 16 10 260 5
Marginal Utility We define marginal utility as the Positive Marginal Utility All the things that people
change in total utility that results from a one-unit enjoy and want more of have a positive marginal
increase in the quantity of a good consumed. utility. Some objects and activities can generate nega-
In Table 8.1, the columns headed ‘Marginal tive marginal utility – and lower total utility. Two
utility’ show Lerato’s marginal utility from chocolate examples are hard labour and polluted air.
and cooldrink. You can see that if Lerato increases But all the goods and services that people value
the cooldrink she buys from 1 to 2 cans a month, her and that we are thinking about here have positive
total utility from cooldrink increases from 75 units to marginal utility: Total utility increases as the quantity
123 units. For Lerato, the marginal utility from the consumed increases.
second can each month is 48 units (123 – 75).
The marginal utility numbers appear midway Diminishing Marginal Utility As Lerato eats more
between the quantities of cooldrink because it is the chocolate, her total utility from chocolate increases
change in the quantity she buys from 1 to 2 cans that but her marginal utility from chocolate decreases.
produces the marginal utility of 48 units. Similarly, as she consumes more cooldrink, her total
Marginal utility is positive, but it diminishes as the utility from cooldrink increases but her marginal
quantity of a good consumed increases. utility from cooldrink decreases.
250
from cooldrink based on the numbers for the first 5 cans of
Increasing
Total cooldrink a month in Table 8.1. Part (a) shows her total utility
total utility…
utility – increasing total utility. The columns along the total utility
200
curve show the extra total utility from each additional can of
cooldrink – marginal utility. Part (b) shows Lerato’s diminishing
150 marginal utility from cooldrink.
… and diminishing
Units of
utility
80
75
60
50
40 Marginal
utility
20
0 1 2 3 4 5 0 1 2 3 4 5
Quantity (cans per month) Quantity (cans per month)
The tendency for marginal utility to decrease as the 40 units for the second and 32 units for the third.
consumption of a good increases is so general and Lerato’s marginal utility diminishes as she buys more
universal that we give it the status of a principle – the of each good.
principle of diminishing marginal utility.
You can see Lerato’s diminishing marginal utility Your Diminishing Marginal Utility You have been
by calculating a few numbers. Her marginal utility studying all day and into the evening, and you have been
from cooldrink decreases from 75 units from the first too busy finishing an assignment to shop for cooldrink.
can to 48 units from the second can and to 36 units A friend drops by with a can of cooldrink. The utility you
from the third. Her marginal utility from chocolate get from that cooldrink is the marginal utility from your
decreases from 50 units for the first chocolate bar to first cooldrink of the day – from one can. On another
day you have been on a cooldrink binge. You have been and calculations shown in Table 8.2. Let us see what
working on an assignment, but you have guzzled 10 cans that table tells us.
of cooldrink while doing so, and are now sick of cool-
drink. You are happy enough to have one more can, but Find the Just-Affordable Combinations Table
the thrill that you get from it is not very large. It is the 8.2 shows the combinations of chocolate and cool-
marginal utility from the eleventh can in a day. drink that Lerato can afford and that exhaust her R40
income. For example, in row A, Lerato buys only
Graphing Lerato’s Utility Schedules Figure 8.2(a) cooldrink and at R4 per can she can buy 10 cans. In
illustrates Lerato’s total utility from cooldrink. The more row B, Lerato eats 1 chocolate bar and buys 8 cans of
cooldrink Lerato consumes in a month, the more total cooldrink. She spends R8 on the chocolate bar.
utility she gets. Her total utility curve slopes upward. At R4 per can, she spends R32 on cooldrink and is
Figure 8.2(b) illustrates Lerato’s marginal utility from able to buy 8 cans. The combination in row B just
cooldrink. It is a graph of the marginal utility numbers in exhausts her R40. The combinations shown in the
Table 8.1. This graph shows Lerato’s diminishing marginal table are the same as those plotted on her budget line
utility from cooldrink. Her marginal utility curve slopes in Fig. 8.1.
downward as she consumes more cooldrink. We noted that the budget line shows that Lerato
We have described Lerato’s consumption possi- can also afford any combination inside the budget
bilities and preferences. Your next task is to see how line. The quantities in those combinations would be
Lerato chooses what to consume. smaller than the ones shown in Table 8.2 and they
do not exhaust her R40. But smaller quantities do
REVIEW QUIZ not maximise her utility. Why? The marginal utilities
of chocolate bars and cooldrink are positive, so the
1 Explain how a consumer’s income and more of each that Lerato buys, the more total utility
the prices of goods limit consumption she gets.
possibilities.
2 What is utility and how do we use the concept Find the Total Utility for Each Just-Affordable
of utility to describe a consumer’s preferences? Combination Table 8.2 shows the total utility that
3 What is the distinction between total utility Lerato gets from the just-affordable quantities of
and marginal utility? chocolate bars and cooldrink. The second and third
4 What is the key assumption about marginal columns show the numbers for chocolate bars and
utility? fourth and fifth columns show those for cooldrink.
The centre column adds the total utility from choco-
late bars to the total utility from cooldrink. This
number, the total utility from chocolate bars and
Utility-Maximising Choice cooldrink, is what Lerato wants to maximise.
Consumers want to get the most utility possible from In row A of the table, Lerato eats no choco-
their limited resources. They make the choice that late bars and buys 10 cans of cooldrink. She gets
maximises utility. no utility from chocolate and 260 units of utility
To discover this choice, we combine the from cooldrink. Her total utility from chocolate and
constraint imposed by the budget and the consumer’s cooldrink (the centre column) is 260 units.
preferences and find the point on the budget line that In row C of the table, Lerato eats 2 chocolate
gives the consumer the maximum attainable utility. bars and buys 6 cans of cooldrink. She gets 90 units
Let us find Lerato’s utility-maximising choice. of utility from chocolate and 225 units of utility
from cooldrink. Her total utility from chocolate and
cooldrink is 315 units. This combination of chocolate
A Spreadsheet Solution and cooldrink maximises Lerato’s total utility. That
Lerato’s most direct way of finding the quantities of is, given the prices of chocolate and cooldrink,
chocolate and cooldrink that maximise her utility is Lerato’s best choice when she has R40 to spend is to
to make a table in a spreadsheet with the information eat 2 chocolate bars and buy 6 cans of cooldrink.
If Lerato eats 1 chocolate bar, she is able to buy Marginal Utility per Rand Economists interpret your
8 cans of cooldrink, but she gets only 298 units of best possible choice by using the idea of marginal utility
total utility – 17 units less than the maximum attain- per rand. Marginal utility is the increase in total utility
able. If she eats 3 chocolate bars, she is able to buy that results from consuming one more unit of a good.
only 4 cans of cooldrink. She gets 305 units of total Marginal utility per rand is the marginal utility from a
utility – 10 units less than the maximum attainable. good that results from spending one more rand on it.
The distinction between these two marginal
Consumer Equilibrium We have just described concepts is clearest for a good that is infinitely
Lerato’s consumer equilibrium. Consumer equilibrium divisible, such as petrol.
is a situation in which a consumer has allocated all You can buy petrol by the smallest fraction of a
of his or her available income in the way that maxi- litre and literally choose to spend one more or one
mises his or her total utility, given the prices of less rand at the pump. The increase in total utility that
goods and services. Lerato’s consumer equilibrium results from spending one more rand at the pump is
is 2 chocolate bars and 6 cans of cooldrink. the marginal utility per rand from petrol. When you
To find Lerato’s consumer equilibrium, we buy a chocolate bar or a can of cooldrink, you must
did something that an economist might do but spend your rand in bigger lumps.
that a consumer is not likely to do: We measured To buy our marginal chocolate bar or can of cool-
her total utility from all the affordable combinations drink, you must spend the price of one unit and your total
of chocolate and cooldrink and then, by inspection of utility increases by the marginal utility from that item.
the numbers, selected the combination that gives the So to calculate the marginal utility per rand for
highest total utility. There is a more natural way chocolate (or cooldrink), we must divide marginal
of finding a consumer’s equilibrium – a way that utility from the good by its price.
uses the idea that choices are made at the margin, as Call the marginal utility from chocolate MUCh
you first met in Chapter 1. Let us look at this approach. and the price of a chocolate bar PCh. Then the marginal
utility per rand from chocolate bars is
Choosing at the Margin MUCh /PCh
When you go shopping you do not do utility calcula-
Call the marginal utility from cooldrink MUCd
tions. But you do decide how to allocate your budget,
and the price of a can of cooldrink PCd. Then the
and you do so in a way that you think is best for you.
marginal utility per rand from cooldrink is
If you could make yourself better off by spending a
few more rand on an extra unit of one item and the MUCd /PCd
same number of rand less on something else, you
would make that change. So, when you have allocated By comparing the marginal utility per rand from
your budget in the best possible way, you cannot all the goods that a person buys, we can determine
make yourself better off by spending more on one whether the budget has been allocated in the way that
item and less on others. maximises total utility.
Let us see how we use the marginal utility per marginal utility per rand from chocolate bars is 50 units
rand to define a utility-maximising rule. divided by R8, or 6.25 units of utility per rand.
Lerato’s marginal utility from cooldrink when she
Utility-Maximising Rule A consumer’s total utility is consumes 8 cans of cooldrink a month is 10 units.
maximised by following the rule: Because the price of cooldrink is R4 a can, Lerato’s
◆ Spend all the available income marginal utility per rand from cooldrink is 10 units
◆ Equalise the marginal utility per rand for all goods divided by R4, or 2.50 units of utility per rand.
When Lerato eats 1 chocolate bar and consumes
Spend All the Available Income Because more 8 cans of cooldrink a month, her marginal utility per
consumption brings more utility, only those choices rand from cooldrink is less than her marginal utility per
that exhaust income can maximise utility. For Lerato, rand from chocolate bars. That is,
combinations of chocolate and cooldrink that MUCd < MUCh
leave her with money to spend do not give her as PCd PCh
much total utility as those that exhaust her R40 per
month income. If Lerato spent an extra rand on chocolate and
a rand less on cooldrink, her total utility would
Equalise the Marginal Utility per Rand The basic increase. She would get 6.25 units from the extra
idea behind this rule is to move rand from good A to rand spent on chocolate and lose 2.50 units from the
good B if doing so increases the utility from good A by rand less spent on cooldrink. Her total utility would
more than it decreases the utility from good B. Such a increase by 3.75 units (6.25 – 2.50).
utility-increasing move is possible if the marginal utility Too Little Cooldrink and Too Many Chocolate Bars
per rand from good A exceeds that from good B. In row D, Lerato eats 3 chocolate bars a month
But buying more of good A decreases its marginal and consumes 4 cans of cooldrink. Her marginal
utility. And buying less of good B increases its utility from eating the third chocolate bar a month
marginal utility. So by moving rand from good A to is 32 units. At a price of R8 a chocolate bar, Lerato’s
good B, total utility rises, but the gap between the marginal utility per rand from chocolate bars is
marginal utilities per rand gets smaller. 32 units divided by R8, or 4 units of utility per rand.
As long as the gap exists – as long as the marginal Lerato’s marginal utility from cooldrink when she
utility per rand from good A exceeds that from good buys 4 cans a month is 24 units. At a price of R4 a can,
B – total utility can be increased by spending more on Lerato’s marginal utility per rand from cooldrink is
A and less on B. But when enough rands have been 24 units divided by R4, or 6 units of utility per rand.
moved from B to A to make the two marginal utili- When Lerato eats 3 chocolate bars and consumes
ties per rand equal, total utility cannot be increased 4 cans of cooldrink a month, her marginal utility
further. Total utility is maximised. from cooldrink exceeds her marginal utility from
chocolate. That is,
Lerato’s Marginal Calculation Let us apply the basic
idea to Lerato. To calculate Lerato’s marginal utility per MUCd > MUCh
rand, we divide her marginal utility numbers for each PCd PCh
quantity of each good by the price of the good. The If Lerato spent an extra rand on cooldrink and a
table in Figure 8.3 shows these calculations for Lerato, rand less on chocolate, her total utility would increase.
and the graph illustrates the situation on Lerato’s She would get 6 units from the extra rand spent on
budget line. The rows of the table are three of her cooldrink and she would lose 4 units from the rand
affordable combinations of chocolate and cooldrink. less spent on chocolate.
Her total utility would increase by 2 units (6 – 4).
Too Much Cooldrink and Too Few Chocolate Bars
In row B, Lerato eats 1 chocolate bar a month and Utility-Maximising Chocolate Bars and Cooldrink
consumes 8 cans of cooldrink a month. Her marginal In Fig. 8.3, if Lerato moves from row B to row C,
utility from eating 1 chocolate bar a month is 50 units. she increases the chocolate bars she eats from 1 to 2
Because the price of a chocolate bar is R8, Lerato’s a month and decreases the cooldrink she consumes
from 8 to 6 cans a month. Her marginal utility per When Lerato eats 2 chocolate bars and consumes
rand from chocolate falls to 5 and her marginal utility 6 cans of cooldrink a month, her marginal utility per
per rand from cooldrink rises to 5. rand from cooldrink equals her marginal utility per
Similarly, if Lerato moves from row D to row C, rand from chocolate. That is,
she decreases the chocolate she eats from 3 to 2 bars a MUCd = MUCh
month and increases the cooldrink she consumes from PCd PCh
4 to 6 cans a month. Her marginal utility per rand
from chocolate rises to 5 and her marginal utility per Lerato cannot move from this allocation of her
rand from cooldrink falls to 5. budget without making herself worse off.
of cooldrink each month. Then, with no change New Marginal Utilities per Rand from Chocolate
in her R40 income and no change in the price A person’s preferences do not change just because a
of cooldrink, the price of a chocolate bar falls price has changed. With no change in her preferences,
from R8 to R4. How does Lerato change her Lerato’s marginal utilities in Table 8.3 are the same as
buying plans? those in Table 8.1. But because the price of a chocolate
bar has changed, the marginal utility per rand from
Finding the New Quantities of Chocolate Bars chocolate bars changes. In fact, with a halving of the
and Cooldrink price of a chocolate bar from R8 to R4, the marginal
You can find the effect of a fall in the price of a choco- utility per rand from chocolate bars has doubled.
late bar on the quantities of chocolate and cooldrink The numbers in Table 8.3 show Lerato’s new
that Lerato buys in a three-step calculation. marginal utility per rand from chocolate bars for each
1. Determine the just-affordable combinations of quantity of chocolate bars. The table also shows Lerato’s
chocolate and cooldrink at the new prices. marginal utility per rand from cooldrink for each quantity.
2. Calculate the new marginal utilities per rand
from the good whose price has changed. Equalising the Marginal Utilities per Rand You can see
3. Determine the quantities of chocolate and that if Lerato continues to eat 2 chocolate bars a month
cooldrink that make their marginal utilities and buy 6 cans of cooldrink, her marginal utility per rand
per rand equal. from chocolate (row A) is 10 units and her marginal
utility per rand from cooldrink (row B) is 5 units. Lerato
Affordable Combinations The lower price of a choc- is buying too much cooldrink and too few chocolate bars.
olate bar means that Lerato can afford more chocolate If she spends a rand more on chocolate and a rand less on
or more cooldrink. Table 8.3 shows her new afford- cooldrink, her total utility increases by 5 units (10 – 5).
able combinations. In row A, if she continues to eat If Lerato continues to buy 6 cans of cooldrink and
2 chocolate bars a month, she can now afford 8 cans decreases the number of chocolate bars to 4 (row B), her
of cooldrink and in row B, if she continues to buy marginal utility per rand from chocolate bars falls to
6 cans of cooldrink, she can now afford 4 chocolate 7 units, but her marginal utility per rand from cooldrink
bars. Lerato can afford any of the combinations shown is 5 units. Lerato is still buying too much cooldrink and
in the rows of Table 8.3. eating too few chocolate bars. If she spends a rand
The next step is to find her new marginal utilities more on chocolate and a rand less on cooldrink, her
per rand from chocolate. total utility increases by 2 units (7 – 5).
TABLE 8.3 How a Change in the Price of Chocolate Bars Affects Lerato’s Choices
Possibility Chocolate bars Cooldrink
Quantity Marginal utility Marginal utility Cans Marginal utility Marginal utility
(per rand) (per rand)
0 0 10 5 1.25
1 50 12.50 9 7 1.75
A 2 40 10.00 8 10 2.50
3 32 8.00 7 13 3.25
B 4 28 7.00 6 20 5.00
5 26 6.50 5 22 5.50
C 6 24 6.00 4 24 6.00
7 22 5.50 3 36 9.00
8 20 5.00 2 48 12.00
9 17 4.25 1 75 18.75
10 16 4.00 0 0
But if Lerato eats 6 chocolate bars and buys 4 cans utility per rand from cooldrink and she is maximising
of cooldrink a month (row C ), her marginal utility utility. If Lerato moves from this allocation of her
per rand from chocolate (6 units) equals her marginal budget in either direction, her total utility decreases.
A Change in the Quantity Demanded Lerato’s A Change in Demand The decrease in the quantity
increase in the quantity of chocolate that she eats is of cooldrink that Lerato buys is the change in the
R8, Lerato eats 2 chocolate bars a month. When the buys 6 cans of cooldrink on demand curve D0.
price of a chocolate bar falls to R4, she eats 6 choco- When the price of a chocolate bar falls to R4,
late bars a month. Lerato moves downward along her Lerato buys 4 cans of cooldrink on demand curve D1.
D
demand curve for chocolate. The fall in the price of a chocolate bar decreases
The demand curve traces the quantities that Lerato’s demand for cooldrink. Her demand curve for
0 2 4 6 8
maximise utility at each price, with all other influ- cooldrink shifts leftward. For Lerato, cooldrink
Quantity (chocolate bars per month)
and
ences remaining the same. You can also see that chocolate are substitutes.
(a) Demand for chocolate bars
4 4
D0
D
D1
0 0 2 4 6 8
2 4 6 8
Quantity (chocolate bars per month) Quantity (cans per month)
When the price of a chocolate bar falls and the price of price of a chocolate bar falls, Lerato’s demand for cooldrink
cooldrink remains the same, the quantity of chocolate bars decreases, and in part (b), her demand curve for cooldrink
Price (rand per can)
demanded by Lerato increases, and in part (a), Lerato moves shifts leftward. For Lerato, cooldrink and chocolate are
along her demand curve for chocolate. Also, for
Lerato's demand when the substitutes.
8 cooldrink when the
price of a chocolate
bar is ...
... R8
... R4
A Rise in the Price of Cooldrink (row A), her marginal utility per rand from cooldrink
Now suppose that with the price of a chocolate bar at is 3. But she must reduce the chocolate bars she eats
R4, the price of cooldrink rises from R4 to R8 a can. to 2, which increases her marginal utility per rand
How does this price change influence Lerato’s buying from chocolate bars to 10. Lerato is buying too much
plans? We find the answer by repeating the three-step cooldrink and too few chocolate bars. If she spends a
calculation with the new price of cooldrink. rand less on cooldrink and a rand more on chocolate
Table 8.4 shows Lerato’s new affordable combi- bars, her utility increases by 7 units (10 – 3).
nations. In row A, if she continues to buy 4 cans of But if Lerato eats 6 chocolate bars a month and reduces
cooldrink a month she can afford to eat only 2 chocolate her cooldrink to 2 cans (row B ), her marginal utility per
bars; and in row B, if she continues to eat 6 chocolate rand from chocolate bars (6 units) equals her marginal
bars a month, she can afford only 2 cans of cooldrink. utility per rand from cooldrink. She is maximising utility.
Table 8.4 show Lerato’s marginal utility per rand Lerato’s decreased purchases of cooldrink results
from cooldrink for each quantity of cooldrink when the from an income effect – she can afford fewer cans and
price is R8 a can. The table also shows Lerato’s marginal she buys fewer cans.
utility per rand from chocolate for each quantity. But she continues to buy the same quantity of
If Lerato continues to buy 4 cans of cooldrink chocolate.
TABLE 8.4 How a Change in the Price of Cooldrink Affects Lerato’s Choices
Possibility Chocolate bars Cooldrink cans
Quantity Marginal utility Marginal utility Quantity Marginal utility Marginal utility
(per rand) (per rand)
0 0 5 22 2.75
A 2 40 10.00 4 24 3.00
4 28 7.00 3 36 4.50
B 6 24 6.00 2 48 6.00
8 20 5.00 1 75 9.38
10 16 4.00 0 0
FIGURE 8.5 A Rise in the Price of Cooldrink Lerato’s Demand for Cooldrink Now that we
have calculated the effect of a change in the price of
Price (rand per can)
changes. Next, we will see how marginal utility theory Table 8.5 shows the calculations needed to
predicts the effect of a change in income on demand. answer this question. If Lerato continues to eat
6 chocolate bars a month, she can now afford to
buy 8 cans of cooldrink (row A); if she continues to
A Rise in Income buy 4 cans of cooldrink, she can now afford to eat
Suppose that Lerato’s income increases from R40 to 10 chocolate bars (row C ).
R56 a month and that the price of a chocolate bar is In row A, Lerato’s marginal utility per rand from
R4 and the price of a cooldrink is R4 a can. With these chocolate is greater than her marginal utility per rand
prices and with an income of R40 a month, Lerato eats from cooldrink. She is buying too much cooldrink and
6 chocolate bars and buys 4 cans of cooldrink a month too few chocolate bars. In row C, Lerato’s marginal
(Table 8.3). How does the increase in Lerato’s income utility per rand from chocolate is less than her
from R40 to R56 change her buying plans? marginal utility per rand from cooldrink.
D1 D1
D0 D0
0 4 6 8 10 0 2 4 6 8
Quantity (chocolate bars per month) Quantity (cans per month)
When Lerato’s income increases, her demand for chocolate shift rightward. For Lerato, chocolate and cooldrink are
and her demand for cooldrink increase. Lerato’s demand normal goods.
curves for chocolate, in part (a), and for cooldrink, in part (b),
She is buying too little cooldrink and too many choco- low price of water. The marginal utility per rand is the
late bars. But in row B, when Lerato eats 8 choco- same for diamonds and water.
late bars a month and buys 6 cans of cooldrink, her
marginal utility per rand from chocolate bars equals Value and Consumer Surplus Another way to
that from cooldrink. She is maximising utility. think about the paradox of value and to illustrate
Figure 8.6 shows the effects of the rise in Lerato’s how it is resolved uses consumer surplus. Figure 8.7
income on her demand curves for chocolate and explains the paradox of value by using this idea.
of water
cooldrink. The price of each good is R4. When Lerato’s
of water
income rises to R56 a month, she eats 2 more chocolate FIGURE 8.7 The Paradox of Value
Price
water
bars and buys 2 more cans of cooldrink. Her demand
ofPrice
of water
curves for both chocolate and cooldrink shift rightward Consumer
– her demand for both chocolate bars and cooldrink surplus from
Price
Consumer
water
surplus from
Price
increases. With a larger income, the consumer always water
Consumer
buys more of a normal good. For Lerato, chocolate and surplus
Consumerfrom
water
cooldrink are normal goods. surplus from
water
PW S
The Paradox of Value PW S
D
The price of water is low and the price of a diamond is PW
0 QW DS
high, but water is essential to life while diamonds are PW
0 Quantity
QW of water S
used mostly for decoration. How can valuable water be so (a) Water
D
Quantity of water
0 QW D
cheap while a relatively useless diamond is so expensive? (a) Water
Quantity
0 QW of water
This so-called paradox of value has puzzled philosophers Quantity of water
(a) Water
for centuries. Not until the theory of marginal utility had S
a diamond
surplus
Consumerfrom
diamonds
surplus from
S
diamond
PD surplus from
by distinguishing between total utility and marginal Consumer
diamonds
Price
surplus from
utility. The total utility that we get from water is PD diamonds
enormous. But remember, the more we consume of
Price
PD
Price
The supply of water in part (a) is perfectly elastic at price call the units of temperature degrees. But like the units
PW, so the quantity of water consumed is QW and the of utility, these degree units are arbitrary. We can use
large green area shows the consumer surplus from water. Celsius units or Fahrenheit units or some other units.
The supply of diamonds in part (b) is perfectly The concept of utility helps us to make predic-
inelastic at the quantity Q D, so the price of a diamond tions about consumption choices in much the same
is PD and the small green area shows the consumer way that the concept of temperature helps us to make
surplus from diamonds. Water is cheap, but brings a predictions about physical phenomena.
large consumer surplus; diamonds are expensive, but Admittedly, marginal utility theory does not enable
bring a small consumer surplus. us to predict how buying plans change with the same
precision that a thermometer enables us to predict when
water will turn to ice or steam. But the theory provides
Temperature: An Analogy important insights into buying plans and has some
Utility is similar to temperature – both are abstract powerful implications. It helps us to understand why
concepts. You cannot observe temperature. You can people buy more of a good or service when its price falls
observe water turning to steam if it is hot enough and why people buy more of most goods when their
or turning to ice if it is cold enough. You can also incomes increase. It also resolves the paradox of value.
construct an instrument – a thermometer – that can We are going to end this chapter by looking
help you to predict when such changes will occur. We at some new ways of studying individual economic
call the scale on the thermometer temperature and we choices and consumer behaviour.
REVIEW QUIZ
1 When the price of a good falls and the prices of 3 If a consumer’s income increases and if all goods
other goods and a consumer’s income remain the are normal goods, explain how the quantity
same, explain what happens to the consumption bought of each good changes.
of the good whose price has fallen and to the 4 What is the paradox of value and how is the
consumption of other goods. paradox resolved?
2 Elaborate on your answer to the previous ques- 5 What are the similarities between utility and
tion by using demand curves. For which good temperature?
does demand change and for which good does
the quantity demanded change?
New Ways of Explaining Consumer A few researchers have paid attention to the
Choices potential payoff from exploring economic problems
by using the tools of psychology. These researchers,
When William Stanley Jevons developed marginal
some economists and some psychologists, think that
utility theory in the 1860s, he would have loved to
marginal utility theory is based on a view of how
look inside people’s brains and ‘see’ their utility. But
people make choices that attributes too much to
he believed that the human brain was the ultimate
reason and rationality. They propose an alternative
black box that could never be observed directly. For
approach based on the methods of psychology.
Jevons, and for most economists today, the purpose
Other researchers, some economists and some
of marginal utility theory is to explain our actions, not
neuroscientists, are using new tools to look inside the
what goes on inside our brains.
human brain and open up Jevons’ ‘black box’.
Economics has developed over the past 150 years
This section provides a very brief introduction to
with little help from and paying little attention to
these new and exciting areas of economics. We will
advances being made in psychology. Both economics and
explore the two related research agendas:
psychology seek to explain human behaviour, but they
◆ Behavioural economics
have developed different ways of attacking the challenge.
◆ Neuroeconomics
If people make rational utility-maximising decisions, it decisions that we observe people making and not to
is in this region of the brain that the decision occurs. explain what goes on inside people’s heads.
But observations also show that some economic Most economists would prefer to probe apparent
decisions generate activity in the region of the brain anomalies more deeply and figure out why they are
(called the hippocampus) where we store memories not anomalies after all.
of anxiety and fear. Decisions that are influenced by Economists also point to the power of marginal
activity in this part of the brain might not be rational utility theory and its ability to explain consumer choice
and be driven by fear or panic. and demand, as well as resolve the paradox of value.
Neuroeconomists are also able to observe the
amount of a brain hormone (called dopamine), the quan-
tity of which increases in response to pleasurable events REVIEW QUIZ
and decreases in response to disappointing events. These 1 Define behavioural economics.
observations might one day enable neuroeconomists to 2 What are the three limitations on human ration-
actually measure utility and shine a bright light inside ality that behavioural economics emphasises?
what was once believed to be the ultimate black box. 3 Define neuroeconomics.
4 What do behavioural economics and neuro-
economics seek to achieve?
Controversy
The new ways of studying consumer choice that we You have now completed your study of the
have briefly described here are being used more widely marginal utility theory and some new ideas about
to study business decisions and decisions in financial how people make economic choices. You can see
markets, and this type of research is surely going to marginal utility theory in action once again in
become more popular. Reading Between the Lines on pp. 185–187, where it
But behavioural economics and neuroeconomics is used to explain why nurses who save people’s lives
generate controversy. Most economists hold the view earn so much less than football players who merely
of Jevons that the goal of economics is to explain the provide entertainment.
One of the most decorated African players in the history of the game, Samuel Eto’o sent shock-
waves through the football world in August when he left Inter Milan to join Russian side FC Anzhi
Makhachkala to become the highest paid player on the planet.
Reportedly earning a salary of €20.5 million per season, the Cameroon captain signed a three-year
deal for a fee said to total $36 million plus performance-related add-ons. Counting Puma and Ford
among his sponsors, (Eto’o drives the iconic Ford GT) Eto’o could rake in much more through
personal promotions and advertising deals.
Source: Excerpted from ‘Africa’s Highest Paid Sports Stars’ by Melissa Rudd. African Business Review 2011.
‘I see a minimum of 60 patients a day, many days up to 100’, says Sister Jaconuum Cupido, who
works in a primary health clinic in Springbok in the Northern Cape.
Cupido cares for a wide range of needs from pregnant women to psychiatric patients.
Work pressure has increased substantially on primary health care nurses like Cupido since government
moved from expensive hospital-based care to clinic-based primary health care (PHC).
But it is at these clinics that staff shortages are often felt most acutely.
Given that there is a worldwide shortage of health professionals, nurses with poor working conditions
are vulnerable to overtures from wealthier nations able to pay good salaries.
Countries such as the UK, Canada and the US are facing a growing demand for health care from
their aging populations and have embarked on aggressive recruitment policies, according to the SA
Health Review.
◆ Figure 1 shows the market for nurses. The ◆ Not only is the marginal utility from a nurse
equilibrium quantity is 100 000 workers and greater than that from a football player, but
the average wage rate is R90 000 a year. nurses also create a greater consumer surplus.
◆ Figure 2 shows the market for just the top
earners of overseas-based professional football N.B. The wages for the football players are paid in
players. The equilibrium quantity is 50 players an overseas currency yet are expressed here in South
and the average wage rate for this small group African rand thereby elevating their wages and the
of elite top players is R60 000 000 a year. consumer surplus. This further adds to how important
(Samuel Eto’o is one of the highest paid nurses are to society as reflected by the much higher
overseas players.) consumer surplus.
Wage rate (thousands of rand per year)
SN 70.0
90
80
DN
60.0
60
DF
0 50 100 0 50 100
Quantity (thousands of nurses) Quantity (football players)
Key Terms
Behavioural economics, 184 Diminishing marginal Marginal utility per Preferences, 171
Budget line, 170 utility, 172 rand, 174 Total utility, 171
Consumer equilibrium, 174 Marginal utility, 172 Neuroeconomics, 184 Utility, 171
Predictions of Marginal Utility Theory Use the following info byte to work out Problems
Use the data in Problem 3 to work out Problems 12 to 16. 19 to 21.
12. Johan is offered a special deal: The price of renting
windsurfing equipment is cut to R50 an hour. Exclusive Status: It’s Your Call; R52 500 Cellphones.
How many hours does Johan spend windsurfing 20 Worldwide. 1 in South Africa.
and how many hours does he spend snorkelling? Forget your Nokia. Put away your BlackBerry. Even
13. Draw Johan’s demand curve for rented wind- the iPhone seems positively discount. The Gucci
surfing equipment. Over the price range from Tribute cellphone with real gold and diamonds for
R50 to R100 an hour, is Johan’s demand for the cover case is the ultimate status phone, ringing in
windsurfing equipment elastic or inelastic? at R52 500, and the company is offering only ten for
14. How does Johan’s demand for snorkelling equip- sale in South Africa and 100 worldwide.
ment change when the price of windsurfing 19. Use marginal utility theory to explain the facts
equipment falls? What is Johan’s cross elasticity of reported in the info byte.
demand for snorkelling with respect to the price 20. If Gucci offered 50 of these Tribute phones in
of windsurfing? Are windsurfing and snorkelling South Africa and 2 000 worldwide, what do you
substitutes or complements for Johan? predict would happen to the price that buyers
15. If Johan’s income increases from R350 to R550 a would be willing to pay and what would happen
day, how does his demand for rented windsurfing to the consumer surplus?
equipment change? Is windsurfing a normal good 21. If the Tribute phone is copied and thousands are
or an inferior good for Johan? Explain. sold illegally, what do you predict would happen
16. If Johan’s income increases from R350 to R550 a to the price that buyers would be willing to pay
day, how does his demand for rented snorkelling for a genuine phone and what would happen to
equipment change? Is snorkelling a normal good the consumer surplus?
or an inferior good for Johan? Explain.
New Ways of Explaining Consumer Choices
Use the following info byte to work out Problems Use the following info byte to work out Problems
17 and 18. 22 and 23.
bought R20 000 40-inch TVs are the ones that New Ways of Explaining Consumer Choices
will lead the change. Everyone else will come Use the following info byte to work out Problems
along when the price falls. Blu-ray machine prices 35 to 37.
are now starting to drop and a Samsung Blu-ray
player can be bought for less than R1 000. That’s How Much Does a Human Life Cost?
cheaper than most alternatives, but a hefty price Researchers have valued a healthy human life at about
hike from a typical R200 DVD player. R2 200 000. Using health insurance records on treat-
a. What does marginal utility theory predict ment costs for kidney failure as a benchmark, they set
about the marginal utility from a Samsung the threshold beyond which ensuring another year of
Blu-ray machine compared to the marginal life was no longer financially worthwhile. This is part
utility from a typical DVD player? of the debate over whether health insurance compa-
b. What will have to happen to the marginal nies should limit health care to what is cost effective.
utility from a Blu-ray machine before it 35. Why might insurance companies ration health care
is able to ‘claim victory over the good old according to treatment that is ‘financially worth-
DVD’? while’ as opposed to providing as much treatment
34. Ben spends R500 a year on 2 bunches of flowers as is needed by a patient, regardless of costs?
and R500 a year on 10 000 litres of tap water. 36. What conflict might exist between a person’s
Ben is maximising utility and his marginal utility valuation of his or her own life and the rest
from water is 0.5 units per litre. of society’s valuation of that person’s life?
a. Are flowers or water more valuable to Ben? 37. How does the potential conflict between self-
b. Explain how Ben’s expenditure on flowers interest and the social interest complicate setting a
and water illustrates the paradox of value. financial threshold for health insurance treatments?
9
Y ou buy your music online and play it on an iPod. As the prices
of a music download and an iPod have tumbled, the volume of
downloads and sales of iPods have skyrocketed.
The price of a DVD rental has also fallen and we are renting ever
more of them. But we are also going to movie theatres in ever-greater
numbers. Why are we going to the movies
of cooldrink.
D
The price of a bar of chocolate is R8, and the 4 Affordable
price of cooldrink is R4 a can.
Figure 9.1 shows the alternative combinations E
2
of chocolate and cooldrink that Lerato can afford. Budget line
1 If you have studied Chapter 8 on marginal utility theory, you have already met
Lerato. This tale of her thirst for cooldrink and zeal for chocolate will sound familiar
to you – up to a point. In this chapter, we are going to explore her budget line in
more detail and use a different method for representing a budget equation.
Budget Equation First, set QCh equal to zero. The budget equation
tells us that QCd, the quantity of cooldrink, is Y/PCd,
We can describe the budget line by using a budget
which is 10 cans. This combination of QCh and
equation. The budget equation starts with the fact that
QCd is the one shown in row A of the table in
Expenditure = Income Fig. 9.1. Next set QCh equal to 5. QCd now equals
zero (row F of the table). Check that you can derive
Expenditure is equal to the sum of the price of each the other rows.
good multiplied by the quantity bought. For Lerato, The budget equation contains two variables
chosen by the household (QCh and QCd) and
Expenditure = (Price of cooldrink × Quantity
two variables that the household takes as given
of cooldrink)
(Y/PCd and PCh/PCd). Let us look more closely at
+ (Price of chocolate × Quantity of chocolate)
these variables.
Call the price of cooldrink PCd , the quantity of
cooldrink QCd , the price of a bar of chocolate PCh, the Real Income A household’s real income is its income
quantity of bars of chocolate QCh, and income Y. expressed as a quantity of goods that the household
We can now write Lerato’s budget equation as can afford to buy. Expressed in terms of cooldrink,
Lerato’s real income is Y/PCd. This quantity is the
PCdQCd + PChQCh = Y maximum quantity of cooldrink that she can buy.
Or, using the prices Lerato faces, R4 a can of It is equal to her money income divided by the price
cooldrink and R8 a bar of chocolate, and Lerato’s of cooldrink. Lerato’s money income is R40 and the
income, R40, we get price of cooldrink is R4 a can, so her real income in
terms of cooldrink is 10 cans, which is shown in
R4QCd + R8QCh = R40 Fig. 9.1 as the point at which the budget line
intersects the y-axis.
Lerato can choose any quantities of cooldrink
(QCd) and chocolate (QCh) that satisfy this equation. To Relative Price A relative price is the price of one
find the relationship between these quantities, divide good divided by the price of another good. In Lerato’s
both sides of the equation by the price of cooldrink budget equation, the variable PCh /PCd is the relative
(PCd) to get price of a bar of chocolate in terms of cooldrink. For
P Y Lerato, PCh is R8 a bar of chocolate and PCd is R4 a
QCd + ( Ch ) × QCh =
PCd PCd can, so PCh /PCd is equal to 2 cans of cooldrink per bar
Now subtract the term (PCh /PCd) × QCh from both of chocolate. That is, to eat 1 bar of chocolate, Lerato
sides of this equation to get must give up 2 cans of cooldrink.
You have just calculated Lerato’s opportunity
Y P cost of eating a bar of chocolate. Recall that the
QCd = ( ) – ( Ch × QCh)
PCd PCd opportunity cost of an action is the best alternative
For Lerato, income (Y ) is R40, the price of a bar forgone. For Lerato to eat 1 more bar of chocolate a
of chocolate (PCh) is R8, and the price of cooldrink month, she must forgo 2 cans of cooldrink. You have
(PCd ) is R4 a can. So Lerato must choose the quantities also calculated Lerato’s opportunity cost of cooldrink.
of chocolate and cooldrink to satisfy the equation For Lerato to buy 2 more cans of cooldrink a month,
she must forgo eating 1 bar of chocolate. So her
R40 R8 opportunity cost of 2 cans of cooldrink is 1 bar
QCd = ( )–( × QCh)
R4 R4 of chocolate.
or The relative price of a bar of chocolate in terms
QCd = 10 – 2QCh of cooldrink is the magnitude of the slope of Lerato’s
budget line. To calculate the slope of the budget
To interpret the equation, look at the budget line line, recall the formula for slope (see the Chapter 1
in Fig. 9.1 and check that the equation delivers that Appendix): Slope equals the change in the variable
budget line. measured on the y-axis divided by the change in the
variable measured on the x-axis as we move along The higher the price of the good measured on the
the line. In Lerato’s case (Fig. 9.1), the variable x-axis, other things remaining the same, the steeper is
measured on the y-axis is the quantity of cooldrink the budget line. For example, if the price of a bar of
and the variable measured on the x-axis is the quantity chocolate rises from R8 to R16, the relative price of
of chocolate. a bar of chocolate increases. The budget line rotates
Along Lerato’s budget line, as cooldrink decreases inward and becomes steeper, as Fig. 9.2(a) illustrates.
from 10 to 0 cans, bars of chocolate increase from
0 to 5. So the magnitude of the slope of the budget A Change in Income A change in money income
line is 10 cans divided by 5 bars of chocolate, or changes real income but does not change the relative
A A
10 10
Price of a
9 chocolate is … 9
8 8
7 7
6 6
5 5
4 4
3 3
2 2 Income Income
R20 R40
... R16 ... R8 ... R4 1
1
F F
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5
Chocolate (bars per month) Chocolate (bars per month)
In part (a), the price of a bar of chocolate changes. A fall in In part (b), income falls from R40 to R20 while the prices of
the price fromA R8 to R4 rotates the budget line outward and chocolate and cooldrink remain the same. The budget line
Cooldrink (cans per month)
10
makes it flatter. A rise in the price from R8 to R16 rotates the shifts leftward, but its slope does not change.
9 inward and makes it steeper.
budget line
8
6
5 PART THREE Households’ Choices
4
9781775785026_gsp_eco_stb_ter_eng_za.indb 195 2014/03/14 7:11 AM
196 CHAPTER 9 Possibilities, Preferences and Choices
10 10
8 8
C Preferred C
6 6
J
4 4
2 Indifference 2 G I2
Not G
preferred cur ve
I1
I0
0 2 4 6 8 10 0 2 4 6 8 10
Chocolate (bars per month) Chocolate (bars per month)
Part (a) shows one of Lerato’s indifference curves. She prefers points on the indifference curve to points below it (in
Cooldrink (cans per month)
10
is indifferent between point C (with 2 bars of chocolate the grey area).
and 6 cans of cooldrink) and all other points on the green Part (b) shows three of the indifference curves – I0, I1 and
indifference
8 curve, such as G. She prefers points above the I2 – in Lerato’s preference map. She prefers point J to point C
indifference curve (in the yellow area) to points on it, and she or G, and she prefers all the points on I2 to those on I1.
C
6
J
4
PART THREE Households’ Choices
2
9781775785026_gsp_eco_stb_ter_eng_za.indb 196 G I2 2014/03/14 7:11 AM
Preferences and Indifference Curves 197
that Lerato is just as happy to eat 2 bars of chocolate and Her marginal rate of substitution is the
buy 6 cans of cooldrink a month at point C as she is magnitude of the slope of the indifference curve at
to have the combination of chocolate and cooldrink at point C. To measure this magnitude, place a straight
point G or at any other point along the curve. line against, or tangent to, the indifference curve at
Lerato also says that she prefers all the combinations point C. Along that line, as the quantity of cooldrink
of chocolate and cooldrink above the indifference decreases by 10 cans, the number of bars of chocolate
curve in Fig. 9.3(a) – the yellow area – to those on the increases by 5 – or 2 cans per bar of chocolate. At
indifference curve. And she prefers any combination on point C, Lerato is willing to give up cooldrink for
the indifference curve to any combination in the grey chocolate at the rate of 2 cans per bar of chocolate –
area below the indifference curve. a marginal rate of substitution of 2.
The indifference curve in Fig. 9.3(a) is just one of At point G on indifference curve I1, Lerato buys
a whole family of such curves. This indifference curve 1.5 cans of cooldrink and eats 6 bars of chocolate. Her
appears again in Fig. 9.3(b), labelled I1. The curves marginal rate of substitution is measured by the slope
labelled I0 and I2 are two other indifference curves. of the indifference curve at point G. That slope is the
Lerato prefers any point on indifference curve I2 same as the slope of the tangent to the indifference
to any point on indifference curve I1, and she prefers curve at point G. Now, as the quantity of cooldrink
any point on I1 to any point on I0. We refer to I2 as decreases by 4.5 cans, the number of bars of chocolate
being a higher indifference curve than I1 and I1 as increases by 9 – or 12 can per bar of chocolate. At point
being higher than I0. G, Lerato is willing to give up cooldrink for chocolate
A preference map is a series of indifference curves at the rate of 12 can per bar of chocolate – a marginal
that resemble the contour lines on a map. By looking rate of substitution of 12 .
at the shape of the contour lines on a map, we can
draw conclusions about the terrain. Similarly, by
looking at the shape of the indifference curves, we can FIGURE 9.4 The Marginal Rate of Substitution
draw conclusions about a person’s preferences.
Cooldrink (cans per month)
10.0
Let us learn how to ‘read’ a preference map.
As Lerato eats more chocolate and buys smaller is the quantity of cooldrink you are willing
less cooldrink, her marginal rate of substitution to give up to eat one additional bar of chocolate.
diminishes. Diminishing marginal rate of substitution The shape of a person’s indifference curves
is the key assumption about preferences. A diminishing incorporates the principle of the diminishing marginal
marginal rate of substitution is a general tendency for rate of substitution because the curves are bowed toward
a person to be willing to give up less of good y to the origin. The tightness of the bend of an indifference
get one more unit of good x, while at the same time curve tells us how willing a person is to substitute one
remaining indifferent as the quantity of x increases. good for another while remaining indifferent. Let us look
In Lerato’s case, she is less willing to give up cooldrink at some examples that make this point clear.
to eat one more bar of chocolate as the number of
bars of chocolate she eats increases.
Degree of Substitutability
Your Diminishing Marginal Rate of Substitution Most of us would not regard chocolate and cooldrink
Think about your own diminishing marginal rate as being close substitutes, but they are substitutes. No
of substitution. Imagine that in a week, you drink matter how much you love cooldrink, some increase
10 cans of cooldrink and eat no chocolate. Most in the amount of chocolate you eat will compensate
likely, you are willing to give up a lot of cooldrink you for being deprived of a can of cooldrink. Similarly,
so that you can eat just 1 bar of chocolate. But now no matter how much you love eating chocolate, some
imagine that in a week, you buy 1 can of cooldrink number of cans of cooldrink will compensate you
and eat 6 bars of chocolate. Most likely, you will for being deprived of eating one bar of chocolate. A
now not be willing to give up much cooldrink to person’s indifference curves for chocolate and cooldrink
eat a seventh bar of chocolate. As a general rule, the might look something like those for most ordinary
greater the number of bars of chocolate you eat, the goods and services shown in Figure 9.5(a).
10 10 5
Ordinar y Perfect Perfect
goods substitutes complements
8 8 4
6 6 3
4 4 2
2 2 1
0 2 4 6 8 10 0 2 4 6 8 10 0 1 2 3 4 5
Chocolate (bars) Marker pens at the campus bookstore Right running shoes
The shape of the indifference curves reveals the degree indifferent, one fewer marker pen from the local supermarket
of substitutability between two goods. Part (a) shows the must be replaced by one extra marker pen from the campus
indifference curves for two ordinary goods: chocolate and bookstore. Part (c) shows two perfect complements – goods
cooldrink. To drink less cooldrink and remain indifferent, one that cannot be substituted for each other at all. Having two
must eat more chocolate. The number of bars of chocolate left running shoes with one right running shoe is no better than
that compensates for a reduction in cooldrink increases as having one of each. But having two of each is preferred to
less cooldrink is consumed. Part (b) shows the indifference having one of each.
curves for two perfect substitutes. For the consumer to remain
Close Substitutes Some goods substitute so easily for We will now use these components to work out a
each other that most of us do not even notice which household’s choice and to predict how choices change
we are consuming. The different brands of marker when prices and income change.
pens and pencils are examples. Most people do not
care which brand of these items they use or where they
buy them. A marker pen from the campus bookstore
Predicting Consumer Choices
is just as good as one from the local supermarket. You We are now going to predict the quantities of
would be willing to forgo a pen from the campus chocolate and cooldrink that Lerato chooses to
store if you could get one more pen from the local buy. We are also going to see how these quantities
grocery store. When two goods are perfect substitutes, change when a price changes or when Lerato’s
their indifference curves are straight lines that slope income changes. Finally, we are going to see how the
downward, as Fig. 9.5(b) illustrates. The marginal rate substitution effect and the income effect, two ideas that
of substitution is constant. you met in Chapter 3 (see p. 51), guarantee that for a
normal good, the demand curve slopes downward.
Complements Some goods do not substitute for
each other at all. Instead, they are complements. The
complements in Fig. 9.5(c) are left and right running
Best Affordable Choice
shoes. Indifference curves of perfect complements When Lerato makes her best affordable choice of
are L-shaped. One left running shoe and one right chocolate and cooldrink, she spends all her income
running shoe are as good as one left shoe and two and is on her highest attainable indifference curve.
right shoes. Having two of each is preferred to Figure 9.6 illustrates this choice: The budget line is from
having one of each, but having two of one and one Fig. 9.1 and the indifference curves are from Fig. 9.3(b).
of the other is no better than having one of each.
The extreme cases of perfect substitutes and perfect
complements shown here do not often happen in FIGURE 9.6 The Best Affordable Choice
reality, but they do illustrate that the shape of the
Cooldrink (cans per month)
REVIEW QUIZ H
2
1 What is an indifference curve and how does a I2
Lerato’s best affordable choice is 2 bars of chocolate FIGURE 9.7 Price Effect and Demand Curve
and 6 cans of cooldrink at point C – the best
affordable point.
0 1 2 3 4 5 6 7 8 9 10
Chocolate (bars per month)
A Change in Income
(b) Demand curve for movies
The effect of a change in income on buying plans is
called the income effect. Let us work out the income
effect by examining how buying plans change when A change in income shifts the budget line, changes the best
income changes and prices remain constant. Figure 9.8 affordable point, and changes demand.
shows the income effect when Lerato’s income falls. In part (a), when Lerato’s income decreases from R40 to
With an income of R40, the price of a bar of chocolate R28, she eats fewer bars of chocolate and buys less cooldrink.
at R4, and the price of cooldrink at R4 a can, Lerato’s In part (b), when Lerato’s income is R40, her demand curve
best affordable point is J – she buys 6 bars of chocolate for chocolate is D0. When Lerato’s income falls to R28, her
and 4 cans of cooldrink. If her income falls to R28, her demand curve for chocolate shifts leftward to D1. For Lerato,
best affordable point is K – she eats 4 bars of chocolate eating the chocolate is a normal good. Her demand for
and buys 3 cans of cooldrink. When Lerato’s income chocolate decreases because she now eats fewer bars of
falls, she buys less of both goods. Chocolate and chocolate at each price.
cooldrink are normal goods.
2 IncomeCR40 I2
202 CHAPTER 9 Possibilities, Preferences and Choices 6
Chocolate R8
I1
J
0
4 1 2 3 4 5 6 7 8 9 10
The Demand Curve and the Income Effect A change Figure 9.9(a) shows the price effect and Figs. 9.9(b)
Chocolate (bars per month)
in income leads to a shift in the demand curve, as and 9.9(c)
(a) Price show the two parts into which we separate
effect
shown in Figure 9.8(b). With an income of R40, the price
2 effect.
Income R40 I2
Lerato’s demand curve for chocolate is D0, the same as Chocolate R8
Substitution Effect
Substitution Effect and 6
C
0 1 2 3 4 5 6 7 8 9 10
I1. The substitution effect is the move from
Chocolate C per
(bars to Kmonth)
along
(b) Substitution effect
indifference curve I1 – an increase from 2 to 4 bars of
8
FIGURE 9.9 Substitution Effect and Income Effect chocolate a month.
7
6
Cooldrink (cans per month)
Cooldrink (cans per month)
10 10 Income
Income R40 5 effect
Chocolate R4 J
8 4
8
K
3
7
C 2
6 I2
6
Income
5 effect
I1
J J
4 0
4 1 2 3 4 5 6 7 8 9 10
K
3
(c) Income effect
2 Income R40 I2 2 I2
Chocolate R8
I1 I1
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
Chocolate (bars per month)
(a) Price effect (c) Income effect
When the price of a bar of chocolate falls from R8 to R4, To isolate the income effect, we confront Lerato with the new
Lerato moves from point C to point J in part (a). The price price of chocolate but increase her income so that she can
Cooldrink (cans per month)
10
effect is an increase in the number of bars of chocolate move from the original indifference curve, I1, to the new one,
from 2 to 6 a month. This price effect is separated into a I2. The income effect is the move from K to J – an increase
8
substitution effect in part (b) and an income effect in part (c). from 4 to 6 bars of chocolate a month.
Substitution
7 effect
C
6
Substitution Effect The substitution effect is the effect means that a lower price does not inevitably lead to
of a change in price on the quantity bought when an increase in the quantity demanded. The
the consumer (hypothetically) remains indifferent substitution effect of a fall in the price increases
between the original situation and the new one. To the quantity demanded, but the negative income
work out Lerato’s substitution effect when the price of effect works in the opposite direction and offsets the
chocolate falls, we must lower her income by enough substitution effect to some degree. The key question
to keep her on the same indifference curve as before. is to what degree.
Figure 9.9(a) shows the price effect of a fall in If the negative income effect equals the positive
the price of a bar of chocolate from R8 to R4. The substitution effect, a fall in price leaves the quantity
number of bars of chocolate increases from 2 to 6 a bought the same.
month. When the price falls, suppose (hypothetically) When a fall in price leaves the quantity
that we lower Lerato’s income to R28. What is special demanded unchanged, the demand curve is vertical
about R28? It is the income that is just enough, at and demand is perfectly inelastic.
the new price of chocolate, to keep Lerato’s best If the negative income effect is smaller than the
affordable point on the same indifference curve (I1) as positive substitution effect, a fall in price increases
her original point C. Lerato’s budget line is now the the quantity bought and the demand curve still
medium orange line in Fig. 9.9(b). With the lower slopes downward like that for a normal good. But the
price of chocolate and a smaller income, Lerato’s best demand for an inferior good might be less elastic than
affordable point is K. The move from C to K along that for a normal good.
indifference curve I1 is the substitution effect of the If the negative income effect exceeds the positive
price change. The substitution effect of the fall in the substitution effect, a fall in the price decreases the
price of chocolate is an increase in the quantity of quantity bought and the demand curve slopes upward.
bars of chocolate from 2 to 4. The direction of the This case does not appear to occur in the real world.
substitution effect never varies: When the relative You can apply the indifference curve model
price of a good falls, the consumer substitutes more of that you have studied in this chapter to explain the
that good for the other good. changes in the way we buy recorded music, eat bars
of chocolate, and make all our other consumption
Income Effect To calculate the substitution effect, we choices. We allocate our budgets to make our best
gave Lerato a R12 pay cut. To calculate the income affordable choices. Changes in prices and incomes
effect, we give Lerato back her R12. The R12 increase in change our best affordable choices and change
income shifts Lerato’s budget line outward, as shown in consumption patterns.
Fig. 9.9(c). The slope of the budget line does not change
because both prices remain the same. This change in REVIEW QUIZ
Lerato’s budget line is similar to the one illustrated in
Fig. 9.8. As Lerato’s budget line shifts outward, her 1 When a consumer chooses the combination
consumption possibilities expand and her best affordable of goods and services to buy, what is she or he
point becomes J on indifference curve I2. The move from trying to achieve?
K to J is the income effect of the price change. 2 Explain the conditions that are met when
As Lerato’s income increases, she eats more a consumer has found the best affordable
chocolate. For Lerato, chocolate is a normal good. For a combination of goods to buy. (Use the terms
normal good, the income effect reinforces the substitution budget line, marginal rate of substitution and
effect. Because the two effects work in the same relative price in your explanation.)
direction, we can be sure that the demand curve slopes 3 If the price of a normal good falls, what happens
downward. But some goods are inferior goods. What can to the quantity demanded of that good?
we say about the demand for an inferior good? 4 Into what two effects can we divide the effect
of a price change?
Inferior Goods Recall that an inferior good is a good 5 For a normal good, does the income effect
for which demand decreases when income increases. For reinforce the substitution effect or does it
an inferior good, the income effect is negative, which partly offset the substitution effect?
Reading Between the Lines on pp. 204–206 shows In the chapters that follow, we study the choices
you how the theory of household choice explains why that firms make in their pursuit of profit and how
gaming is taking off in South Africa, and how people those choices determine the supply of goods and
chose whether to buy DVDs, music or games. services and the demand for productive resources.
A number of sources overseas have shown that gaming internationally is a bigger industry than music
or movies. Now local figures show that this is fast becoming the case in South Africa as well.
According to statistics from GFK Chart-track Ltd, one of the largest market research companies in
the world, gaming in South Africa turned over about R1.6 billion from October 2007 to October
2008. And according to Aquidneck Consulting, a tracking company, music made approximately
R1.4 billion, while movies and DVD sales also earned about R1.4 billion.
It is hopeful that stats like these will start to break the stereotype that gaming is for unsporty kids who
have nothing better to do. The average gamer in the United States has been playing for 12 years and
is 35 years old according to the US Video Games Industry Report IBISWorld (August 2008) referenced
on Wikipedia.
While South Africa’s average must be lower, things are changing fast. Stalwart clans like Advanced
Special Forces finished fifth in the Call of Duty: World at War league and average 26 years of age.
Some of the teams in the First in Battle (FIB) clan boast similar average ages as well. Many of these
players have wives and even kids, but are still avid gamers …
Music sales are higher than both movie and DVD sales, which is not surprising. There are way more
retail outlets, more genres and artists, and a CD lasts far longer than a movie or even the enjoyment
of watching that favourite DVD over and over again. CD sales come in at a whopping R1.4 billion
annually and this figure does not include online figures from services like Telkom’s Getmo service.
Gaming sales
In 2008 to October, according to GFK Chart-track Ltd, a total of 3.64 million gaming units
(consoles, titles and accessories) were sold. Of this figure, 2.978 million sales belong to titles (games),
of which approximately 30 per cent were made up of PC games. Almost a quarter of a million
consoles (all consoles) were sold and 419 000 gaming accessories were sold.
Game title sales totalled R848 million and together with console and accessories sales, totalled about
R1.6 billion – R200 million more than music’s turnover.
However, seeing as the music figure does not include hardware sales (CD players, iPods, etc.)
the comparison is not an ‘apples vs. apples’ scenario. However, this is a grey area because of the
convergence of technology and one that will be almost impossible to track into the future.
For example, PS3s and Xboxes are really home entertainment centres. Gamers cannot only play
games, but watch videos online or from their hard drives or listen to music – the Xbox integrates
nicely with Windows Media Centre. It could therefore be argued that consoles could be tracked in
the DVD and music hardware sales figures as well.
Coming back to the game title sales, despite the economic downturn, gaming sales continue to do
well overseas as well. Last year, Time Magazine reported towards the end of the year that the gaming
industry was on track to reach record sales of $22 billion for the year.
The article went on to say that Halo 3, the best-selling game of 2007, achieved more revenue in
its first day of sales than Spiderman 3’s opening of US$151 million dollars – the biggest opening
weekend ever for a film at the time – and more than the final Harry Potter book, which sold
15 million copies on opening day.
Source: Greg Blyth and Steve Whitford, Da Gaming.
◆ Sandile’s annual budget for albums, DVDs and he can afford 15 CD albums [(5 × R600) +
games is R7 800. The price of a CD album is (15 × R200) = R6 000].
R200 and the prices of a DVD and game are the ◆ If Sandile buys CDs and DVDs and no game
same as those that Bongi faces. console (and plays DVDs and CDs on his dad’s
◆ Figure 2 shows Sandile’s two budget lines: one if he system), he can afford 25 CDs and 14 DVDs
buys only games and CDs and another if he buys [(25 × R200) + (14 × R200) = R7 800].
only DVDs and CDs. He can play CDs and DVDs ◆ Sandile’s best affordable choice is 25 CDs and
on his dad’s audio-visual system if he wishes. Note: 14 DVDs.
the horizontal axis is labelled for both DVDs and ◆ So even Sandile, who thinks that games and
games as they are, for Sandile, perfect substitutes. DVDs are perfect substitutes, does not buy games.
◆ If Sandile buys games, he must spend R1 800 But he probably would if he had a larger budget.
on a console, which leaves him with R6 000 for
DVDs, games and albums. If he buys 5 games,
20 I0 I1 I2
40 Budget line for
CDs and DVDs
16
Best
30
affordable
Budget line
point
if Bongi buys 25
12
console games
8 I1
15
0 12 24 28 33 0 10 14 20 30 40
DVDs (number per year) Games/DVDs (number per year)
FigureFigure
1 DVDs versusversus
1 DVDs gamesgames
for a DVD
for alover
DVD lover Figure 2 Games/DVDs versus CDs
Key Terms
Budget line, 193 Income effect, 201 Marginal rate of substitution, Real income, 194
Diminishing marginal rate of Indifference curve, 197 Relative price, 194
substitution, 198 196 Price effect, 200 Substitution effect, 203
that they have cancelled their Africa Day road trip and year, the company took in R200 million in sales, up
9% will take a shorter trip near home. That may save 5% from the previous year. Sales are already up 5%
consumers some money, but it will also likely hurt this year.
freeway service stations, which will sell less fuel and 19. a. According to the info byte, is used clothing a
food and hurt hotels, which will have fewer rooms normal good or an inferior good?
used and serve fewer casual meals. b. If the price of used clothing falls and income
15. Describe the degree of substitutability between remains the same, explain how the quantity
Africa Day trips and other trip-related goods and of used clothing bought changes.
services and sketch a consumer’s preference map c. If the price of used clothing falls and income
that illustrates your description. remains the same, describe the substitution
effect and the income effect that occur.
Predicting Consumer Choices 20. a. Use a graph to illustrate a family’s
16. a. Sketch a consumer’s preference map between indifference curves for used clothing and
Africa Day trips and other goods and other goods and services.
services. Draw a consumer’s budget line b. In your graph in part (a), draw two budget
prior to the rise in the price of petrol and lines to show the effect of a fall in income on
mark the consumer’s best affordable point. the quantity of used clothing purchased.
b. On your graph, show how the best affordable
point changes when the price of petrol rises. Economics in the News
Use the following information to work out
Use the following information to work out Problems Problems 21 and 22.
17 and 18.
Fuel Prices Send Travellers to Public Transport
Pam has chosen her best affordable combination With the price of fuel (such as petrol) approaching
of cupcakes and granola bars. She spends all of her R12 a litre, more commuters are abandoning their
weekly income on 30 cupcakes at R10 each and cars and taking the train or bus.
5 granola bars at R20 each. Next week, people expect
the price of a cupcake to fall to R5 and the price of It is very clear that a significant portion of the increase
a granola bar to rise to R50. in public transport use is directly caused by people
17. a. Will Pam be able to buy and want to buy who are looking for alternatives to paying R11.50 a
30 cupcakes and 5 granola bars next week? litre for fuel. Major cities such as Cape Town, have
b. Which situation does Pam prefer: cupcakes seen increases in ridership of 5 per cent, but the
at R10 and granola bars at R20 or cupcakes biggest surges – of 10 to 15 per cent over last year
at R5 and granola bars at R50? – are occurring in less developed regions such as the
18. a. If Pam changes how she spends her weekly Free State where the driving culture is strongest and
income, will she buy more or fewer cupcakes bus and rail lines are more limited.
and more or fewer granola bars? 21. a. Sketch a graph of a preference map and a
b. When the prices change next week, will budget line to illustrate the best affordable
there be an income effect, a substitution combination of petrol and public transport.
effect or both at work? b. On your graph in part (a), show the effect of
a rise in the price of petrol on the quantities
Use the following information to work out of petrol and public transport services
Problems 19 and 20. purchased.
22. If the fuel price rise has been similar in
Demand For Second-hand Clothes all regions, compare the marginal rates of
Most retailers are blaming the economy for their substitution in the Free State and the major
poor sales, but one chainstore that sells used brand- cities. Explain how you have inferred the
name children’s clothes holds that an economic different marginal rates of substitution from the
downturn can actually be great for its business. Last information in the info byte.
5
27. Calculate Aneka’s real income in terms of cake.
Calculate the relative price of cake in terms
4
of cocktails.
28. Calculate the equation for Aneka’s budget line
(with glasses of cocktails on the left side). 3
29. If Aneka’s income increases to R240 a week and
the prices of cocktails and cake remain unchanged,
2
describe the change in her budget line.
30. If the price of cake doubles while the price of
cocktails remains at R40 a glass and Aneka’s 1 I1
income remains at R200, describe the change in I0
her budget line.
0 1 2 3 4 5 6 7 8 9 10
CDs
Use the following info byte to work out Problems 31
and 32.
33. a. If Rashid chooses 3 books and 2 CDs, what
Petrol Prices Straining Budgets is his marginal rate of substitution?
With petrol prices rising, many people say they are b. If Rashid chooses 2 books and 6 CDs, what
staying in and scaling back spending to try to keep is his marginal rate of substitution?
within their budget. They are driving as little as 34. Do Rashid’s indifference curves display
possible, cutting back on shopping and eating out, diminishing marginal rate of substitution?
and reducing other discretionary spending. Explain why or why not.
3 I3
2
I2
1
I1
I0
0 1 2 3 4 5 6 7 8
Cooldrink (cans)
Making the Most of Life consumption plans and the allocation of time. These
explanations of consumption plans can also explain
The powerful forces of demand and supply shape the ‘non-economic’ choices, such as whether to marry and
fortunes of families, businesses, nations and empires how many children to have. In a sense, there are no
in the same unrelenting way that the tides and winds non-economic choices. If there is scarcity, there must
shape rocks and coastlines. You saw in Chapters 3 to 7 be choice, and economics studies all choices.
how these forces raise and lower prices, increase and The earliest economists (Adam Smith and
decrease quantities bought and sold, cause revenues to his contemporaries) did not have a very deep
fluctuate and send resources to their most valuable uses. understanding of households’ choices. It was not until
These powerful forces begin quietly and privately the nineteenth century that progress was made in
with the choices that each one of us makes. Chapters this area when Jeremy Bentham (below) introduced
8 and 9 probe these individual choices, offering the concept of utility and applied it to the study of
two alternative approaches to explaining both human choices.
Jeremy Bentham (1748–1832), who lived in was ready to use his ideas to tell people how they
London, was the son and grandson of lawyers and ought to behave. He was one of the first to propose
was himself trained as a barrister. But Bentham pensions for the retired, guaranteed employment,
rejected the opportunity to maintain the family minimum wages and social benefits such as free
tradition and, instead, spent his life as a writer, education and free medical care.
activist and Member of Parliament in the pursuit
of rational laws that would bring the greatest ‘... It is the greatest happiness of the greatest
happiness to the greatest number of people.
number that is the measure of right and
Bentham, whose embalmed body is preserved
to this day in a glass cabinet in the University of wrong.’
London, was the first person to use the concept of
utility to explain human choices. But in Bentham’s JEREMY BENTHAM
day, the distinction between explaining and Fragment on Government
prescribing was not a sharp one, and Bentham
I
10
n the autumn of 1990, a British scientist named Tim Berners-Lee
invented the World Wide Web. This remarkable idea paved the way for
the creation of thousands of profitable businesses that include Facebook
and Twitter, Apple, Microsoft, Google and Yahoo!.
Some of these successful dot-com firms sell goods and others sell
services. But many firms, especially those that you can name, do not
make the things they sell: They buy them from
Organising Production other firms. For example, Apple does not make the
iPhone. Intel makes its memory chip and Foxconn,
a firm in Taiwan, assembles its components.
Why does Apple not make the iPhone? How do firms decide what to
make themselves and what to buy from other firms? How do Facebook,
Twitter, Apple, Microsoft, Google, Intel, Foxconn and the millions of
other firms make their business decisions?
In this chapter, you are going to learn about firms and the choices
they make. In Reading Between the Lines at the end of the chapter,
we will apply some of what you have learned and look at some of
the choices made by Facebook, Yahoo! and Google in the internet
advertising game.
Economic Depreciation Accountants measure Entrepreneurship The factor of production that organises
depreciation, the fall in the value of a firm’s capital, a firm and makes its decisions might be supplied by
using formulas that are unrelated to the change in the the firm’s owner or by a hired entrepreneur. The return
market value of capital. Economic depreciation is the to entrepreneurship is profit and the profit that an
fall in the market value of a firm’s capital over a given entrepreneur earns on average is called normal profit.
period. It equals the market price of the capital at the Normal profit is the cost of entrepreneurship and
beginning of the period minus the market price of the is an opportunity cost of production. If Juju supplies
capital at the end of the period. entrepreneurial services herself, and if the normal profit she
Suppose that Juju’s Jerseys could have sold its can earn on these services is R45 000 a year, this amount is
buildings and knitting machines on 1 January 2012, an opportunity cost of production at Juju’s Jerseys.
for R400 000 and that it can sell the same capital
on 31 December 2012, for R375 000. The firm’s Owner’s Labour Services In addition to supplying
economic depreciation during 2012 is R25 000 entrepreneurship, the owner of a firm might supply
(R400 000 – R375 000). This forgone R25 000 is an labour but not take a wage. The opportunity cost of
opportunity cost of production. the owner’s labour is the wage income forgone by not
taking the best alternative job.
Forgone Interest The funds used to buy capital If Juju supplies labour to Juju’s Jerseys, and if the
could have been used for some other purpose, and in wage she can earn on this labour at another firm is
their next best use, they would have earned interest. R55 000 a year, this amount of wages forgone is an
This forgone interest is an opportunity cost of opportunity cost of production at Juju’s Jerseys.
production.
Suppose that Juju’s Jerseys used R300 000 of its
Economic Accounting: A Summary
own funds to buy capital. If the firm invested its
R300 000 in bonds instead of a knitting factory Table 10.1 summarises the economic accounting.
(and rented the capital it needs to produce jerseys), Juju’s Jerseys’ total revenue is R400 000; its
it would have earned R15 000 a year in interest. This opportunity cost of production is R370 000; and its
forgone interest is an opportunity cost of production. economic profit is R30 000.
Juju’s personal income is the R30 000 of
Resources Supplied by the Firm’s Owner A firm’s economic profit plus the R100 000 that she earns by
owner might supply both entrepreneurship and labour. supplying resources to Juju’s Jerseys.
One of the three technologically efficient In Table 10.3(c), the wage rate is R1 a day and
methods is economically efficient. The other two the rental rate of capital is R1 000 a day. You can
are economically inefficient. But which method is see that method C has the lowest cost and is the
economically efficient depends on factor prices. economically efficient method. In this case, labour is
In Table 10.3(a), the wage rate is R75 per day and so cheap relative to capital that the method that uses
the rental rate of capital is R250 per day. By studying the most labour is the economically efficient method.
Table 10.3(a), you can see that method B has the lowest Economic efficiency depends on the relative costs of
cost and is the economically efficient method. resources. The economically efficient method is the one
In Table 10.3(b), the wage rate is R150 a day and that uses a smaller amount of the more expensive resource
the rental rate of capital is R1 a day. Looking at and a larger amount of the less expensive resource.
Table 10.3(b), you can see that method A has the A firm that is not economically efficient does not
lowest cost and is the economically efficient method. maximise profit. Natural selection favours efficient
In this case, capital is so cheap relative to labour firms and inefficient firms disappear. Inefficient firms
that the method that uses the most capital is the go out of business or are taken over by firms that
economically efficient method. produce at lower costs.
(b) Wage rate R150 per day; Capital rental rate R1 per day
Inputs Labour cost Capital cost Total cost
(R150 per day) (R1 per day)
Method Labour Capital
A 1 1 000 150 + 1 000 = 1 150
B 10 10 1 500 + 10 = 1 510
C 1 000 1 150 000 + 1 = 150 001
(c) Wage rate R1 per day; Capital rental rate R1 000 per day
Inputs Labour cost Capital cost Total cost
(R1 per day) (R1 000 per day)
Method Labour Capital
A 1 1 000 1 + 1 000 000 = 1 000 001
B 10 10 10 + 10 000 = 10 010
C 1 000 1 1 000 + 1 000 = 2 000
REVIEW QUIZ
1 Is a firm technologically efficient if it uses the 4 Why do some firms use large amounts of capital
latest technology? Why or why not? and small amounts of labour while others use
2 Is a firm economically inefficient if it can cut its small amounts of capital and large amounts
costs by producing less? Why or why not? of labour?
3 Explain the key distinction between technolog-
ical efficiency and economic efficiency.
Next we study the information constraints Managers make enormous efforts to be well
that firms face and the wide array of organisation informed. They try hard to make good decisions
structures these constraints generate. and issue commands that end up using resources
efficiently. But managers always have incomplete
information about what is happening in the divisions
of the firm for which they are responsible. For
Information and Organisation this reason, firms use incentive systems, as well as
Each firm organises the production of goods command systems to organise production.
and services by combining and coordinating the
productive resources it hires. But there is variety across
firms in how they organise production. Firms use a Incentive Systems
mixture of two systems: An incentive system is a method of organising
◆ Command systems production that uses a market-like mechanism inside
◆ Incentive systems the firm. Instead of issuing commands, senior managers
create compensation schemes to induce workers to
perform in ways that maximise the firm’s profit.
Command Systems Selling organisations use incentive systems most
A command system is a method of organising extensively. Sales representatives who spend most
production that uses a managerial hierarchy. of their working time alone and unsupervised are
Commands pass downward through the induced to work hard by being paid a small salary and
hierarchy and information passes upward. Managers a large performance-related bonus.
spend most of their time collecting and processing But incentive systems operate at all levels in a
information about the performance of the people firm. The compensation plan of a CEO includes a
under their control and making decisions about share in the firm’s profit, and factory floor workers
what commands to issue and how best to get those sometimes receive compensation based on the
commands implemented. The army of any nation is quantity they produce.
the purest form of a command system.
Command systems in firms are not as rigid as those
in the military, but they share some similar features. Mixing the Systems
A chief executive officer (CEO) sits at the top of a Firms use a mixture of commands and incentives
firm’s command system. Senior executives who report and they choose the mixture that maximises profit.
to and receive commands from the CEO specialise in Firms use commands when it is easy to monitor
managing production, marketing, finance, personnel performance or when a small deviation from an ideal
and perhaps other aspects of the firm’s operations. performance is very costly. They use incentives when
Beneath these senior managers might be several tiers of it is either not possible to monitor performance or too
middle management ranks that stretch downward to the costly to be worth doing.
managers who supervise the day-to-day operations of For example, PepsiCo can easily monitor the
the business. Beneath these managers are the people who performance of workers on a production line. If one
operate the firm’s machines and who make and sell the person works too slowly, the entire line slows, so a
firm’s goods and services. production line is organised with a command system.
Small firms have one or two layers of managers, In contrast, it is costly to monitor a CEO. For
while large firms have several layers. As production example, what did Steve Jobs, the former CEO
processes have become ever more complex, of Apple Inc., contribute to Apple’s success? This
management ranks have swollen. Today, more people question cannot be answered with certainty, yet
have management jobs than ever before, even though Apple’s shareholders have to put someone in charge of
the information revolution of the 1990s slowed the the business and provide that person with an incentive
growth of management. In some industries, the to maximise shareholders’ returns. The performance
information revolution reduced the number of layers of of Apple illustrates a general problem, known as the
managers and brought a shakeout of middle managers. principal–agent problem.
Close Corporation (CC) A close corporation is a investment. This limitation of liability means that
separate legal entity that was one of the most popular if the company becomes bankrupt, its owners are
structures in South Africa where the owners have not required to use their personal wealth to pay the
limited liability. CCs were popular because they were company’s debts. Under the previous Companies Act,
cost-effective and constituted a simple business entity companies were limited to 50 shareholders. The new
under which to conduct business. In May 2011 the Companies Act of 2008 allows unlimited shareholding.
Companies Act No. 71 of 2008 was introduced, Company profits are taxed independently of
replacing the Companies Act No. 61 of 1973 and shareholders’ incomes. Shareholders pay a capital
the Close Corporations Act No. 69 of 1984. Existing gains tax on the profit they earn when they sell shares
CCs do not have to change to private companies, but for a higher price than they paid for it. Company
government wants new companies to register as private shares generate capital gains when a company retains
companies (Pty Ltds) or personal liability companies some of its profit and reinvests it in profitable
(Incs). Under the old Close Corporations Act of 1984, activities. So retained earnings are taxed twice because
CCs could have up to 10 members but all needed to be the capital gains they generate are taxed. Dividend
natural persons (trusts could be members under certain payments are also taxed but at a lower rate than other
conditions). The profits of a CC are taxed at 28%. sources of income.
At the time of writing, the South African Revenue
Service (SARS) had a special dispensation for close
Pros and Cons of Different Types of Firms
corporations and private companies that employed
a minimum of 3 people. The first R300 000 annual The different types of business organisation arise
profit would be taxed at 10%, allowing the business a from firms trying to cope with the principal–agent
potential tax saving of a maximum value of R60 000. problem. Each type has advantages in particular
situations and because of its special advantages,
Private Company A private company (Pty Ltd) each type continues to exist. Each type of business
is a firm owned by one or more limited liability organisation also has disadvantages.
shareholders. Limited liability means that the owners Table 10.4 summarises these and other pros and
have legal liability only for the value of their initial cons of the different types of firms.
Private Company • Owners have limited liability • Complex management structure can
• Large-scale, low-cost capital available make decisions slow and expensive
• Professional management not restricted • Retained profits taxed twice: as
by ability of owners company profit and as shareholders’
• Perpetual life capital gains
• Long-term labour contracts cut
labour costs
In perfect competition, the HHI is small. The HHI became a popular measure of the
For example, if each of the largest 50 firms in an degree of competition during the 1980s. A market in
industry has a market share of 0.1 per cent, then which the HHI is less than 1 000 is regarded as being
the HHI is 0.12 × 50 = 0.5. In a monopoly, the competitive. A market in which the HHI lies between
HHI is 10 000. The firm has 100 per cent of the 1 000 and 1 800 is regarded as being moderately
market: 1002 = 10 000. competitive. But a market in which the HHI exceeds
1 800 is regarded as being uncompetitive.
Limitations of a Concentration Measure First, markets are often narrower than industries.
The three main limitations of using only For example, the pharmaceutical industry, which has
concentration measures as determinants of market a low concentration ratio, operates in many separate
structure are their failure to take proper account of: markets for individual products for example, measles
◆ The geographical scope of the market vaccine and Aids-fighting medicines.
◆ Barriers to entry and firm turnover
◆ The correspondence between a market and FIGURE 10.1 Concentration Measures in
an industry South Africa Four-Firm Concentration Measures
Glass and glass products
Geographical Scope of Market Concentration Basic iron and steel
measures take a national view of the market. Many goods Dair y products
are sold in a national market, but some are sold in a Motor vehicles
regional market and some in a global one. The newspaper Beverages
industry consists of local markets. The concentration Paper and paper products
measures for newspapers are low, but there is a high degree Rubber products
of concentration in the newspaper industry in most cities. Basic chemicals
The motor vehicle industry has a global market. Household appliances
Clothing
in a market face competition from the many potential The industries that produce glass and glassSource of data:
products,
Statistics South Africa
firms that will enter the market if economic profit dairy products, motor vehicles
The and beverages
Manufacturing arey 200
Industr highly
5
opportunities arise. concentrated, while those that produce furniture,
(releasedfootwear,
2006)
printing, publishing and clothing are highly competitive.
Market and Industry Correspondence To The industries that produce household appliances and basic
calculate concentration ratios, Statistics South Africa chemicals have an intermediate degree of concentration.
classifies each firm as being in a particular industry.
Source of data: Statistics South Africa The Manufacturing Industry 2005
But markets do not always correspond closely to
(released 2006).
industries for three reasons.
tyres and many other vehicle parts. Apple outsources Economies of Scale When the
Economies of Scale
the entire production of iPods and iPhones. cost of producing a unit of a good
falls as its output rate increases,
economies of scale exist. A vehicle
Why Firms? manufacturer experiences economies
What determines whether a firm or a market of scale because as the scale of
coordinates a particular set of activities? How does production increases, the firm can
a firm decide whether to buy an item from another use cost-saving equipment and
firm or manufacture it itself? The answer is cost. highly specialised labour. A vehicle
Taking account of the opportunity cost of time, as manufacturer that produces only a www.quickto.mobi/
well as the costs of the other inputs, a firm uses the few cars a year must use hand-tool PEA-SCALE
method that costs least. In other words, it uses the methods that are costly.
economically efficient method. Economies of scale arise from
If a task can be performed at a lower cost by specialisation and the division of labour that can be
markets than by a firm, markets will do the job, and reaped more effectively by firm coordination rather
any attempt to set up a firm to replace such market than market coordination.
activity will be doomed to failure.
Firms coordinate economic activity when a task can Economies of Scope A firm experiences economies
be performed more efficiently by a firm than by markets. of scope when it uses specialised (and often expensive)
In such a situation, it is profitable to set up a firm. Firms resources to produce a range of goods and services. For
are often more efficient than markets as coordinators of example, Toshiba uses its designers and specialised
economic activity because they can achieve: equipment to make the hard drive for the iPod. But
◆ Lower transactions costs it makes many different types of hard drives and other
◆ Economies of scale related products. As a result, Toshiba produces the
◆ Economies of scope iPod hard drive at a lower cost than a firm making
◆ Economies of team production only the iPod hard drive could achieve.
Transactions Costs Firms eliminate transactions costs. Economies of Team Production A production process
Transactions costs are the costs that arise from in which the individuals in a group specialise in mutually
finding someone with whom to do business, of supportive tasks is team production. Sports provide the
reaching an agreement about the price and other best examples of team activity. In baseball, some team
aspects of the exchange, and of ensuring that members specialise in pitching and others in fielding. In
the terms of the agreement are fulfilled. Market basketball, some team members specialise in defence and
transactions require buyers and sellers to get some in offence. The production of goods and services
together and to negotiate the terms and conditions offers many examples of team activity. For example,
of their trading. production lines in a TV manufacturing plant work
Sometimes, lawyers have to be hired to draw most efficiently when individual activity is organised in
up contracts. A broken contract leads to still more teams, each worker specialising in a few tasks. You can
expense. A firm can lower such transactions costs also think of an entire firm as being a team. The team
by reducing the number of individual transactions has buyers of raw materials and other inputs, production
undertaken. workers and salespeople. Each individual member of the
Imagine getting your car fixed using market team specialises, but the value of the output of the team
coordination. You hire a mechanic to diagnose the and the profit that it earns depend on the coordinated
problems and make a list of the parts and tools needed activities of all the team’s members.
to fix them. You buy the parts from several dealers, Because firms can economise on transactions
rent the tools from ABC Rentals, hire a mechanic, costs, reap economies of scale and economies of
return the tools and pay your bills. You can avoid scope, and organise efficient team production, it is
all these transactions and the time they cost you by firms rather than markets that coordinate most of our
letting your local garage fix the car. economic activity.
REVIEW QUIZ
Economics in Action 1 What are the two ways in which economic
activity can be coordinated?
Apple Does Not Make the iPhone! 2 What determines whether a firm or markets
Apple designed the iPhone and markets it, but Apple coordinate production?
does not manufacture it. Why? Apple wants to 3 What are the main reasons why firms can often
produce the iPhone at the lowest possible cost. Apple coordinate production at a lower cost than
achieves its goal by assigning the production task to markets can?
more than 30 firms, some of which are listed in the
table below. These 30 firms produce the components Reading Between the Lines on pp. 227–228 explores
in Asia, Europe and North America and then the the market for internet advertising. In the next four
components are assembled in the familiar case by chapters, we continue to study firms and their
Foxconn and Quanta in Taiwan. decisions. In Chapter 11, we learn about the
Most electronic products – TVs, DVD players, relationships between cost and output at different output
iPods and iPads, and personal computers – are levels. These relationships are common to all types of
produced in a similar way to the iPhone with a firms in all types of markets. We then turn to problems
combination of firm and market coordination. that are specific to firms in different types of markets.
Hundreds of little known firms compete fiercely to get
their components into well-known consumer products.
Altus-Tech Taiwan
Balda Germany
Broadcom United States
Cambridge Silicon Radio UK
Catcher Taiwan
Cyntec Taiwan
Delta Electronics Taiwan
Epson Japan
Foxconn Taiwan
Infineon Technology Germany
Intel United States
Largan Precision Taiwan
Lite On Taiwan
Marvell United States
Micron United States
National Semiconductor United States
Novatek Taiwan
Primax Taiwan
Quanta Taiwan
Samsung Korea
Sanyo Japan
Sharp Japan
Taiwan Semiconductor Taiwan
TMD Japan
Global advertisers spent more than $116 billion on digital advertising in 2013. Google earned more
than one third of this, making it the top earner in the digital ad space. Facebook came in second, but
their net digital advertising revenues are only 15% of what Google earned in 2013.
Comparisons of the growth rates of digital advertising revenues reveal some interesting facts. While
Google and Facebook continue to outpace market growth in advertising revenues, companies growing
off much smaller bases, such as Twitter and Pandora, experience much higher growth rates. It seems
that Google and Facebook might be very big companies in the digital ad space but excessive growth
rates could be a thing of the past as advertisers seek additional ways to reach their target markets.
Google and Facebook already have a large international presence, especially among the younger
segment in developing economies. Twitter is starting to gain traction in these markets, as is evidenced
by many companies creating Twitter accounts.
40 40
Profit (billions of dollars per year)
(billions of dollars per year)
Total revenue
35 35
35 Google 35
30 30
Google
30 30
25 25
25 25 Google
20 20
Google
20 20
15 15
15 15
10 10
Yahoo!
10 10 Yahoo!
5 Yahoo! 5
Facebook Yahoo!
5 5 Facebook
0 Facebook 0 Facebook
0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Year 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Year
Year Year
Figure 1 Total revenue comparison Figure 2 Profit comparison
Figure 1 Total revenue comparison Figure 2 Profit comparison
Key Terms
Command system, 218 Firm, 213 Incentive system, 218 Perfect competition, 221
Economic depreciation, 214 Four-firm concentration Monopolistic competition, Principal–agent problem, 219
Economic efficiency, 216 ratio, 222 221 Product differentiation, 221
Economic profit, 213 Herfindahl-Hirschman Monopoly, 221 Technological efficiency, 216
Economies of scale, 225 Index, 222 Normal profit, 214 Technology, 215
Economies of scope, 225 Implicit rental rate, 213 Oligopoly, 221 Transactions costs, 225
its costs of capital, not on measures like earnings Produce or Outsource? Firms and Markets
per share. Bonus payouts should also be delayed. 11. Stateopian motor vehicle manufacturers buy car
a. What is the economic problem that CEO parts from independent suppliers rather than
compensation schemes are designed to solve? produce the parts themselves. In the 1980s,
b. How do the proposed changes to CEO Clyster got about 70 per cent of its car parts
compensation outlined in the info byte from independent suppliers, while Texa got about
address the problem you described in part (a)? 60 per cent and Savvy got 25 per cent. A decade
earlier, the proportions were 50 per cent at Clyster,
Use the following info byte to work out Problems 5 per cent at Texa and 20 per cent at Savvy.
7 and 8. a. Why did Stateopian motor vehicle manu-
facturers decide to outsource most of their
From Risk To Riches part’s production?
Entrepreneurship is an acknowledged contributor to b. Explain why independent producers of
job creation but few people can handle the risks. One car parts are more efficient than the motor
in three new start-ups fail in the first two years and less vehicle manufacturers.
than half survive into a fifth year. Starting a business is 12. Less Is More
also costly using savings, family loans, credit cards or The Courier Link (TCL) is a growing courier
home mortgages. Failure is thus an expensive lesson. company in South Africa that contracts with
7. When starting a business, what are the risks and independent owner-drivers to deliver parcels
potential rewards associated with a proprietorship? directly. This cuts out the need for warehouse and
8. How might (i) a partnership and (ii) a corporation sorting hubs and ensures speedier service.
help to overcome the risks identified in the info byte? Why does TCL not buy more trucks and hire
more drivers? What incentive problems might
Markets and the Competitive Environment arise from this arrangement?
9. Sales of the firms in the tattoo industry are 13. Building It Again
Firm Sales (rand per year)
Consider the recent company history of a
well-known European toy manufacturer.
Bright Spots 450 Due to competition from copycat producers
Freckles 325 that sold cheaper versions, it experienced
Love Galore 250 economic losses in 2003 and 2004. This
Native Birds 200
resulted in a massive downsizing and
Other 15 firms 800
restructuring exercise that reduced its workforce
from 8 000 to 4 500 workers, closed down
Calculate the four-firm concentration ratio. What is factories in Western countries and replaced them
the structure of the tattoo industry? with factories in third world countries. It also
10. Playing For High Scores restructured pay packages for managers around
Video gaming is a favourite pastime in the performance. In 2005, it was again profitable.
Stateopia with retailers Max-Mart and Gamers a. Describe the problems that it faced in 2003
leading in market share, with 21.3% and 21.1% and 2004, using the concepts of the three
respectively. Women gamers, however, prefer to types of constraints that all firms face.
shop at retailer Talent and their interest might b. Which of the actions that it took to restore
just erode Shopit’s rise to the top. profits addressed an inefficiency? How did it
a. According to the info byte, what is the struc- seek to achieve economic efficiency?
ture of the Stateopia’s retail video-game market? c. Which of its actions addressed an informa-
b. Estimate a range for the four-firm concentra- tion and organisation problem? How did it
tion ratio and the HHI for the game market change the way in which it coped with the
in the Stateopia based on the information principal–agent problem?
provided in the info byte. d. In what type of market does it operate?
W
11
hat does a big electricity supplier like Koeberg Nuclear Power
Station, and Campus Sweaters, a small (fictional) producer of knitwear
have in common? Like every firm, they must decide how much to
produce, how many people to employ and how much and what type of
capital equipment to use. How do firms make these decisions?
Koeberg Power Station faces a demand for electricity that fluctuates
throughout the day and that fluctuates from day to day
Output and Costs depending on the temperature. How do electric utilities cope
with these demand fluctuations?
We are going to answer these questions in this chapter.
To explain the basic ideas as clearly as possible, we focus on the
economic decisions of Campus Sweaters, Pty (Ltd). Studying the way
this firm copes with its economic problems will give us a clear view of
the problems faced by all firms. We will then apply what we learn in
this chapter to the real-world costs of producing cars and electricity.
In Reading Between the Lines, we will look at the costs of producing
electricity in South Africa.
Decision Time Frames factors of production and labour is the variable factor
of production. We call the fixed factors of production
People who operate firms make many decisions, and the firm’s factory: In the short run, a firm’s factory
all of their decisions are aimed at achieving one over- is fixed.
riding goal: maximum attainable profit. But not all For Campus Sweaters, the fixed factory is its
decisions are equally critical. Some decisions are big factory building and its knitting machines. For an
ones. Once made, they are costly (or impossible) to electricity producer, the fixed factory is its buildings,
reverse. If such a decision turns out to be incorrect, it generators, computers and control systems.
might lead to the failure of the firm. Other decisions To increase output in the short run, a firm
are small. They are easily changed. If one of these must increase the quantity of a variable factor of
decisions turns out to be incorrect, the firm can production, which is usually labour. So to produce
change its actions and survive. more output, Campus Sweaters must hire more labour
The biggest decision that an entrepreneur makes and operate its knitting machines for more hours a
is in what industry to establish a firm. For most day. Similarly, an electricity producer must hire more
entrepreneurs, their background knowledge and labour and operate its generators for more hours a day.
interests drive this decision. But the decision also Short-run decisions are easily reversed. The firm
depends on profit prospects – on the expectation that can increase or decrease its output in the short run by
total revenue will exceed total cost. increasing or decreasing the amount of labour it hires.
Cindy has already decided to set up Campus
Sweaters. She has also decided the most effective
method of organising the firm. But she has not The Long Run
decided the quantity to produce, the factors of The long run is a time frame in which the quantities of
production to hire, or the price to charge for sweaters. all factors of production can be varied. That is, the long
Decisions about the quantity to produce and the run is a period in which the firm can change its factory.
price to charge depend on the type of market in which To increase output in the long run, a firm can
the firm operates. Perfect competition, monopolistic change its factory, as well as the quantity of labour it
competition, oligopoly and monopoly all confront the hires. Campus Sweaters can decide whether to install
firm with their own special problems. Decisions about more knitting machines, use a new type of machine,
how to produce a given output do not depend on the reorganise its management or hire more labour.
type of market in which the firm operates. Long-run decisions are not easily reversed. Once a
All types of firms in all types of markets make similar factory decision is made, the firm usually must live
decisions about how to produce. with it for some time. To emphasise this fact, we call
The actions that a firm can take to influence the past expenditure on a factory that has no resale
the relationship between output and cost depend on value a sunk cost. A sunk cost is irrelevant to the firm’s
how soon the firm wants to act. A firm that plans to current decisions. The only costs that influence its
change its output rate tomorrow has fewer options current decisions are the short-run cost of changing
than one that plans to change its output rate six its labour inputs and the long-run cost of changing
months or six years from now. its factory.
To study the relationship between a firm’s output
decision and its costs, we distinguish between two
decision time frames: REVIEW QUIZ
◆ The short run 1 Distinguish between the short run and the
◆ The long run long run.
2 Why is a sunk cost irrelevant to a firm’s
current decisions?
The Short Run
The short run is a time frame in which the quantity We are going to study costs in the short run
of at least one factor of production is fixed. For most and the long run. We begin with the short run and
firms, capital, land and entrepreneurship are fixed describe a firm’s technology constraint.
Total product is the total amount produced. Marginal product of going from 1 to 2 workers is 5 sweaters. Average
is the change in total product that results from a one-unit product is total product divided by the quantity of labour
increase in labour. For example, when labour increases employed. For example, the average product of 2 workers
from 1 to 2 workers a day (row B to row C ), total product is 4.5 sweaters per worker (9 sweaters a day divided by
increases from 4 to 9 sweaters a day. The marginal product 2 workers).
For example, marginal product increases from product schedule. Points A to G correspond to rows
4 sweaters a day for the first worker to 5 sweaters A to G in Table 11.1. Notice the shape of the total
a day for the second worker and then decreases to product curve. As employment increases from zero to
4 sweaters a day for the third worker. 1 worker a day, the curve becomes steeper. Then, as
Average product increases at first and then employment increases to 3, 4 and 5 workers a day,
decreases. You can see the relationships between the the curve becomes less steep.
quantity of labour hired and the three product concepts The total product curve is similar to the
more clearly by looking at the product curves. production possibilities frontier (explained in Chapter 2).
It separates the attainable output levels from those
that are unattainable. All the points that lie above
Product Curves the curve, are unattainable. Points that lie below the
The product curves are graphs of the relationships curve, are attainable, but they are inefficient – they
between employment and the three product concepts use more labour than is necessary to produce a given
you have just studied. output. Only the points on the total product curve
They show how total product, marginal product are technologically efficient.
and average product change as employment changes.
They also show the relationships among the three
concepts. Let us look at the product curves.
Marginal Product Curve
Figure 11.1 shows Campus Sweaters’ total Figure 11.2 shows Campus Sweaters’ marginal and
product curve, TP, which is a graph of the total average product of labour. Part (a) reproduces the total
product curve from Fig. 11.1 and part (b) shows the
marginal product (MP ) and average product (AP ) curves.
FIGURE 11.1 Total Product Curve In part (a), the slope of the total product curve
yields marginal product. Recall that the slope of
a curve is the change in the value of the variable
TP measured on the y-axis – output – divided by the
Output (sweaters per day)
18
G
F change in the variable measured on the x-axis – labour
16
Unattainable E – as we move along the curve. A one-unit increase in
14 labour, from 1 to 2 workers, increases output from
D
12 4 to 9 sweaters, so the slope from point B to point
10
C is 5 sweaters per additional worker, the same as the
C marginal product we have just calculated.
8 Attainable
Again varying the amount of labour in the
6
smallest units possible, we can draw the marginal
4
B
product curve shown in Fig. 11.2(b). The height of
2 this curve measures the slope of the total product
A curve at a point. Part (a) shows that an increase in
0 1 2 3 4 5 6 employment from 1 to 2 workers increases output
Labour (workers per day)
from 4 to 9 sweaters (an increase of 5). The increase in
output of 5 sweaters appears on the y-axis of part (b)
The total product curve, TP, is based on the data in Table 11.1. as the marginal product of going from 1 to 2 workers.
The total product curve shows how the quantity of sweaters We plot that marginal product at the midpoint
produced changes as the quantity of labour employed between 1 and 2 workers. Notice that the marginal
changes. For example, 2 workers can produce 9 sweaters product shown in Fig. 11.2(b) reaches a peak at
a day (point C ). Points A to G on the curve correspond to 1.5 workers, and at that point, marginal product is
the rows of Table 11.1. The total product curve separates 5 sweaters per additional worker. The peak occurs
attainable outputs from unattainable outputs. Points below the at 1.5 workers because the total product curve is
TP curve are inefficient. steepest when employment increases from 1 worker
to 2 workers.
The total product and marginal product curves machines are running without the need for further
differ across firms and types of goods. Volkswagen’s attention. Hiring more and more workers continues to
product curves are different from those of Nando’s, increase output but by successively smaller amounts.
whose curves in turn are different from those of Marginal returns are diminishing. This
Campus Sweaters. But the shapes of the product phenomenon is such a pervasive one that it is called
curves are similar because almost every production a ‘law’ – the law of diminishing returns. The law of
process has two features: diminishing returns states that:
◆ Increasing marginal returns initially
◆ Diminishing marginal returns eventually As a firm uses more of a variable factor of
production with a given quantity of the fixed
Increasing Marginal Returns Increasing marginal
returns occur when the marginal product of an factor of production, the marginal product of the
additional worker exceeds the marginal product of the variable factor eventually diminishes.
previous worker. Increasing marginal returns arise from
increased specialisation and division of labour in the You are going to return to the law of diminishing
production process. returns when we study a firm’s costs, but before we do
For example, if Campus Sweaters employs one that, let us look at the average product of labour and
worker, that person must learn all the aspects of the average product curve.
sweater production: running the knitting machines,
fixing breakdowns, packaging and mailing sweaters,
buying and checking the type and colour of the wool. Average Product Curve
All these tasks must be performed by that one person. Figure 11.2(b) illustrates Campus Sweaters’ average
If Campus Sweaters hires a second person, the product of labour and shows the relationship between
two workers can specialise in different parts of the average product and marginal product.
production process and can produce more than twice Average product increases from 1 to 2 workers
as much as one worker. The marginal product of the (its maximum value is at point C ) but then decreases
second worker is greater than the marginal product of as yet more workers are employed. Notice also that
the first worker. Marginal returns are increasing. average product is largest when average product and
marginal product are equal. That is, the marginal
Diminishing Marginal Returns Most production product curve cuts the average product curve at the
processes experience increasing marginal returns point of maximum average product. For the number
initially, but all production processes eventually reach of workers at which marginal product exceeds average
a point of diminishing marginal returns. Diminishing product, average product is increasing. For the number
marginal returns occur when the marginal product of of workers at which marginal product is less than
an additional worker is less than the marginal product average product, average product is decreasing.
of the previous worker. Looking closely at Fig 11.2(b) we observe another
Diminishing marginal returns arise from the fact interesting relationship between marginal product and
that more and more workers are using the same capital average product. Marginal product reaches a maximum
and working in the same space. As more workers are at point (a), at which total product is at its steepest.
added, there is less and less for the additional workers Thereafter diminishing returns to labour set in. Point
to do that is productive. For example, if Campus (a) is the point of inflection, at which marginal product
Sweaters hires a third worker, output increases but not is at its highest. Average product is rising until point (b)
by as much as it did when it hired the second worker. as marginal product is pulling the average product up.
In this case, after two workers are hired, all the gains As long as marginal product is above average product,
from specialisation and the division of labour have average product will keep rising. Beyond point (b),
been exhausted. By hiring a third worker, the factory additional workers add less and less to total output,
produces more sweaters, but the equipment is being pulling average product down. By adding the 6th
operated closer to its limits. There are even times worker, total output remains constant at 18 sweaters
when the third worker has nothing to do because the per day and marginal product becomes zero.
TP
18
G
F your average will not change. If your marginal grade is
16
E below your average grade (like the fourth semester in
14 the figure), your average will fall.
D
12 The relationship between your marginal and
10 Point of average grades is exactly the same as that between
inflexion C marginal product and average product.
8
6
4
Grade point average (GPA)
4 Average
B
grade
2
A 3
1 0 2 3 4 5 6
(a) Total product Labour (workers per day)
Marginal
Output (sweaters per day)
Maximum 2
grade
marginal
product
Maximum 1
average
5
product
4 0
First Second Third Fourth
3 Semester
Marginal and Average Grade Curves
2 AP
1
MP REVIEW QUIZ
0 1 2 3 4 5 6 7
Labour (workers per day) 1 Explain how the marginal product and average
(b) Marginal product and average product product of labour change as the labour employed
Marginal product is illustrated by the red line in graph (b). For increases (a) initially and (b) eventually.
example, when labour increases from 1 to 2 workers a day, 2 What is the law of diminishing returns? Why
marginal product is 5 sweaters. (Marginal product is shown does marginal product eventually diminish?
midway between the quantities of labour to emphasise that 3 Explain the relationship between marginal
marginal product results from changing the quantity of labour.) product and average product.
The steeper the slope of the total product curve (TP ) in part (a),
the larger is marginal product (MP ) in part (b). Marginal product Campus Sweaters’ product curves influence its
increases to a maximum (in this example when 1.5 workers a day costs, as you are now going to see.
are employed) and then declines – diminishing marginal product.
Short-Run Cost Short-Run Cost Total variable cost (TVC ) is the cost of the firm’s
To produce more output in the variable factors. For Campus Sweaters, labour is the
short run, a firm must employ more variable factor, so this component of cost is its wage
labour, which means that it must bill. Total variable cost changes as output changes.
increase its costs. We describe the Total cost is the sum of total fixed cost and total
relationship between output and variable cost. That is,
cost by using three cost concepts:
TC = TFC + TVC
◆ Total cost
◆ Marginal cost The table in Fig. 11.3 shows total costs. Campus
www.quickto.mobi/
◆ Average cost Sweaters rents one knitting machine for R100 a day,
PEA-SHORT
so its TFC is R100.
To produce sweaters, the firm hires labour, which
costs R100 a day. TVC is the number of workers
Total Cost
multiplied by R100. For example, to produce 9
A firm’s total cost (TC ) is the cost of all the factors of sweaters a day, in row D, the firm hires 2 workers and
production it uses. We separate total cost into total TVC is R200. TC is the sum of TFC and TVC, so
fixed cost and total variable cost. to produce 9 sweaters a day, TC is R300. Check the
Total fixed cost (TFC ) is the cost of the firm’s calculations in the other rows of the table.
fixed factors. For Campus Sweaters, total fixed cost Figure 11.3 shows Campus Sweaters’ total cost
includes the cost of renting knitting machines and curves, which graph total cost against output. The
normal profit, which is the opportunity cost of Cindy’s green TFC curve is horizontal because total fixed cost
entrepreneurship (see Chapter 10, p. 213). (R100 a day) does not change when output changes.
The quantities of fixed factors do not change The purple TVC curve and the blue TC curve both
as output changes, so total fixed cost is the same at slope upward because to increase output, more labour
all outputs. must be employed, which increases total variable cost.
FIGURE 11.3 Total Cost Curves Campus Sweaters rents a knitting machine for R100 a
day, so this cost is the firm’s total fixed cost. The firm hires
Cost (rand per day)
TC
workers at a wage rate of R100 a day and this cost is its
total variable cost. For example, in row D, Campus Sweaters
TC = TFC + TVC
TVC
employs 3 workers and its total variable cost is 3 × R100,
which equals R300. Total cost is the sum of total fixed
R400
cost and total variable cost. For example, when Campus
Sweaters employs 3 workers, total cost is R400 – total fixed
cost of R100 plus total variable cost of R300.
R200 The graph shows Campus Sweaters’ total cost curves.
Total fixed cost is constant – the TFC curve is a horizontal
R100 TFC line. Total variable cost increases as output increases, so the
TVC curve and the TC curve increase as output increases.
0 4 13 The vertical distance between the TC curve and the TVC
Output (sweaters per day) curve equals total fixed cost, as illustrated by the two arrows.
Labour Output Total fixed cost (TFC ) Total variable Cost Total cost (TC )
(workers per day) (sweaters per day) (rand per day) (TVC ) (rand per day) (rand per day)
A 0 0 100 0 100
B 1 4 100 100 200
C 2 9 100 200 300
D 3 13 100 300 400
E 4 16 100 400 500
F 5 18 100 500 600
G 6 18 100 600 700
Total fixed cost equals the vertical distance Average fixed cost (AFC ) is total fixed cost per
between the TVC and TC curves. unit of output. Average variable cost (AVC ) is total
Let us now look at a firm’s marginal cost. variable cost per unit of output. Average total cost
(ATC ) is total cost per unit of output. The average
cost concepts are calculated from the total cost
Marginal Cost concepts as follows:
Figure 11.3 shows that total variable cost and total
TC = TFV + TVC
cost increase at a decreasing rate at small outputs but
eventually, as output increases, total variable cost and Divide each total cost term by the quantity produced,
total cost increase at an increasing rate. To understand Q, to get
this pattern in the change in total cost as output
increases, we need to use the concept of marginal cost. TC TFC TVC
Q = Q Q
A firm’s marginal cost is the increase in total cost that
results from a one-unit increase in output. We calculate or
marginal cost as the increase in total cost divided by
the increase in output. The table in Figure 11.4 shows ATC = AFC + AVC
this calculation. When, for example, output increases
from 4 sweaters to 9 sweaters, total cost increases from The table in Fig. 11.4 shows the calculation of
R200 to R300. The change in output is 5 sweaters and average total cost. For example, in row C, output is
the change in total cost is R100. The marginal cost of 9 sweaters. Average fixed cost is (R100 ÷ 9), which
one of those 5 sweaters is (R100 ÷ 5), which equals R20. equals R11.11, average variable cost is (R200 ÷ 9),
Figure 11.4 graphs the marginal cost data in the which equals R22.22, and average total cost is
table as the red marginal cost curve, MC. This curve (R300 ÷ 9), which equals R33.33. Note that average
is U-shaped because when Campus Sweaters hires total cost is equal to average fixed cost (R11.11)
a second worker, marginal cost decreases, but when plus average variable cost (R22.22). Figure 11.4
it hires a third, fourth or fifth worker, marginal cost shows the average cost curves. The green average
successively increases. fixed cost curve (AFC ) slopes downward. As output
At small outputs, marginal cost decreases as increases, the same constant total fixed cost is spread
output increases because of greater specialisation and over a larger output. The blue average total cost
the division of labour. curve (ATC ) and the purple average variable cost
But as output increases further, marginal cost curve (AVC ) are U-shaped. The vertical distance
eventually increases because of the law of diminishing between the average total cost and average variable
returns. The law of diminishing returns means that cost curves is equal to average fixed cost – as indicated
the output produced by each additional worker is by the two arrows. That distance shrinks as output
successively smaller. To produce an additional unit of increases because average fixed cost declines with
output, ever more workers are required, and the cost of increasing output.
producing the additional unit of output – marginal cost
– must eventually increase.
Marginal cost tells us how total cost changes as
Marginal Cost and Average Cost
output increases. The final cost concept tells us what it The marginal cost curve (MC ) intersects the average
costs, on average, to produce a unit of output. Let us variable cost curve and the average total cost curve at their
now look at Campus Sweaters’ average costs. minimum points. When marginal cost is less than average
cost, average cost is decreasing, and when marginal cost
exceeds average cost, average cost is increasing. This
Average Cost relationship holds for both the ATC curve and the AVC
Three average costs of production are: curve. It is another example of the relationship you saw
1. Average fixed cost in Fig. 11.2 for average product and marginal product
2. Average variable cost and in your average and marginal grades.
3. Average total cost
FIGURE 11.4 Marginal Cost and Average Costs Marginal cost is calculated as the change in total cost divided
by the change in output. When output increases from 5 to
MC
Cost (rand per sweater)
Labour Output Total fixed Total Total cost Marginal AFC AVC ATC
cost (TFC) variable (TC) cost
cost (TVC)
(workers (sweaters (rand (rand per (rand per
per day) per day) per day) additional sweater)
sweater)
A 0 0 100 0 100
...............25
B 1 4 100 100 200 25 25 50.00
...............20
C 2 9 100 200 300 11.11 22.22 33.33
...............25
D 3 13 100 300 400 7.69 23.08 30.77
...............33
E 4 16 100 400 500 6.25 25.0 31.25
...............50
F 5 18 100 500 600 5.56 27.78 33.33
average variable cost is increasing, the ATC curve relationships between their product curves and cost
continues to slope downward. Eventually, average curves have not changed. The curves are still linked in
variable cost starts to increase more quickly than the way shown in Fig. 11.5.
average fixed cost decreases, so average total cost Often, as in the case of robots producing cars,
starts to increase. The ATC curve slopes upward. a technological advance results in a firm using more
capital, a fixed factor, and less labour, a variable factor.
Cost Curves and Product Curves
FIGURE 11.5 Product Curves and Cost Curves
The technology that a firm uses determines its costs.
Figure 11.5 shows the links between the firm’s
have 2, 3, and 4 machines. If Campus Sweaters uses Diminishing Returns Diminishing returns occur
Factory 2 with 2 knitting machines, the various with each of the four factory sizes as the quantity
amounts of labour can produce the outputs shown in of labour increases. You can check that fact by
the second column of the table. calculating the marginal product of labour in each
The other two columns show the outputs of of the factories with 2, 3 and 4 machines. With
yet larger quantities of capital. Each column of the each factory size, as the firm increases the quantity
table could be graphed as a total product curve for of labour employed, the marginal product of labour
each factory. (eventually) diminishes.
The table shows the total product data for four quantities of capital size, the marginal product of labour diminishes as more labour is
(factory sizes). The greater the factory size, the larger is the output employed. For a given quantity of labour, the marginal product
produced by any given quantity of labour. For a given factory of capital diminishes as the quantity of capital used increases.
0 3 6 9 12 15 18 21 24 27 30
Output (sweaters per day)
Diminishing Marginal Product of Capital The minimum average total cost for a larger factory
Diminishing returns also occur with each quantity of occurs at a greater output than it does for a smaller factory
labour as the quantity of capital increases. You can check because the larger factory has a higher total fixed cost and
that fact by calculating the marginal product of capital therefore, for any given output, a higher average fixed cost.
at a given quantity of labour. The marginal product of Which short-run ATC curve a firm operates on
capital is the change in total product divided by the depends on the factory it has. In the long run, the
change in capital when the quantity of labour is constant firm can choose its factory and the factory it chooses
– equivalently, the change in output resulting from a is the one that enables it to produce its planned
one-unit increase in the quantity of capital. For example, output at the lowest average total cost.
if Campus Sweaters has 3 workers and increases its To see why, suppose that Campus Sweaters plans
capital from 1 machine to 2 machines, output increases to produce 18 sweaters a day. In Fig. 11.6, with 1
from 13 to 18 sweaters a day. The marginal product machine, the average total cost curve is ATC1 and
of the second machine is 5 sweaters a day. If Campus the average total cost of 18 sweaters a day is R33.33
Sweaters continues to employ 3 workers and increases a sweater. With 2 machines, on ATC2, average total
the number of machines from 2 to 3, output increases cost is R27.78 a sweater. With 3 machines, on ATC3,
from 18 to 20 sweaters a day. The marginal product average total cost is R30.63 a sweater, the same as
of the third machine is 2 sweaters a day, down from with 1 machine. Finally, with 4 machines, on ATC4,
5 sweaters a day for the second machine. average total cost is R35.00 a sweater.
Let us now see what the production function The economically efficient factory for producing
implies for long-run costs. a given output is the one that has the lowest average
total cost. For Campus Sweaters, the economically
efficient factory to use to produce 18 sweaters a day is
Short-Run Cost and Long-Run Cost the one with 2 machines, employing 3 workers.
As before, Campus Sweaters can hire workers for R100 In the long run, Cindy chooses the factory
a day and rent knitting machines for R100 a day. that minimises average total cost. When a firm is
Using these factor prices and the data in Table 11.3, producing a given output at the least possible cost, it
we can calculate the average total cost and graph the ATC is operating on its long-run average cost curve.
curves for factories with 1, 2, 3 and 4 knitting machines. The long-run average cost curve is the relationship
We have already studied the costs of a factory with between the lowest attainable average total cost and
1 machine in Figs. 11.3 and 11.4. In Fig. 11.6, the output when the firm can change both the factory it
average total cost curve for that case is ATC1. uses and the quantity of labour it employs.
Figure 11.6 also shows the average total cost The long-run average cost curve is a planning
curve for a factory with 2 machines, ATC2, with curve. It tells the firm the factory and the quantity of
3 machines, ATC3, and with 4 machines, ATC4. labour to use at each output to minimise average cost.
You can see, in Fig. 11.6, that the factory size has Once the firm chooses a factory, the firm operates on
a big effect on the firm’s average total cost. the short-run cost curves that apply to that factory.
blue scallop-shaped curve made up of the pieces of the The challenge of managing a large enterprise is
four ATC curves is the LRAC curve. the main source of diseconomies of scale.
Constant returns to scale are features of a firm’s
technology that keep average total cost constant as
Economies and Diseconomies of Scale output increases.
Economies of scale are features of a firm’s technology When constant returns to scale are present, the
that make average total cost fall as output increases. LRAC curve is horizontal.
When economies of scale are present, the LRAC
curve slopes downward. In Fig. 11.7, Campus Sweaters Economies of Scale at Campus Sweaters The
has economies of scale for outputs up to 18 sweaters a day. economies of scale and diseconomies of scale at
Greater specialisation of both labour and capital Campus Sweaters arise from the firm’s production
is the main source of economies of scale. For example, function in Table 11.3. With 1 machine and 1
if Volkswagen produces 100 cars a week, each worker worker, the firm produces 4 sweaters a day. With
must perform many different tasks and the capital 2 machines and 2 workers, total cost doubles but
must be general-purpose machines and tools. But if output more than doubles to 14 sweaters a day,
Volkswagen produces 10 000 cars a week, each worker so average cost decreases and Campus Sweaters
specialises in a small number of tasks, uses task- experiences economies of scale. Diseconomies of scale
specific tools and becomes highly proficient. are experienced when the firm attempts to expand
Diseconomies of scale are features of a firm’s production beyond a given point but the average cost
technology that make average total cost rise as output is higher than when producing smaller quantities.
increases. When diseconomies of scale are present, With 4 machines and 4 workers, total cost doubles
the LRAC curve slopes upward. In Fig. 11.7, Campus again but output less than doubles to 24 sweaters a
Sweaters experiences diseconomies of scale at outputs day, so average cost increases and the firm experiences
greater than 18 sweaters a day. diseconomies of scale.
0 3 6 9 12 15 18 21 24 27 30
Output (sweaters per day)
Minimum Efficient Scale A firm’s minimum efficient the market has room for many firms and the market
scale is the smallest output at which long-run average is competitive. In a market in which the minimum
cost reaches its lowest level. At Campus Sweaters, efficient scale is large relative to market demand,
the minimum efficient scale is 18 sweaters a day. The only a small number of firms, and possibly only one
minimum efficient scale plays a role in determining firm, can make a profit and the market is either an
market structure. In a market in which the minimum oligopoly or monopoly. We will return to this idea in
efficient scale is small relative to market demand, the next three chapters.
REVIEW QUIZ
1 What does a firm’s production function show 4 What are economies of scale and diseconomies
and how is it related to a total product curve? of scale? How do they arise? What do they imply
2 Does the law of diminishing returns apply to capital for the shape of the LRAC curve?
as well as labour? Explain why or why not. 5 What is a firm’s minimum efficient scale?
3 What does a firm’s LRAC curve show? How is it
related to the firm’s short-run ATC curves?
Reading Between the Lines on pp. 248–249 curves. It looks at the costs of producing electricity
applies what you have learned about a firm’s cost in South Africa.
In 2012 the government seeks to support renewable energy projects at an estimated cost of
R60-billion. This is in addition to projects approved in 2011, bringing the total cost of alternative
energy to R120-billion for 3 750 MW. Initial reports have suggested that renewable energy would be
cheaper than coal-based electricity.
Dennis Dykes, chief economist at Nedbank, said that when the average cost of coal energy was
calculated, it did not take into consideration the marginal cost of obtaining additional megawatts
from coal. The cost of building massive power stations, which some estimated was running at three
times the original costing, completely changed the relative price of coal versus green energy.
‘Renewable energy could be cheaper and it could also come online far quicker’, said Dykes, who
added that it was not inconceivable that, within 10 years, we could be charged a carbon-emission tax
on our exports, which could make coal power unaffordable and coal power plants might be forced
to close. The indirect costs of coal-produced electricity and the impact this has on the environment
remains a great concern. That is why renewable energy is becoming so attractive.
Unlike the increasing cost of the coal power stations, the cost of renewable energy was falling as
technology evolved and competition was growing. Nedbank Capital has been involved in the
funding of 40% of the projects, and the bank’s infrastructure, energy and telecommunications head,
Mike Peo, said 28 projects were awarded in the first bidding round, out of 53 bids. ‘There was
a massive interest as it has been well supported by the
energy department. All the projects are banked and
have funders’. As a result, the industry was expecting ESSENCE OF THE STORY
stiff competition in the second round, which would
◆ Renewable energy is seen as providing energy
benefit pricing.
more cheaply than coal in the future.
Source: Adapted from ‘R120-billion clean power boom’ by Maya Fisher- ◆ Evolving technology and growing competition
French (Business/Energy) Mail & Guardian online http://mg.co.za/ in the renewable energy sector is seen to keep
article/2012-01-27-r120bn-clean-power-boom prices low.
◆ Renewable energy is available quicker to
consumers than traditional coal-based elec-
tricity due to the construction time of massive
power stations.
TP
Output (sweaters per day)
18
F G
16
Unattainable E
14
D
12
10
C
8 Attainable
4
B
2
A
0 1 2 3 4 5 6
Labour (workers per day)
From this table you can see that when you made
A Product 0 mugs of pineapple beer you still have a cost of R50.
Let us start with a product. I suggest we use When you make 6 mugs of pineapple beer then you
pineapple beer. Pineapple beer is made by mixing still only pay R50. This is why we refer to this value as
water, pineapples, sugar and brewer’s yeast into a the TFC or Total Fixed Cost.
bucket of water. It is left to stand for a few days and
is then ready to drink.
Next, you need to see yourself as a producer.
Variable Cost
Every decision you make is going to revolve around The Variable Cost (VC ) is an easier concept to play
the cost of production and output. This step is the with. As you produce more pineapple beer, you have
most important part of this section. to expect an increase in costs. 0 mugs of pineapple
Once you have determined that you are a beer will have 0 variable costs, but for every mug
producer, you now need to determine what kind of of pineapple beer that are produced, costs start to
costs you are going to be dealing with. There are two increase. See the table below.
costs, fixed and variable. Let us look at fixed cost first.
Mugs of Total Fixed Cost Total Variable
Pineapple Beer Costs
Fixed Cost
0 50 0
The fixed cost is always present and does not 1 50 6
change in the short run. In the long run everything 2 50 10
changes. Our friends change, our bosses change, our 3 50 15
waist size changes. But in the short run, everything 4 50 22
seems to stay somewhat constant. So when we talk 5 50 34
about the short run, we assume that the fixed cost 6 50 52
does not change.
Using our product as an example, let us start with From this table you can see that the costs of
the bucket. Assume that you do not own a bucket. producing the beer are not fixed, but have a tendency
You decide to hire one from a friend who promises to increase. Remember the law of increasing costs:
not to tell anyone as long as you give him R50 a week. as you produce more, the variable costs that you are
So whether you produce any pineapple beer that week incurring tend to increase. The variable costs are most
or not, does not matter. You have to pay for the ‘rent’ often referred to as the Total Variable Costs (TVC ).
of the bucket, and this remains fixed (constant). The
reason you decide not to buy a bucket, is because
Total Cost
this particular bucket has a tap at the bottom, and is
slightly larger than usual, and is easy to transport as it Together, the fixed costs and the variable costs give
just fits into your car, when full. You agree. you the total costs that you would be expected to pay
TC = TFC + TVC
Marginal Cost 20
Marginal Cost (MC ) is considered one of the most 18 MC
important calculations that you need to do in this 16
section. It can be calculated by taking the change in 14
Cost in rand
the Total Cost (∆TC ) and dividing it by the change in 12
the Quantity (∆Q) of mugs of pineapple beer 10
AVC
∆TC 8
MC =
∆Q 6
4
Mugs of Total Total Total Cost Marginal 2
Pineapple Fixed Variable Cost
Beer Cost Costs 0 0 1 2 3 4 5 6
0 50 0 50 Number of bottles of pineapple beer
40
Cost in rand
Example
30
Here is an additional example.
20
Using the appropriate formulas, complete the
ATC following table by replacing each letter with an
10
AFC appropriate value. Use this table to explain where the
cut-off point is.
0 1 2 3 4 5 6
Number of bottles of pineapple beer
Q TC TVC TFC ATC AVC MC
Figure 2 Average total cost and average fixed cost 0 300 a f b c d
1 800 e f g h i
The ATC and the AFC will slope downwards
from left to right along the graph. This shows that as 2 j 1 050 f l m n
you produce more pineapple beer, the average cost 3 1 950 o f q r s
comes down. 4 t 2 900 f u v w
5 x 4 000 f k p z
Now, when you complete this table, start by placing c AVC is TVC/Q, and TVC is 0, and zero divided
down the formulas. Start with the most basic, namely by zero, is undefined, leave it blank.
d MC is change in (∆) TC divided by change in
TC = TFC + TVC (∆) Q. As we are dividing by zero, leave it blank.
e TFC is 300 (stays 300) and TC = TVC +TFC.
Now, divide each of these by the Q to get the So 800 = e + 300. Therefore e is 500.
corresponding formulas f If TC is 300, and TVC is zero, then 0 + 300 is
300, therefore f is 300.
TC = TFC + TVC g ATC is TC/Q, and TC is 800, Q is 1, so g is
Q Q Q 800/1 = 800.
h AVC is TVC/Q, so TVC is 500 (see ‘e’) so 500/1
ATC = TC is equal to 500.
Q i ... Try and do the rest yourself, and as you go
along, complete the table, with all the numbers
AFC = TFC outstanding. It should look like this.
Q
Q TC TVC TFC ATC AVC MC
AVC = TVC 0 300 0 300
Q
1 800 500 300 800 500 500
And finally,
2 1350 1050 300 675 525 550
MC = ∆TC 3 1950 1650 300 650 550 600
∆Q 4 3200 2900 300 800 725 1250
With these formulas, the rest is easy. 5 4300 4000 300 860 800 1100
a Q is zero, so the TVC must also be zero, therefore
a=0 The cut-off point is where the MC is equal to the
b When you do b, first work out f ( f is 300, see lowest part of the AVC curve, which is at 500. So 1 is
alongside). ATC is TC/Q and Q is 0, you cannot the lowest quantity you can sell.
divide by zero, so it stays blank.
Key Terms
Average fixed cost, 240 Diminishing marginal Law of diminishing Minimum efficient scale, 247
Average product, 235 returns, 237 returns, 237 Short run, 234
Average total cost, 240 Diseconomies of scale, 246 Long run, 234 Sunk cost, 234
Average variable cost, 240 Economies of scale, 246 Long-run average cost Total cost, 239
Constant returns to scale, Increasing marginal curve, 245 Total fixed cost, 239
246 returns, 237 Marginal cost, 240 Total product, 235
Marginal product, 235 Total variable cost, 239
13. Workers at Sue’s Surfboards negotiate a wage Jackie’s pays R100 a day for each canoe it rents and
increase of R100 a week for each worker. If R50 a day for each canoe operator it hires.
other things remain the same, explain how Sue’s 17. Graph the ATC curves for Factory 1 and Factory 2.
Surfboards’ short-run average cost curves and Explain why these ATC curves differ.
marginal cost curve change. 18. Graph the ATC curves for Factory 3 and
14. Grain Prices Just Keep Rising Factory 4. Explain why these ATC curves differ.
Every morning millions of South Africans 19. a. On Jackie’s LRAC curve, what is the average
confront the latest trend in commodities markets cost of producing 40, 75 and 85 rides a week?
at their kitchen table. Rising prices for crops have b. What is Jackie’s minimum efficient scale?
begun to drive up the cost of breakfast. 20. a. Explain how Jackie’s uses its LRAC curve to
Explain how the rising price of crops affects the decide how many canoes to rent.
average total cost and marginal cost of producing b. Does Jackie’s production function feature
breakfast cereals. economies of scale or diseconomies of scale?
A
12
Free State maize farmer must make many decisions, but figuring
out the price to charge for his maize is not one of them. Maize farmers
must accept the price determined by supply and demand. The producers
of most crops – among them wheat, rice, soybean, sugar and coffee –
must also accept the prices that markets determine.
During the booming economic conditions
of 2006 and 2007, crop prices and production
you can sell all your output for R2 400 a tonne, so you
What Is Perfect Competition? are just giving away R100 a tonne. You can do no better
The firms that you study in this chapter face the force than sell for the market price – you are a price taker.
of raw competition. We call this extreme form of
competition perfect competition. Perfect competition is
a market in which:
Economic Profit and Revenue
◆ Many firms sell identical products to many buyers. A firm’s goal is to maximise economic profit, which
◆ There are no restrictions on entry into or exit is equal to total revenue minus total cost. Total cost
from the market. is the opportunity cost of production, which includes
◆ Established firms have no advantage over new ones. normal profit. (See Chapter 10, p. 213.)
◆ Sellers and buyers are well informed about prices. A firm’s total revenue equals the price of its
output multiplied by the number of units of output
Farming, fishing, wood pulping and paper milling, the sold (price × quantity).
manufacture of paper cups and shopping bags, grocery Marginal revenue is the change in total revenue that
and fresh flower retailing, photo finishing, lawn services, results from a one-unit increase in the quantity sold.
plumbing, painting, dry cleaning and laundry services Marginal revenue is calculated by dividing the change in
are all examples of highly competitive industries. total revenue by the change in the quantity sold.
Figure 12.1 illustrates these revenue concepts.
In part (a), the market demand curve, D, and market
How Perfect Competition Arises supply curve, S, determine the market price. The
Perfect competition arises if the minimum efficient scale market price is R250 a sweater. Campus Sweaters is
of a single producer is small relative to the market demand just one of many producers of sweaters, so the best it
for the good or service. In this situation, there is room in can do is to sell its sweaters for R250 each.
the market for many firms. A firm’s minimum efficient
scale is the smallest output at which long-run average cost Total Revenue Total revenue is equal to the price
reaches its lowest level. (See Chapter 11, p. 247.) multiplied by the quantity sold. In the table in
In perfect competition, each firm produces a Fig. 12.1, if Campus Sweaters sells 9 sweaters, its
good that has no unique characteristics, so consumers total revenue is R2 250 (9 × R250).
do not care which firm’s good they buy. Figure 12.1(b) shows the firm’s total revenue
curve (TR), which graphs the relationship between
total revenue and the quantity sold. At point A on
Price Takers the TR curve, the firm sells 9 sweaters and has a total
Firms in perfect competition are price takers. A price taker revenue of R2 250. Because each additional sweater
is a firm that cannot influence the market price because its sold brings in a constant amount – R250 – the total
production is an insignificant part of the total market. revenue curve is an upward-sloping straight line.
Imagine that you are a farmer in the Western
Cape. You have a thousand hectares under cultiva- Marginal Revenue Marginal revenue is the change
tion – which sounds like a lot. But compared to the in total revenue that results from a one-unit increase
thousands of hectares in the rest of the country, as in quantity sold. In the table in Fig. 12.1, when the
well as the millions more in Botswana, Mozambique quantity sold increases from 8 to 9 sweaters, total
and Lesotho, your thousand hectares is a drop in the revenue increases from R2 000 to R2 250, so marginal
ocean. Nothing makes your wheat any better than any revenue is R250 a sweater.
other farmer’s, and all the buyers of wheat know the Because the firm in perfect competition is a price
price at which they can do business. taker, the change in total revenue that results from
If the market price of wheat is R2 400 a tonne and a one-unit increase in the quantity sold equals the
you ask for R2 500, no one will buy from you. People market price. In perfect competition, the firm’s marginal
can go to the next farmer and the next and the one after revenue equals the market price. Figure 12.1(c) shows
that and buy all they need for R2 400 a tonne. If you set the firm’s marginal revenue curve (MR) as the hori-
your price at R2 300, you will have lots of buyers. But zontal line at the market price.
Demand for the Firm’s Product The firm can sell revenue curve. While the firm, because of its small size,
any quantity it chooses at the market price. So the believes that it can sell any amount without impact on
demand curve for the firm’s product is a horizontal the market price, if many firms make similar decisions,
line at the market price, the same as the firm’s marginal the overall effect is an impact on the market price.
day)
sweater)
sweater)
perday)
persweater)
persweater)
500 500
500 500
S TR
S (randper TR
Demand for
Demand for
revenue(rand
(randper
(randper
Campus
Campus
Sweaters
Price(rand
Price(rand
Sweaters
Market
Totalrevenue
Market
demand
demand
Price
Price
250 curve 2 250 A 250 MR
250 curve 2 250 A 250 MR
Total
D
D
0 9 20 0 9 20 0 10 20
0 9 20 0 9 20 0 10 20
Quantity (thousands of Quantity (sweaters per day) Quantity (sweaters per day)
Quantity (thousands of Quantity (sweaters per day) Quantity (sweaters per day)
sweaters per day)
sweaters per day)
In part (a), market demand and market supply determine marginal revenue curve (MR). This curve is also the demand
the market price (and quantity). Part (b) shows the firm’s total curve for the firm’s sweaters.
revenue curve (TR). Point A corresponds to the second row The demand for sweaters from Campus Sweaters is
of the table – Campus Sweaters sells 9 sweaters at R250 a perfectly elastic at the market price of R250 a sweater.
sweater, so total revenue is R2 250. Part (c) shows the firm’s
A horizontal demand curve illustrates a perfectly To achieve its goal, a firm must decide:
elastic demand, so the demand for the firm’s product 1. How to produce at minimum cost
is perfectly elastic. A sweater from Campus Sweaters 2. What quantity to produce
is a perfect substitute for a sweater from any other 3. Whether to enter or exit a market
factory. But the market demand for sweaters is not
perfectly elastic: its elasticity depends on the substitut- You have already seen how a firm makes the first
ability of sweaters for other goods and services. decision. It does so by operating with the plant that
minimises long-run average cost – by being on its
long-run average cost curve. We will now see how
The Firm’s Decisions the firm makes the other two decisions. We start by
The goal of the competitive firm is to maximise looking at the firm’s output decision.
economic profit, given the constraints it faces.
FIGURE 12.2 Total Revenue, Total Cost and Quantity Total revenue Total cost Economic
Economic Profit (Q) (TR) (TC ) profit
(sweaters (rand) (rand) (TR – TC )
per day) (rand)
TC TR
0 0 220 –220
Total revenue and total cost (rand per day)
420
Economic and economic profit. Part (a) graphs the total revenue and
profit total cost curves and part (b) graphs economic profit.
200 Economic
loss Campus Sweaters makes maximum economic profit,
0 R420 a day (R2 250 – R1 830), when it produces 9 sweaters
4 9 12 Quantity
(sweaters a day. At outputs of 4 sweaters and 12 sweaters a day,
–200 per day)
Profit- Campus Sweaters makes zero economic profit – these are
maximising
quantity
EP break-even points. At outputs less than 4 sweaters and
–400
greater than 12 sweaters a day, Campus Sweaters incurs
(b) Economic profit and loss an economic loss.
Economic profit equals total revenue minus total revenue, MR, with marginal cost, MC. As output
cost. The fourth column of the table in Fig. 12.2 increases, the firm’s marginal revenue is constant but
shows the economic profit made by Campus Sweaters, its marginal cost eventually increases.
and part (b) of the figure graphs these numbers as its If marginal revenue exceeds marginal cost
economic profit curve, EP. (MR > MC ), then the revenue from selling one more
Campus Sweaters maximises its economic profit unit exceeds the cost of producing it and an increase in
by producing 9 sweaters a day: Total revenue is output increases economic profit. If marginal revenue is
R2 250, total cost is R1 830 and economic profit is less than marginal cost (MR < MC ), then the revenue
R420. No other output rate achieves a larger profit. from selling one more unit is less than the cost of
At outputs of less than 4 sweaters and more than producing that unit and a decrease in output increases
12 sweaters a day, the Campus Sweaters would incur economic profit. If marginal revenue equals marginal
an economic loss. At either 4 or 12 sweaters a day, the cost (MR = MC ), then the revenue from selling one
Campus Sweaters would make zero economic profit, more unit equals the cost incurred to produce that unit.
called a break-even point. Economic profit is maximised and either an increase
or a decrease in output decreases economic profit.
Figure 12.3 illustrates these propositions. If
Marginal Analysis and the Supply Decision
Campus Sweaters increases its output from 8 sweaters
Another way to find the profit-maximising output is to 9 sweaters a day, marginal revenue (R250) exceeds
to use marginal analysis, which compares marginal marginal cost (R230), so by producing the 9th sweater
Quantity Total revenue Marginal revenue Total cost Marginal cost Economic profit
(Q) (TR) (MR) (TC ) (MC ) (TR – TC )
(sweaters per day) (rand) (rand per (rand) (rand per (rand)
additional sweater) additional sweater)
7 1 750 1 410 340
250 190
8 2 000 1 600 400
250 230
9 2 250 1 830 420
250 270
10 2 500 2 100 400
250 350
11 2 750 2 450 300
economic profit increases by R20 from R400 to R420 Loss Comparisons A firm’s economic loss equals
a day. The blue area in the figure shows the increase in total fixed cost, TFC, plus total variable cost, TVC
economic profit when the firm increases production minus total revenue, TR . Total variable cost equals
from 8 to 9 sweaters per day. average variable cost, AVC, multiplied by the quantity
If Campus Sweaters increases its output from produced, Q, and total revenue equals price, P, multi-
9 sweaters to 10 sweaters a day, marginal revenue plied by the quantity Q. So
(R250) is less than marginal cost (R270), so by
producing the 10th sweater, economic profit Economic loss = TFC + (AVC – P) × Q
decreases. The last column of the table shows that
economic profit decreases from R420 to R400 a day. If the firm shuts down, it produces no output
The red area in the figure shows the economic loss (Q = 0). The firm has no variable costs and no revenue
that arises from increasing production from 9 to 10 but it must pay its fixed costs, so its economic loss
sweaters a day. equals total fixed cost.
Campus Sweaters maximises economic profit If the firm produces, then in addition to its
by producing 9 sweaters a day, the quantity at which fixed costs, it incurs variable costs. But it also receives
marginal revenue equals marginal cost. revenue. Its economic loss equals total fixed cost –
A firm’s profit-maximising output is its quantity the loss when shut down – plus total variable cost
supplied at the market price. The quantity supplied minus total revenue. If total variable cost exceeds
at a price of R250 a sweater is 9 sweaters a day. If total revenue, this loss exceeds total fixed cost and the
the price were higher than R250 a sweater, the firm shuts down. Equivalently, if average variable cost
firm would increase production. If the price were exceeds price, this loss exceeds total fixed cost and the
lower than R250 a sweater, the firm would decrease firm shuts down.
production. These profit-maximising responses to
different market prices are the foundation of the law The Shutdown Point A firm’s shutdown point is the
of supply: price and quantity at which it is indifferent between
producing and shutting down. The shutdown point
Other things remaining the same, the higher the occurs at the price and the quantity at which average
market price of a good, the greater is the quantity variable cost is a minimum. At the shutdown point,
the firm is minimising its loss and its loss equals total
supplied of that good.
fixed cost. If the price falls below minimum average
variable cost, the firm shuts down and continues to
Shutdown Decision incur a loss equal to total fixed cost. At prices above
minimum average variable cost but below average
You have seen that a firm maximises profit by producing
total cost, the firm produces the loss-minimising
the quantity at which marginal revenue (price) equals
output and incurs a loss, but a loss that is less than
marginal cost. But suppose that at this quantity, price is
total fixed cost.
less than average total cost. In this case, the firm incurs
Figure 12.4 illustrates the firm’s shutdown
an economic loss. Maximum profit can also be viewed as
decision and the shutdown point that we have just
a minimum loss. What does the firm do?
described for Campus Sweaters.
If the firm expects the loss to be permanent, it
The firm’s average variable cost curve is AVC and
goes out of business. But if it expects the loss to be
the marginal cost curve is MC. Average variable cost
temporary, the firm must decide whether to shut
has a minimum of R170 a sweater when output is
down temporarily and produce no output, or to keep
7 sweaters a day. The MC curve intersects the AVC
producing. To make this decision, the firm compares
curve at its minimum. (We explained this relationship
the loss from shutting down with the loss from
between marginal cost and average cost in Chapter 11;
producing and takes the action that minimises its loss.
see pp. 240–241.)
In the absence of expectations, the firm shuts down if
The figure shows the marginal revenue curve MR
the average variable cost exceeds marginal revenue.
when the price is R170 a sweater, a price equal to
minimum average variable cost.
sweater)
MC
persweater)
MC
shows that the firm’s average total cost of producing
7 sweaters a day is R201.43 a sweater, that is R1 410/7.
(randper
The firm incurs a loss equal to R31.43 a sweater 310
310
MR 2
MR 2
cost(rand
on 7 sweaters a day, so its loss is R220 a day, which
equals total fixed cost.
andcost
250 MR 1
Priceand
250 MR 1
FIGURE 12.4 The Shutdown Decision AVC
Price
Shutdown AVC
Shutdown
point
point
Price (rand per sweater)
MC
T
300.00 170 T MR 0
170 MR 0
ATC
250.00
AVC 0 7 9 10
0 7 9 10
Quantity (sweaters per day)
Quantity (sweaters per day)
201.43 (a) Marginal cost and average variable cost
(a) Marginal cost and average variable cost
170.00 MR
Shutdown
150.00
sweater)
point S
persweater)
S
(randper
310
0 4 7 10 13 310
Price(rand
When the price is less than minimum average Market Supply in the Short Run
variable cost (less than R170 a sweater), the firm
The short-run market supply curve shows the quan-
maximises profit by shutting down and producing no
tity supplied by all the firms in the market at each
output. The firm produces zero output at all prices
price when each firm’s plant and the number of firms
below minimum average variable cost.
remain the same.
When the price equals minimum average vari-
You have seen how an individual firm’s supply
able cost, the firm maximises profit either by shutting
curve is determined. The market supply curve is
down and producing no output or by producing the
derived from the individual supply curves. The
output at which average variable cost is a minimum –
quantity supplied by the market at a given price is the
the shutdown point, T.
sum of the quantities supplied by all the firms in the
The firm never produces a quantity between zero
market at that price.
and the quantity at the shutdown point T (a quantity
Figure 12.6 shows the supply curve for the
greater than zero and less than 7 sweaters a day).
competitive sweater market. In this example, the
The firm’s supply curve in Fig. 12.5(b) runs
market consists of 1 000 firms exactly like Campus
along the y-axis from a price of zero to a price equal
Sweaters. At each price, the quantity supplied by
to minimum average variable cost, jumps to point T,
the market is 1 000 times the quantity supplied by a
and then, as the price rises above minimum average
single firm.
variable cost, follows the marginal cost curve.
The table accompanying Fig. 12.6 shows
the firm’s and the market’s supply schedules and
REVIEW QUIZ how the market supply curve is constructed. At
1 Why does a firm in perfect competition prices below R170 a sweater, every firm in the
produce the quantity at which marginal market shuts down; the quantity supplied by the
cost equals price? market is zero. At R170 a sweater, each firm is indif-
2 What is the lowest price at which a firm ferent between shutting down and producing
produces an output? Explain why. nothing or operating and producing 7 sweaters a
3 What is the relationship between a firm’s day. Some firms will shut down, and others will
supply curve, its marginal cost curve and its supply 7 sweaters a day. The quantity supplied by
average variable cost curve? each firm is either 0 or 7 sweaters, and the quantity
supplied by the market is between 0 (all firms shut
So far, we have studied a single firm in isolation. down) and 7 000 (all firms produce 7 sweaters a
We have seen that the firm’s profit-maximising deci- day each).
sion depends on the market price, which it takes as The market supply curve is a graph of the market
given. How is the market price determined? Let us supply schedules and the points on the supply curve A
find out. to D represent the rows of the table.
To construct the market supply curve, we
sum the quantities supplied by all the firms at each
price. Each of the 1 000 firms in the market has
Output, Price and Profit in the Short a supply schedule like Campus Sweaters. At prices
Run below R170 a sweater, the market supply curve
To determine the price and quantity in a perfectly runs along the y-axis. At R170 a sweater, the market
competitive market, we need to know how market supply curve is horizontal – supply is perfectly
demand and market supply interact. We start by elastic. As the price rises above R170 a sweater,
studying a perfectly competitive market in the short each firm increases its quantity supplied and the
run. The short run is a situation in which the number quantity supplied by the market increases by
of firms is fixed. 1 000 times that of one firm.
SM
D
310
Price Quantity supplied by Quantity supplied
(rand per Campus Sweaters by market
250
C sweater) (sweaters per day) (sweaters per
day)
B A 170 0 or 7 0 to 7 000
200
A B 200 8 8 000
170
C 250 9 9 000
D 310 10 10 000
0 7 8 9 10
Quantity (thousands of sweaters per day)
The market supply schedule is the sum of the supply schedules Points A, B, C, and D correspond to the rows of the table. At
of all the individual firms. A market that consists of 1 000 the shutdown price of R170 a sweater, each firm produces
identical firms has a supply schedule similar to that of one either 0 or 7 sweaters a day and the quantity supplied by the
firm, but the quantity supplied by the market is 1 000 times as market is between 0 and 7 000 sweaters a day. The market
large as that of the one firm (see the table). The market supply supply is perfectly elastic at the shutdown price.
curve is SM.
average total cost, a firm breaks even – the entrepre- loss. Figure 12.8 shows these three possible short-run
neur makes normal profit. If price exceeds average profit outcomes for Campus Sweaters.
total cost, a firm makes an economic profit. If price is These outcomes correspond to the three different
less than average total cost, a firm incurs an economic levels of market demand that we have just examined.
D2 D2
200 200 200 200
(a) Equilibrium
(a) Equilibrium (b) Change
(b) Change in equilibrium
in equilibrium
In part (a), the market supply curve is S and the market In part (b), if the market demand increases to D2, the price
demand curve is D1. The market price is R200 a sweater. rises to R250 a sweater. Each firm produces 9 sweaters a
At this price, each firm produces 8 sweaters a day and the day and market output is 9 000 sweaters. If market demand
market produces 8 000 sweaters a day. decreases to D3, the price falls to R170 a sweater and each
firm decreases its output. If each firm produces 7 sweaters a
day, the market output is 7 000 sweaters a day.
Three Possible Short-Run Outcomes this economic profit. The height of that rectangle is
Figure 12.8(a) corresponds to the situation in Fig. profit per sweater, R46.67, and the length is the quantity
12.7(a) where the market demand is D1. The equilib- of sweaters produced, 9 a day. So the area of the rectangle
rium price of a sweater is R200 and the firm produces is economic profit of R420 a day.
8 sweaters a day. Figure 12.8(c) corresponds to the situation in
Average total cost is R200 a sweater. Price equals Fig. 12.7(b) where the market demand is D3. The
average total cost (ATC ), so the firm breaks even equilibrium price of a sweater is R170. Here, the price
(makes zero economic profit). is less than average total cost, so the firm incurs an
Figure 12.8(b) corresponds to the situation in economic loss. Price and marginal revenue are R170 a
Fig. 12.7(b) where the market demand is D2. The equi- sweater, and the profit-maximising (in this case, loss-
librium price of a sweater is R250 and the firm produces minimising) output is 7 sweaters a day. Total revenue
9 sweaters a day. Here, price exceeds average total cost, so is R1 190 a day (7 × R170). Average total cost is
the firm makes an economic profit. Its economic profit is R201.43 a sweater, so the economic loss is R31.43
R420 a day, which equals R46.67 per sweater (R250.00 per sweater (R201.43 – R170.00). This loss per
– R203.33) multiplied by 9, the profit-maximising sweater multiplied by the number of sweaters is
number of sweaters produced. The blue rectangle shows R220. The red rectangle shows this economic loss.
The height of that rectangle is economic loss per is the firm’s economic loss of R220 a day. If the price
sweater, R31.43, and the length is the quantity of dips below R170 a sweater, the firm shuts down and
sweaters produced, 7 a day. So the area of the rectangle incurs an economic loss equal to total fixed cost.
0 8 10 0 9 10 0 7 10
Quantity (sweaters per day) Quantity (sweaters per day) Quantity (sweaters per day)
In the short run, the firm might break even (make zero a sweater. At the profit-maximising output, the price exceeds
economic profit), make an economic profit or incur an average total cost and the firm makes an economic profit equal
economic loss. to the area of the blue rectangle. In part (c), the market price
In part (a), the price equals minimum average total cost. At is R170 a sweater. At the profit-maximising output, the price
the profit-maximising output, the firm breaks even and makes is below minimum average total cost and the firm incurs an
zero economic profit. In part (b), the market price is R250 economic loss equal to the area of the red rectangle.
Entry and Exit supply lowers the market price and eventually elimi-
Entry occurs in a market when new firms come into nates economic profit. When economic profit reaches
the market and the number of firms increases. Exit zero, entry stops.
occurs when existing firms leave a market and the If firms exit a market, supply decreases and the
number of firms decreases. market supply curve shifts leftward. The market
Firms respond to economic profit and economic price rises and economic loss decreases. Eventually,
loss by either entering or exiting a market. New firms economic loss is eliminated and exit stops.
enter a market in which existing firms are making an To summarise:
economic profit. Firms exit a market in which they are ◆ New firms enter a market in which existing firms
incurring an economic loss. are making an economic profit.
Temporary economic profit and temporary ◆ As new firms enter a market, the market price falls
economic loss do not trigger entry and exit. It is the and the economic profit of each firm decreases.
expectation of persistent economic profit or loss that ◆ Firms exit a market in which they are incurring
triggers entry and exit. an economic loss.
Entry and exit change the market supply, which ◆ As firms leave a market, the market price rises
influences the market price, the quantity produced by and the economic loss incurred by the remaining
each firm, and its economic profit (or loss). firms decreases.
If firms enter a market, supply increases and the ◆ Entry and exit stop when firms make zero
market supply curve shifts rightward. The increase in economic profit.
S1 S* S2
MC
Zero
economic
profit ATC
D
0 6 7 8 9 10 0 7.2 8.0 8.4
Quantity (sweaters per day) Quantity (thousands of sweaters per day)
Each firm has cost curves like those of Campus Sweaters in When the market supply curve is S2, the price is R170
part (a). The market demand curve is D in part (b). a sweater. In part (a), each firm produces 7 sweaters a day
When the market supply curve in part (b) is S1, the price and incurs an economic loss. Loss triggers exit and as firms
is R250 a sweater. In part (a), each firm produces 9 sweaters exit, the market supply curve shifts leftward from S2 towards
a day and makes an economic profit. Profit triggers the entry S1. The price rises from R170 to R200 a sweater, and the
of new firms and as new firms enter, the market supply curve quantity produced decreases from 8 400 to 8 000 sweaters.
shifts rightward from S1 toward S*. The price falls from R250 Each firm’s output increases from 7 to 8 sweaters a day and
to R200 a sweater, and the quality produced increases from economic profit rises to zero.
7 200 to 8 000 sweaters. Each firm’s output decreases to
8 sweaters a day and economic profit falls to zero.
A Closer Look at Entry This economic loss is a signal for firms to exit
The sweater market has 800 firms with cost curves the market. As exit takes place, supply decreases and
like those in Figure 12.9(a). The market demand curve the market supply curve shifts leftward toward S*.
is D, the market supply curve is S1 and the price is As supply decreases with no change in demand, the
R250 a sweater in Figure 12.9(b). Each firm produces market price gradually rises from R170 to R200 a
9 sweaters a day and makes an economic profit. sweater. At this higher price, losses are eliminated,
This economic profit is a signal for new firms each firm makes zero economic profit and exit stops.
to enter the market. As entry takes place, supply Exit results in a decrease in market output, but each
increases and the market supply curve shifts firm’s output increases. Because the price rises, each firm
rightward toward S*. As supply increases with moves up its supply curve and produces more. Because
no change in demand, the market price gradually the number of firms decreases, the market produces less.
falls from R250 to R200 a sweater. At this lower
price, each firm makes zero economic profit and
entry stops. Long-Run Equilibrium
Long-Run Equilibrium
Entry results in an increase in market output, but You have now seen how economic
each firm’s output decreases. Because the price falls, profit induces entry, which in turn
each firm moves down its supply curve and produces eliminates profit. You have also seen
less. Because the number of firms increases, the how economic loss induces exit,
market produces more. which in turn eliminates loss.
When economic profit and
economic loss have been eliminated
A Closer Look at Exit and entry and exit have stopped,
Now consider the situation where the sweater market a competitive market is in long-run www.quickto.mobi/
has 1 200 firms with cost curves like those in equilibrium. PEA-LONG
Fig. 12.9(a). The market demand curve is D, the You have seen how a competitive
market supply curve is S2 and the price is R170 a market adjusts toward its long-run
sweater in Fig. 12.9(b). Each firm produces 7 sweaters equilibrium. But a competitive market is
a day and incurs an economic loss. rarely in a state of long-run equilibrium.
Instead, it is constantly and restlessly evolving toward Let us use the theory of perfect competition to
long-run equilibrium. The reason is that the market answer these questions.
is constantly bombarded with events that change the
constraints that firms face.
Markets are constantly adjusting to keep up with A Permanent Change in Demand
changes in tastes, which change demand, and changes Figure 12.10(a) shows a competitive market that
in technology, which change costs. initially is in long-run equilibrium. The demand curve
In the next sections, we are going to see how a is D0, the supply curve is S0, the market price is P0 and
competitive market reacts to changing tastes and tech- market output is Q 0. Figure 12.10(b) shows a single
nology and how it guides resources to their highest- firm in this initial long-run equilibrium. The firm
valued use. produces q0 and makes zero economic profit.
Now suppose that demand decreases and the
REVIEW QUIZ demand curve shifts leftward to D1, as shown in
Fig. 12.10(a). The market price falls to P1, and the
1 What triggers entry in a competitive market?
quantity supplied by the market decreases from Q 0
Describe the process that ends further entry.
to Q1 as the market moves down along its short-run
2 What triggers exit in a competitive market?
supply curve S0. Figure 12.10(b) shows the situa-
Describe the process that ends further exit.
tion facing a firm. The market price is now below the
firm’s minimum average total cost, so the firm incurs
an economic loss. But to minimise its loss, the firm
adjusts its output to keep marginal cost equal to price.
Changing Tastes and Advancing At a price of P1, each firm produces an output of q1.
Technology The market is now in short-run equilibrium but
Increased awareness of the health hazards of smoking not long-run equilibrium. It is in short-run equilib-
has decreased the demand for tobacco products. The rium because each firm is maximising profit; it is
development of inexpensive motor vehicle and air not in long-run equilibrium because each firm is
transportation during the 1990s decreased the demand incurring an economic loss – its average total cost
for long-distance trains and buses. Solid-state electronics exceeds the price.
has decreased the demand for TV and radio repair. The economic loss is a signal for some firms
The development of good-quality inexpensive clothing to exit the market. As they do so, short-run market
has decreased the demand for sewing machines. What supply decreases and the market supply curve gradu-
happens in a competitive market when there is a perma- ally shifts leftward. As market supply decreases,
nent decrease in the demand for its product? the price rises. At each higher price, a firm’s profit-
Microwave food preparation has increased the maximising output is greater, so the firms remaining
demand for paper, glass and plastic cooking utensils in the market increase their output as the price rises.
and for plastic wrap. Each firm moves up along its marginal cost or supply
The internet has increased the demand for personal curve in Fig. 12.10(b). That is, as some firms exit the
computers and the widespread use of computers has market, market output decreases but the output of the
increased the demand for high-speed connections and firms that remain in the market increases.
music downloads. What happens in a competitive Eventually, enough firms have exited the market
market when the demand for its output increases? for the market supply curve to have shifted to S1 in
Advances in technology are constantly lowering Fig. 12.10(a). The market price has returned to its
the costs of production. New biotechnologies have original level, P0. At this price, the firms remaining in
dramatically lowered the costs of producing many the market produce q0, the same quantity that they
food and pharmaceutical products. New electronic produced before the decrease in demand. Because
technologies have lowered the cost of producing just firms are now making zero economic profit, no firm
about every good and service. What happens in a has an incentive to enter or exit the market. The
competitive market for a good when technological market supply curve remains at S1, and market output
change lowers its production costs? is Q 2. The market is again in long-run equilibrium.
The difference between the initial long-run arose in this market. The result was a massive rate
equilibrium and the final long-run equilibrium is of entry of internet service providers. The process
the number of firms in the market. A permanent of competition and change in the internet service
decrease in demand has decreased the number of market is similar to what we have just studied but
firms. Each firm remaining in the market produces with an increase in demand rather than a decrease
the same output in the new long-run equilibrium as in demand.
it did initially and makes zero economic profit. In the We have now studied the effects of a permanent
process of moving from the initial equilibrium to the change in demand for a good. In doing so, we began
new one, firms incur economic losses. and ended in a long-run equilibrium and examined
We have just worked out how a competitive market the process that takes a market from one equilibrium
responds to a permanent decrease in demand. A perma- to another. It is this process, not the equilibrium
nent increase in demand triggers a similar response, points, that describes the real world.
except in the opposite direction. The increase in demand One feature of the predictions that we have just
brings a higher price, economic profit and entry. Entry generated seems odd: In the long run, regardless of
increases market supply and eventually lowers the price whether demand increases or decreases, the market price
to its original level and economic profit to zero. returns to its original level. Is this outcome inevitable?
The demand for internet service increased perma- In fact, it is not. It is possible for the equilibrium market
nently during the 1990s and huge profit opportunities price in the long run to remain the same, rise or fall.
S0 MC
ATC
P0 P0 MR 0
P1 P1 MR 1
D0
D1
0 Q2 Q1 Q0 Quantity 0 q1 q0 Quantity
A market starts out in long-run competitive equilibrium. Part (a) its output to Q1 in part (b).and the market output decreases to
shows the market demand curve D0, the market supply curve Q1 in part (a). Firms now incur economic losses.
S0, the market price P0 and the equilibrium quantity Q0. Some firms exit the market, and as they do so, the market
Each firm sells its output at the price P0, so its marginal supply curve gradually shifts leftward, from S0 toward S1.
revenue curve is MR0 in part (b). Each firm produces q0 and This shift gradually raises the market price from P1 back to P0.
makes zero economic profit. While the price is below P0, firms incur economic losses and
Market demand decreases permanently from D0 to D1 in some firms exit the market. Once the price has returned to P0,
part (a) and the market price falls to P1. Each firm decreases each firm makes zero economic profit and has no incentive to
exit. Each firm produces q0, and the market output is Q2.
Price
Price
Price
Price
Price
S0 S1 S0 S2 S0
S0 S1 S0 S2 S0
PS PS PS
PS PS PS
S3
S3
LSB
P2 LSB
P2
P0 LSA P P
P0 LSA P00 P00
P3
P3 LSC
LSC
D1 D1 D1
D1 D1 D1
D0 D0 D0
D0 D0 D0
0 Q0 QS Q1 0 Q0 QS Q2 0 Q0 QS Q3
0 Q0 QS Q1 0 Q0 QS Q2 0 Q0 QS Q3
Quantity Quantity Quantity
Quantity Quantity Quantity
(a) Constant-cost industry (b) Increasing-cost industry (c) Decreasing-cost industry
(a) Constant-cost industry (b) Increasing-cost industry (c) Decreasing-cost industry
Three possible changes in price and quantity occur in the In part (b), the long-run market supply curve is LSB; the price
long run. When demand increases from D0 to D1, entry rises to P2 and the quantity increases to Q2. This case occurs
occurs and the market supply curve shifts rightward from S0 in industries with external diseconomies. In part (c), the
to S1. In part (a), the long-run market supply curve, LSA, is long-run market supply curve is LSC; the price falls to P3 and
horizontal. The quantity increases from Q0 to Q1 and the the quantity increases to Q3. This case occurs in a market with
price remains constant at P0. external economies.
Figure 12.11(c) shows the case of external econo- Two forces are at work in a market undergoing
mies. The long-run market supply curve (LSC) slopes technological change. Firms that adopt the new tech-
downward. A permanent increase in demand from D0 nology make an economic profit, so there is entry by
to D1 increases the price in the short run and lowers it new-technology firms. Firms that stick with the old
in the long run. Again, the increase in demand brings technology incur economic losses. They either exit the
a temporary increase in price to PS and in the short market or switch to the new technology.
run the quantity increases from Q 0 to Q S. As old-technology firms disappear and new-
Entry increases short-run supply from S0 to S3, which technology firms enter, the price falls and the quantity
lowers the price to P3 and increases the quantity to Q 3. produced increases.
An example of external economies is the growth of Eventually, the market arrives at a long-run equi-
specialist support services for a market as it expands. librium in which all the firms use the new technology
As farm output increased in the nineteenth and make a zero economic profit.
and early twentieth centuries, the services available Because in the long run competition eliminates
to farmers expanded. New firms specialised in the economic profit, technological change brings only
development and marketing of farm machinery and temporary gains to producers. But the lower prices
fertilisers. As a result, average farm costs decreased. and better products that technological advances bring
Farms enjoyed the benefits of external economies. are permanent gains for consumers.
As a consequence, as the demand for farm products The process that we have just described is one in
increased, the output increased but the price fell. which some firms experience economic profits and
Over the long term, the prices of many goods others experience economic losses. It is a period of
and services have fallen, not because of external dynamic change in a market. Some firms do well and
economies but because of technological change. Let us others do badly. Often, the process has a geographical
now study this influence on a competitive market. dimension – the expanding new-technology firms
bring prosperity to what was once a very small town
and traditional industrial regions decline.
Technological Change Sometimes the new tecnology firms are in a
Industries are constantly discovering lower-cost tech- foreign country, while the old-technology firms are in
niques of production. Most cost-saving production the domestic economy.
techniques cannot be implemented, however, without Technological advances are not confined to the
investing in new plants and equipment. As a conse- information and entertainment industries. Even
quence, it takes time for a technological advance to food production is undergoing a major technological
spread through a market. Some firms whose plants are change because of genetic engineering.
on the verge of being replaced will be quick to adopt
the new technology, while other firms whose plants REVIEW QUIZ
have recently been replaced will continue to operate
with an old technology until they can no longer cover 1 Describe the course of events in a competi-
their average variable cost. Once average variable cost tive market following a permanent decrease in
cannot be covered, a firm will scrap even a relatively demand. What happens to output, price and
new plant (embodying an old technology) in favour of economic profit in the short run and in the
a plant with a new technology. long run?
New technology allows firms to produce at a 2 Describe the course of events in a competitive
lower cost. As a result, as firms adopt a new tech- market following a permanent increase in demand.
nology, their cost curves shift downward. With lower What happens to output, price and economic
costs, firms are willing to supply a given quantity at a profit in the short run and in the long run?
lower price or, equivalently, they are willing to supply 3 Describe the course of events in a competi-
a larger quantity at a given price. In other words, tive market following the adoption of a new
market supply increases and the market supply curve technology. What happens to output, price and
shifts rightward. With a given demand, the quantity economic profit in the short run and in the
produced increases and the price falls. long run?
We have seen how a competitive market operates consumers get the most value out of their resources
in the short run and the long run, but is a competitive at all points along their demand curves. If the people
market efficient? who consume a good or service are the only ones
who benefit from it, then the market demand curve
measures the benefit to the entire society and is the
Competition and Efficiency marginal social benefit curve.
A competitive market can achieve an efficient use of Competitive firms produce the quantity that
resources. You first studied efficiency in Chapter 2. maximises profit. We derive the firm’s supply curve by
Then in Chapter 5, using only the concepts of finding the profit maximising quantity at each price.
demand, supply, consumer surplus and producer So firms get the most value out of their resources at all
surplus, you saw how a competitive market achieves points along their supply curves.
efficiency. Now that you have learned what lies behind If the firms that produce a good or service bear all
the demand and supply curves of a competitive the costs of producing it, then the market supply curve
market, you can gain a deeper understanding of the measures the marginal cost to the entire society and the
efficiency of a competitive market. market supply curve is the marginal social cost curve.
Producers get the most out of their resources at When firms in perfect competition are away from
all points on the market supply curve, S = MSC. long-run equilibrium, either entry or exit is taking place
Producer surplus is the blue area. Resources are and the market is moving toward the situation depicted
used efficiently at the quantity Q* and price P *. At in Fig. 12.12. But the market is still efficient. As long as
this point, marginal social benefit equals marginal marginal social benefit (on the market demand curve)
social cost, and total surplus (the sum of producer equals marginal social cost (on the market supply curve),
surplus and consumer surplus) is maximised. the market is efficient. But it is only in long-run equilib-
rium that consumers pay the lowest possible price.
Price
Price and cost
S = MSC
MC
LRAC
SRAC
Consumer
surplus
Efficient
P* MR P* allocation
Producer
Long-run surplus
competitive
equilibrium
D = MSB
0 q* 0 Q*
Quantity Quantity
Demand, D, and supply, S, determine the equilibrium price, on the market demand curve, and firms are producing at
P*. A firm in perfect competition in part (a) produces q* at least cost and are on the market supply curve. With no
the lowest possible long-run average total cost. In part (b), externalities, marginal social benefit equals marginal social
consumers have made the best available choices and are cost, so resources are used efficiently at the quantity Q*.
There is no better fertiliser than high prices, the old farming adage goes. Trends in agriculture appear
to be proving this resoundingly true.
The spike in prices that caused the first global food crisis in 30 years in 2007–08 has led to large
increases in production of foods such as maize and wheat. Farmers have responded to higher prices. ...
However, a drought in the midwest US has seen severe scaling back of crops which has sent maize
prices rocketing by more than a third.
The US is the largest grower and exporter of maize, and is suffering from extreme heat and dry
conditions … Prices for wheat and soybeans are also likely to rise as yield per hectare have declined
due to the drought.
◆ The farm maximised profit by producing ◆ But the unfortunate weather decreased farm
83 500 metric tonnes and (we will assume) productivity and raised the cost of producing maize.
made zero economic profit. The average total cost curve shifted upward to ATC1
◆ In 2012, bad weather conditions decreased the and the marginal cost curve shifted upward to MC1.
supply of maize. By 2012, the supply curve had ◆ The combination of the higher price and higher
shifted leftward to S1. The price rose to R2 300 costs might leave the farm with an economic
per metric tonne and production decreased to profit. In Fig. 2 we are assuming that the farm
800 million metric tonnes. again made zero economic profit.
◆ Back on the farm in Fig. 2, the higher price ◆ If farms did make a positive (or negative)
increased marginal revenue and the MR curve economic profit, entry (or exit) would eventually
shifted upward to MR1. return them to a zero economic profit position
like that shown in Fig. 2.
S1 MC0
S0 MC1
ATC 0
1 800
D1
D0
0 800 835 0 80 000 83 500
Quantity (millions of metric tonnes) Quantity (metric tonnes)
Key Terms
External diseconomies, 271 Marginal revenue, 257 Price taker, 257 Shutdown point, 261
External economies, 271 Perfect competition, 257 Short-run market supply Total revenue, 257
Long-run market supply curve, 263
curve, 271
If each firm producing paper has the costs set out in Use the following info byte to work out Problems 13
Problem 7, what is the market price and the economic and 14.
profit or loss of each firm in the short run?
9. Rising Fuel Prices Squeeze Cheap Flights Hops Brewing to Expand
Airlines are having difficulty keeping prices low, Hops Brewing Co. expands its South African pack-
especially as fuel prices keep rising. Airlines have aging plant at a cost of R24 million.
passed on rising fuel costs to customers in the The addition will accommodate a new produc-
form of higher prices. tion line, which will bottle beer faster. Hops Brewing
a. Explain how an increase in fuel prices employs 470 people at its South African plant. The
might cause an airline to change its output expanded packaging line will add another eight jobs.
(number of flights) in the short run. 13. a. How will Hops’ expansion change its marginal
b. Draw a graph to show the increase in fuel cost curve and short-run supply curve?
prices on an airline’s output in the short run. b. What does this expansion decision imply
c. Explain why an airline might incur an about the point on Hops’ LRAC curve at
economic loss in the short run as fuel prices rise. which the firm was before the expansion?
14. a. If other breweries follow the lead of Hops,
Output, Price and Profit in the Long Run what will happen to the market price of beer?
10. The pizza market is perfectly competitive, and all b. How will the adjustment that you have
pizza producers have the same costs as Pat’s Pizza described in part (a) influence the economic
Kitchen in Problem 4. profit of Hops and other beer producers?
a. At what price will some firms exit the pizza 15. Explain and illustrate graphically how the
market in the long run? growing world population is influencing the
b. At what price will firms enter the pizza world market for wheat and a representative indi-
market in the long run? vidual wheat farmer.
11. In Problem 7, in the long run,
a. Do firms have an incentive to enter or exit Competition and Efficiency
the paper market? 16. In a perfectly competitive market in long-run
b. If firms do enter or exit the market, explain equilibrium, can consumer surplus be increased?
how the economic profit or loss of the Can producer surplus be increased? Can a
remaining paper producers will change. consumer become better off by making a substi-
c. What is the long-run equilibrium market tution away from this market?
price and the quantity of paper produced? 17. Never Pay Recommended Retail Prices Again
What is the number of firms in the market? Consumers are using the internet to gain an
advantage over retailers. Internet sites run by
Changing Tastes and Advancing Technology creative shoppers are assisting consumers to find
12. If in the long run, the market demand for paper the best deals available by sharing discount codes
remains the same as in Problem 8, and offering price check comparisons online.
a. What is the long-run equilibrium price of a. Explain the effect of the internet on the
paper, the market output and the economic degree of competition in the market.
profit or loss of each firm? b. Explain how the internet influences market
b. Does this market experience external econo- efficiency.
mies, external diseconomies, or constant cost?
Illustrate by drawing the long-run supply curve.
12 MC ATC
9 8.00 3.33 4.44
10
a. What is the market price of a smoothie?
8 b. What is the market quantity of smoothies?
c. How many smoothies does each firm sell?
6
d. What is the economic profit made or
4 economic loss incurred by each firm?
Output, Price and Profit in the Short Run Economics in the News
24. Farming is Not an Easy Business 29. After you have studied Reading Between the Lines
Take another look at Reading Between the Lines on pp. 275–276 answer the following questions.
on pp. 275–276 . The market for maize is highly a. What are the features of the global market
competitive and farmers react to price incentives. for maize that make it competitive?
After the 2007/08 food crisis, farmers increased b. If the increase in production during 2010
output, good weather conditions resulted in and 2011 was due entirely to good weather,
further increases in supply during the 2009–2011 what will happen to the price and quantity
seasons, but bad weather in 2012 promises a produced when normal weather returns?
weak harvest. c. What will happen to an individual farmer’s
Draw a graph to show the short-run effect of this marginal revenue, marginal cost, average
on an individual farmer’s economic profit. total cost and economic profit if the events
in part (b) occur?
Output, Price and Profit in the Long Run d. If the increase in production during 2010
25. In Problem 22, do firms enter or exit the market and 2011 was due mainly to a revolution in
in the long run? What is the market price and the farm technology, what will happen to the
equilibrium quantity in the long run? price and quantity produced when normal
26. In Problem 23, under what conditions will Tuff weather returns?
Timber exit the market? 30. Cellphone Sales Hit 1.5 Billion Mark
More than 1.7 billion mobile phones were sold
Changing Tastes and Advancing Technology worldwide in 2011, a 20 per cent increase in a
27. Another DVD Format That is Cheaper? year. Emerging markets, especially China and
New Medium Enterprises claims the quality of its India, provided much of the growth as many
new system, HD VMD, is equal to Blu-ray’s but people bought their first phone. Market research
it costs only R990, cheaper than the R2 000 cost indicates that in mature markets such as the US
of a Blu-ray player. Chairman of the Blu-ray Disc and Europe, consumers prefer phones that have
Association says New Medium will fail because superior cameras, touch screens, tv tuners and
it believes that Blu-ray technology will always be global positioning satellite funtions.
more expensive. But mass production will cut the a. Explain the effects of the increase in global
cost of a Blu-ray player to R600. demand for cellphones on the market for
a. Explain how technological change in Blu-ray cellphones and on an individual cellphone
production might support the prediction of producer in the short run.
lower prices in the long run. Illustrate your b. Draw a graph to illustrate your explanation
explanation with a graph. in part (a).
b. Even if Blu-ray prices drop to R600 in the c. Explain the long-run effects of the increase
long run, why might the HD VMD still end in global demand for cellphones on the
up being less expensive at that time? market for cellphones.
d. What factors will determine whether the
Competition and Efficiency price of cellphones will rise, fall or stay the
28. In a perfectly competitive market, each firm same in the new long-run equilibrium?
maximises its profit by choosing only the quan-
tity to produce. Regardless of whether the firm
makes an economic profit or incurs an economic
loss, the short-run equilibrium is efficient. Is the
statement true? Explain why or why not.
M
13
icrosoft, Google and eBay are dominant players in the markets
they serve. Because most PCs use Windows, programmers write most
applications for this operating system, which attracts more users. Because
most web searchers use Google, most advertisers use it too, which
attracts more searchers. Because most online auction buyers use eBay,
most online sellers do too, which attracts more buyers. Each of these firms
benefits from a phenomenon called a network externality, which makes it
services. Licencing does not always create a monopoly, There are two monopoly situations that create two
but it does restrict competition. pricing strategies:
A patent is an exclusive right granted to the ◆ Single price
inventor of a product or service. A copyright is an ◆ Price discrimination
exclusive right granted to the author or composer of a
literary, musical, dramatic or artistic work. Patents and Single Price A single-price monopoly is a firm that
copyrights are valid for a limited time period that varies must sell each unit of its output for the same price to
from country to country. In South Africa, a patent all its customers. Before 2000, De Beers was regarded
is valid for 20 years. Patents encourage the invention as a typical example of a monopoly. De Beers sold
of new products and production methods. They also diamonds (of a given size and quality) for the same
stimulate innovation – the use of new inventions – by price to all its customers. If it tried to sell at a low
encouraging inventors to publicise their discoveries and price to some customers and at a higher price to
offer them for use under licence. Patents have stimu- others, only the low-price customers would buy from
lated innovations in areas as diverse as soybean seeds, De Beers. Others would buy from De Beers’ low-price
pharmaceuticals, memory chips and video games. customers. De Beers was a single-price monopoly. Note
that the De Beers model was no longer regarded as
a monopolistic one after 2000, largely due to factors
FIGURE 13.1 Natural Monopoly such as the decision by producers in Russia, Canada
and Australia to distribute diamonds outside of the
Price and cost (cents per kilowatt-hour)
20 De Beers channel.
Monopoly’s Output and A Single-Price Monopoly’s FIGURE 13.2 Demand and Marginal Revenue
Price Decision Output and Price Decision
If she lowers the price to R140, she sells 3 haircuts increase in quantity sold outweighs the revenue loss
and has a revenue gain of R140 on the third haircut. from the lower price – and marginal revenue is positive.
But she now receives only R140 on the first two If demand is inelastic, a fall in the price brings a decrease
haircuts – R20 less than before. As a result, she loses in total revenue – the revenue gain from the increase in
R40 of revenue on the first 2 haircuts. To calculate quantity sold is outweighed by the revenue loss from
marginal revenue, she must deduct this amount from the lower price – and marginal revenue is negative. If
the revenue gain of R140. So her marginal revenue is demand is unit elastic, total revenue does not change
R100, which is less than the price. – the revenue gain from the increase in the quantity
sold offsets the revenue loss from the lower price – and
Zero
(rand per haircut)
Price and marginal revenue
500
marginal
Elastic revenue
200
Unit elastic 400
100
Inelastic
300
D Quantity
0 (haircuts
5 10 per hour) 200
Maximum
total revenue
–100 100
Quantity
TR
(haircuts
–200 MR 0 5 10 per hour)
(a) Demand and marginal revenue curves (b) Total revenue curve
In part (a), the demand curve is D and the marginal range 5 to 10 haircuts an hour, a price cut decreases total
revenue curve is MR. In part (b), the total revenue curve revenue, so marginal revenue is negative – as shown by the
Total revenue (rand per hour)
Zero
is TR. Over
500 the range 0 to 5 haircuts an hour, a price cut red bars. Demand is inelastic. At 5 haircuts an hour, total
marginal
increases total revenue, so marginal revenue is positive –
revenue revenue is maximised and marginal revenue is zero. Demand
as shown by the blue bars. Demand is elastic. Over the is unit elastic.
400
300
In Monopoly, Demand Is Always Elastic The maximum, and then decreases. The maximum profit
relationship between marginal revenue and elasticity (R120) occurs when Sara sells 3 haircuts for R140
of demand that you have just discovered implies that a each. If she sells 2 haircuts for R160 each or 4 haircuts
profit-maximising monopoly never produces an output for R120 each, her economic profit will be only R80.
in the inelastic range of the market demand curve. If it
did so, it could charge a higher price, produce a smaller Marginal Revenue Equals Marginal Cost You
quantity and increase its profit. Let us now look at a can see Sara’s marginal revenue (MR) and marginal
monopoly’s price and output decision. cost (MC ) in Table 13.1 and Fig. 13.4(b).
When Sara increases output from 2 to 3 haircuts,
MR is R100 and MC is R60. MR exceeds MC by R40
Price and Output Decision and Sara’s profit increases by that amount. If Sara
A monopoly sets its price and output at the levels increases output yet further, from 3 to 4 haircuts, MR
that maximise economic profit. To determine this is R60 and MC is R100. In this case, MC exceeds MR
price and output level, we need to study the behav- by R40, so profit decreases by that amount. When
iour of both cost and revenue as output varies. A MR exceeds MC, profit increases if output increases.
monopoly faces the same types of technology and cost When MC exceeds MR, profit increases if output
constraints as a competitive firm, so its costs (total decreases. When MC equals MR, profit is maximised.
cost, average cost and marginal cost) behave just like Figure 13.4(b) shows the maximum profit as
those of a firm in perfect competition. And a monop- price (on the demand curve D) minus average total
oly’s revenues (total revenue, price and marginal cost (on the ATC curve) multiplied by the quantity
revenue) behave in the way we have just described. produced – the blue rectangle.
Table 13.1 provides information about Sara’s
costs, revenues, and economic profit, and Figure 13.4 Maximum Price the Market Will Bear Unlike a
shows the same information graphically. firm in perfect competition, a monopoly influences
the price of what it sells. But a monopoly does not
Maximising Economic Profit You can see in set the price at the maximum possible price. At the
Table 13.1 and Fig. 13.4(a) that total cost (TC ) and maximum possible price, the firm would be able
total revenue (TR) both rise as output increases, to sell only one unit of output, which in general is
but TC rises at an increasing rate and TR rises at a less than the profit-maximising quantity. Rather, a
decreasing rate. Economic profit, which equals TR monopoly produces the profit-maximising quantity
minus TC, increases at small output levels, reaches a and sells that quantity for the highest price it can get.
This table gives the information needed to find the profit- minus total cost (TC). Profit is maximised when 3 haircuts are
maximising output and price. Total revenue (TR) equals price sold at a price of R140 each. Total revenue is R420, total
multiplied by the quantity sold. Profit equals total revenue cost is R300, and economic profit is R120 (R420 – R300).
500 Economic TR average total cost is R100 (on the ATC curve) and
profit = R120 her price is R140 (on the D curve), so her profit per
420
haircut is R40 (R140 minus R100). Sara’s economic
profit is shown by the area of the blue rectangle,
300 which equals the profit per haircut (R40) multiplied
by the number of haircuts (3), for a total of R120.
200 If firms in a perfectly competitive market make a
positive economic profit, new firms enter. That does
100
not happen in monopoly. Barriers to entry prevent new
firms from entering the market, so a monopoly can
make a positive economic profit and might continue to
0 1 2 3 4 5 6 do so indefinitely. Sometimes that economic profit is
Quantity (haircuts per hour)
large, as in the international diamond business.
(a) Total revenue and total cost curves Sara makes a positive economic profit. But
suppose that Sara’s landlord increases the rent on her
salon. If Sara pays an additional R120 an hour for
200 rent, her fixed cost increases by R120 an hour. Her
Price and cost (rand per haircut)
Will economic profit increase or decrease? Will either The output at which marginal revenue equals
the original competitive situation or the new monopoly marginal cost is Q M. This output is smaller than the
situation be efficient? competitive output Q C. And the monopoly charges
These are the questions we are now going to the price PM, which is higher than PC. We have
answer. First, we look at the effects of monopoly on established that compared to a perfectly competitive
the price and quantity produced. Then we turn to the market, a single-price monopoly produces a smaller
questions about efficiency. output and charges a higher price.
We have seen how the output and price of a
monopoly compare with those in a competitive market.
Comparing Price and Output Let us now compare the efficiency of the two
Figure 13.5 shows the market we will study. The types of market.
market demand curve is D. The demand curve is the
same regardless of how the industry is organised. But FIGURE 13.5 Monopoly’s Smaller Output and
the supply side and the equilibrium are different in Higher Price
monopoly and competition. First, let us look at the
Consumer surplus is the green triangle under the above the supply curve and below the equilibrium
demand curve and above the equilibrium price (see price (see Chapter 5, p. 105). Total surplus (consumer
Chapter 5, p. 104). Producer surplus is the blue area surplus and producer surplus) is maximised.
Also, in long-run competitive equilibrium, entry
FIGURE 13.6 Inefficiency of Monopoly and exit ensure that each firm produces its output at
the minimum possible long-run average cost.
Price and cost
Some of the lost consumer surplus goes to the process. Such influence might be sought by making
monopoly. In Fig. 13.6, the monopoly takes the campaign contributions in exchange for legislative
difference between the higher price, PM, and the support or by indirectly seeking to influence political
competitive price, PC, on the quantity sold, Q M. So outcomes through publicity in the media or more
the monopoly takes that part of the consumer surplus. direct contacts with politicians and bureaucrats.
This portion of the loss of consumer surplus is not a An example of a monopoly created in this way is
loss to society. It is redistribution from consumers to the government-imposed restrictions on the
the monopoly producer. quantities of textiles that may be imported into
South Africa. These are regulations that restrict
output and increase prices.
Rent Seeking This type of rent seeking is a costly activity that
You have seen that monopoly creates a deadweight uses up scarce resources. Taken together, firms spend
loss and is inefficient. But the social cost of monopoly millions of rands lobbying legislators, and local
can exceed the deadweight loss because of an activity officials in the pursuit of licences and laws that create
called rent seeking. Any surplus – consumer surplus, barriers to entry and establish a monopoly.
producer surplus, or economic profit – is called Alternatively, a monopoly can be created by
economic rent. The pursuit of wealth by capturing buying up and merging competing firms to create one
economic rent is called rent seeking. single monopolistic firm.
You have seen that a monopoly makes its economic
profit by diverting part of consumer surplus to itself – by
converting consumer surplus into economic profit. So
Rent-Seeking Equilibrium
the pursuit of economic profit by a monopoly is rent Barriers to entry create monopoly, but there is no
seeking. It is the attempt to capture consumer surplus. barrier to entry into rent seeking. Rent seeking is
Rent seekers pursue their goals in two main ways. like perfect competition. If an economic profit is
They might: available, a new rent seeker will try to get some of it.
◆ Buy a monopoly And competition among rent seekers pushes up the
◆ Create a monopoly price that must be paid for a monopoly, to the point
at which the rent seeker makes zero economic profit
Buy a Monopoly To rent seek by buying a monopoly, a by operating the monopoly. For example, competi-
person searches for a monopoly that is for sale at a lower tion for the right to operate a taxi in Johannesburg’s
price than the monopoly’s economic profit. Trading of Northern suburbs leads to a price of approximately
taxi licences is an example of this type of rent seeking. In R150 000 for a taxi licence, which is sufficiently high
most towns and cities in South Africa, taxis are regulated. to eliminate the economic profit made by a
Both the fares and the number of taxis that can taxi operator.
operate are regulated, so that operating a taxi results in Figure 13.7 shows a rent-seeking equilibrium.
economic profit. A person who wants to operate a taxi The cost of rent seeking is a fixed cost that must
must buy a licence from someone who already has one. be added to a monopoly’s other costs. Rent seeking
People rationally devote time and effort to seeking out and rent-seeking costs increase to the point at
profitable monopoly businesses to buy. In the process, which no economic profit is made. The average
they use up scarce resources that could otherwise have total cost curve, which includes the fixed cost of
been used to produce goods and services. The value rent seeking, shifts upward until it just touches the
of this lost production is part of the social cost of demand curve.
monopoly. The amount paid for a monopoly is not a Economic profit is zero. It has been lost in
social cost because the payment is just a transfer of an rent seeking.
existing producer surplus from the buyer to the seller. Consumer surplus is unaffected, but the dead-
weight loss from monopoly is larger. The deadweight
Create a Monopoly Rent seeking by creating a loss now includes the original deadweight loss triangle
monopoly is mainly a political activity. It takes the plus the lost producer surplus, shown by the enlarged
form of lobbying and trying to influence the political grey area in Fig. 13.7.
willing to pay more than holiday travellers are, it is These travellers know two weeks ahead when they
possible for an airline to profit by price discriminating will travel and also do not want to stay away over
between these two groups. a weekend.
Tropical announces a new fare schedule: no
Discriminating Among Units of a Good Everyone restrictions, R1 800; 7-day advance purchase, non-
experiences diminishing marginal benefit and has a refundable, R1 600; 14-day advance purchase, non-
downward-sloping demand curve. For this reason, refundable, R1 400; 14-day advance purchase, must
if all the units of the good are sold for a single price, stay over a weekend, R1 200.
buyers end up with a consumer surplus equal to the
value they get from each unit of the good minus the FIGURE 13.8 A Single Price of Air Travel
price paid for it.
A firm that price discriminates by charging a
MC
2 100 Increased economic ATC equal to marginal cost.
profit from price
discrimination
So Tropical seeks new travellers who will not pay
1 800
as much as R1 200 a trip but who will pay more than
1 600 marginal cost.
1 400 Tropical offers a variety of holiday specials at
different low fares that appeal only to new travellers.
1 200
Existing customers continue to pay the higher fares.
900
With all these fares and specials, Tropical increases
sales, extracts the entire consumer surplus and
600
maximises economic profit.
Figure 13.10 shows the outcome with perfect
300 price discrimination. The fares paid by the original
D travellers extract the entire consumer surplus from this
group. The new fares between R900 and R1 200
0 2 4 6 8 10 15 20
Trips (thousands per year)
attract 3 000 additional travellers and take their
entire consumer surplus also. Tropical now makes an
Tropical revises its fare structure: no restrictions at R1 800, economic profit of more than R9 million.
7-day advance purchase at R1 600, 14-day advance
purchase at R1 400 and must stay over a weekend at
R1 200. Tropical sells 2 000 trips at each of its four new FIGURE 13.10 Perfect Price Discrimination
fares. Its economic profit increases by R2.4 million a year
to R7.2 million a year, which is shown by the original blue
Price and cost (rand per trip)
2 100 MC
rectangle plus the dark blue steps. Tropical’s customers’ Increase in economic ATC
consumer surplus shrinks. profit from perfect
1 800 price discrimination
1 500
the efficient quantity of satellite TV service? The A natural monopoly satellite TV supplier faces the demand
answer is by being regulated to set its price equal to curve D. The firm’s marginal cost is constant at R200 per
marginal cost, known as the marginal cost pricing rule. household per month, as shown by the curve labelled MC.
The quantity demanded at a price equal to marginal The long-run average cost curve is LRAC.
cost is the efficient quantity – the quantity at which Unregulated, as a profit-maximiser, the firm serves
marginal benefit equals marginal cost. 5 million households at a price of R800 a month. An efficient
Figure 13.11 illustrates the marginal cost marginal cost pricing rule sets the price at R200 a month.
pricing rule. The demand curve for cable satellite The monopoly serves 10 million households and incurs an
TV is D. Multichoice’s marginal cost curve is MC. economic loss. A second-best average cost pricing rule sets
That marginal cost curve is (assumed to be) the price at R400 a month. The monopoly serves 8 million
horizontal at R200 per household per month – households and earns zero economic profit.
that is, the cost of providing each additional house-
hold with a month of DStv programming is R200.
The efficient outcome occurs if the price is regulated Similarly, a satellite TV operator can charge a one-
at R200 per household per month with 10 million time connection fee that covers its fixed cost and then
households served. charge a monthly fee equal to marginal cost.
But there is a problem: At the efficient output,
average total cost exceeds marginal cost, so a firm
Second-Best Regulation of a Natural
that uses marginal cost pricing incurs an economic
loss. A satellite TV company that is required to use
Monopoly
a marginal cost pricing rule will not stay in business A natural monopoly cannot always be regulated to achieve
for long. How can the firm cover its costs and, at the an efficient outcome. Two possible ways of enabling a
same time, obey a marginal cost pricing rule? regulated monopoly to avoid an economic loss are:
There are two possible ways of enabling the firm ◆ Average cost pricing
to cover its costs: price discrimination and a two-part ◆ Government subsidy
price (called a two-part tariff).
For example, Vodacom offers plans at a fixed Average Cost Pricing The average cost pricing rule
monthly price that give access to the cellphone sets price equal to average total cost. With this rule
network and unlimited free ‘minutes’. The price of a the firm produces the quantity at which the average
call (zero) equals Vodacom’s marginal cost of a call. total cost curve cuts the demand curve. This rule
now incurs an economic loss. It can decrease the loss REVIEW QUIZ
by increasing output to 8 million households. To 1 What is the pricing rule that achieves an effi-
increase output above 8 million households, the firm cient outcome for a regulated monopoly? What
would have to lower the price and again it would is the problem with this rule?
incur a loss. So the profit-maximising quantity is 2 What is the average cost pricing rule? Why is it
8 million households – the same as with average not an efficient way of regulating monopoly?
cost pricing. 3 What is a price cap? Why might it be a more
Notice that a price cap lowers the price and effective way of regulating monopoly than rate
increases output. This outcome is in sharp contrast to of return regulation?
the effect of a price ceiling in a competitive market
4 Compare the consumer surplus, producer surplus,
that you studied in Chapter 6 (pp. 120–124). The
and deadweight loss that arise from average cost
reason is that in a monopoly, the unregulated equilib-
pricing with those that arise from profit-maximisa-
rium output is less than the competitive equilibrium
tion pricing and marginal cost pricing.
output, and the price cap regulation replicates the
conditions of a competitive market.
In Fig. 13.12, the price cap delivers average cost You have now completed your study of
pricing. In practice, the regulator might set the cap monopoly. Reading Between the Lines on pp. 297–298
too high. For this reason, price cap regulation is often looks at Eskom’s monopoly in the energy sector.
combined with earnings sharing regulation – a regula- In the next chapter, we study markets that lie
tion that requires firms to make refunds to customers between the extremes of perfect competition and
when profits rise above a target level. monopoly and that blend elements of the two.
Power Shifts
News that Eskom plans to seek a nearly 15 per cent electricity price hike this year has sparked a call
for greater energy efficiency, while the Democratic Alliance (DA) says the state-owned company’s
monopoly should be ended.
DA deputy energy spokesman David Ross said he would write to the Competition Commission to
ask it to examine the case for separating Eskom’s electricity generation and distribution components.
This would allow the utility to own only the former and force it to sell off the latter. ‘This would
greatly reduce (its) monopoly and improve competition in the energy sector.’
Ross said the proposed 14.6 per cent price hike was triple the rate of inflation that the Reserve Bank
worked hard to contain. On the back of tariff increases of 24.8 per cent, 25.2 per cent and 16.09 per
cent over the past three years ‘the time is surely ripe for intervention to remove Eskom’s monopoly
power.’ … Growing the available electricity supply would be far more efficiently attained by democra-
tising access to the distribution grid …
ECONOMIC ANALYSIS
per kilowatt-hour)
per kilowatt-hour)
components. MR D
◆ This would open the market for competitors in MR D0 1
the distribution business. 0 1
Quantity (millions of kilowatt-hours)
◆ Figure 1 shows Eskom’s position as a natural Figure 1 Eskom as a natural monopoly
Quantity (millions of kilowatt-hours)
monopoly, which has a flat MC curve (numbers
per kilowatt-hour)
S = MC
are fictitious).
per kilowatt-hour)
S = MC
◆ Eskom will supply 1 million KWh at a price of
110c each.
◆ If the electricity distribution market were to
cost (cents
110
Eskom would now act as a competitor in that
110
market – see Figure 2. 80
and cost
80
80c each due to its marginal cost structure now
having to become more competitive. MR D
0 1 2 D
MR
Quantity (millions of kilowatt-hours)
0 1 2
Quantity (millions of kilowatt-hours)
Figure 2 Eskom in a perfectly competitive market
P = D(Q)
Perfect Competition
We know already from Chapter 10 that a perfectly This firm’s total revenue is then represented by
competitive firm will produce where its marginal revenue
is equal to its marginal costs – which will be equal to the TR = PQ = QD(Q)
market price. But how can we prove this mathematically?
Let us assume that the total cost curve facing a The profit for this firm is
perfectly competitive firm is represented by C(Q),
where Q is the quantity to be produced. If the market π = TR – TC = QD(Q) – C(Q)
price is represented by P, then we know that this firm’s
total revenue is To maximise this profit function, we need to take the
derivative with respect to Q, and set it equal to zero
TR = PQ
dπ/dQ = 0
The profit for this firm is then D(Q) + QD’(Q) – C’(Q) = 0
D(Q) + QD’(Q) = C’(Q)
π = TR – TC = PQ – C(Q)
The left-hand side of the identity above is the
To maximise this profit function, we need to take the marginal revenue of the monopolist, whilst the
derivative with respect to Q, and set it equal to zero right-hand side is the marginal cost. Therefore, we
have proven that under monopoly, like under perfect
dπ/dQ = 0 competition, equilibrium is where
P – C’(Q) = 0
P = C’(Q) MR = MC
Note that the left-hand side of the identity above is However, in contrast to perfect competition, this is not
none other than the marginal revenue of the firm, equal to the equilibrium price charged by the firm
whilst the right-hand side is the marginal cost.
Therefore, we have proven that under perfect compe- P ≠ MC
tition, equilibrium is where
MR = P = MC
Key Terms
Average cost pricing Legal monopoly, 282 Perfect price Regulation, 294
rule, 295 Local monopoly, 284 discrimination, 293 Rent seeking, 290
Barrier to entry, 282 Marginal cost pricing Price cap regulation, 296 Single-price monopoly,
Capture theory, 294 rule, 295 Price discrimination, 283 283
Deregulation, 294 Monopoly, 282 Rate of return regulation, Social interest theory, 294
Economic rent, 290 Natural monopoly, 282 296
brand name drug loses its patent, both the price of Use the following information to work out Problems
the drug and the dollar value of its sales each tend 15 and 16.
to drop 80 per cent over the next year, as competi-
tion opens to a host of generic drugmakers. The real La Bella Pizza can produce a pizza for a marginal cost
winners are the patients and the medical aid insurers, of R20. Its standard price is R150 a pizza. It offers a
who pay much lower prices. The Food and Drug second pizza for R50. It also distributes coupons that
Administration (of the US) insists that generics work give a R50 rebate on a standard-priced pizza.
identically to brand names. 15. How can La Bella Pizza make a larger economic
10. a. Assume that the drug’s manufacturer has profit with this range of prices than it could if it
a monopoly in the market and that it sold every pizza for R150? Use a graph to illus-
cannot price discriminate. Use a graph to trate your answer.
illustrate the market price and quantity of 16. How might La Bella Pizza make even more
Cholfix sold. economic profit? Would La Bella Pizza then be
b. On your graph, identify consumer surplus, more efficient than it would be if it charged R150
producer surplus and deadweight loss. for each pizza?
11. How might you justify protecting the drug’s
manufacturer from competition with a legal Monopoly Regulation
barrier to entry? Use the following information to work out Problems
12. a. Explain how the market for a drug changes 17 to 19.
when a patent expires.
b. Draw a graph to illustrate how the expira- The figure shows the situation facing Gaslight, a firm
tion of the Cholfix patent will change the that operates an oil distribution system in West Africa.
price and quantity in the market. Gaslight is a natural monopoly that cannot price
c. Explain how consumer surplus, producer discriminate.
surplus and deadweight loss change with the
expiration of the Cholfix patent.
Price and cost (cents per cubic metre)
100
Price Discrimination
Use the following info byte to work out Problems 13 80
and 14.
60
30. Telecoms Grow by Acquisition operator agreed to buy another for $28.1 billion
Multibillion-dollar telecommunications mergers – a deal that would make the company the
show how global cellular powerhouses are looking biggest mobile phone operator in the United
for growth in emerging economies while consoli- States. A combination of the French and the
dating in their own markets. Swedish-Finnish one would create the world’s
Recently a French operator offered to buy a fourth-largest mobile operator.
Swedish-Finnish telecommunications operator, a. Explain the rent-seeking behaviour of global
but was rejected as the offer was too low. Analysts telecommunications companies.
said higher bids could persuade them to sell. b. Explain how mergers may affect the effi-
In the United States, one telecommunications ciency of the telecommunications market.
T
14
here are tens of thousands of hair salons in South Africa, catering for
many categories of consumers, selling different hair products and
different hair-styling services. A hair cut may range from R50 to more
than R1 000. There are salons specialising in products and services
for men, for women and even for children. Because there are many
different types of hair-styling services and products, the market for them
is not perfectly competitive. Hairdressers compete, but each has a
Monopolistic monopoly on its own special service and brand of styling product sold.
Most of the things that you buy are like hair cuts – they come in many
Competition different types. Running shoes, shaving cream, toilet paper, pizza and
cellphones are some more striking examples.
The model of monopolistic competition that is explained in this
chapter helps us to understand the competition that we see every
day in the markets for hair cuts, pizza, cellphones and for most other
consumer goods and services. This chapter blends the models in the
two preceding chapters on perfect competition and monopoly so as to
create the model of monopolistic competition. To get the most out of this
chapter, you will have studied the two preceding ones.
Reading Between the Lines, at the end of this chapter, applies the
monopolistic competition model to the market for tablets and the entry of
other firms in that market following the success of the iPad.
Ignore Other Firms A firm in monopolistic compe- Price Because of product differentiation, a firm in
tition must be sensitive to the average market price of monopolistic competition faces a downward-sloping
the product, but the firm does not pay attention to demand curve. So, like a monopoly, the firm can set
any one individual competitor. Because all the firms both its price and its output. But there is a trade-off
are relatively small, no one firm can dictate market between the product’s quality and price. A firm that
conditions, and so no one firm’s actions directly affect makes a high-quality product can charge a higher
the actions of the other firms. price than a firm that makes a low-quality product.
Collusion Impossible Firms in monopolistic compe- Marketing Because of product differentiation, a firm
tition would like to be able to conspire to fix a higher in monopolistic competition must market its product.
Marketing takes two main forms: advertising at K-Way. First, you must decide on the design
and packaging. A firm that produces a high-quality and quality of jackets and on your marketing
product wants to sell it for a suitably high price. programme.
To be able to do so, it must advertise and package Second, you must decide on the quantity of
its product in a way that convinces buyers that they jackets to produce and the price at which to sell them.
are getting the higher quality for which they are We will suppose that K-Way has already made
paying a higher price. For example, pharmaceutical its decisions about design, quality, and marketing and
companies advertise and package their brand- now we will concentrate on the output and pricing
name drugs to persuade buyers that these items are decision. We will study quality and marketing deci-
superior to the lower-priced generic alternatives. sions in the next section.
Similarly, a low-quality producer uses advertising For a given quality of jackets and marketing
and packaging to persuade buyers that although the activity, K-Way faces given costs and market
quality is low, the low price more than compensates conditions. Given its costs and the demand for
for this fact. its jackets, how does K-Way decide the quantity
of jackets to produce and the price at which to
sell them?
Entry and Exit
Monopolistic competition has no barriers to prevent
new firms from entering the industry in the long run.
The Firm’s Short-Run Output and Price
Consequently, a firm in monopolistic competition Decision
cannot make an economic profit in the long run. In the short run, a firm in monopolistic competi-
When existing firms make an economic profit, tion makes its output and price decision just like a
new firms enter the industry. This entry lowers prices monopoly firm does.
and eventually eliminates economic profit. When Figure 14.1 illustrates this decision for K-Way jackets.
firms incur economic losses, some firms leave the The demand curve for K-Way jackets is D.
industry in the long run. This exit increases prices and This demand curve tells us the quantity of K-Way
eventually eliminates the economic loss. jackets demanded at each price, given the prices of
In long-run equilibrium, firms neither enter nor other jackets. It is not the demand curve for jackets
leave the industry and the firms in the industry make in general.
zero economic profit. The MR curve shows the marginal revenue
curve associated with the demand curve for K-Way
REVIEW QUIZ jackets. It is derived just like the marginal revenue
curve of a single-price monopoly that you studied in
1 What are the distinguishing characteristics of Chapter 13.
monopolistic competition? The ATC curve and the MC curve show the
2 How do firms in monopolistic competition average total cost and the marginal cost of producing
compete? K-Way jackets.
3 Provide some examples of businesses or K-Way’s goal is to maximise its economic profit.
industries near your campus that operate in To do so, it produces the output at which marginal
monopolistic competition. revenue equals marginal cost. In Fig. 14.1, this
output is 125 jackets a day. K-Way charges the
price that buyers are willing to pay for this quantity,
Price and Output in Monopolistic which is determined by the demand curve. This
Competition price is R750 per jacket. When K-Way produces
125 jackets a day, its average total cost is R250 per
Suppose you have been hired by K-Way, to manage jacket and it makes an economic profit of R62 500 a
the production and marketing of K-Way jackets. day (R500 per jacket multiplied by 125 jackets a day).
Think about the decisions that you must make The blue rectangle shows K-Way’s economic profit.
FIGURE 14.1 Economic Profit in the Short Run was determined by the demand curve and which was
R449 per one-way ticket between Johannesburg and
Cape Town. With 40 000 customers per month, Velvet
Price and cost (rand per K-Way jacket)
MC
ATC
A firm might face a level of demand for its product that 500
Marginal revenue
is too low for it to make an economic profit. 449 = marginal cost
Velvet Sky was such a company. Offering afford-
able aeroplane tickets on the major flight routes in D
Price less
South Africa, Velvet Sky hoped to capture a large 200
than average
Profit-maximising
MR (loss-minimising)
share of the low-cost airline market in competition total cost quantity
with Kulula Air, Mango Airline, 1time Airline and
SAA. Figure 14.2 illustrates the situation facing 0 20 40 60 80 100
Quantity (thousands of customers)
Velvet Sky in 2012.
The demand curve for its service is D, the Profit is maximised where marginal revenue equals marginal
marginal revenue curve is MR, the average total cost cost. The loss-minimising quantity is 40 000 customers per
curve is ATC and the marginal cost curve is MC. month. The price of R449 for a one-way Johannesburg-Cape
Velvet Sky maximised profit – equivalently, it mini- Town ticket is less than the average total cost of R500 a
mised its loss – by producing the output at which month, so the firm incurs an economic loss of R51 a customer.
marginal revenue equals marginal cost. In Fig. 14.2 The red rectangle illustrates economic loss, which equals
(showing fictitious numbers), this output is 40 000 R2 040 000 a month (R51 a customer multiplied by 40 000
customers per month. Velvet Sky charged the price customers). (These amounts are merely illustrative.)
that buyers were willing to pay for this quantity, which
Long Run: Zero Economic Profit FIGURE 14.3 Output and Price in the Long Run
A firm like Velvet Sky is not going to incur an
economic loss for long. Eventually, it goes out of
output level, average total cost is also R250 per jacket. 0 50 75 100 150
So K-Way is making zero economic profit on its Quantity (K-Way jackets per day)
400 400
100 100
Marginal Quantity =
Excess MR Efficient
cost Efficient scale
capacity scale
The efficient scale is 100 jackets a day. In monopolistic In contrast, because in perfect competition the demand for
competition in the long run, because the firm faces a each firm’s product is perfectly elastic, the quantity produced
downward-sloping demand curve for its product, the quantity in the long run equals the efficient scale and price equals
produced is less than the efficient scale and the firm has marginal cost. The firm produces at the least possible cost
excess capacity. Price exceeds marginal cost by the amount and there is no markup.
of the markup.
Is Monopolistic Competition Efficient? The markup that drives a gap between price and
Resources are used efficiently when marginal social marginal cost in monopolistic competition arises from
benefit equals marginal social cost. Price equals marginal product differentiation. It is because K-Way jackets
social benefit and the firm’s marginal cost equals are not quite the same as jackets from Cape Storm,
marginal social cost (assuming there are no external First Ascent or any of the other dozens of producers
benefits or costs). So if the price of a K-Way jacket of jackets that the demand for K-Way jackets is not
exceeds the marginal cost of producing it, the quantity of perfectly elastic. The only way in which the demand for
K-Way jackets produced is less than the efficient quan- jackets from K-Way might be perfectly elastic is if there
tity. And you have just seen that in long-run equilibrium is only one kind of jacket and all firms make it. In this
in monopolistic competition, price does exceed marginal situation, K-Way jackets are indistinguishable from all
cost. So is the quantity produced in monopolistic other jackets. They do not even have identifying labels.
competition less than the efficient quantity? If there was only one kind of jacket, the total
benefit of jackets would almost certainly be less than
Making the Relevant Comparison Two econo- it is with variety.
mists meet in the street, and one asks the other, ‘How People value variety – not only because it enables
is your husband?’ The quick reply is ‘Compared to each person to select what he or she likes best but also
what?’ This bit of economic wit illustrates a key point: because it provides an external benefit. Most of us
Before we can conclude that something needs fixing, enjoy seeing variety in the choices of others. Contrast
we must check out the available alternatives. a scene from the China of the 1960s, when everyone
Efficiency and Product Innovation Is the profit- When you buy a pair of running shoes for
maximising amount of product innovation also the R700, you are paying R100 for the materials
efficient amount? Efficiency is achieved if the marginal from which the shoes are made, R30 for the services
social benefit of a new and improved product equals of the Malaysian worker who made the shoes and
its marginal social cost. R50 for the production and transportation services
The marginal social benefit of an innovation of a manufacturing firm in Asia and a shipping
is the increase in price that consumers are willing company. These amounts total R180. You pay
to pay for it. The marginal social cost is the amount R220 to the South African government in import
that the firm must pay to make the innovation. duty. So we now have accounted for a total of
Profit is maximised when marginal revenue R400. Where did the other R300 go? It is the cost
equals marginal cost. But in monopolistic competi- of advertising, retailing and other sales and distribu-
tion, marginal revenue is less than price, so tion services.
product innovation is probably not pushed to The selling costs associated with running shoes
its efficient level. are not unusual.
Monopolistic competition brings many product Almost everything that you buy includes a selling
innovations that cost little to implement and cost component that exceeds one half of the total cost.
are purely cosmetic, such as new and improved Your clothing, food, electronic items, DVDs, maga-
packaging or a new scent in laundry powder. And zines and even your textbooks cost more to sell than
even when there is a genuine improved product, they cost to manufacture.
it is never as good as what the consumer is willing The biggest part of selling costs is not the cost
to pay for. of advertising. It is the cost of retailing services. The
retailer’s selling costs (and economic profit) are often
as much as 50 per cent of the price you pay.
Advertising
A firm with a differentiated product needs to ensure Selling Costs and Total Cost Selling costs are
that its customers know how its product is different fixed costs which increase the firm’s total cost.
from the competition. A firm might also attempt So like the fixed cost of producing a good, advertising
to create a consumer perception that its product is costs per unit decrease as the quantity produced
different from its competitors, even when that differ- increases.
ence is small. Firms use advertising and packaging to Figure 14.5 shows how selling costs change a
achieve this goal. firm’s average total cost. The blue curve shows the
average total cost of production. The red curve
Advertising Expenditures Firms in monopolistic shows the firm’s average total cost of production
competition incur huge costs to ensure that buyers plus advertising. The height of the red area between
appreciate and value the differences between the two curves shows the average fixed cost of adver-
their own products and those of their competitors. tising. The total cost of advertising is fixed. But
So a large proportion of the price that we pay for a the average cost of advertising decreases as output
good covers the cost of selling it, and this proportion increases.
is increasing. Advertising in newspapers and maga- Figure 14.5 shows that if advertising increases
zines and on radio, television and the internet the quantity sold by a large enough amount, it
is the main selling cost. But it is not the only can lower average total cost. For example, if the
one. Selling costs include the cost of shopping quantity sold increases from 25 jackets a day
malls that look like movie sets, glossy catalogues with no advertising to 100 jackets a day with
and brochures, and the salaries, airfares and hotel advertising, average total cost falls from R600 to
bills of salespeople. R400 a jacket. The reason is that although the
Advertising expenditures affect the profits of total fixed cost has increased, the greater fixed cost
firms in two ways: They increase costs and they is spread over a greater output, so average total
change demand. Let us look at these effects. cost decreases.
FIGURE 14.5 Selling Costs and Total Cost Selling Costs and Demand Advertising and
other selling efforts change the demand for a firm’s
Cost (rand per K-Way jacket)
1 000
product. But how? Does demand increase or does
By increasing the it decrease? The most natural answer is that adver-
quantity bought, tising increases demand. By informing people
advertising can
800 lower average Average total cost about the quality of its products or by persuading
total cost with advertising people to switch from the products of other firms,
600
a firm might expect to increase the demand for its
Advertising own products.
cost
But all firms in monopolistic competition adver-
400 tise, and all seek to persuade customers that they
have the best deal. If advertising enables a firm to
Average total cost survive, the number of firms in the market might
200
with no advertising increase. And to the extent that the number of firms
does increase, advertising decreases the demand faced
0 25 50 100 150 200 250
by any one firm. It also makes the demand for any
Quantity (K-Way jackets per day) one firm’s product more elastic. So advertising can
end up not only lowering average total cost but also
Selling costs such as the cost of advertising are fixed costs.
lowering the markup and the price.
When added to the average total cost of production, selling
Figure 14.6 illustrates the possible effect of
costs increase average total cost by a greater amount at small
advertising. In part (a), with no advertising, the
outputs than at large outputs. If advertising enables sales
demand for K-Way jackets is not very elastic. Profit
to increase from 25 jackets a day to 100 jackets a day,
is maximised at 75 jackets per day and the markup
average total cost falls from R600 to R400 a jacket.
is large.
MC MC
800 800
… markup ATC 1
600 is large 600
ATC
550 ATC 0
450
400 400
D
… price falls
200 200 and markup
shrinks MR
D
MR
0 50 75 100 150 200 250 0 50 100 125 150 200 250
Quantity (K-Way jackets per day) Quantity (K-Way jackets per day)
If no firms advertise, demand for each firm’s product is low Advertising increases average total cost and shifts the ATC
and not very elastic. The profit-maximising output is small, the curve upward from ATC0 to ATC1. If all firms advertise, the
markup is large and the price is high. demand for each firm’s product becomes more elastic.
Output increases, the price falls and the markup shrinks.
In part (b), advertising, which is a fixed cost, brand name bring to justify the sometimes high cost
increases average total cost from ATC0 to ATC1 but of establishing it?
leaves marginal cost unchanged at MC. Demand The basic answer is that a brand name provides
becomes much more elastic, the profit-maximising information to consumers about the quality of a
quantity increases and the markup shrinks. product, and is an incentive to the producer to
achieve a high and consistent quality standard.
To see how a brand name helps the consumer,
Using Advertising to Signal Quality think about how you use brand names to get informa-
Some advertising, like the Charlize Theron Sun tion about quality.
International ads on television or the huge amount You are on a road trip, and it is time to find a
that Coke spends, seems hard to understand. There place to spend the night. You see roadside advertise-
does not seem to be any concrete information about a ments for Holiday Inn, Miriam’s Motel and Sipho’s
hotel and casino chain in an actress’s glistening smile. Stop. You know about Holiday Inn because you have
And surely everyone knows about Coke. What is the stayed in it before. You have also seen their advertise-
gain from pouring millions of rand into advertising ments and know what to expect. You have no infor-
this well-known drink? mation at all about Miriam’s and Sipho’s.
One answer is that advertising is a signal to the They might be better than the lodgings you do
consumer of a high-quality product. A signal is an know about, but without that knowledge, you are not
action taken by an informed person (or firm) to send a going to try them. You use the brand name as infor-
message to uninformed people. Think about two colas: mation and stay at Holiday Inn.
Coke and Oke. Oke knows that its cola is not very This same story explains why a brand name
good and that its taste varies a lot depending provides an incentive to achieve high and consistent
on which cheap batch of unsold cola it happens to buy quality. Because no one would know whether Sipho’s
each week. So Oke knows that while it could and Miriam’s were offering a high standard of service,
get a lot of people to try Oke by advertising, they they have no incentive to do so. But equally, because
would all quickly discover what a poor product it is and everyone expects a given standard of service from
switch back to the cola they bought before. Holiday Inn, a failure to meet a customer’s expectation
Coke, in contrast, knows that its product has a would almost surely lose that customer to a competitor.
high-quality consistent taste and that once consumers So Holiday Inn has a strong incentive to deliver what it
have tried it, there is a good chance they will never promises in the advertising that creates its brand name.
drink anything else. On the basis of this reasoning, Oke
does not advertise but Coke does. And Coke spends a
lot of money to garner a lot of public attention.
Efficiency of Advertising and Brand Names
Cola drinkers who see Coke’s ads know that the To the extent that advertising and brand names provide
firm would not spend so much money advertising if consumers with information about the precise nature of
its product were not truly good. So consumers reason product differences and about product quality, they benefit
that Coke is indeed a really good product. The flashy the consumer and enable a better product choice to be
expensive ad has signalled that Coke is really good made. But the opportunity cost of the additional informa-
without saying anything about Coke. tion must be weighed against the gain to the consumer.
Notice that if advertising is a signal, it does not The final verdict on the efficiency of monopolistic
need any specific product information. It just needs competition is ambiguous. In some cases, the gains from
to be expensive and hard to miss. That is what a lot of extra product variety unquestionably offset the selling
advertising looks like. So the signalling theory of adver- costs and the extra cost arising from excess capacity. The
tising predicts much of the advertising that we see. tremendous varieties of books and magazines, clothing,
food and drinks are examples of such gains. It is less
easy to see the gains from being able to buy brand-name
Brand Names medication that has a chemical composition identical
Many firms create and spend a lot of money to that of a generic alternative, but many people do
promoting a brand name. Why? What benefit does a willingly pay more for the brand-name alternative.
Apple has so far seen off most of its competitors in the tablet computer market including BlackBerry
maker Research in Motion and Hewlett Packard. Amazon’s Kindle has challenged Apple’s dominance
but with a far less versatile and powerful machine.
In 2011, Apple sold over 40 million iPads, out of worldwide tablet sales of 60 million.
At the presentation, Ballmer and Steven Sinofsky, the president of Microsoft’s Windows division,
stressed Surface’s computing power.
Sinofsky called the device a ‘tablet that’s a great PC – a PC that’s a great tablet’.
Competitive space
Milanesi said the Surface might appeal to business users already used to Microsoft software, an area
where Apple has been making inroads with iPads and iPhones. ‘It is certainly a very competitive
product in that space’, she said.
The company did not reveal pricing or release dates
but at the event Sinofsky said it would be ‘priced like ESSENCE OF THE STORY
comparable tablets’. ◆ Microsoft has developed its first commercial
Milanesi said she expected the Surface to cost less than tablet, the Surface, to enter the market.
$699 in the US and be launched before the all-impor- ◆ Microsoft hopes that Windows 8, which
tant Christmas selling season. the Surface devices will operate on, will
make up ground lost to Apple and Android
The tech firm has a spotty record in launching its own devices.
hardware products and has usually left the making of ◆ It is believed that the Surface tablets will
hardware to partners such as Dell or Hewlett Packard. become stiff competition to Apple’s iPad.
◆ Sales of Apple iPads made up more than
While Microsoft’s Xbox video gaming system is a world two-thirds of total global tablet sales in
leader, its iPod rival Zune and Kin telephones proved 2011.
disasters. ◆ The Surface will be competitively priced.
Source: © Guardian News and Media 2012.
16 000 16 000
2 000 D 2 000 MR D
MR Excess capacity
0 3 6 0 3 6
Quantity (millions of iPads per month) Quantity (millions of iPads per month)
Figure 1 Economic profit in the short run Figure 2 Zero economic profit in the long run
Key Terms
Efficient scale, 308 Markup, 308 Product differentiation, 305
Excess capacity, 308 Monopolistic competition, 305 Signal, 313
Use the following figure, which shows the situation for a pair, they were sold out. After doing some
facing a producer of running shoes, to work out online research, Jaco discovered that the distrib-
Problems 4 to 9. utor of these sneakers deliberately controls distri-
bution to ensure that supply does not outstrip
Price and cost (rand per pair)
4. What quantity does the firm produce, what price Suppose that Naartjie’s marginal cost of a child’s jacket
does it charge and what is its economic profit or is a constant R100 and the total fixed cost at one of
economic loss? its stores is R2 000 a day. This store sells 20 jackets a
5. In the long run, how does the number of firms day, which is its profit-maximising number of jackets.
producing running shoes change? Then the stores nearby start to advertise their jackets.
6. In the long run, how does the price of running The Naartjie store now spends R2 000 a day adver-
shoes and the quantity the firm produces change? tising its jackets, and its profit maximising number
What happens to the market output? of jackets sold jumps to 50 a day.
7. Does the firm have excess capacity in the long 12. a. What is this store’s average total cost of a
run? If the firm has excess capacity in the long jacket sold before the advertising begins?
run, why does it not decrease its capacity? b. What is this store’s average total cost of a
8. In the long run, compare the price of a pair jacket sold after the advertising begins?
of running shoes and the marginal cost of 13. a. Can you say what happens to the price of a
producing the pair. Naartjie jacket? Why or why not?
9. Is the market for running shoes efficient or inef- b. Can you say what happens to Naartjie’s
ficient in the long run? Explain your answer. markup? Why or why not?
10. Slow that Coffee! c. Can you say what happens to Naartjie’s
Coffee Crew thought that by taking away baristas economic profit? Why or why not?
and automating espresso machines it could 14. How might Naartjie use advertising as a signal?
smooth operations and boost sales. The public How is a signal sent and how does it work?
did not agree and sales fell. Today Coffee Crew 15. How does having a brand name help Naartjie to
is back to baristas who operate its new espresso increase its economic profit?
machines while customers linger in comfortable
armchairs or use the free wi-fi. Use the following information to work out Problems
a. Explain how Coffee Crew’s past attempts to 16 and 17.
maximise profits ended up eroding product
differentiation. Having the Edge
b. Explain how Coffee Crew’s new plan intends Shoes of Flavour is not South Africa’s biggest brand of
to increase economic profit. sandals, but it has an edge over many of its competi-
11. Sneaky Selling tors because of the unique beaded sandals it produces;
Jaco decided to buy a pair of elite brand-name and because the shoes are handmade by disadvantaged
sneakers. But when he went to the mall to look communities in Khayalitsha.
16. How do you expect advertising and the Shoes of 17. Are long-run economic profits a possibility for
Flavour brand name will affect Shoes of Flavour’s Shoes of Flavour? In long-run equilibrium, will
ability to make a positive economic profit? Shoes of Flavour have excess capacity or a markup?
2 500
Price and Output in Monopolistic Competition
2 000
Use the following information to work out D
Problems 19 and 20. 1 500
1 000
MR
Bongi teaches singing. Her fixed costs are R10 000 500
a month, and it costs her R500 of labour to give
one class. 0 100 200
Quantity (mountain bikes per week)
26. a. Explain how Nirvana’s distributers have Product Development and Marketing
differentiated its Nirvanas to compete with Use the following information to work out
other beer brands in terms of quality, price Problems 30 to 32.
and marketing.
b. Predict whether Nirvana’s distributers Herman bakes delicious rusks. His total fixed cost is
produce at, above, or below the efficient R400 a day and his average variable cost is R10 a bag.
scale in the short run. Few people know about Herman’s Rusks, and he is
27. a. Predict whether the R120 price tag on the maximising his profit by selling 10 bags a day for
Nirvanas is at, above or below marginal cost: R50 a bag. Herman thinks that if he spends R500 a
(i) In the short run. day on advertising, he can increase his market share
(ii) In the long run. and sell 25 bags a day for R50 a bag.
b. Do you think that Nirvana makes the 30. If Herman’s advertising works as he expects, can
market for beer inefficient? he increase his economic profit by advertising?
31. If Herman advertises, will his average total cost
Use the following information to work out increase or decrease at the quantity produced?
Problems 28 and 29. 32. If Herman advertises, will he continue to sell his
rusks for R50 a bag or will he change his price?
Women Golfers on the Rise
The number of women golfers is on the rise. They Use the following information to work out Problems
make up roughly a quarter of golfers worldwide. 33 and 34.
Leading manufacturers, such as Yonex and Ping, are
now designing women’s golf clubs and accessories. Champagne Bubbling
28. a. How are Yonex and Ping attempting to A bottle of champagne may only be marketed as such
maintain economic profit? if it is produced in the Champagne region of northern
b. Draw a graph to illustrate the cost curves France. In 1927 there were 319 villages which made
and revenue curves of Yonex or Ping in the up the region. However, due to burgeoning global
market for golf clubs for women. sales of champagne (peaking at nearly 340 million
c. Show on your graph in part (b) the short- bottles in 2007), the need arose to expand the
run economic profit. Champagne region to meet demand. In 2008, the
29. a. Explain why the economic profit that Yonex region was expanded to 357 villages, whose earliest
and Ping make on golf clubs for women is new plantings are likely to take place in 2015. It is
likely to be temporary. expected that land value in these villages will increase
b. Draw a graph to illustrate the cost curves from €5 000 per hectare to €1 million per hectare.
and revenue curves of Yonex or Ping in the 33. a. Why is France so strict about designating the
market for golf clubs for women in the long vineyards that can use the Champagne label?
run. Mark the firm’s excess capacity. b. Explain who would most likely oppose
the plan.
34. Assuming that vineyards in the 38 new villages
are producing the same quality of grapes with
or without the plan, why will their land values
increase so drastically if the plan is approved?
T
15
he chip in your laptop was made by either Intel or Advanced Micro
Devices; the battery in your TV remote is most likely a Duracell or
Energizer; if you use a high-tech razor, it is either a Gillette or a Schick;
and if you take a long-distance trip by air, you will fly in an aeroplane
made by either Boeing, an American aircraft manufacturer, or the
European firm Airbus. In the markets for computer chips, batteries,
high-tech razors and big aeroplanes, two producers compete for market
OLIGOPOLY share in the pursuit of maximum profit. Many other markets have only
a small number of firms. Among them are the markets for light bulbs,
breakfast cereals and major appliances.
How does a market work when only a handful of firms compete?
Is the market efficient like perfect competition with the firms operating
in the social interest? Or is the market inefficient like monopoly with the
firms restricting output to increase profit?
To answer these questions, we need to understand the models
of oligopoly. These models use game theory, which the chapter explains.
At the end of the chapter, in Reading Between the Lines, we will
look at the game that SAA and Qantas are playing in their battle for
market shares and maximum profit.
25 25
20 20
ATC 1 ATC 2
15 15
10 10
Lowest D
possible D
price = Efficient Two firms Efficient Three firms
5 5
minimum scale of can meet scale of can meet
ATC one firm demand one firm demand
0 30 60 90 0 20 40 60 80
Quantity (rides per day) Quantity (rides per day)
The lowest possible price is R10 a ride, which is the minimum When the efficient scale of one firm is 20 rides per day, three
average total cost. When a firm produces 30 rides a day, firms can satisfy the market demand at the lowest possible
the efficient scale, two firms can satisfy the market demand. price. This natural oligopoly has three firms.
This natural oligopoly has two firms – a natural duopoly.
a car. Facing airtight cases, they will receive a sentence Confess Deny
of two years each for their crime. During his interviews
with the two prisoners, the public prosecutor begins to 3 years 10 years
suspect that he has stumbled on the two people who Confess
were responsible for a multimillion-rand bank robbery
some months earlier. But this is just a suspicion. 3 years 1 year
and eliminate those that are dominated – that are not the other to deny. So each prisoner knows that he must
as good as some other choice. Let us find the Nash confess, thereby delivering a bad outcome for both.
equilibrium for the prisoners’ dilemma game. The firms in an oligopoly are in a similar situ-
ation to Kallie and Mike in the prisoners’ dilemma
Finding the Nash Equilibrium Look at the situa- game. Let us see how we can use this game to under-
tion from Kallie’s point of view. If Mike confesses (top stand oligopoly.
row), Kallie’s best action is to confess because in that
case, he is sentenced to 3 years rather than 10 years. If
Mike denies (bottom row), Kallie’s best action is still An Oligopoly Price-Fixing Game
to confess because in that case he receives 1 year rather We can use game theory and a game like the prisoners’
than 2 years. So Kallie’s best action is to confess. dilemma to understand price fixing, price wars and
Now look at the situation from Mike’s point other aspects of the behaviour of firms in oligopoly.
of view. If Kallie confesses (left column), Mike’s We will begin with a price-fixing game.
best action is to confess because in that case, he is To understand price fixing, we are going to study
sentenced to 3 years rather than 10 years. If Kallie the special case of duopoly – an oligopoly with two
denies (right column), Mike’s best action is still to firms. Duopoly is easier to study than oligopoly with
confess because in that case, he receives 1 year rather three or more firms, and it captures the essence of all
than 2 years. So Mike’s best action is to confess. oligopoly situations. Somehow, the two firms must
Because each player’s best action is to confess, share the market. And how they share it depends on
each does confess, each goes to jail for 3 years and the the actions of each. We are going to describe the costs
public prosecutor has solved the bank robbery. This is of the two firms and the market demand for the item
the Nash equilibrium of the game. they produce. We are then going to see how game
The Nash equilibrium for the prisoners’ dilemma is theory helps us to predict the prices charged and the
called a dominant-strategy equilibrium, which is an equi- quantities produced by the two firms in a duopoly.
librium in which the best strategy of each player is to
confess (cheat) regardless of the strategy of the other player. Cost and Demand Conditions Two firms, Dunder
and Mifflin, produce paper. They have identical costs.
The Dilemma The dilemma arises as each prisoner Figure 15.2(a) shows their average total cost curve (ATC )
contemplates the consequences of his decision and puts and marginal cost curve (MC ). Figure 15.2(b) shows the
himself in the place of his accomplice. Each knows that market demand curve for reams of paper (D). The two
it would be best if both denied. But each also knows firms produce identical paper, so one firm’s ream of paper
that if he denies it is in the best interest of the other to is a perfect substitute for the other’s, and the market
confess. So each considers whether to deny and relies price of each firm’s product is identical. The quantity
on his accomplice to deny or to confess hoping that his demanded depends on that price – the higher the price,
accomplice denies but expecting him to confess. The the smaller is the quantity demanded.
dilemma leads to the equilibrium of the game. The industry is a natural duopoly. Two firms can
produce the good at a lower cost than either one firm
A Bad Outcome For the prisoners, the equilibrium or three firms can. For each firm, average total cost is
of the game, with each confessing, is not the best at its minimum when production is 30 000 units a
outcome. If neither of them confesses, each gets only week. When price equals minimum average total cost,
2 years for the lesser crime. Is there some way in which the total quantity demanded is 60 000 units a week,
this better outcome can be achieved? It seems that there and two firms can just produce that quantity.
is not, because the players cannot communicate with
each other. Each player can put himself in the other Collusion We will suppose that Dunder and
player’s place, and so each player can figure out that Mifflin enter into a collusive agreement. A collusive
there is a best strategy for each of them. The prisoners agreement is an agreement between two (or more)
are indeed in a dilemma. Each knows that he can serve producers to form a cartel to restrict output, raise
2 years only if he can trust the other to deny. But each the price, and increase profits. Such an agreement is
prisoner also knows that it is not in the best interest of illegal in South Africa and is undertaken in secret.
The strategies that firms in a cartel can pursue are to: each firm produces the same quantity of output.
◆ Comply This curve is constructed by adding together the
◆ Cheat outputs of the two firms at each level of marginal cost.
Because the two firms are the same size, at each
A firm that complies carries out the agreement. A firm level of marginal cost, the industry output is twice the
that cheats breaks the agreement to its own benefit output of one firm. The curve MCI in part (b) is twice
and to the cost of the other firm. as far to the right as the curve MC in part (a).
Because each firm has two strategies, there are To maximise industry profit, the firms in the
four possible combinations of actions for the firms: duopoly agree to restrict output to the rate that makes
1. Both firms comply. the industry marginal cost and marginal revenue equal.
2. Both firms cheat. That output rate, as shown in part (b), is 40 000 units
3. Dunder complies and Mifflin cheats. a week. The demand curve shows that the highest price
4. Mifflin complies and Dunder cheats. for which the 40 000 reams of paper can be sold is
R90 each. Dunder and Mifflin agree to charge this price.
Colluding to Maximise Profits Let us work out To hold the price at R90 a unit, production
the payoffs to the two firms if they collude to make must be 40 000 units a week. So Dunder and Mifflin
the maximum profit for the cartel by acting like must agree on output rates for each of them that total
a monopoly. The calculations that the two firms 40 000 units a week. Let us suppose that they agree
perform are the same calculations that a monopoly to split the market equally so that each firm produces
performs. (You can refresh your memory of these 20 000 reams of paper a week. Because the firms are
calculations by looking at Chapter 13, pp. 286–287.) identical, this division is the most likely.
The only thing that the firms in duopoly must do The average total cost (ATC ) of producing
beyond what a monopoly does is to agree on how 20 000 reams of paper a week is R80, so the profit
much of the total output each of them will produce. per unit is R10 and economic profit is R200 000
Figure 15.3 shows the price and quantity that (20 000 units × R10 per unit). The economic profit
maximise industry profit for the duopoly. Part (a) of each firm is represented by the blue rectangle in
shows the situation for each firm, and part (b) shows Fig. 15.3(a).
the situation for the industry as a whole. The curve We have just described one possible outcome for
labelled MR is the industry marginal revenue curve. a duopoly game: The two firms collude to produce the
This marginal revenue curve is like that of a single- monopoly profit-maximising output and divide that
price monopoly (Chapter 13, p. 284).The curve output equally between themselves. From the industry
labelled MCI is the industry marginal cost curve if point of view, this solution is identical to a monopoly.
A duopoly that operates in this way is indistinguish- Mifflin continues to produce 20 000 units a
able from a monopoly. The economic profit that week at a cost of R80 a unit and incurs a loss of
is made by a monopoly is the maximum total R5 a unit, or R100 000 a week. This economic loss
profit that can be made by the duopoly when the is shown by the red rectangle in part (a). Dunder
firms collude. produces 30 000 units a week at a cost of R60 a
But with price greater than marginal cost, either unit. With a price of R75, Dunder makes a profit
firm might think of trying to increase profit by of R15 a unit and therefore an economic profit of
cheating on the agreement and producing more than R450 000. This economic profit is the blue rectangle
the agreed amount. Let us see what happens if one of in part (b).
the firms does cheat in this way. We have now described a second possible
outcome for the duopoly game: One of the firms
One Firm Cheats on a Collusive Agreement cheats on the collusive agreement. In this case, the
To set the stage for cheating on their agreement, industry output is larger than the monopoly output
Dunder convinces Mifflin that demand has decreased and the industry price is lower than the monopoly
and that it cannot sell 20 000 units a week. Dunder price. The total economic profit made by the industry
tells Mifflin that it plans to cut its price so that it is also smaller than the monopoly’s economic profit.
can sell the agreed 20 000 units each week. Because Dunder (the cheat) makes an economic profit of
the two firms produce an identical product, Mifflin R450 000, and Mifflin (the complier) incurs an
matches Dunder’s price cut but still produces only economic loss of R100 000. The industry makes an
20 000 units a week. economic profit of R350 000. This industry profit
In fact, there has been no decrease in demand. is R50 000 less than the economic profit that a
Dunder plans to increase output, which it knows will monopoly would make, but it is distributed unevenly.
lower the price, and Dunder wants to ensure that Dunder makes a bigger economic profit than it would
Mifflin’s output remains at the agreed level. under the collusive agreement, while Mifflin incurs an
Figure 15.4 illustrates the consequences of economic loss.
Dunder’s cheating. Part (a) shows Mifflin (the A similar outcome would arise if Mifflin cheated
complier); part (b) shows Dunder (the cheat); and part and Dunder complied with the agreement. The
(c) shows the industry as a whole. Suppose that Dunder industry profit and price would be the same, but in
increases output to 30 000 units a week. If Mifflin this case, Mifflin (the cheat) would make an economic
sticks to the agreement to produce only 20 000 units profit of R450 000 and Dunder (the complier) would
a week, total output is now 50 000 a week, and given incur an economic loss of R100 000. Let us see next
demand in part (c), the price falls to R75 a unit. what happens if both firms cheat.
Economic 60
loss
Economic D
profit Complier's Cheat's
output output
0 10 20 30 40 50 0 10 20 30 40 50 0 10 20 30 40 50 60 70
Quantity (thousands of Quantity (thousands of Quantity (thousands of
reams of paper per week) reams of paper per week) reams of paper per week)
One firm, shown in part (a), complies with the agreement falls to R75 a unit. At this price, the complier in part (a) incurs
and produces 20 000 units. The other firm, shown in an economic loss of R100 000 (R5 per unit x 20 000 units),
part (b), cheats on the agreement and increases its output shown by the red rectangle. In part (b), the cheat makes an
to 30 000 units a week. economic profit of R450 000 (R15 per unit x 30 000 units),
Given the market demand curve, shown in part (c), and shown by the blue rectangle.
with a total production of 50 000 units a week, the price
Both Firms Cheat Suppose that both firms cheat and Each firm has lowered its price and increased its
that each firm behaves like the cheating firm that we output to try to gain an advantage over the other firm.
have just analysed. Each tells the other that it is unable to Each has pushed this process as far as it can without
sell its output at the going price and that it plans to cut incurring an economic loss.
its price. But because both firms cheat, each will propose We have now described a third possible outcome
a successively lower price. As long as price exceeds of this duopoly game: Both firms cheat. If both firms
marginal cost, each firm has an incentive to increase its cheat on the collusive agreement, the output of each
production – to cheat. Only when price equals marginal firm is 30 000 units a week and the price is R60 a
cost is there no further incentive to cheat. unit. Each firm makes zero economic profit.
This situation arises when the price has reached
R60. At this price, marginal cost equals price. Also, The Payoff Matrix Now that we have described the
price equals minimum average total cost. At a price strategies and payoffs in the duopoly game, we can
less than R60, each firm incurs an economic loss. summarise the strategies and the payoffs in the form
At a price of R60, each firm covers all its costs of the game’s payoff matrix. Then we can find the
and makes zero economic profit. Also, at a price of Nash equilibrium.
R60, each firm wants to produce 30 000 units a week, Table 15.2 sets out the payoff matrix for this
so the industry output is 60 000 units a week. game. It is constructed in the same way as the payoff
Given the demand conditions, 60 000 units can matrix for the prisoners’ dilemma in Table 15.1. The
be sold at a price of R60 each. squares show the payoffs for the two firms – Mifflin
Figure 15.5 illustrates the situation just described. and Dunder. In this case, the payoffs are profits. (For
Each firm, in part (a), produces 30 000 units a week, the prisoners’ dilemma, the payoffs were losses.)
and its average total cost is a minimum (R60 per The table shows that if both firms cheat (top left),
unit). The market as a whole, in part (b), operates they achieve the perfectly competitive outcome – each
at the point at which the market demand curve (D) firm makes zero economic profit. If both firms comply
intersects the industry marginal cost curve (MCI). (bottom right), the industry makes the monopoly
profit and each firm makes an economic profit of complies. The firm that cheats makes an economic
R200 000. The top right and bottom left squares profit of R450 000, and the one that complies incurs
show the payoff if one firm cheats while the other a loss of R100 000.
100 100
Nash Equilibrium in the Duopolists’ Dilemma Look at things from Mifflin’s point of view.
The duopolists have a dilemma like the prisoners’ Mifflin reasons as follows: Suppose that Dunder
dilemma. Do they comply or cheat? To answer this cheats. If I comply, I will incur an economic loss
question, we must find the Nash equilibrium. of R100 000. If I also cheat, I will make zero
economic profit. Zero is better than minus
TABLE 15.2 Duopoly Payoff Matrix R100 000, so I am better off if I cheat. Now suppose
Mifflin's strategies Dunder complies. If I cheat, I will make an economic
Cheat Comply
profit of R450 000, and if I comply, I will make
an economic profit of R200 000. A R450 000
R0 –R100 000 profit is better than a R200 000 profit, so I am
better off if I cheat. So regardless of whether
Cheat
Dunder cheats or complies, it pays Mifflin to cheat.
R0 +R450 000 Cheating is Mifflin’s best strategy.
Dunder's Dunder comes to the same conclusion as Mifflin
strategies because the two firms face an identical situation. So
+R450 000 +R200 000 both firms cheat.
The Nash equilibrium of the duopoly game is
Comply
that both firms cheat. And although the industry
–R100 000 +R200 000 has only two firms, they charge the same price and
produce the same quantity as those in a competitive
industry. Also, as in perfect competition, each firm
Each square shows the payoffs from a pair of actions.
makes zero economic profit.
For example, if both firms comply with the collusive agreement,
This conclusion is not general and will not always
the payoffs are recorded in the bottom right square.
arise. We will see why not by looking first at some
The red triangle shows Mifflin’s payoff and the blue
other games that are like the prisoners’ dilemma. Then
triangle shows Dunder’s. In Nash equilibrium, both firms cheat.
we will broaden the types of games we consider.
Other Oligopoly Games firm does R&D, every firm can be better off, but if one
Firms in oligopoly must decide whether to mount firm initiates the R&D activity, all must follow.
expensive advertising campaigns; whether to modify Table 15.3 illustrates the dilemma (with hypo-
their product; whether to make their product more thetical numbers) for the R&D game that Kreepy
reliable and more durable; whether to price discrimi- Krauly and Zodiac play. Each firm has two strategies:
nate and, if so, among which groups of customers Spend R25 million a year on R&D or spend nothing
and to what degree; whether to undertake a large on R&D. If neither firm spends on R&D, they make
research and development (R&D) effort aimed at a joint profit of R100 million: R30 million for Kreepy
lowering production costs; and whether to enter or Krauly and R70 million for Zodiac (bottom right
leave an industry. of the payoff matrix). If each firm conducts R&D,
All of these choices can be analysed as games that market shares are maintained but each firm’s profit is
are similar to the one that we have just studied. Let us lower by the amount spent on R&D (top left square
look at one example: an R&D game. Kreepy Krauly of the payoff matrix). If Kreepy Krauly pays for R&D
and Zodiac (the owners of Baracuda) are the leading but Zodiac does not, Kreepy Krauly gains a large part
electronic pool-cleaners in South Africa. Kreepy of Zodiac’s market.
Krauly was started in 1975 by a South African door- Kreepy Krauly profits and Zodiac loses
to-door pool equipment salesman, Daniel Chauvier, (top right square of the payoff matrix). Finally, if
and his engineer-father, Ferdi. The company has Zodiac conducts R&D and Kreepy Krauly does
grown over the years, selling millions of devices. not, Zodiac gains market share from Kreepy Krauly,
R&D over the years has improved the Kreepy Krauly, increasing its profit, while Kreepy Krauly incurs a
to a point where it is has become all-plastic, elimi- loss (bottom left square).
nating the problem of rust. Zodiac is an American
company, and the key distinction between a Kreepy TABLE 15.3 Kreepy Krauly Versus Zodiac:
Krauly and a Zodiac pool-cleaner is the noise factor An R&D Game
– Zodiacs are silent. Kreepy Krauly engaged in
significant R&D and marketing exercises to assess the Zodiac's strategies
viability of a silent machine, but decided against it, as R&D No R&D
Zodiac owners have complained about not knowing
whether the cleaner is working or not – unlike a R45m –R10m
Kreepy Krauly whose ‘putt-putt’ sound indicates that R&D
it is operational. Both Kreepy Krauly and Zodiac
have developed competing products over the years, R5m +R85m
servicing a wider market, such as the Kreepy Krauly Kreepy
Hug Bug® and the Zodiac Ranger®. Both manufac- Krauly's
strategies
turers constantly engage in R&D to keep abreast of
+R85m +R70m
new designs and of their competitor’s advancements,
No R&D
so as to remain one step ahead.
The key to success in this industry (as in any –R10m +R30m
other) is to design a product that people value
highly relative to the cost of producing it. The firm
If both firms undertake R&D, their payoffs are those shown
that creates the most highly valued product and also
in the top left square. If neither firm undertakes R&D, their
develops the least-cost technology for producing it
payoffs are in the bottom right square.
gains a competitive edge, undercutting the rest of
When one firm undertakes R&D and the other one does
the market, increasing its market share and
not, their payoffs are in the top right and bottom left squares.
increasing its profit.
The red triangle shows Zodiac’s payoff and the blue triangle
But the R&D that must be undertaken to improve
shows Kreepy Krauly’s. The Nash equilibrium for this game is
product quality and cut costs is itself costly. So the cost of
for both firms to undertake R&D. The structure of this game is
R&D must be deducted from the profit resulting from
the same as that of the prisoners’ dilemma.
the increased market share that lower costs achieve. If no
would be better off not doing it. To decide which firm Repeated Games and Sequential Games
does the R&D, the firms might toss a coin, called a
The games that we have studied are played just once.
mixed strategy.
In contrast, many real-world games are played repeat-
edly. This feature of games turns out to enable real-
TABLE 15.4 An R&D Game of Chicken world duopolists to cooperate, collude and make a
Kreepy Krauly's strategies monopoly profit.
Another feature of the games that we have
R&D No R&D
studied is that the players move simultaneously. But in
many real-world situations, one player moves first and
R5m R10m
then the other moves – the play is sequential rather
R&D
than simultaneous. This feature of real-world games
R5m R1m creates a large number of possible outcomes.
Zodiac's
We are now going to examine these two aspects
strategies of strategic decision making.
R1m R0
Table 15.5 shows the economic profit that Dunder cooperates. Mifflin now makes an economic profit
and Mifflin will make over a number of periods under of R450 000 and Dunder incurs an economic loss of
two alternative sequences of events: colluding and R100 000.
cheating with a tit-for-tat response by the other firm. Adding up the profits over two periods of play,
If both firms stick to the collusive agreement in Dunder would have made more profit by cooperating
period 1, each makes an economic profit of R200 000. – R400 000 compared with R350 000.
Suppose that Dunder contemplates cheating in What is true for Dunder is also true for Mifflin.
period 1. The cheating produces a quick R450 000 Because each firm makes a larger profit by sticking
economic profit and inflicts a R100 000 economic with the collusive agreement, both firms do so and the
loss on Mifflin. But a cheat in period 1 produces a monopoly price, quantity and profit prevail.
response from Mifflin in period 2. If Dunder wants to In reality, whether a cartel works like a one-
get back into a profit-making situation, it must return play game or a repeated game depends primarily on
to the agreement in period 2 even though it knows the number of players and the ease of detecting and
that Mifflin will punish it for cheating in period 1. punishing cheating. The larger the number of players,
So in period 2, Mifflin punishes Dunder and Dunder the harder it is to maintain a cartel.
If duopolists repeatedly collude, each makes a profit of must be paid for in the next period by incurring a loss. Over
R200 000 per period of play. If one player cheats in period 1, two periods of play, the best that a duopolist can achieve by
the other player plays a tit-for-tat strategy and cheats in period 2. cheating is a profit of R350 000, compared to an economic
The profit from cheating can be made for only one period and profit of R450 000 by colluding.
Games and Price Wars A repeated duopoly game Fluctuations in the world price of oil might be
can help us understand real-world behaviour and, in interpreted in this way.
particular, price wars. Some price wars arise from the entry of a small
Some price wars can be interpreted as the imple- number of firms into an industry that had previously
mentation of a tit-for-tat strategy. But the game is a been a monopoly.
bit more complicated than the one we have looked at Although the industry has a small number of
because the players are uncertain about the demand firms, the firms are in a prisoners’ dilemma and they
for the product. cannot impose effective penalties for price cutting. The
Playing a tit-for-tat strategy, firms have an incen- behaviour of prices and outputs in the computer chip
tive to stick to the monopoly price. But fluctuations industry during 1995 and 1996 can be explained in
in demand lead to fluctuations in the monopoly price, this way. Until 1995, the market for Pentium chips
and sometimes, when the price changes, it might seem for IBM-compatible computers was dominated by
to one of the firms that the price has fallen because one firm, Intel Corporation, which was able to make
the other has cheated. In this case, a price war will maximum economic profit by producing the quantity of
break out. The price war will end only when each firm chips at which marginal cost equalled marginal revenue.
is satisfied that the other is ready to cooperate again. The price of Intel’s chips was set to ensure that the quan-
There will be cycles of price wars and the restoration tity demanded equalled the quantity produced. Then
of collusive agreements. in 1995 and 1996, with the entry of a small number
of new firms, the industry became an oligopoly. If the (there are no frequent-flyer programmes) and they buy
firms had maintained Intel’s price and shared the from the lowest-price firm. So if Wanabe enters, it sets a
market, together they could have made economic profits price just below Agile’s and takes all the business.
equal to Intel’s profit. But the firms were in a prisoners’ Figure 15.6 shows the payoffs from the various
dilemma, so prices fell toward the competitive level. decisions (Agile’s in the red triangles and Wanabe’s in
Let us now study a sequential game. There are the blue triangles).
many such games, and the one we will examine is To decide on its price, Agile’s CEO reasons as
among the simplest. It has an interesting implication follows: Suppose that Agile sets the monopoly price.
and it will give you the flavour of this type of game. If Wanabe enters, it earns 900 (think of all payoff
The sequential game that we will study is an entry numbers as thousands of rand). If Wanabe stays out, it
game in a contestable market. earns nothing.
So Wanabe will enter. In this case Agile will
lose 500.
A Sequential Entry Game in a Now suppose that Agile sets the competitive
Contestable Market price. If Wanabe stays out, it earns nothing, and if it
If two firms play a sequential game, one firm makes enters, it loses 100, so Wanabe will stay out. In this
a decision at the first stage of the game and the other case, Agile will make zero economic profit.
makes a decision at the second stage. Agile’s best strategy is to set its price at the
We are going to study a sequential game in a competitive level and make zero economic profit.
contestable market – a market in which firms can The option of earning 1 000 by setting the monopoly
enter and leave so easily that firms in the market face price with Wanabe staying out is not available to
competition from potential entrants. Examples of Agile. If Agile sets the monopoly price, Wanabe
contestable markets are routes served by airlines and enters, undercuts Agile, and takes all the business.
by barge companies that operate on the major water- In this example, Agile sets its price at the compet-
ways. These markets are contestable because firms itive level and makes zero economic profit. A less
could enter if an opportunity for economic profit costly strategy, called limit pricing, sets the price at
arose and could exit with no penalty if the opportu- the highest level that inflicts a loss on the entrant.
nity for economic profit disappeared. Any loss is big enough to deter entry, so it is not
If the Herfindahl-Hirschman Index (p. 222) always necessary to set the price as low as the competi-
is used to determine the degree of competition, a tive price. In the example of Agile and Wanabe, at the
contestable market appears to be uncompetitive. But competitive price, Wanabe incurs a loss of 100 if it
a contestable market can behave as if it were perfectly enters. A smaller loss would still keep Wanabe out.
competitive. To see why, let us look at an entry game This game is interesting because it points to the
for a contestable air route. possibility of a monopoly behaving like a competitive
industry and serving the social interest without regula-
A Contestable Air Route Agile Air is the only firm tion. But the result is not general and depends on one
operating on a particular route. Demand and cost crucial feature of the setup of the game: At the second
conditions are such that there is room for only one stage, Agile is locked in to the price set at the first stage.
airline to operate. Wanabe Inc. is another airline that If Agile could change its price in the second stage,
could offer services on the route. it would want to set the monopoly price if Wanabe
We describe the structure of a sequential game stayed out – 1 000 with the monopoly price beats zero
by using a game tree like that in Figure 15.6. At the with the competitive price. But Wanabe can figure out
first stage, Agile Air must set a price. Once the price what Agile would do, so the price set at the first stage
is set and advertised, Agile cannot change it. That is, has no effect on Wanabe. Agile sets the monopoly
once set, Agile’s price is fixed and Agile cannot react price and Wanabe might either stay out or enter.
to Wanabe’s entry decision. Agile can set its price at We have looked at two of the many possible
either the monopoly level or the competitive level. repeated and sequential games, and you have seen
At the second stage, Wanabe must decide whether how these types of games can provide insights into the
to enter or to stay out. Customers have no loyalty complex forces that determine prices and profits.
FIGURE 15.6 Agile Versus Wanabe: A Sequential Entry Game in a Contestable Market
First stage Second stage Payoffs
900
Enter
–500
Wanabe
Competitive price 0
Stay out 0
If Agile sets the monopoly price, Wanabe makes 900 (thousand If Agile sets the competitive price, Wanabe earns nothing
rand) by entering and earns nothing by staying out. if it stays out and incurs a loss if it enters. So if Agile sets the
So if Agile sets the monopoly price, Wanabe enters. competitive price, Wanabe stays out.
◆ To ensure that small and medium-sized enter- Practices which the Competition Commission
prises have an equal opportunity to participate in regulates as being uncompetitive include, inter alia,
the economy; the following: price-fixing, dividing markets, collusive
◆ To promote a greater spread of ownership, in tendering, restricting market competition and abusing
particular to increase the ownership stakes of a dominant position.
historically disadvantaged persons. Oligopoly is a market structure that you often
encounter in your daily life. Reading Between the Lines
Three institutions were created in terms of the Act to on pp. 335–336 looks at the game that SAA and
achieve its objectives: Qantas are playing in their battle for market shares
◆ The Competition Commission and maximum profit.
◆ The Competition Tribunal
◆ The Competition Appeal Court
ECONOMIC ANALYSIS ◆ If Qantas does not reduce its fares and neither
does SAA, neither will make additional profit.
◆ The market for direct flights from Australia to So it is in Qantas’ best interest to reduce its fares.
South Africa is dominated by Qantas and SAA – ◆ If both airlines lower their fares, they will both
it is a duopoly. receive increased profits of R45 million each (versus
◆ The airlines have been warned by the zero profit if neither of them lower their fares).
International Air Services Commission that they ◆ So both firms will lower their fares, which is not
need to stop increasing their fares by reducing a Nash equilibrium, since only one airline would
their capacity. be better off lowering their fares.
◆ It is possible that the Commission is going to
Qantas strategies
cancel the airlines’ code-share at the end of 2012.
◆ The game is an example of a game of chicken
Reduce fares Do not reduce fares
like that on p. 330, and can be interpreted as a
prisoners’ dilemma. +R45mn –R90mn
◆ Table 1 shows the pay-off matrix (millions
Reduce fares
of rand of profit) for the game played by
Qantas and SAA. (The numbers are hypothetical,
and it is assumed that the airlines share the +R45mn +R90mn
SAA
market equally.) strategies
◆ If SAA reduces its fares while Qantas retains its +R90mn R0
current fare structure, SAA’s profit will increase
by R90 million due to higher demand, while Do not reduce fares
Qantas’ profit will decrease by the same amount.
◆ If SAA does not reduce its fares and neither does –R90mn R0
Key Terms
Cartel, 322 Dominant-strategy Limit pricing, 333 Payoff matrix, 323
Collusive agreement, 324 equilibrium, 324 Nash equilibrium, 323 Strategies, 323
Contestable market, 333 Duopoly, 321 Oligopoly, 321
Cooperative equilibrium, 331 Game theory, 322
18. Agile Airlines’ profit on a route on which it has a 20. Boeing and Airbus compete in the Asia-Pacific
monopoly is R10 million a year. Wanabe Airlines region for what could be about $1.2 trillion
is considering entering the market and operating worth of planes in the next two decades.
on this route. Agile warns Wanabe to stay out a. In what type of market are big aeroplanes
and threatens to cut the price so that if Wanabe sold?
enters it will make no profit. Wanabe determines b. Thinking of competition between Boeing
that the payoff matrix for the game in which it is and Airbus as a game, what are the strategies
engaged with Agile is shown in the table. and the payoffs?
c. Set out a hypothetical payoff matrix for the
Agile
High price Low price game you have described in part (b). What is
7 1 the equilibrium of the game?
Enter d. Do you think the market for big aeroplanes
5 0
is efficient? Explain and illustrate your
Wanabe answer.
10 5
Do not enter
0 0
John von Neumann was one of the great minds Von Neumann believed that the social sciences
of the twentieth century. Born in Budapest, would progress only if they used their own math-
Hungary, in 1903, Johnny, as he was known, showed ematical tools, not those of the physical sciences.
early mathematical brilliance. He was 25 when he
published the article that changed the social sciences
‘Real life consists of bluffing, of little tactics of
and began a flood of research on game theory –
a flood that has not subsided. In that article, von deception, of asking yourself what is the other
Neumann proved that in a zero-sum game (such man going to think I mean to do.’
as sharing a pie), there exists a best strategy for
each player. JOHN VON NEUMANN, told to Jacob
Von Neumann did more than invent game Bronowski (in a London taxi) and reported in
theory: He also invented and built the first practical
The Ascent of Man
computer, and he worked on the Manhattan Project,
which developed the atomic bomb during World
War II.
F
16
ighting a Knysna wildfire, screening passengers at an airport,
providing good schools and universities, defending the nation’s borders
and interests around the globe, policing neighbourhoods and highways,
operating courts and a legal system: Governments are involved in all
these activities. But why? Why does government provide some goods
and services and not others? Why do we not leave it to private firms to
provide and sell all goods and services?
Firms also engage in lobbying activity to persuade Bureaucrats Bureaucrats are the public servants who
politicians to propose policies that benefit them. work in government departments. They administer tax
collection, the delivery of public goods and services
Politicians Politicians are the elected persons in the and the administration of rules and regulations.
national, provincial and local governments – from the The self-interest of a bureaucrat is best served
President of South Africa to the principal of a high when the budget of her or his department is maxim-
school in the Free State. National and provincial poli- ised. The bigger the budget of a department, the
ticians form coalitions – political parties – to develop greater is the prestige of its chief and the greater are
policy proposals, which they present to voters in the the opportunities for promotion for people further
hope of attracting majority support. Politicians also down the bureaucratic ladder. So all the members
direct bureaucrats in the delivery of public goods and of a department have an interest in maximising the
services and other policy actions. department’s budget. This economic assumption does
The goal of a politician is to get elected and to not imply that bureaucrats do a poor job. Rather it
remain in office. Votes, to a politician, are like profit implies that, in doing what they perceive to be a good
to a firm. job, they take care of their own self-interest too.
Excludable A good is excludable if it is possible to marginal cost is zero. The fixed cost of producing such
prevent someone from enjoying its benefits. Fidelity a good is usually high so economies of scale exist over
Guards’ security services, CTFM’s fish and a U2 the entire range of output for which there is a demand
concert are examples. People must pay to benefit (see p. 282). An iTunes song and DStv are examples
from them. of natural monopoly goods.
A good is non-excludable if it is impossible (or
extremely costly) to prevent anyone from benefit-
Mixed Goods and Externalities
ting from it. The services of the Metro Police Service,
fish in the Atlantic Ocean and a concert on public Some goods do not fit neatly into the
television are examples. When a Metro Police officer four-fold classification of Fig. 16.2. Externality
enforces the speed limit, everyone on the highway They are mixed goods. A mixed good
benefits; anyone with a boat can fish in the ocean; and is a private good the production or
anyone with a TV can watch a public broadcast. consumption of which creates an
externality. An externality is a cost
Rival A good is rival if one person’s use of it decreases (external cost) or a benefit (external
the quantity available for someone else. A Fidelity benefit) that arises from the produc-
Guards’ truck cannot deliver cash to two banks at the tion or consumption of a private
same time. A fish can be consumed only once. good and that falls on someone other www.quickto.mobi/
A good is non-rival if one person’s use of it does than its producer or consumer. A PEA-EXTERNALITIES
not decrease the quantity available for someone else. negative externality imposes a cost
The services of the South African Police Service (SAPS) and a positive externality provides
and a concert on public television are non-rival. One a benefit.
person’s benefit does not lower the benefit of others. We will look at some examples of mixed goods
with externalities and study those with positive exter-
nalities later in this chapter and those with negative
A Fourfold Classification externalities in Chapter 17.
Figure 16.2 classifies goods, services and resources into
four types.
Private Goods A private good is both rival and FIGURE 16.2 Fourfold Classification of Goods
excludable. A can of Coke and a fish on a private trout
Private goods Common resources
farm are examples of private goods.
Food and drink Fish in ocean
Public Goods A public good is both non-rival and Rival Car Atmosphere
Mixed Goods with External Benefits Two of the dioxide and other chemicals pour into the atmos-
things that have the greatest impact on your welfare, phere. This consequence of consuming a private good
your education and health care, are mixed goods with creates an external cost and is a public bad. (A ‘bad’ is
external benefits. the opposite of a good.) No one can be excluded from
Think about a flu vaccination. It is excludable bearing the external cost and one person’s discomfort
because it would be possible to sell vaccinations and does not rival another’s. Electricity and transportation
exclude those not willing to pay from benefitting from are mixed goods with external costs.
them. A flu vaccination is also rival because providing Other private goods that generate external costs
one person with a vaccination means one fewer avail- include logging and the clearing of forests, which destroy
able for everyone else. A flu vaccination is a private the habitat of wildlife and influence the amount of
good, but it creates an externality. carbon dioxide in the atmosphere; smoking cigarettes
If you decide to get a flu vaccination, you benefit in a confined space, which imposes a health risk on
from a lower risk of getting infected in the coming flu others; and driving under the influence of alcohol, which
season. But if you avoid the flu, your neighbour who increases the risk of accident and injury for others.
did not get vaccinated has a better chance of avoiding
it too. A flu vaccination brings a benefit to others, so
Inefficiencies that Require Public Choices
it is a mixed good with an external benefit.
The external benefit of a flu vaccination is like a Public goods, mixed goods, common resources and
public good. It is non-excludable because everyone natural monopoly goods all create inefficiency prob-
with whom you come into contact benefits. You lems that require public choices. Public choices must
cannot selectively benefit only your friends! And it is be made to:
non-rival – protecting one person from the flu does ◆ Provide public goods and mixed goods
not diminish the protection for others. ◆ Conserve common resources
Your education is another example of a mixed ◆ Regulate natural monopoly
good with external benefits. If all education was
organised by private schools and universities, those Provide Public Goods and Mixed Goods Because
not willing or able to pay would be excluded, and one no one can be excluded from enjoying the benefits of
person’s place in class would rival another’s. So educa- a public good, no one has an incentive to pay for their
tion is a private good. share of it. Even people with a social conscience have
But your being educated brings benefits to no incentive to pay because one person’s enjoyment of
others. It brings benefits to your friends who enjoy a public good does not lower the enjoyment of others
your sharp, educated wit and it brings benefits to the – it is non-rival.
community in which you live because well-educated If private firms tried to produce and sell public
people with a strong sense of fellowship and respon- goods to consumers, they would not remain in busi-
sibility toward others make good neighbours. These ness for very long.
external benefits are like a public good. You cannot The market economy would fail to deliver the
selectively decide who benefits from your good neigh- efficient quantity of those goods. For example, there
bourliness and one person’s enjoyment of your good would be too little national defence, police services
behaviour does not rival someone else’s. So education and law enforcement, courts and judges, stormwater
is a mixed good with an external benefit. and sewage disposal services.
Mixed goods pose a less extreme problem. The
Mixed Goods with External Costs Mixed goods market economy would underprovide mixed goods
with external costs have become a huge political with external benefits because their producers and
issue in recent years. The main ones are electricity consumers do not take the external benefits into
and transportation (road, rail and air) produced by account when they make their own choices. The
burning hydrocarbon fuels – coal, oil and natural gas. market economy would overprovide mixed goods with
Electricity and transportation are excludable and external costs because their producers and consumers
rival – they are private goods. But when you use elec- do not take the external costs into account when they
tricity or travel by car, bus, train, or aeroplane, carbon make their own choices.
FIGURE 16.3 Benefits of a Public Good Marginal Social Cost of a Public Good
The marginal social cost of a public good is
(rand per aeroplane)
Marginal benefit
60
benefit equals marginal social cost.
40 Figure 16.4 shows the marginal social benefit
20
curve, MSB, and the marginal social cost curve, MSC,
MBD
for firefighting aeroplanes. (We will now think of
society as consisting of Thandi and David and the
0 1 2 3 4 5
Quantity (number of aeroplanes) other roughly 100 000 inhabitants of Knysna.)
(b) David's marginal benefit
140
Marginal benefit
Public Good
120
(millions of rand per aeroplane)
Marginal cost and marginal benefit
4.0
100
MSC
80 MSC = MSB
3.0
MSB > MSC
60
Thandi 2.5 MSC > MSB
40 2.0
David
20 MSB
MSB
1.0
0 1 2 3 4 5
Private Efficient
Quantity (number of aeroplanes)
underprovision quantity
(c) Economy’s marginal social benefit
0 1 2 3 4 5
Quantity (number of aeroplanes)
The marginal social benefit at each quantity of the public
good is the sum of the marginal benefits of all individuals. With fewer than 3 aeroplanes, marginal social benefit,
The marginal benefit curves are MBT for Thandi and MBD MSB, exceeds marginal social cost, MSC. With more than
for David. The economy’s marginal social benefit curve 3 aeroplanes, MSC exceeds MSB. Only with 3 aeroplanes is
is MSB. MSC equal to MSB and the number of aeroplanes is efficient.
If marginal social benefit exceeds marginal social overprovision of 1 aeroplane. The deadweight losses
cost, as it does with 2 aeroplanes, resources can be are equal and the election would be too close to call.
used more efficiently by increasing the number of Contemplating this outcome, the Fears realise that
aeroplanes. The extra benefit exceeds the extra cost. they are too fearful to get elected. They figure that, if they
If marginal social cost exceeds marginal social benefit, scale back to 3 aeroplanes, they will win the election if
as it does with 4 aeroplanes, resources can be used the Hopes stick with 2. The Hopes reason in a similar way
more efficiently by decreasing the number of aero- and figure that, if they increase the number of aeroplanes
planes. The cost saving exceeds the loss of benefit. to 3, they can win the election if the Fears propose 4.
If marginal social benefit equals marginal social So they both propose 3 aeroplanes. The voters are
cost, as it does with 3 aeroplanes, resources are indifferent between the parties, and each party receives
allocated efficiently. Resources cannot be used more 50 per cent of the vote. But regardless of which party
efficiently because to provide more than 3 aeroplanes wins the election, 3 aeroplanes are provided and this
increases cost by more than the extra benefit, and to quantity is efficient. Competition in the political place
provide fewer aeroplanes lowers the benefit by more results in the efficient provision of a public good.
than the cost saving.
4.0
quantity of firefighting aeroplanes? Most likely it could Hopes' Fears'
MSC
preference preference
not, because no one would have an incentive to buy his
or her share of the aeroplanes. Everyone would reason as
3.0
follows: The number of aeroplanes provided by SAFFA is
not affected by my decision to pay my share or not. But 2.5
my own private consumption will be greater if I free ride
and do not pay my share of the cost of the aeroplanes. If 2.0
3.0
Inefficient Public Overprovision Bureaucrats
know but voters
2.5 rationally do
If competition between two political parties is to deliver not know that
the efficient quantity of a public good, bureaucrats 2.0
MSC > MSB
must cooperate and help to achieve this outcome. But
bureaucrats might have a different idea and end up
MSB
frustrating rather than facilitating an efficient outcome.
1.0
Their actions might bring government failure.
Efficient Equilibrium
quantity overprovision
Objective of Bureaucrats Bureaucrats want to
maximise their department’s budget because a 0 1 2 3 4 5
Quantity (number of aeroplanes)
bigger budget brings greater status and more
power. So the South African Air Force’s (SAAF’s) Well-informed bureaucrats want to maximise their budget and
objective is to maximise the budget for firefighting rationally ignorant voters enable the bureaucrats to go some
aeroplanes. way toward achieving their goal. A public good might be
Figure 16.6 shows the outcome if the bureaucrats inefficiently overprovided with a deadweight loss.
are successful in the pursuit of their goal. They
might try to persuade the politicians that 3 aeroplanes
cost more than the originally budgeted amount; or
they might press their position more strongly and REVIEW QUIZ
argue for more than 3 aeroplanes. 1 What is the free-rider problem? Why do free
In Fig. 16.6, the SAAF persuades the politicians riders make the private provision of a public
to provide 4 aeroplanes. good inefficient?
Why do the politicians not block the bureau- 2 Under what conditions will competition
crats? Would overproviding aeroplanes not cost future among politicians for votes result in an effi-
votes? It will if voters are well informed and know cient provision of a public good?
what is best for them. But voters might not be well 3 How do rationally ignorant voters and budget-
informed, and well-informed interest groups might maximising bureaucrats prevent the political
enable the bureaucrats to achieve their objective and marketplace from delivering the efficient
overcome the objections of the politicians. quantity of a public good?
4 Explain why public choices might lead to the
Rational Ignorance A principle of the economic overprovision rather than the underprovision
analysis of public choices is that it is rational for a of a public good.
voter to be ignorant about an issue unless that issue
has a perceptible effect on the voter’s economic
welfare. Each voter knows that he or she can make You have seen how the political marketplace
virtually no difference to the fire protection policy provides public goods and why it might overpro-
of the local government of Knysna and that it would vide them. Your next task is to see how the political
take an enormous amount of time and effort to marketplace provides mixed goods that bring
become even moderately well informed about alter- external benefits.
native fire-protection technologies. Rationally unin-
formed voters enable bureaucrats and special interest
groups to overprovide public goods.
Providing Mixed Goods with External Figure 16.7 shows an example of the relationship
between marginal private benefit, marginal external
Benefits
benefit and marginal social benefit. The marginal
Most of the goods and services provided by govern- benefit curve, MB, describes the marginal private
ments are mixed goods, not public goods. Two of the benefit enjoyed by the people who receive a university
largest mixed goods with external benefits are educa- education. Marginal private benefit decreases as the
tion and health care. We are going to look at how number of students enrolled in university increases.
governments operate in such markets. In the example in Fig. 16.7, when 150 thousand
We are also going to look at possible improve- students enroll in university, the marginal external
ments on the current arrangements in these markets. benefit is R15 000 per student per year.
To keep our explanation clear, we will focus first The marginal social benefit curve, MSB, is the
on the market for university education. We will then sum of marginal private benefit and marginal external
apply the lessons we learn to the market for health care. benefit at each number of students. For example, when
We begin our study of the provision of mixed 150 thousand students a year enroll in university, the
goods by distinguishing between private benefits and marginal private benefit is R10 000 per student and the
social benefits. marginal external benefit is R15 000 per student, so the
marginal social benefit is R25 000 per student.
When people make education decisions, they
Private Benefits and Social Benefits ignore its external benefits and consider only its
A private benefit is a benefit that the consumer of a private benefits. So if education were provided by
good or service receives. For example, expanded job private universities that charged full-cost tuition, there
opportunities and a higher income are private benefits would be too few university graduates.
of a university education.
Marginal benefit is the benefit from an additional FIGURE 16.7 An External Benefit
unit of a good or service. So marginal private benefit
(MB) is the benefit that the consumer of a good or
Price (thousands of rand per student per year)
40
service receives from an additional unit of it. When
one additional student attends university, the benefit Marginal
that student receives is the marginal private benefit social
benefit
from university education. 30
Figure 16.8 illustrates this private underprovision. price and the taxpayer must somehow pay for the
The supply curve is the marginal social cost curve, costs not covered by what the student pays.
S = MSC. The demand curve is the marginal private Figure 16.9 illustrates an efficient outcome. With
benefit curve, D = MB. Market equilibrium occurs at marginal social cost curve MSC and marginal social
a tuition of R15 000 per student per year and benefit curve MSB, the efficient number of university
75 thousand students per year. At this equilibrium, the students is 150 thousand. The marginal private benefit
marginal social benefit of R38 000 per student exceeds curve MB, tells us that 150 thousand students will enroll
the marginal social cost by R23 000 per student. Too only if the tuition is R10 000 per year. But the marginal
few students are enrolled in university. The efficient social cost of 150 thousand students is R25 000 per year.
number is 150 thousand per year, where marginal To enable the marginal social cost to be paid, taxpayers
social benefit equals marginal social cost. The grey must pay the balance of R15 000 per student per year.
triangle shows the deadweight loss created.
To get closer to producing the efficient quantity
of a mixed good with an external benefit, we make FIGURE 16.9 An Efficient Outcome with an
public choices, through governments, to modify the External Benefit
MSC
FIGURE 16.8 Inefficiency with an External Benefit
30 MSB = MSC
Price and cost (thousands of rand per student per year)
40
Deadweight 25
38 loss Paid by
S = MSC taxpayer
Marginal 20
social
30 benefit
The education services produced by state universities reason is that there is another type of bureaucratic
and colleges and public schools are examples of public budget maximisation: budget padding and waste.
production. Bureaucrats often incur costs that exceed the
In the example in Fig. 16.9, efficient public minimum efficient cost. They might hire more
production occurs if public universities receive funds assistants than the number needed to do their work
from government equal to R15 000 per student per efficiently; give themselves sumptuous offices; get
year, charge tuition of R10 000 per student per year, generous expense allowances; build schools in the
and enrol 150 thousand students. wrong places where land costs are too high.
Private Subsidies A subsidy is a payment that the Problems with Private Subsidies Subsidising
government makes to private producers. By making private producers might overcome some of the prob-
the subsidy depend on the level of output, the govern- lems created by public production. A private producer
ment can induce private decision makers to consider has an incentive to produce at minimum cost and
external benefits when they make their choices. avoid the budget padding of a bureaucratic producer.
In the example in Fig. 16.9, efficient private But two problems arise with private subsidies.
provision would occur if private universities First, the subsidy budget must be allocated
received a government subsidy of R15 000 per by a bureau. A national, or provincial, department
student per year. This subsidy reduces the universities’ of education must lobby for its own budget and
costs and would make their marginal cost equal allocate this budget between school subsidies and
to R10 000 per student at the efficient quantity. its own administration costs. To the extent that
Tuition of R10 000 would cover this cost, and the the bureaucrats succeed in maximising their own
subsidy of R15 000 per student would cover the adminstration budget, they siphon off resources
balance of the cost. from schools and a problem similar to that of public
production arises.
Second, it is in the self-interest of subsidised
Bureaucratic Inefficiency and Government producers to maximise their subsidy. These producers
Failure might even spend some of the subsidy they receive
You have seen two government actions that achieve an effi- lobbying for an even bigger one.
cient provision of a mixed good with an external benefit. So neither public production nor subsidised
In each case, if the government estimates the marginal private provision are likely to achieve an efficient allo-
external benefit correctly and makes marginal social benefit cation of resources in the face of external benefits.
equal to marginal social cost, the outcome is efficient.
Does the comparison that we have just made
Health-Care Services
mean that public provision and subsidised private
provision are equivalent? It does not. And the reason Health care is another example of a mixed good with
lies in something that you have already encountered external benefits. The external benefits from health
in your study of public goods earlier in this chapter – care include avoiding infectious diseases, living and
the behaviour of bureaucrats combined with rational working with healthy neighbours, and for many
ignorance that leads to government failure. people, just living in a society in which poor, sick
people have access to affordable health care.
The Problem with Public Production Public univer- An additional problem arises in the case of health
sities (and schools) are operated by a bureaucracy and care: People with the biggest health problems are
are subject to the same problems as the provision of the elderly and the poor, who are least able to afford
public goods. If bureaucrats seek to maximise their health care.
budgets, the outcome might be inefficient. Because of its special features, no country just
But overprovision of universities (and schools) leaves the delivery of health care to the private market
does not seem to be a problem. Just the opposite: economy. In almost all countries, health care is
People complain about underprovision – about inad- provided at a zero price, or very low price, and doctors
equate public universities and schools. The probable and other health-care professionals and the hospitals
South Africa’s ruling African National Congress (ANC) wants to start implementing National Health
Insurance, which aims to provide South Africans with affordable universal health coverage, from 2012.
The programme is expected to cost R128-billion in its first year, increasing to R376-billion by 2025.
‘Implementation will be phased in over 14 years and rolled out for start in 2012 in the seriously under-
served areas where people have difficulty accessing health care’, the ANC’s health sub-committee chairman,
Zweli Mkhize, said at the ruling party’s national general council in Durban on Tuesday.
‘Membership to the NHI would be compulsory for the whole population, but the public can choose
whether to continue with voluntary medical scheme cover’, Mkhize said, reading from proposals that will be
discussed at the ANC’s national general council.
‘The main source of revenue for the NHI fund will be allocations from general taxation’, Mkhize said.
All of this will be combined in the NHI fund from which all services covered by the NHI system will be funded.
Olive Shisana, chairwoman of the Parliamentary Portfolio Committee on Health, said private hospi-
tals could choose to remain private if they wanted to.
She said, however, they would forfeit the right to be funded from the state.
Hospitals to be NHI-accredited
‘If a private hospital is not accredited to become part of the NHI, it will not get funded from the
NHI’, she said. ‘All hospitals must get accredited for quality and affordable services’.
The aim is to have 25 per cent of hospitals NHI-accredited by the start of the implementation phase in 2012.
The Department of Health had started a project to look at an audit of all health facilities in the
country to understand the physical infrastructure and equipment needs.
Mkhize said the government would aim to train extra health-care workers and look externally for
more specialists. ‘The South African health system requires more doctors and nurses’, Mkhize said.
MSB
30 MSC 30 Over MSC
expenditure
25 25
MSB = MSC
20 20
Deadweight
loss
15 15
10 Quantity 10 Quantity
demanded demanded
at zero price Expenditure at zero price
5 Efficient 5 on efficient
quantity quantity
MB MB
0 10 20 30 40 0 10 20 30 40
Quantity (millions of patients per year) Quantity (millions of patients per year)
Figure
Figure11Overprovision
Overprovisionofoffree health and
Medicare care Medicaid Figure
Figure22Uncontrolled
Uncontrolledexpenditure
expenditureononfree health care
Medicare
and Medicaid
Key Terms
Common resource, 344 Marginal private benefit, Non-excludable, 344 Public choice, 342
Excludable, 344 350 Non-rival, 344 Public good, 344
Externality, 344 Marginal social benefit, 350 Political equilibrium, 343 Public production, 351
Free-rider problem, 346 Mixed good, 344 Postive externality, 344 Rival, 344
Government failure, 342 Natural monopoly good, Principle of minimum Subsidy, 352
Marginal external benefit, 344 differentiation, 348
350 Negative externality, 344 Private good, 344
Use the following figure to work out 13. What quantity of spraying would a private
Problems 10 to 12. mosquito control programme provide? What is
the efficient quantity of spraying? In a single-issue
The figure provides information about a waste election on the quantity of spraying, what quan-
disposal system that a city of 1 million people is tity would the winner of the election provide?
considering installing. 14. If the government sets up a Department of
Mosquito Control and appoints a bureaucrat to
run it, would mosquito spraying most likely be
(rand per person)
Marginal social benefit and marginal social cost
MSC
100 underprovided, overprovided or provided at the
efficient quantity?
80
W
17
e burn huge quantities of fossil fuels – coal, natural gas and
oil – that cause acid rain and global warming. We dump toxic
waste into rivers, dams and oceans. These environmental issues are
simultaneously everybody’s problem and nobody’s problem. How can
we take account of the damage that we cause others every time we turn
on our heating or air-conditioning systems?
More and more people with ever-increasing
THE ENVIRONMENT more and more of is fish grown wild in the ocean.
The fish stocks of the world’s oceans are not owned
by anyone. They are common resources and
everyone is free to use them. But we are overusing our fish stocks and
bringing some species to extinction. Must the price of fish inevitably
keep rising? What can be done to conserve the world’s fish stocks?
In this chapter, we study the problems that arise because many of
our actions impose costs on other people in ways that we do not take
into account when we make our own economic choices. We focus
on two big issues – air pollution and overfishing. In Reading Between
the Lines at the end of the chapter, we look at the effects of measuring
emissions in South Africa, and a proposed pollution tax.
Sources of Pollution alcohol, natural gas, propane and butane and hydrogen.
Economic activity pollutes air, water and land, and Another way of making cars and trucks ‘greener’ is to
these individual areas of pollution interact through change the chemistry of fuel. Refiners, such as Sasol, are
the ecosystem. The three biggest sources of pollution working on reformulations of fuel that reduce exhaust
are road transportation, electricity generation and emissions. Similarly, electricity can be generated in
industrial processes. cleaner ways by harnessing wind power, solar power,
tidal power or geo-thermal power. While technically
Air Pollution Sixty per cent of air pollution comes possible, these methods are more costly than conven-
from road transportation and industrial processes. Only tional carbon-fuelled generators. Another alternative is
16 per cent arises from electric power generation. nuclear power. This method is good for air pollution but
In many developing countries, air pollution is creates a potential long-term problem for land and water
getting worse. But air pollution in the United States, pollution because there is no known entirely safe method
for example, is getting less severe. of disposing of spent nuclear fuel. 2011’s earthquake and
While the facts about the sources and trends in air tsunami disaster in Japan, which caused major damage
pollution are not in doubt, there is disagreement about to a number of nuclear power plants, most notably the
the effects of air pollution. The least controversial is acid Fukushima I plant, was a stark reminder of the dangers
rain caused by sulphur dioxide and nitrogen oxide emis- of pollution from nuclear power plants.
sions from coal and oil-fired generators of electricity
power stations. Acid rain begins with air pollution, and it Water Pollution The largest sources of water pollu-
leads to water pollution and damages vegetation. tion are the dumping of industrial waste and treated
More controversial are airborne substances sewage in dams and rivers and the runoff from
(suspended particulates) such as lead from leaded fertilisers. A more dramatic source is the accidental
petrol. Some scientists believe that in sufficiently large spilling of crude oil into the oceans such as the
concentrations, these substances (189 of which have Treasure spill near Cape Town in 2000.
currently been identified) cause cancer and other life- There are two main alternatives to polluting the
threatening conditions. waterways and oceans. One is the chemical processing
Even more controversial is global warming, which of waste to render it inert or biodegradable. The other,
some scientists believe results from carbon dioxide emis- in wide use for nuclear waste, is to use land sites for
sions. The earth’s average temperature has increased over storage in secure containers.
the past 100 years, but most of the increase occurred
before 1940. Determining what causes changes in the Land Pollution Land pollution arises from dumping
earth’s temperature and isolating the effect of carbon toxic waste products. Ordinary household garbage does
dioxide from other factors are proving to be difficult. not pose a pollution problem unless contaminants from
Equally controversial is the problem of ozone layer dumped garbage seep into the water supply. This possibility
depletion. There is no doubt that a hole in the ozone increases as landfills reach capacity and less suitable landfill
layer exists over Antarctica and that the ozone layer sites are used. It is estimated that 80 per cent of existing
protects us from cancer-causing ultraviolet rays from landfills were full by 2010. Some regions and countries are
the sun. But how our industrial activity influences the seeking less costly alternatives to landfill, such as recycling
ozone layer is simply not understood at this time. and incineration. Recycling is an apparently attractive
One air pollution problem has almost been elimi- alternative, but it requires an investment in new technolo-
nated: lead from petrol. In part, this happened because gies to be effective. Incineration is a high-cost alternative
the cost of living without leaded petrol, it turns out, is to landfill, and it produces air pollution. Furthermore,
not high. But sulphur dioxide and the so-called green- these alternatives are not free, and they become efficient
house gases are a much tougher problem to tackle. Their only when the cost of using landfill is high.
alternatives are costly or have pollution problems of their The effects of pollution mean that production
own. The major sources of these pollutants are road and consumption decisions impose costs that are not
vehicles and electricity power stations. Road vehicles taken fully into account when decisions are made.
can be made ‘greener’ in a variety of ways. One is with You are now going to see how economists analyse
new fuels, and some alternatives being investigated are these decisions and solve the pollution problem.
Private Cost and Social Cost of Pollution The marginal social cost curve, MSC, is found
To study the economics of the external costs that arise by adding the marginal external cost to the marginal
from pollution, we distinguish between the private private cost. So a point on the MSC curve shows the
cost and the social cost of production. sum of the marginal private cost of producing a given
A private cost of production is a cost that is borne output and marginal external cost created.
by the producer of a good or service. Marginal cost is For example, when the chemical industry
the cost of producing an additional unit of a good or produces 4 000 tonnes of chemical a month, its
service. So marginal private cost (MC ) is the cost of marginal private cost is R1 000 a tonne and the
producing an additional unit of a good or service that marginal external cost is R1 250 a tonne, so the
is borne by its producer. marginal social cost is R2 250 a tonne.
An external cost is a cost of producing a good or In Fig. 17.1, when the quantity of chemical
service that is not borne by the producer but borne by produced increases, the amount of pollution increases
other people. A marginal external cost is the cost of and the external cost of pollution increases.
producing an additional unit of a good or service that Figure 17.1 shows the relationship between the
falls on people other than the producer. quantity of chemical produced and the cost of the
Marginal social cost (MSC ) is the marginal cost pollution it creates, but it does not tell us how much
incurred by the producer and by everyone else on whom pollution the chemical industry creates. That quantity
the cost falls – by society. It is the sum of marginal depends on the quantity of the chemical produced,
private cost and marginal external cost. That is, which depends on supply and demand in the market
for the chemical. We now look at that market.
MSC = MC + Marginal external cost
FIGURE 17.1 An External Cost
We express costs in rand, but we must always
remember that a cost is an opportunity cost – some-
Cost (rand per tonne)
3 000
thing real, such as clean air or a clean river, is given up
MSC
to get something. Marginal
social cost
detectable difference between the two rivers and the two 750
locations, the rent decrease of R10 000 per month is the Marginal
private cost
cost of the pollution. With 500 homes on the polluted
river, the external cost of pollution is R5 million a month.
0 2 4 6
Quantity (thousands of tonnes of chemical per month)
External Cost and Output Figure 17.1 shows an
example of the relationship between output and cost in a The MC curve shows the marginal private cost borne by
chemical industry that pollutes. The marginal cost curve, the factories that produce a chemical. The MSC curve
MC, describes the marginal private cost borne by the shows the sum of marginal private cost and marginal
firms that produce the chemical. Marginal cost increases external cost. When output is 4 000 tonnes of chemical a
as the quantity of chemical produced increases. month, marginal private cost is R1 000 a tonne, marginal
If the firms dump waste into a river, they impose external cost is R1 250 a tonne and marginal social cost is
an external cost on other users of the river. We will R2 250 a tonne.
assume that the marginal external cost increases with
the amount of the chemical produced.
Production and Pollution: How Much? the allocation is efficient when marginal social benefit
When an industry is unregulated and free to pollute, equals marginal social cost. This outcome occurs when
the amount of pollution it creates depends on the the quantity of chemical produced is 2 000 tonnes
market equilibrium price and quantity of the good a month. The unregulated market overproduces by
produced. In Figure 17.2, the demand curve for a 2 000 tonnes of chemical a month and creates a dead-
pollution-creating chemical is D. This curve also weight loss shown by the grey triangle.
measures the marginal social benefit, MSB, from the How can the people who live by the polluted river
chemical. The supply curve of the chemical is S. This get the chemical factories to decrease their output of
curve also measures the producers’ marginal private chemical and create less pollution? If some method can
cost, MC. The supply curve is the marginal private cost be found to achieve this outcome, everyone – the owners
curve because when firms make their production and of the chemical factories and the residents of the riverside
supply decisions, they consider only the costs that they homes – can gain. Let us explore some solutions.
will bear. Market equilibrium occurs at a price of
R1 000 a tonne and 4 000 tonnes of chemical a month.
This equilibrium is inefficient. You learned in
Property Rights
Chapter 5 that the allocation of resources is efficient Sometimes it is possible to reduce the
when marginal social benefit equals marginal social inefficiency arising from an external Property
cost. But we must count all the costs – private and cost by establishing a property right
external – when we compare marginal social benefit where one does not currently exist.
and marginal social cost. So with an external cost, Property rights are legally established
titles to the ownership, use and
FIGURE 17.2 Inefficiency with an External Cost disposal of factors of production and
goods and services that are enforce-
Price and cost (rand per tonne)
3 000 Marginal
able in the courts.
social
MSC Suppose that the chemical facto- www.quickto.mobi/
cost
ries own the river and the 500 homes PEA-PROPERTY
alongside it. The rent that people
2 250
Efficient
are willing to pay depends on the
Deadweight
Marginal equilibrium loss amount of pollution. Using the earlier
social example, people are willing to pay R25 000 a month to
benefit Inefficient
1 500 market live alongside a pollution-free river but only R15 000
equilibrium a month to live with the pollution created by 4 000
S = MC tonnes of chemical a month. If the factories produce this
1 000
quantity, they lose R10 000 a month for each home for
750 a total of R5 million a month. The chemical factories
D = MSB
Efficient are now confronted with the cost of their pollution –
quantity
forgone rent from the people who live by the river.
Figure 17.3 illustrates the outcome by using the same
0 2 4 6
Quantity (thousands of tonnes of chemical per month)
example as in Fig. 17.2. With property rights in place, the
MC curve no longer measures all the costs that the facto-
The market supply curve is the factories’ marginal private cost ries face in producing the chemical. It excludes the pollu-
curve, S = MC. The market demand curve is the marginal tion costs that they must now bear. The MSC curve now
social benefit curve, D = MSB. The market equilibrium occurs becomes the factories’ marginal private cost curve MC.
at a price of R1 000 a tonne and 4 000 tonnes of chemical The factories bear all the costs, so the market supply curve
a month. This market outcome is inefficient because marginal based on all the costs is the curve labelled S = MC = MSC.
social cost exceeds marginal social benefit. The efficient Market equilibrium now occurs at a price of
quantity of chemical is 2 000 tonnes a month. The grey R1 500 a tonne and 2 000 tonnes of chemical a month.
triangle shows the deadweight loss created by the pollution. This outcome is efficient. The factories still produce
some pollution, but it is the efficient quantity.
FIGURE 17.3 Property Rights Achieve an own their homes and the river. Now the factories
Efficient Outcome must pay a fee to the homeowners for the right
to dump their waste. The greater the quantity of
waste dumped into the river, the more the factories
Price and cost (rand per tonne)
Government Actions in a Market with Assume that the government has assessed the
External Costs marginal external cost accurately and imposes a tax on
The three main methods that governments use to cope the factories that exactly equals this cost. Figure 17.4
with external costs are: illustrates the effects of the tax.
◆ Taxes The demand curve and marginal social benefit curve,
◆ Emission charges D = MSB, and the firms’ marginal cost curve, MC, are
◆ Cap-and-trade the same as in Fig. 17.2. The pollution tax equals the
marginal external cost of the pollution. We add this tax to
Taxes The government can use taxes as an incentive the marginal private cost to find the market supply curve.
for producers to cut back the pollution they create. This curve is the one labelled S = MC + tax = MSC.
Taxes used in this way are called Pigovian taxes, in The curve is the market supply curve because it tells us the
honour of Arthur Cecil Pigou, the British economist quantity supplied at each price given the firms’ marginal
who first worked out this method of dealing with cost and the tax they must pay. This curve is also the
external costs during the 1920s. marginal social cost curve because the pollution tax has
By setting the tax equal to the marginal external been set equal to the marginal external cost.
cost, firms can be made to behave in the same way Demand and supply now determine the market
as they would if they bore the cost of the externality equilibrium price at R1 500 a tonne and a quantity
directly. To see how government actions can change the of 2 000 tonnes of chemical a month. At this quantity
outcome in a market with external costs, let us return of chemical production, the marginal social cost is
to the example of the chemical factories and the river. R1 500 and the marginal social benefit is R1 500,
so the outcome is efficient. The firms incur a marginal
FIGURE 17.4 A Pollution Tax to Achieve an private cost of R880 a tonne and pay a tax of
Efficient Outcome R620 a tonne. The government collects tax revenue
of R1.24 million a month.
Price and cost (rand per tonne)
3 000
Marginal social S = MC + tax = MSC Emission Charges Emission charges are an alterna-
cost and marginal
social benefit tive to a tax for confronting a polluter with the external
cost of pollution. The government sets a price per unit of
2 250 Efficient
market pollution. The more pollution a firm creates, the more
equilibrium it pays in emission charges. This method of dealing with
Pollution pollution externalities has been used only modestly in
tax
1 500 the United States but is common in Europe where, for
example, France, Germany and the Netherlands make
MC water polluters pay a waste disposal charge.
880 To work out the emission charge that achieves
750
D = MSB efficiency, the government needs information about the
Tax
revenue polluting industry that, in practice, is rarely available.
0 2
Cap-and-Trade Instead of taxing or imposing emis-
4 6
Quantity (thousands of tonnes of chemical per month) sion charges on polluters, each potential polluter might
be assigned a permitted pollution limit. Each firm
When the government imposes a pollution tax equal to the
knows its own costs and its benefits from pollution,
marginal external cost of pollution, the supply curve becomes
and making pollution limits marketable is a clever
the marginal private cost curve, MC, plus the tax – the curve
way of using this private information that is unknown
S = MC + tax. Market equilibrium occurs at a price of
to the government. The government issues each
R1 500 a tonne and a quantity of 2 000 tonnes of chemical
firm a permit to emit a certain amount of pollution,
a month. This equilibrium is efficient because marginal social
and firms can trade these permits. Firms that have
cost equals marginal social benefit. The purple rectangle
a low marginal cost of reducing pollution sell their
shows the government’s tax revenue.
permits, and firms that have a high marginal cost of
reducing pollution buy permits. The market in permits
determines the price at which firms trade permits. Trading in lead pollution permits became
Each firm buys or sells permits until its marginal cost common during the 1980s in the United States,
of pollution equals the market price of a permit. and this marketable permit programme enabled lead
This method of dealing with pollution provides pollution to be virtually eliminated in the United
an even stronger incentive than emission charges States. But this success might not easily translate to
to find lower-polluting technologies because the other pollutants because most lead pollution came
price of a pollution permit rises as the demand for from petrol, which was easy to monitor. In South
permits increases. Africa, the use of leaded petrol was abolished in 2006.
REVIEW QUIZ
1 What is the distinction between private cost and 4 How do taxes help us to cope with external costs?
social cost? At what level must a pollution tax be set to be
2 How do external costs prevent a competitive efficient?
market from allocating resources efficiently? 5 How do emission charges and marketable pollu-
3 How can external costs be eliminated by tion permits work?
assigning property rights?
Your next task is to study common resources and If the stock of fish is small, the quantity of new
the government actions that can bring efficient use. fish born is also small, so the sustainable catch is small.
Maximum
the North Atlantic Ocean during the recent past 300
Overfishing
sustainable
catch
are tragedies of the commons. The tragedy of the depletes
stock
commons is the overuse of a common resource that 250
arises when its users have no incentive to conserve it
and use it sustainably. 200
To study the tragedy of the commons and its
possible remedies, we will focus on a recent and 150
current tragedy – overfishing and depleting the stock
of kabeljou (cob). This is one of the collapsed stock 100
species in South Africa, with less than 2% of the
breeding population still alive. We begin by thinking
50
about the sustainable use of a renewable resource.
0 3 000 6 000
Sustainable Use of a Renewable Resource Kabeljou stock (thousands of tonnes)
Economics in Action
Because the commons were overgrazed, the number
The Original Tragedy of the Commons of cows and sheep that could be fed kept falling, the
The term ‘tragedy of the commons’ comes from longer the overgrazing continued.
fourteenth-century England, where areas of rough During the sixteenth century, the price of wool
grassland surrounded villages. The commons were increased and England became a wool exporter to the
open to all and used for grazing cows and sheep world. Sheep farming became profitable and sheep
owned by the villagers. owners wanted to gain more effective control of the
Because the commons were open to all, no one land they used. So the commons were gradually priva-
had an incentive to ensure that the land was not over- tised and enclosed. Overgrazing ended and land use
grazed. The result was a severe overgrazing situation. became more efficient.
If the fish stock is large, many fish are born, but Marginal Private Cost You can think of the marginal
they must compete with each other for food so only a private cost of catching fish as the additional cost incurred
small number survive to reproduce and to grow large by keeping a boat and crew at sea for long enough to
enough to catch. increase the catch by one tonne. Keeping a fishing boat
Between a small and a large stock is a quantity at sea for an additional amount of time eventually runs
of fish stock that maximises the sustainable catch. into diminishing marginal returns (see p. 237). As the
In Fig. 17.5, this fish stock is 3 000 thousand tonnes crew becomes tired, the storage facilities get overfull, and
and the sustainable catch is 300 thousand tonnes a the boat’s speed is cut to conserve fuel, the catch per hour
year. The maximum sustainable catch arises from a decreases. The cost of keeping the boat at sea for an addi-
balancing of the birth of new fish from the stock and tional hour is constant so the marginal cost of catching
the availability of food to sustain the fish population. fish increases as the quantity caught increases.
If the quantity of fish caught is less than the You have just seen that the principle of increasing
sustainable catch, the fish stock grows; if the quantity marginal cost applies to catching fish just as it applies
caught exceeds the sustainable catch, the fish stock to other production activities: Marginal private cost
shrinks; and if the quantity caught equals the sustain- increases as the quantity of fish caught increases.
able catch, the fish stock remains constant and is The marginal private cost of catching fish deter-
available for future generations of fishers in the same mines an individual fisher’s supply of fish. A profit
quantity that is available today. maximising fisher is willing to supply the quantity
If the fish stock exceeds the level that maximises at which the market price of fish covers the marginal
the sustainable catch, overfishing is not a problem. private cost. And the market supply is the sum of the
But if the fish stock is less than the level that maxi- quantities supplied by each individual fisher.
mises the sustainable catch, overfishing depletes
the stock. Marginal External Cost The marginal external cost
of catching fish is the cost per additional tonne that
one fisher’s production imposes on all other fishers.
The Overuse of a Common Resource This additional cost arises because one fisher’s catch
Why might a fish stock be overused? Why might decreases the remaining stock, which in turn decreases
overfishing occur? The answer is that fishers face only the renewal rate of the stock and makes it harder for
their own private cost and do not face the cost they others to find and catch fish.
impose on others – external cost. The social cost of Marginal external cost also increases as the quantity
fishing combines the private cost and external cost. of fish caught increases. If the quantity of fish caught is
Let us examine the costs of catching fish to see how so large that it drives the species to near extinction, the
the presence of external cost brings overfishing. marginal external cost becomes infinitely large.
Marginal Social Cost The marginal social cost of Overfishing Equilibrium Figure 17.6 illustrates
catching fish is the marginal private cost plus the overfishing and how it arises. The market demand
marginal external cost. Because both of its compo- curve for fish is the marginal social benefit curve,
nents increase as the quantity caught increases, MSB. The market supply curve is the marginal private
marginal social cost also increases with the quantity cost curve, MC. Market equilibrium occurs at the
of fish caught. intersection point of these two curves. The equilib-
rium quantity is 800 thousand tonnes per year and
Marginal Social Benefit and Demand The the equilibrium price is R100 per kg.
marginal social benefit from fish is the price that At this market equilibrium, overfishing is
consumers are willing to pay for an additional kilo- running down the fish stock. Figure 17.6 illustrates
gram of fish. Marginal social benefit decreases as the why overfishing occurs. At the market equilibrium
quantity of fish consumed increases, so the demand quantity, marginal social benefit (and willingness
curve, which is also the marginal social benefit curve, to pay) is R100 per kg, but the marginal social cost
slopes downward. exceeds this amount. The marginal external cost is the
cost of running down the fish stock.
500 MSC
The demand curve is the marginal social benefit curve MSB.
Market equilibrium occurs at a quantity of 800 thousand
400 tonnes and a price of R100 per kg.
370 The marginal social cost curve is MSC and at the market
equilibrium there is overfishing – marginal social cost exceeds
300
Efficient Deadweight loss marginal social benefit.
equilibrium from overfishing The quantity at which MSC equals MSB is the efficient
200 quantity, 300 thousand tonnes per year. The grey triangle
MC shows the deadweight loss from overfishing.
150
Overfishing
100
equilibrium
MSB
0 300 800 1 200 1 600
Quantity (thousands of tonnes per year)
Efficient Equilibrium What is the efficient use of a in Fig. 17.6 illustrates this loss. It is the marginal
common resource? It is the use of the resource that social cost minus the marginal social benefit from all
makes the marginal social benefit from the resource the fish caught in excess of the efficient quantity.
equal to the marginal social cost of using it.
In Fig. 17.6, the efficient quantity of fish is
Achieving an Efficient Outcome
300 thousand tonnes per year – the quantity that
makes marginal social cost (on the MSC curve) equal Defining the conditions under which a common
to marginal social benefit (on the MSB curve). At this resource is used efficiently is easier than delivering
quantity, the marginal catch of each individual fisher those conditions. To use a common resource effi-
costs society what people are willing to pay for it. ciently, it is necessary to design an incentive mecha-
nism that confronts the users of the resource with
Deadweight Loss from Overfishing Deadweight the marginal social consequences of their actions. The
loss measures the cost of overfishing. The grey triangle same principles apply to common resources as those
that you met earlier in this chapter when you studied was previously a common resource, its owner faces the
the external cost of pollution. same conditions as society faces. It does not matter
The three main methods that might be used to who owns the resource.
achieve the efficient use of a common resource are: The users of the resource will be confronted with
◆ Property rights the full cost of using it because they either own it or
◆ Production quotas pay a fee to the owner for permission to use it.
◆ Individual transferable quotas (ITQs) When private property rights over a resource are
established and enforced, the MSC curve becomes
Property Rights A common resource that no one the marginal private cost curve, and the use of the
owns and that anyone is free to use contrasts with resource is efficient.
private property, which is a resource that someone owns Figure 17.7 illustrates an efficient outcome with
and has an incentive to use in the way that maximises property rights. The supply curve S = MC = MSC and the
its value. One way of overcoming the tragedy of the demand curve D = MSB determine the equilibrium price
commons is to convert a common resource to private and quantity. The price equals both marginal social benefit
property. By assigning private property rights to what and marginal social cost and the quantity is efficient.
250 S = MC = MSC
Property rights over
stock for permission to fish and face the full social cost of their
fish make all costs actions. The marginal cost curve includes the external cost,
private costs
200
so the supply curve is the marginal private cost curve and the
marginal social cost curve, S = MC = MSC.
MC excluding Market equilibrium occurs at R150 per kg and at that
150 cost of price, the quantity is 300 thousand tonnes per year. At this
overfishing
quantity, marginal social cost equals marginal social benefit,
and the quantity of fish caught is efficient.
100
DMSB The property rights convert the fish stock from a common
resource to a private resource and it is used efficiently.
50
Efficient
quantity
The private property solution to the tragedy of private property rights to the oceans. It would not
the commons is available in some cases. It was the be impossible, but the cost of enforcing private prop-
solution to the original tragedy of the commons in erty rights over thousands of square kilometres
England’s Middle Ages. It is also a solution that has of ocean would be high. It would be even more diffi-
been used to prevent overuse of the airwaves that cult to assign and protect private property rights to
carry cellphone services. The right to use this space the atmosphere.
(called the frequency spectrum) has been auctioned In some cases, there is an emotional objection
by governments to the highest bidders. The owner of to assigning private property rights. Critics of it have
each part of the spectrum is the only one permitted to a moral objection to someone owning a resource
use it (or to licence someone else to use it). that they regard as public. In the absence of property
But assigning private property rights is not always rights, some form of government intervention is used,
feasible. It would be difficult, for example, to assign one of which is a production quota.
Production Quota A production quota is an upper Figure 17.8 shows a quota that achieves an effi-
limit to the quantity of a good that may be produced cient outcome. The quota limits the catch (produc-
in a specified period. The quota is allocated to indi- tion) to 300 thousand tonnes, the efficient quantity at
vidual producers, so each producer has its own quota. which marginal social benefit, MSB, equals marginal
You studied the effects of a production quota in social cost, MSC. If everyone sticks to their own
Chapter 6 (pp. 132–135) and learned that a quota quota, the outcome is efficient. But implementing a
can drive a wedge between marginal social benefit and production quota has two problems.
marginal social cost and create deadweight loss. In First, it is in every fisher’s self-interest to catch
that earlier example, the market was efficient without more fish than the quantity permitted under the
a quota. But in the case of common resources, the quota. The reason is that price exceeds marginal
market overuses the resource and produces an inef- private cost, so by catching more fish, a fisher gets
ficient quantity. A production quota in this market a higher income. If enough fishers break the quota,
brings a move toward a more efficient outcome. overfishing and the tragedy of the commons remain.
250 MSC
Production this quantity, raises the price to R150 per kg, and lowers
quota
marginal cost to R50 per kg. A fisher who cheats and
200
produces more than the allotted quota increases his profit by
R100 per kg. If all (or most) fishers cheat, production exceeds
Efficient the quota and there is a return to overfishing.
150 equilibrium
Profit on MC
100 marginal
catch ... DMSB
50 ... is incentive
to over fish
Second, marginal cost is not, in general, the same Individual Transferable Quotas Where producers
for all producers – as we are assuming here. Efficiency are difficult to monitor or where marginal cost varies
requires that the quota be allocated to the producers across producers, a more sophisticated quota system
with the lowest marginal cost. But bureaucrats who can be effective. It is an individual transferable quota
allocate quotas do not have information about the (ITQ), which is a production limit that is assigned to an
marginal cost of individual producers. Even if they individual who is then free to transfer (sell) the quota
tried to get this information, producers would have to someone else. A market in ITQs emerges and ITQs
an incentive to lie about their costs so as to get a are traded at their market price.
bigger quota. The market price of an ITQ is the highest price that
So where producers are difficult or very costly someone is willing to pay for one. That price is marginal
to monitor or where marginal cost varies across social benefit minus marginal cost. The price of an ITQ
producers, a production quota cannot achieve an will rise to this level because fishers who do not have a
efficient outcome. quota would be willing to pay this amount to get one.
250 MSC = MC + price of ITQ The external benefit from a good or service is
the benefit that someone other than the consumer
receives. A marginal external benefit is the benefit from
200
an additional unit of a good or service that people
Efficient
other than the consumer enjoy.
150 equilibrium Marginal social benefit (MSB) is the marginal
benefit enjoyed by society – by the consumer of a
MC good or service (marginal private benefit) plus the
Price of ITQ
100 marginal benefit enjoyed by others (the marginal
DMSB
external benefit). That is:
50
MSB = MB + Marginal external benefit
0
Figure 17.10 shows an example of the relation-
300 600 800 900
Quantity (thousands of tonnes per year) ship between marginal private benefit, marginal
external benefit, and marginal social benefit. The
ITQs are issued on a scale that keeps output at the efficient marginal benefit curve, MB, describes the marginal
level. The market price of an ITQ equals the marginal social private benefit – such as expanded job opportunities
benefit minus marginal cost. Because each user of the and higher incomes – enjoyed by university graduates.
common resource faces the opportunity cost of using the Marginal private benefit decreases as the quantity of
resource, self-interest achieves the social interest. education increases.
FIGURE 17.10 An External Benefit Figure 17.11 illustrates the underproduction if the
government left education to the private market. The
supply curve is the marginal social cost curve, S = MSC.
Price (thousands of rand per student per year)
40
The demand curve is the marginal private benefit curve,
D = MB. Market equilibrium occurs at a tuition of
Marginal
social
R15 000 per student per year and 750 000 students
30
benefit per year. At this equilibrium, marginal social benefit
25
is R38 000 per student, which exceeds marginal social
cost by R23 000. There are too few students in univer-
Marginal
20 external sity. The efficient number is 1.5 million per year, where
benefit marginal social benefit equals marginal social cost. The
grey triangle shows the deadweight loss.
MSB
Underproduction similar to that in Fig. 17.11
10
Marginal
would occur in primary school and high school if an
private MB unregulated market produced it. When children learn
benefit basic reading, writing and number skills, they receive
0 0.5 1.0 1.5 2.0 2.5
the private benefit of increased earning power. But
Quantity (millions of students per year) even these basic skills bring the external benefit of
developing better citizens.
The MB curve shows the marginal private benefit enjoyed
by the people who receive a university education. The MSB
FIGURE 17.11 Inefficiency with an
curve shows the sum of marginal private benefit and marginal
External Benefit
external benefit. When 1.5 million students attend university,
marginal private benefit is R10 000 per student, marginal
Price and cost
(thousands of rand per student per year)
40
external benefit is R15 000 per student and marginal social
38
benefit is R25 000 per student. Deadweight S = MSC
loss
Marginal
30 social
benefit
But university graduates generate external bene- 25 Efficient
fits. On the average, they tend to be better citizens. equilibrium
Their crime rates are lower and they are more tolerant 20
of the views of others. A society with a large number
15
of university graduates can support activities such
MSB
as high-quality newspapers and television channels, 10
music, theatre and other organised social activities. Inefficient
market
In the example in Fig. 17.10, the marginal external Marginal
equilibrium Efficient
social cost D = MB
benefit is R15 000 per student per year when 1.5 million quantity
students enrol in university. The marginal social benefit 0 0.5 0.75 1.0 1.5 2.0 2.5
curve, MSB, is the sum of marginal private benefit Quantity (millions of students per year)
and marginal external benefit. For example, when
1.5 million students a year enrol in university, the The market demand curve is the marginal private benefit
marginal private benefit is R10 000 per student and curve, D = MB. The supply curve is the marginal social
the marginal external benefit is R15 000 per student, cost curve, S = MSC. Market equilibrium at a tuition of
so the marginal social benefit is R25 000 per student. R15 000 a year and 750 000 students is inefficient because
When people make education decisions, they marginal social benefit exceeds marginal social cost.
ignore its external benefits and consider only its The efficient quantity is 1.5 million students. A deadweight
private benefits. So if education were provided by loss arises (grey triangle) because too few students enrol
private universities only that charged full-cost tuition, in university.
we would produce too few university graduates.
External benefits also arise from the discovery the marginal private cost against the marginal private
of new knowledge. When Isaac Newton worked out benefit. They ignore the external benefit. As a result, if
the formulas for calculating the rate of response of we left education and research to unregulated market
one variable to another – calculus – everyone was forces, we would get too little of these activities.
free to use his method. When a spreadsheet program To get closer to producing the efficient quantity
called VisiCalc was invented, Lotus Corporation and of a good or service that generates an external benefit,
Microsoft were free to copy the basic idea and create we make public choices, through governments, to
1-2-3 and Excel. When the first shopping mall was modify the market outcome.
built and found to be a successful way of arranging
retailing, everyone was free to copy the idea and malls
spread everywhere. Government Actions in the Face of
Once someone has discovered a basic idea others External Benefits
can copy it. They do have to work to copy an idea, so Four devices that governments can use to achieve a
they face an opportunity cost. But they do not usually more efficient allocation of resources in the presence
have to pay a fee to use it. When people make deci- of external benefits are:
sions, they ignore the external benefits and consider ◆ Public provision
only the private benefits. ◆ Private subsidies
When people make decisions about the amount ◆ Vouchers
of education or research to undertake, they balance ◆ Patents and copyrights
40 40
Efficient S = MSC S0 = MSC
market
Marginal social equilibrium Marginal social
benefit equals benefit equals
30 30
marginal social marginal social
cost cost S1 = MSC
25 25 – subsidy
Subsidy of
R15 000
20 20
per student
Tuition Rand
Paid by
MSB price MSB
taxpayer
10 10
Efficient
Efficient market
quantity D = MB equilibrium D = MB
0 0.5 1.0 1.5 2.0 2.5 0 0.5 1.0 1.5 2.0 2.5
Quantity (millions of students per year) Quantity (millions of students per year)
(a) Public provision (b) Private subsidy
In part (a), marginal social benefit equals marginal social cost In part (b), with a subsidy of R15 000 per student, the supply
with 1.5 million students per year, the efficient quantity. Tuition curve is S1 = MSC – subsidy. The equilibrium price is R10 000,
is set at R10 000 per student equal to marginal private benefit. and the market equilibrium is efficient with 1.5 million students
Taxpayers cover the other R15 000 of cost per student. per year. Marginal social benefit equals marginal social cost.
Public Provision Under public provision, a public Private Subsidies A subsidy is a payment that the
authority that receives its revenue from the govern- government makes to private producers. By making
ment produces the good or service. The education the subsidy depend on the level of output, the govern-
services produced by public universities and schools ment can induce private decision makers to consider
are examples of public provision. external benefits when they make their choices.
Figure 17.12(a) shows how public provision Figure 17.12(b) shows how a subsidy to private
might overcome the underproduction that arises in tertiary institutions works. In the absence of a subsidy,
Fig. 17.11. Public provision cannot lower the cost the market supply curve is S0 = MSC. The demand curve
of production, so marginal social cost is the same as is the marginal private benefit curve, D = MB. If the
before. Marginal private benefit and marginal external government provides a subsidy of R15 000 per student
benefit are also the same as before. per year, we must subtract the subsidy from the institu-
The efficient quantity occurs where marginal social tion’s marginal cost to find the new market supply curve.
benefit equals marginal social cost. In Figure 17.12(a), That curve is S1 = MSC – subsidy.
this quantity is 1.5 million students. Tuition is set to The market equilibrium is tuition of R10 000 a
ensure that the efficient number of students enrol. year and 1.5 million students a year. The marginal social
That is, tuition is set equal to the marginal private cost of educating 1.5 million students is R25 000 and
benefit at the efficient quantity. In Fig. 17.12(a), the marginal social benefit is R25 000. So with marginal
tuition is R10 000 a year. The rest of the cost of the social cost equal to marginal social benefit, the subsidy
public university is borne by the taxpayers and, in this has achieved an efficient outcome. The tuition and the
example, is R15 000 per student per year. subsidy just cover the institution’s marginal cost.
40
Efficient of the voucher, so the demand curve becomes the marginal
S = MSC
market social benefit curve, D = MSB. Market equilibrium is efficient
Price, marginal equilibrium
social benefit, and with 1.5 million students enrolled in university because price,
30 marginal social marginal social benefit, and marginal cost are equal. The
cost are equal
25
tuition consists of the rand price of R10 000 and a voucher
valued at R15 000.
20
Rand
price Value of
voucher D = MSB
10
MB
Vouchers A voucher is a token that a government may education. A school voucher would allow parents to
provide to households, which they can use to buy speci- choose the school their children will attend and to use
fied goods or services. In the United Sates, food stamps the voucher to pay part of the cost. The school would
are examples of vouchers. The vouchers (stamps) can cash the vouchers to pay its bills.
be spent only on food and are designed to improve the A voucher could be provided to a university
diet and health of extremely poor families. student in a similar way, and although technically
Some people have suggested that school vouchers not a voucher, a government sponsored bursary has a
should be used as a means of improving the quality of similar effect.
Because vouchers can be spent only on a speci- carry 525 people nonstop on long-haul transconti-
fied item, they increase the willingness to pay for that nental flights, such as from Los Angeles to Sydney, or
item and so increase the demand for it. Figure 17.13 New York to Tokyo (flights of 13 000 kilometres that
shows how a voucher system works. The govern- take 13 hours). Similar examples can be found in agri-
ment provides a voucher per student equal to the culture, biogenetics, communications, engineering,
marginal external benefit. Parents (or students) use entertainment, and medicine.
these vouchers to supplement the rands they pay for One reason why the stock of knowledge increases
education. The marginal social benefit curve becomes without diminishing returns is the sheer number of
the demand for university education, D = MSB. The different techniques that can in principle be tried.
market equilibrium occurs at a price of R25 000 per Think about all the processes, all the products, and all
student per year, and 1.5 million students attend the different bits and pieces that go into each, and you
university. Each student pays R10 000 tuition, and can see that we have only begun to scratch around the
institutions collect an additional R15 000 per student edges of what is possible.
from the voucher. Because knowledge is productive and generates
If the government estimates the value of the external benefits, it is necessary to use public poli-
external benefit correctly and makes the value of cies to ensure that those who develop new ideas have
the voucher equal the marginal external benefit, incentives to encourage an efficient level of effort. The
the outcome from the voucher scheme is efficient. main way of providing the right incentives uses the
Marginal social cost equals marginal social benefit, central idea of the Coase theorem and assigns property
and the deadweight loss is eliminated. rights – called intellectual property rights – to creators.
Vouchers are similar to subsidies, but their advo- The legal device for establishing intellectual property
cates say that they are more efficient than subsidies rights is the patent or copyright. A patent or copyright
because the consumer can monitor university perfor- is a government-sanctioned exclusive right granted to
mance more effectively than the government can. the inventor of a good, service, or productive process
to produce, use, and sell the invention for a given
Patents and Copyrights Knowledge might be an number of years. A patent enables the developer of
exception to the principle of diminishing marginal a new idea to prevent others from benefitting freely
benefit. Additional knowledge (about the right things) from an invention for a limited number of years.
makes people more productive. And there seems to Although patents encourage invention and inno-
be no tendency for the additional productivity from vation, they do so at an economic cost. While a patent
additional knowledge to diminish. is in place, its holder has a monopoly. And monopoly
For example, in just 15 years, advances in is another source of inefficiency (which is explained
knowledge about microprocessors have given us in Chapter 13). But without a patent, the effort to
a sequence of processor chips that has made our develop new goods, services, or processes is dimin-
personal computers increasingly powerful. Each ished and the flow of new inventions is slowed. So the
advance in knowledge about how to design and efficient outcome is a compromise that balances the
manufacture a processor chip has brought appar- benefits of more inventions against the cost of tempo-
ently ever larger increments in performance and rary monopoly in newly invented activities.
productivity. Similarly, each advance in knowledge
about how to design and build an aeroplane has Reading Between the Lines on pp. 377–379
brought apparently ever larger increments in perfor- looks at the potential use of a pollution tax to
mance: Orville and Wilbur Wright’s 1903 Flyer was discourage emissions.
a one-seat plane that could hop a farmer’s field. The The next two chapters examine the third big
Lockheed Constellation, designed in 1949, was an question of economics: For whom are goods and
aeroplane that could fly 120 passengers from New services produced? We examine the markets for factors
York to London, but with two refuelling stops in of production and discover how factor incomes and
Newfoundland and Ireland. The Airbus A380 can the distribution of income are determined.
The South African Weather Service (SAWS) Amendment Bill, which was gazetted in September, has added
a new weapon to the arsenal of those agencies tasked with enforcing South Africa’s environmental legislation
and has the potential to expose transgressions by polluters.
The legislation extends the aims and functions of the SAWS to deal with ambient air quality information services,
ultimately tasking the State meteorological service with the role of pollution forecaster. Linked to the National
Air Quality Indicator, it will assist in tracking air quality trends on a local, regional and national scale, assessing
whether general air quality in South Africa is improving.
This information will help the DEA to identify air quality ‘hot spots’ and make the necessary inter-
ventions to point large emitters towards compliance with air quality standards over time and achieve
continuous improvements in environmental quality. ‘It will be a tool for setting compliance targets
for those who do not comply with the overall aim of meeting the right of every individual to an envi-
ronment not harmful to their health, as enshrined in the Constitution. The Atmospheric Emission
Licence and the Atmospheric Emission and Greenhouse-Gas Inventory module of the SAAQIS are
tools through which the DEA will enforce the “polluter pays” principle’, he concludes …
The bill is expected to be finalised by mid-2013, with enforcement expected to take place from 2014.
Source: DALRO Engineering News. Creamer Media’s Engineering News Online: Environmental Enforcement.
Marginal
social Marginal social MSC = S = MC + tax
cost MSC cost and marginal
social benefit
400 Efficient
Efficient Deadweight market
Marginal equilibrium loss equilibrium
social
benefit Pollution
300 Inefficient
tax
market
300
equilibrium
S = MC MC
200 200
150
D = MSB D = MSB
Efficient Tax
quantity revenue
◆ Assuming that the government has accurately 100 million tonnes. At this point the MSC is
assessed the mine’s marginal external cost, it sets R300 million and so is MSB – hence the efficiency.
the pollution tax exactly equal to this cost. ◆ The mine incurs a marginal private cost (MC )
◆ The market supply curve is now equal to the of R200 million per tonne and pays a tax of
MC curve plus the marginal external cost curve R100 million per tonne.
(i.e. in total the marginal social cost). In other ◆ The government’s revenue from the pollution
words, S = MSC = MC + tax. tax is R10 billion.
◆ The efficient market equilibrium is now at a
price of R300 million per tonne and quantity of
Key Terms
Coase theorem, 365 Marginal external benefit, Marginal social benefit, Property rights, 364
Copyright, 376 372 372 Public provision, 375
Externality, 361 Marginal external Marginal social cost, 363 Subsidy, 375
Individual transferable cost, 363 Negative externality, 361 Tragedy of the
quota (ITQ), 371 Marginal private benefit, Patent, 376 commons, 367
Intellectual property 372 Pigovian taxes, 366 Transactions costs, 365
rights, 376 Marginal private cost, 363 Positive externality, 361 Voucher, 375
5. Suppose that no one owns the river and that will change the efficiency of a very profitable
the government issues two marketable pollution strawberry farm outside Stellenbosch. Would a
permits: one to the cotton grower and one to cap-and-trade scheme be more efficient?
the city. Each permit allows the same amount
of pollution of the river, and the total pollution Tragedy of the Commons
created is the efficient amount. Use the following figure to work out Problems 13 to 15.
a. What is the quantity of cotton produced and
what is the market price of a pollution permit?
2 500
Use the following info byte to work out
Problems 6 to 8. 2 000
MC
Bag Revolution 1 500
The table sets out the external cost and the social
benefit of water.
17. Draw a graph to illustrate the market equilib- 19. If the government issues ITQs to land owners
rium. On your graph, show the efficient quantity that limit the total amount of water taken to
of water taken. the efficient quantity, what is the market price
18. If the government sets a quota on the total of an ITQ?
amount of water such that the spring is used
efficiently, what would that quota be?
1 500
20. Itumeleng and Siphiwe play for the same soccer
S
club in Soweto. They both must attend a meeting
1 250
in Pretoria, so they decide to drive to the meeting
together. Itumeleng is a cigar smoker and his 1 000
marginal benefit from smoking a pack of cigars a day
is R400. Cigars are R60 a pack. Siphiwe dislikes cigar 750
Use the following information and the figure, which 21. What is the quantity of pesticide produced if no
illustrates the market for a pesticide with no govern- one owns the dam and what is the efficient quan-
ment intervention, to work out Problems 21 to 24. tity of pesticide?
22. If the residents of the town own the dam, what
When factories produce pesticide, they also create is the quantity of pesticide produced and how
waste, which they dump into a dam on the outskirts much do residents of the town charge the facto-
of the town. The marginal external cost of the waste ries to dump waste?
is equal to the marginal private cost of producing the 23. If the pesticide factories own the dam, how much
pesticide (that is, the marginal social cost of producing pesticide is produced?
the pesticide is double the marginal private cost).
24. If no one owns the dam and the government The Tragedy of the Commons
levies a pollution tax, what is the tax that achieves Use the following figure to work out Problems 28 to 30.
the efficient outcome?
The Constitution and Government surpluses that result from specialisation and exchange.
We have created a system of government to deal
The Constitution of the Republic of South Africa with four market failures: (1) monopoly; (2) externali-
was approved by the Constitutional Court on ties; (3) public goods; and (4) common resources.
4 December 1996 and took effect on 4 February Government might help cope with these market
1997. The Constitution is the supreme law of the failures, but it cannot eliminate the pursuit of self-interest.
land and no other law or government action can Voters, politicians, and bureaucrats pursue their self-
supersede the provisions of the Constitution. South interest, sometimes at the expense of the social interest,
Africa’s Constitution is one of the most progressive and instead of market failure, we get government failure.
in the world and enjoys high acclaim internationally. Many economists have thought long and hard
However, any constitution, no matter how advanced, about the problems discussed in this part. But none
cannot effectively block the ability of special interest has had as profound an effect on our ideas in this area
groups to capture the consumer and producer as Ronald Coase.
Ronald Coase (1910–), was born in England and rights for the functioning of the economy. He has
educated at the London School of Economics, revolutionised the way we think about property
where he was deeply influenced by his teacher, rights and externalities and has opened up the
Arnold Plant, and by the issues of his youth: growing field of law and economics.
communist central planning versus free markets.
Professor Coase has lived in the United States
‘The question to be decided is: Is the value of
since 1951. He first visited America as a 20-year-old
on a travelling scholarship during the depths of the fish lost greater or less than the value of the
Great Depression. It was on this visit, and before product which contamination of the stream
he had completed his bachelor’s degree, that he makes possible?’
conceived the ideas that 60 years later were to earn
him the 1991 Nobel Prize for Economic Science. RONALD H. COASE
Ronald Coase discovered and clarified the
The Problem of Social Cost
significance of transactions costs and property
Y
18
ou know that wage rates vary a lot. A worker at McDonald’s earns
R12 an hour. Simphiwe Xulu, who spends his days in a small container
suspended from the top of Johannesburg’s high-rise buildings cleaning
windows, makes R25 an hour. Steven Pienaar, who plays for the Everton
Football Club in England, collects a cool R25 million a year. Some
differences in earnings might seem surprising. For example, a Super
Rugby manager earns much more than your economics professor.
FACTORS OF especially in today’s tough labour markets. Factory jobs are vanishing
as technological change and foreign competition shrink manufacturing
PRODUCTION production in the South Africa. But new job opportunities are opening in
service industries and other emerging industries.
In this chapter, we study labour markets, as well as markets
for capital and natural resources. You will learn how the prices and
quantities of factors of production are determined. In Reading Between
the Lines at the end of the chapter we look at the ever-changing labour
markets and how they constantly reallocate labour resources.
The Demand for a Factor of Production The first two columns show Angelo’s total product
schedule – the number of loaves per hour that each
The demand for a factor of production is a derived quantity of labour can produce. The third column
demand – it is derived from the demand for the goods shows the marginal product of labour – the change in
and services that the labour produces. You have seen, total product that results from a one-unit increase in
in Chapters 10 to 15, how a firm determines its the quantity of labour employed. (See Chapter 11,
profit-maximising output. The quantities of factors of pp. 235–238 for a refresher on product schedules.)
production demanded are a consequence of the firm’s Angelo can sell bread at the going market price of R10
output decision. A firm hires the quantities of factors a loaf. Given this information, we can calculate the
of production that produce the firm’s profit maxim- value of marginal product (fourth column). It equals
ising output. price multiplied by marginal product. For example,
To decide the quantity of a factor of production the marginal product added by hiring the second
to hire, a firm compares the cost of hiring an addi- worker is 6 loaves. Each loaf sold brings in R10, so the
tional unit of the factor with its value to the firm. The value of the marginal product of the second worker is
cost of hiring an additional unit of a factor of produc- R60 (6 loaves at R10 each).
tion is the factor price. The value to the firm of hiring
one more unit of a factor of production is called the
factor’s value of marginal product. We calculate the
A Firm’s Demand for Labour
value of marginal product as the price of a unit of The value of the marginal product of labour tells us
output multiplied by the marginal product of the what an additional worker is worth to a firm. It tells
factor of production. us the revenue that the firm earns by hiring one more
To study the demand for a factor of produc- worker. The wage rate tells us what an additional
tion, we will use labour as the example. But what you worker costs a firm.
learn here about the demand for labour applies to the The value of the marginal product of labour
demand for all factors of production. and the wage rate together determine the quantity
of labour demanded by a firm. Because the value of
marginal product decreases as the quantity of labour
Value of Marginal Product employed increases, there is a simple rule for maxim-
Table 18.1 shows you how to calculate the value of ising profit: Hire the quantity of labour at which the
the marginal product of labour at Angelo’s Bakery. value of marginal product equals the wage rate.
The value of the marginal product of labour equals the price of 6 loaves (in the third column). The price of a loaf is R10, so the
the product multiplied by marginal product of labour. If Angelo value of the marginal product of the second worker is R10 a
hires 2 workers, the marginal product of the second worker is loaf multiplied by 6 loaves, which is R60 (in fourth column).
If the value of marginal product of labour exceeds the Suppose the wage rate is R40 an hour. You can
wage rate, a firm can increase its profit by hiring one more see in Fig.18.1(a) that if Angelo hires 2 workers, the
worker. If the wage rate exceeds the value of marginal value of the marginal product of labour is R60 an
product of labour, a firm can increase its profit by firing hour. At a wage rate of R40 an hour, Angelo makes a
one worker. But if the wage rate equals the value of the profit of R20 an hour on the second worker. If Angelo
marginal product of labour, the firm cannot increase its hires a third worker, the value of the marginal product
profit by changing the number of workers it employs. The of that worker is R50 an hour. On this third worker,
firm is making the maximum possible profit. So, Angelo makes a profit of R10 an hour.
If Angelo hired 4 workers he breaks even, his
The quantity of labour demanded by a firm is profit would fall. The fourth worker generates a value
the quantity at which the value of the marginal of marginal product of R40 an hour and costs R40 an
80
60
70
50
60
50 40
40 30
30
20
20
10 D
10
VMP
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8
Quantity of labour (number of workers) Quantity of labour (number of workers)
Angelo’s Bakery can sell any quantity of bread at R10 a loaf. quantity of labour that makes the value of marginal product
The blue bars in part (a) represent the firm’s value of marginal equal to the wage rate. The demand for labour curve slopes
Wage rate (rand per hour)
product of labour (based on Table 18.1). The line labelled downward because the value of marginal product diminishes
VMP 60
is the firm’s value of marginal product curve. Part (b) as the quantity of labour employed increases.
shows Angelo’s demand for labour curve. Angelo hires the
50
40
20
9781775785026_gsp_eco_stb_ter_eng_za.indb 387 2014/03/14 7:12 AM
388 CHAPTER 18 Markets for Factors of Production
A change in any other influence on a firm’s labour workers. This is because the automated bread-making
hiring plans changes the demand for labour and shifts machine replaces labour at the bakery – decreasing
the demand for labour curve. the marginal product of labour. But the firms that
manufacture and service automated bread-making
machines hire more labour, so there is an increase in
Changes in a Firm’s Demand for Labour the demand for this type of labour. An event similar
A firm’s demand for labour depends on: to this one occurred during the 1990s when the intro-
◆ The price of the firm’s output duction of electronic telephone exchanges decreased
◆ The prices of other factors of production the demand for telephone operators and increased
◆ Technology the demand for computer programmers and elec-
tronics engineers.
The Price of the Firm’s Output The higher the price Table 18.2 summarises the influences on a firm’s
of a firm’s output, the greater is the firm’s demand for demand for labour.
labour. The price of output affects the demand for
labour through its influence on the value of marginal TABLE 18.2 A Firm’s Demand for Labour
product of labour. A higher price for the firm’s output The Law of Demand
increases the value of the marginal product of labour. (Movements along the demand curve for labour)
A change in the price of a firm’s output leads to The quantity of labour demanded by a firm
a shift in the firm’s demand for labour curve. If the Decreases if: Increases if:
price of the firm’s output increases, the demand for • The wage rate increases • The wage rate decreases
labour increases and the demand for labour curve
shifts rightward. Changes in Demand
For example, if the price of bread increased (Shifts in the demand curve for labour)
A firm’s demand for labour
to R15 a loaf, the value of the marginal product of
Angelo’s fourth worker would increase from R40 an Decreases if: Increases if:
hour to R60 an hour. At a wage rate of R25 an hour, • The price of the firm’s • The price of the firm’s
Angelo would now hire 4 workers instead of 3. output decreases output increases
75 Jill's maximum
A Competitive Labour Market work hours
62.50
A competitive labour market is one in which many firms
demand labour and many households supply labour.
50
But at a wage rate above R62.50 an hour, with the Competitive Labour Market
Labour
goods and services that Jill can buy for R2 500, her Equilibrium Labour market equilib-
priority would be a bit more leisure time. So if the rium determines the wage rate and
wage rate increased above R62.50 an hour, Jill would employment. In Fig. 18.3, the market
cut back on her work hours and take more leisure. demand curve for bakery workers is D
Jill’s labour supply curve eventually bends backward. and the market supply curve of bakery
Jill’s labour supply decisions are influenced by a workers is S. The equilibrium wage
substitution effect and an income effect. rate is R25 an hour, and the equilib-
rium quantity is 300 bakery workers.
Substitution Effect At wage rates below R62.50 an hour, If the wage rate exceeded R25 an www.quickto.mobi/
the higher the wage rate Jill is offered, the greater is the hour, there would be a surplus of PEA-LABOUR
quantity of labour that she supplies. Jill’s wage rate is her bakery workers. More people would
opportunity cost of leisure. If she quits work an hour early be looking for jobs in bakeries than
to catch a movie, the cost of that extra hour of leisure is firms were willing to hire. In such a situation, the wage
the wage rate that Jill forgoes. The higher the wage rate, rate would fall as firms found it easy to hire people at
the less willing Jill is to forgo the income and take the a lower wage rate. If the wage rate were less than R25
extra leisure time. This tendency for a higher wage rate to an hour, there would be a shortage of bakery workers.
induce Jill to work longer hours is a substitution effect. Firms would not be able to fill all the positions they
had available. In this situation, the wage rate would
Income Effect The higher Jill’s wage rate, the higher is rise as firms found it necessary to offer higher wages to
her income. A higher income, other things remaining attract labour. Only at a wage rate of R25 an hour are
the same, induces Jill to increase her demand for most there no forces operating to change the wage rate.
goods and services. Leisure is one of those goods.
Because an increase in income creates an increase in FIGURE 18.3 The Market for Bakery Workers
the demand for leisure, it also creates a decrease in the
Wage rate (rand per hour)
Also, along a supply curve in a particular job 0 100 200 300 400 500
market, the wage rates available in other job markets Quantity of labour (number of workers)
remain the same. For example, along the supply curve
A competitive labour market coordinates firms’ and
of car-wash workers, the wage rates of car salespeople,
households’ plans. The market is in equilibrium – the quantity
mechanics and all other labour are constant.
of labour demanded equals the quantity supplied at a wage
Despite the fact that an individual’s labour supply
rate of R25 an hour when 300 workers are employed. If
curve eventually bends backward, the market supply
the wage rate exceeds R25 an hour, the quantity supplied
curve of labour slopes upward. The higher the wage
exceeds the quantity demanded and the wage rate will fall. If
rate for car-wash workers, the greater is the quantity
the wage rate is below R25 an hour, the quantity demanded
of labour supplied in that labour market.
exceeds the quantity supplied and the wage rate will rise.
Let us now look at labour market equilibrium.
A Labour Market with a Union all the union is able to do, employment falls to
200 workers and the wage rate rises to R37.50 an hour.
A labour union is an organised group of workers that Suppose now that the union is also able to
aims to increase the wage rate and influence other job increase the demand for labour to DU. The union can
conditions. Let us see what happens when a union get an even bigger increase in the wage rate and with
enters a competitive labour market. a smaller fall in employment. By maintaining the
restricted labour supply at SU, the union increases the
Influences on Labour Supply One way of raising wage rate to R50 an hour and achieves an employ-
the wage rate is to decrease the supply of labour. In ment level of 250 workers.
some labour markets, a union can restrict supply by Because a union restricts the supply of labour in
controlling entry into apprenticeship programmes or the market in which it operates, the union’s actions
by influencing job qualification standards. Markets for spill over into non-union markets. Workers who
skilled workers, doctors, dentists and lawyers are the cannot get union jobs must look elsewhere for work.
easiest ones to control in this way. This action increases the supply of labour in non-
If there is an abundant supply of non-union union markets and lowers the wage rate in those
labour, a union cannot decrease supply. On the markets. This spillover effect further widens the gap
demand side of the labour market, the union faces a between union and non-union wages.
trade-off: The demand for labour curve slopes down-
ward, so restricting supply to raise the wage rate costs FIGURE 18.4 A Union Enters a Competitive
jobs. For this reason, unions also try to influence the Labour Market
demand for union labour.
Wage rate (rand per hour)
62.50 SU
Union
Influences on Labour Demand A union tries to equilibrium
SC
Monopsony in the Labour Market Not all labour firm’s average cost curve and marginal cost curve
markets in which unions operate are competi- (see pp. 240–241).
tive. Rather, some are labour markets in which the To find the profit-maximising quantity of labour
employer possesses market power and the union enters to hire, the monopsony sets the marginal cost of
to try to counteract that power. labour equal to the value of marginal product of
A market in which there is a single buyer is called labour. In Fig. 18.5, this outcome occurs when the
a monopsony. A monopsony labour market has one firm employs 100 workers.
employer. In some parts of the country, managed To hire 100 workers, the firm must pay
health-care organisations are the major employer R25 an hour (on the supply of labour curve).
of health-care professionals. In some communities, Each worker is paid R25 an hour, but the value
Pick n Pay is the main employer of sales clerks. As of marginal product of labour is R50 an hour, so
the primary employer in a community with high the firm makes an economic profit of R25 an hour
unemployment, as in South Africa, the employer can on the marginal worker.
choose who it wants to hire as workers do not have If the labour market in Fig. 18.5 were competi-
alternative choices for employment. These firms have tive, the equilibrium wage rate and employment
monopsony power. would be determined by the demand and supply
A monopsony acts on the buying side of a market curves. The wage rate would be R37.50 an hour and
in a similar way to a monopoly on the selling side. 150 workers would be employed. So compared with a
The firm maximises profit by hiring the quantity of competitive labour market, a monopsony pays a lower
labour that makes the marginal cost of labour equal wage rate and employs fewer workers.
to the value of marginal product of labour and by
paying the lowest wage rate at which it can attract this FIGURE 18.5 A Monopsony Labour Market
quantity of labour.
Figure 18.5 illustrates a monopsony labour
Wage rate (rand per hour)
A Union and a Monopsony A union is like a That is, the monopsony hires 150 workers and
monopoly. If the union (monopoly seller) faces a pays R37.50 an hour. The minimum wage law has
monopsony buyer, the situation is called bilateral succeeded in raising the wage rate and increasing the
monopoly. number of workers employed.
In bilateral monopoly, the outcome is determined
by bargaining, which depends on the costs that each FIGURE 18.6 Minimum Wage Law in
party can inflict on the other. The firm can shut down Monopsony
temporarily and lock out its workers, and the workers
can shut down the firm by striking. Each party esti-
mates the other’s strength and what it will lose if it
20 000
makes the demand curve slope downward. The lower
the price, the greater is the quantity demanded.
The higher the expected future price of oil, the
greater is the present demand for oil. The expected
future price is a speculative influence on demand.
Equilibrium
rental rate Oil in the ground and oil in storage tanks are
10 000 inventories that can be held or sold. A trader might
plan to buy oil to hold now and to sell it later for a
profit. Instead of buying oil to hold and sell later, the
trader could buy a bond and earn interest. The interest
forgone is the opportunity cost of holding the oil. If
the price of oil is expected to rise by a bigger percentage
VMP = D than the interest rate, a trader will hold oil and incur
0 10 20 the opportunity cost. In this case, the return from
Land (hectares) holding oil exceeds the return from holding bonds.
The value of marginal product of a 10-hectare block, VMP,
determines the rental demand, D, for this land. With the
The Supply of Oil The three key influences on the
supply curve, S, the block rents for R10 000 a day.
supply of oil are:
1. The known oil reserves
2. The scale of current oil production facilities
3. The expected future price of oil
Non-Renewable Natural Resource Markets
The non-renewable natural resources considered are oil, Known oil reserves is the oil that has been discov-
gas and coal. Burning one of these fuels converts it to ered and can be extracted with today’s technology.
energy and other by-products, and the used resource This quantity increases over time because advances
cannot be reused. The natural resources that we use to in technology enable ever-less accessible sources to
make metals are also non-renewable, but they can be be discovered. The greater the size of known reserves,
used again, at some cost, by recycling them. the greater is the supply of oil. But this influence on
Oil, gas and coal are traded in global commodity supply is small and indirect. It operates by changing
markets. The price of a given grade of crude oil is the the expected distant future price of oil. Even a major
same in New York, London and Singapore. Traders, new discovery of oil would have a negligible effect on
linked by telephone and the internet, operate these current supply of oil.
markets around the clock every day of the year. The scale of current oil production facilities is the
Demand and supply determine the prices and the fundamental influence on the supply of oil. Producing oil
quantities traded in these commodity markets. We is like any production activity: It is subject to increasing
will look at the influences on demand and supply by marginal cost. The increasing marginal cost of extracting
considering the global market for crude oil. oil means that the supply curve of oil slopes upward.
The higher the price of oil, the greater is the quantity
The Demand for Oil The two key influences on the supplied. When new oil wells are sunk or when new
demand for oil are: faster pumps are installed, the supply of oil increases.
1. The value of marginal product of oil When existing wells run dry, the supply of oil decreases.
2. The expected future price of oil Over time, the factors that increase supply are more
powerful than those that decrease supply, so changes in
The value of marginal product of oil is the funda- the fundamental influence increase the supply of oil.
mental influence on demand. It works in exactly the Speculative forces based on expectations about the
same way for a non-renewable resource as it does for future price also influence the supply of oil. The higher
the expected future price of oil, the smaller is the present The Hotelling Principle Harold Hotelling, an econo-
supply of oil. A trader with an oil inventory might plan mist at Columbia University, had an amazing insight:
to sell now or to hold and sell later. You have seen that Traders expect the price of a non-renewable natural
interest forgone is the opportunity cost of holding the oil. resource to rise at a rate equal to the interest rate. We call
If the price of oil is expected to rise by a bigger percentage this idea the Hotelling Principle. Let us see why it is correct.
than the interest rate, it is profitable to incur the opportu- You have seen that the interest rate is the oppor-
nity cost of holding oil rather than selling it immediately. tunity cost of holding an oil inventory. If the price
of oil is expected to rise at a rate that exceeds the
The Equilibrium Price of Oil The demand for oil interest rate, it is profitable to hold a bigger inven-
and the supply of oil determine the equilibrium price tory. Demand increases, supply decreases and the
and quantity traded. Figure 18.9 illustrates the market price rises. If the interest rate exceeds the rate at which
equilibrium. the price of oil is expected to rise, it is not profitable
The value of marginal product of oil, VMP, is to hold an oil inventory. Demand decreases, supply
the fundamental determinant of demand, and the increases and the price falls. But if the price of oil is
marginal cost of extraction, MC, is the fundamental expected to rise at a rate equal to the interest rate,
determinant of supply. Together, they determine the holding an inventory of oil is just as good as holding
market fundamentals price. bonds. Demand and supply do not change and the
If expectations about the future price are also based price does not change. Only when the price of oil is
on fundamentals, the equilibrium price is the market expected to rise at a rate equal to the interest rate is
fundamentals price. But if expectations about the future the price at its equilibrium.
price of oil depart from what the market fundamentals
imply, speculation can drive a wedge between the equi-
librium price and the market fundamentals price.
Economics in Action
The World and US Markets for Oil
FIGURE 18.9 A Non-Renewable Natural
The world produced about 31 billion barrels of oil in
Resource Market
2008 and the price shot upward from $85 in January
Price (dollars per barrel)
150
S MC to $135 in June. The high price and foreign depend-
ence became major political issues.
Although the United States imports almost three
Equilibrium quarters of its oil from other countries, much of it
price
100
comes from close to home. Figure 1 provides the
Expected price next
year of $110
details: Only 14 per cent of the US oil supply comes
Market
increases demand, from the Middle East and more than one third
decreases supply,
fundamentals
and drives price to comes from Canada, Mexico and other Western
price
$100. Hemisphere nations.
50
Even if the United States produced all its own
oil, it would still face a fluctuating global price. US
D producers would not willingly sell to US buyers for a
VMP
price below the world price. So energy independence
0 75 80 85 90 95 100 does not mean an independent oil price.
Quantity (millions of barrels per day)
The Hotelling Principle tells us that we must
The value of marginal product of a natural resource, VMP, expect the price of oil to rise at a rate equal to the
and the marginal cost of extraction, MC, determine the interest rate. But expecting the price to rise at a rate
market fundamentals price. Demand, D, and supply, S, equal to the interest rate does not mean that the price
which determine the equilibrium price, are influenced by the will rise at this rate. As you can see in Fig. 2, the price
expected future price. Speculation can bring a gap between of oil over the past 50 or so years has not followed the
the market fundamentals price and the equilibrium price. path predicted by the Hotelling Principle.
The forces that influence expectations are not well about other people’s expectations. These guesses can
understood. The expected future price of oil depends change abruptly and become self-reinforcing. When
on its expected future rate of use and the rate of the expected future price of oil changes for whatever
discovery of new sources of supply. One person’s expec- reason, demand and supply change, and so does the
tation about a future price also depends on guesses price. Prices in speculative markets are always volatile.
200
All but two sectors registered employment gains in 2011. Manufacturing has been shedding jobs steadily since
the middle 1990s, with an estimated 30 per cent of job losses incurred during this time.
According to the South African Reserve Bank, even though the manufacturing sector continued to observe
increases in gross fixed capital formation, the need to mechanise in order the remain competitive meant
very few new jobs were created in this sector. While the manufacturing sector showed marginal increases in
employment in the fourth quarter of 2011 and first quarter of 2012, it remains susceptible to weakness in the
global economy, particularly the euro area, which is one of South Africa’s main trading partners.
MATHEMATICAL NOTE Check that the above formula delivers that answer:
present value of R110 one year from today is R100. the future. Most practical applications of present value
But let us use the formula. Putting the numbers into calculate the present value of a sequence of future amounts
the above formula, we have of money that are spread over several years. An airline’s
payment of rent for the lease of aeroplanes is an example.
Present Value = R110 To calculate the present value of a sequence of
(1 + 0.1) amounts over several years, we use the formula you
= R110 = R100 have learned and apply it to each year. We then sum
1.1 the present values for all the years to find the present
To calculate the present value of an amount of value of the sequence of amounts.
money two years in the future, we use the formula: For example, suppose that a firm expects to pay
Amount of money two R100 a year for each of the next five years and the
years in future interest rate is 10 per cent a year (r = 0.1). The present
Present value =
(1 + r)2 value (PV ) of these five payments of R100 each is
calculated by using the following formula:
Use this formula to calculate the present value of
R121 two years from now at an interest rate of 10 per PV = R100 + R100 + R100 + R100 + R100
cent a year. With these numbers, the formula gives 1.1 1.12 1.13 1.14 1.15
which equals
Present value = R121
(1 + 0.1)2 PV = R90.91 + R82.64 + R75.13 + R68.30 + R62.09
= R1212 = R379.07
(1.1)
= R121 You can see that the firm pays R500 over five
1.21 years. But because the money is paid in the future,
= R100 it is not worth R500 today. Its present value is only
R379.07. And the farther in the future the money is
We can calculate the present value of an amount paid, the smaller is its present value. The R100 paid
of money n years in the future by using the general one year in the future is worth R90.91 today, but
formula the R100 paid five years in the future is worth only
Amount of money n R62.09 today.
years in future
Present value =
(1 + r)n The Decision
For example, if the interest rate is 10 per cent a year, If this firm could lease a machine for five years at R100 a
R100 to be received 10 years from now has a present year or buy the machine for R500, it would not hesitate
value of R38.55. That is, if R38.55 is invested today at to lease the machine. Only if the firm could buy the
10 per cent a year it will accumulate to R100 in 10 years. machine for less than R379.07 would it want to buy.
Many personal and business decisions turn on
calculations like the one you have just made. A deci-
Present Value of a Sequence of Future Amounts sion to buy or rent an apartment, to lease or rent a car,
You have seen how to calculate the present value of an to pay off a student loan or let the loan run another
amount of money one year, two years, and n years in year can all be made using the above calculation.
Key Terms
Bilateral monopoly, 393 Discounting, 401 Labour union, 391 Present value, 401
Compound interest, 401 Hotelling Principle, 397 Monopsony, 392 Value of marginal
Derived demand, 386 Job, 385 Non-renewable natural product, 386
resources, 385
Capital and Natural Resource Markets over centuries. Though South Africa has large tracts
12. Classify the following items as a non-renewable of vacant land, these are seldom viable for agricul-
natural resource, a renewable natural resource or ture. The only solution is to increase productivity per
not a natural resource. Explain your answers. hectare, generating more output from fewer inputs.
a. Ponti Tower in Johannesburg Some suggested ways are consolidating farms onto
b. Vaal Dam larger, more productive units and using technology,
c. Coal in a Witbank coal mine such as genetic engineering to increase output.
d. The internet 15. a. Is farmland a renewable or non-renewable
e. Kruger National Park resource?
f. Power generated by wind turbines b. Explain how the growing demand for farm
13. No More Urban Farmers products will affect the market for land and
Rapid urbanisation has caused a housing shortage draw a graph to illustrate your answer.
in and around Johannesburg. Agricultural hold- 16. How might farmers meet the growing demand
ings on the city boundaries are being rapidly for farm products without having to use a greater
purchased by developers for high-density quantity of farmland?
housing, causing land prices to soar. Sellers are 17. Helicopter Market Soars
benefitting from this higher demand for their Demand for helicopters has increased substan-
homes and moving further away from the busy tially, resulting in a backlog of orders and even
inner city. a shortage of second-hand helicopters. Demand
a. Why has the price of land around is fuelled by growth in the offshore oil and gas
Johannesburg increased? In your answer industry as exploration and operation moves to
include a discussion of the demand for and deep-sea wells.
supply of land. a. Explain how high oil prices influence the
b. Use a graph to show why the price of land market for helicopter leases and services.
around Johannesburg has increased. b. What happens to the value of marginal
c. Is the supply of land around Johannesburg product of a helicopter as a firm leases or
perfectly inelastic? buys additional helicopters?
14. In the info byte in Problem 8,
a. Explain how a fall in house prices influences Mathematical Note
the market for construction equipment 18. Keshia is opening a new bookkeeping service.
leases. She is considering buying or leasing some new
b. Draw a graph to illustrate the effect of a fall laptop computers. The purchase price of a
in house prices in the market for construc- laptop is R1 500 and after three years it is worth-
tion equipment leases. less. The annual lease rate is R550 per laptop.
The value of marginal product of one laptop
Use the following info byte to work out Problems 15 is R700 a year. The value of marginal product
and 16. of a second laptop is R625 a year. The value of
marginal product of a third laptop is R575 a year.
Meeting Demand And the value of marginal product of a fourth
A growing population and higher urbanisation laptop is R500 a year.
ensures increased demand for agricultural products, a. How many laptops will Keshia lease or buy?
while simultaneously limiting availability of land. b. If the interest rate is 4 per cent a year, will
Historically settlements started up within the most Keshia lease or buy her laptops?
viable agricultural pockets and then became urbanised c. If the interest rate is 6 per cent a year, will
Keshia lease or buy her laptops?
20. Calculate the marginal product of hiring the Shopping Right at Shoprite?
fourth worker and the fourth worker’s value of In 2012 the Shoprite Group of Companies cemented
marginal product. its status as one of the largest employers in Africa
21. How many workers will Smooth Move hire to by employing 100 000 workers. Known for its low
maximise its profit and how many smoothies a prices, unions can argue that Shoprite’s success is
day will Smooth Move produce? built on the exploitation of its workers. But Shoprite
22. If the price rises to R5 a smoothie, how many distributes 58% of its wealth to employees, less
workers will Smooth Move hire? than Pick n Pay’s 65% but substantially more than
23. Smooth Move buys a new blender that increases Massmart’s 33%.
the productivity of workers by 50 per cent. If 26. a. Assuming that Shoprite has market
the price of a smoothie remains at R4 and the power in a labour market, explain how
wage rises to R48 a day, how many workers does the firm could use that market power in
Smooth Move hire? setting wages.
24. Coega’s Mthombo Project in the Pipeline b. Draw a graph to illustrate how Shoprite
PetroSA has finally secured an investor to develop might use labour market power to set wages.
its Mthombo refinery at Coega. China’s Sinopec 27. Explain how a union of Shoprite’s employees
will invest a portion of the billion rand price would attempt to counteract Shoprite’s wage
tag to produce around 400 000 barrels per day. offers (a bilateral monopoly).
28. Based upon evidence presented in this info byte, b. Who will benefit from drilling for oil in the
does Shoprite function as a monopsony in labour Gulf of Mexico? Explain your answer.
markets, or is the market for retail labour more 33. Water is a natural resource that is plentiful in
competitive? Explain. Lesotho but not plentiful in Gauteng.
29. If the market for retail labour is competitive, a. Assuming Lesotho did not previously export
explain the potential effect of a union on the bulk water to Gauteng, if Lesotho now starts
wage rates. Draw a graph to illustrate your to export bulk water to Gauteng, what do
answer. you predict will be the effect on the price of
bulk water?
Capital and Natural Resource Markets b. Will Lesotho eventually run out of water?
Use the following info byte to work out Problems 30 c. Do you think the Hotelling Principle applies
and 31. to Lesotho’s water? Explain why or why not.
T
19
wenty five per cent of working age adults in the Western Cape, some
615 000 people, experienced unemployment during the third quarter
of 2012. In the same province is Constantia, with its mansions that are
home to some very wealthy individuals. Cape Town is not unusual. In
Johannesburg in Gauteng, the largest productive centre in the country,
some 1.4 million people are unemployed. Extreme poverty and extreme
wealth exist side by side in every major city in South Africa and in most
Inequality
Economic Inequality in FIGURE 19.1 The Distribution of Income in
South Africa South Africa in 2010/2011
The most commonly used measure
Percentage of households
Mode (most common)
of economic inequality in South income: R1 750
15
Africa is the distribution of monthly
income. Statistics South Africa
defines income as money income, Median (middle)
income: R2 500
which equals market income plus
cash payments to households by 10
www.quickto.mobi/ government. Market income equals
PEA-INEQUALITY wages, interest, rent and profit
earned in factor markets, before
Mean (average)
paying income taxes. 5
income: R5 000
1 750
2 500
across 13.7 million households in South Africa for Income (rand per month)
2011.
Note that the x-axis measures household income The distribution of income is positively skewed. The mode
and the y-axis is percentage of households. (most common) income is less than the median (middle)
The most common household income, called the income, which in turn is less than the mean (average) income.
mode income, was received by the 11 per cent of the The distribution shown here ends at R20 000, but the
households whose incomes fell between R1 500 and distribution goes up to several million rand a year.
R2 000. The value of R1 750 marked on the figure is
Source of data: Southern African Labour and Development Research Unit.
an estimate.
National Income Dynamics Study 2010–2011, Wave 2 (dataset) Version 1.
The middle level of household income in
Cape Town: Southern Africa Research and Development Unit [producer],
2010/2011, called the median income, was R2 500.
2012. Cape Town: DataFirst [distributor], 2012. (Author’s own calculations).
Fifty per cent of households have an income that
exceeds the median and fifty per cent have an income
below the median.
The monthly average household money income Data are reported for five groups – called quintiles
in 2010/2011, called the mean income, was R5 000. or fifth shares – each consisting of 20 per cent of
You can see in Fig. 19.1 that the mode is less than the households.
median and that the median is less than the mean. Figure 19.2 shows the distribution based on these
This feature of the distribution of income tells us that shares in 2011. The poorest 20 per cent of households
there are more households with low incomes than received 3.4 per cent of total income; the second
with high incomes. It also tells us that some of the poorest 20 per cent received 6.7 per cent of total
high incomes are very high. income; the middle 20 per cent received 10.6 per cent
The income distribution in Fig. 19.1 is called a of total income; the next highest 20 per cent received
positively skewed distribution, which means that it has 17.8 per cent of total income and the highest 20 per
a long tail of high values. This distribution contrasts cent received 61.5 per cent of total income.
with the bell that describes the distribution of people’s The distribution of income in Fig. 19.1 and
heights. In a bell-shaped distribution, the mean, the quintile shares in Fig. 19.2 tell us that income is
median and mode are all equal. distributed unequally.
Another way of looking at the distribution of But we need a way of comparing the distribution
income is to measure the percentage of total income of income in different periods and using different
received by each given percentage of households. measures. A clever graphical tool called the Lorenz
curve enables us to make such comparisons.
Lowest fifth
Households Income
Second fifth
(percentage) (percentage of total
income)
Middle fifth Lowest 20 3.4
Second 20 6.7
Next highest fifth
Middle 20 10.6
Highest fifth
Next highest 20 17.8
0 10 20 30 40 50 60 70 Highest 20 61.5
Percentage of total income
In 2011, the poorest 20 per cent of households received per cent; the next highest 20 per cent received 17.8 per cent
3.4 per cent of total income; the second poorest 20 per cent and the highest 20 per cent received 61.5 per cent.
received 6.7 per cent; the middle 20 per cent received 10.6
Source of data: See Fig 19.1.
80
60
Line of
equality Households Income
D
40 Percentage Cumulative Percentage Cumulative
percentage percentage
Income
Lorenz A Lowest 20 20 3.4 3.4
C curve
20 B Second 20 40 6.7 10.1
B C Middle 20 60 10.6 20.6
A
D Next highest 20 80 17.8 38.5
0 20 40 60 80 100
E Highest 20 100 61.5 100
Cumulative percentage of households
The cumulative percentage of income is graphed against the would receive 20 per cent of total income and the Lorenz
cumulative percentage of households. Points A to E on the curve would fall along the line of equality. The Lorenz curve
Lorenz curve correspond to the rows of the table. If incomes shows that income is unequally distributed.
were distributed equally, each 20 per cent of households
Source of data: See Fig 19.1.
The Income Lorenz Curve almost all the wealth, we need to break the group into
The income Lorenz curve graphs the cumulative smaller parts. That is what rows D' through G' do.
percentage of income against the cumulative The richest 1 per cent of households in row G' own
percentage of households. 38.1 per cent of total wealth.
Figure 19.3 shows the income Lorenz curve using Figure 19.4 shows the income Lorenz curve
the quintile shares from Fig. 19.2. The table shows (from Fig. 19.3) alongside the wealth Lorenz curve.
the percentage of income of each quintile group. For You can see that the Lorenz curve for wealth is
example, row A tells us that the lowest quintile of much farther away from the line of equality than is
households receives 3.4 per cent of total income. The the Lorenz curve for income, which means that the
table also shows the cumulative percentages of households distribution of wealth is much more unequal than the
and income. For example, row B tells us that the lowest distribution of income.
two quintiles (lowest 40 per cent) of households receive
10.1 per cent of total income (3.4 per cent for the lowest
Wealth or Income?
quintile plus 6.7 per cent for the next lowest).
The Lorenz curve provides a direct visual clue We have seen that wealth is much more unequally
about the degree of income inequality by comparing distributed than is income. Which distribution
it with the line of equality. This line, identified in provides the better description of the degree of
Fig. 19.3, shows what the Lorenz curve would be if inequality? To answer this question, we need to think
everyone had the same level of income. about the connection between wealth and income.
If income were distributed equally across all Wealth is a stock of assets, and income is the
the households, each quintile would receive 20 per flow of earnings that results from the stock of wealth.
cent of total income and the cumulative percentages Suppose that a person owns assets worth R1 million
of income received would equal the cumulative – has a wealth of R1 million. If the rate of return on
percentages of households, so the Lorenz curve would assets is 5 per cent a year, then this person receives an
be the straight line labelled ‘Line of equality’. income of R50 000 a year from those assets. We can
The actual distribution of income shown by the describe this person’s economic condition by using
curve labelled ‘Income Lorenz curve’ can be compared either the wealth of R1 million or the income of
with the line of equality. The closer the Lorenz R50 000. When the rate of return is 5 per cent a year,
curve is to the line of equality, the more equal is the R1 million of wealth equals R50 000 of income in
distribution of income. perpetuity. Wealth and income are just different ways
of looking at the same thing.
But in Fig. 19.4, the distribution of wealth is
The Distribution of Wealth more unequal than the distribution of income. Why?
The distribution of wealth provides another way of It is because the wealth data do not include the value
measuring economic inequality. A household’s wealth of human capital, while the income data measure
is the value of the things that it owns at a point in income from all wealth, including human capital.
time. In contrast, income is the amount that the Think about Layla and Ridwaan, two people
household receives over a given period of time. with equal income and equal wealth. Layla’s wealth
Figure 19.4 shows the Lorenz curve for wealth is human capital and her entire income is from
in South Africa in 2011 (the most recent year for employment. Ridwaan’s wealth is in the form of
which we have wealth distribution data). The median investments in stocks and bonds and his entire
household wealth in 2011 was R260 000. Wealth is income is from these investments.
extremely unequally distributed, and for this reason, When a Statistics South Africa (StatsSA) agent
the data are grouped by seven unequal groups of interviews Layla and Ridwaan in a national income and
households. The poorest 40 per cent of households own wealth survey, their incomes are recorded as being equal,
only 0.6 per cent of total wealth (row A' in the table in but Layla’s wealth is recorded as zero, while Ridwaan’s
Fig. 19.4). The richest 20 per cent of households own wealth is recorded as the value of his investments. Ridwaan
94.1 per cent of total wealth. Because this group owns looks vastly wealthier than Layla in the survey data.
G'
80
Households Wealth
60 Percentage Cumulative Percentage Cumulative
percentage percentage
Line of
equality A’ Lowest 40 40 0.6 0.6
D
40 B’ Next 20 60 1.2 1.8
Income F'
C’ Next 20 80 4.1 5.9
E'
20
C D’ Next 10 90 5.0 10.9
D'
B
E’ Next 5 95 7.6 18.5
C'
A B' F’ Next 4 99 9.0 27.5
A' Wealth
The cumulative percentage of wealth is graphed against the comparing the Lorenz curves for income and wealth, we can see
cumulative percentage of households. Points A’ to G’ on the that wealth is distributed much more unequally than is income.
Lorenz curve for wealth correspond to the rows of the table. By
Source of data: See Fig 19.1.
Because the national survey of wealth excludes wealth data overstates lifetime inequality because
human capital, the income distribution is a more households are at different stages in their life cycles.
accurate measure of economic inequality than the
wealth distribution.
Trends in Inequality
To see trends in the income distribution, we need a
Annual or Lifetime Income and Wealth? measure that enables us to rank distributions on the
A typical household’s income changes over its life scale of more equal and less equal. No perfect scale
cycle. Income starts out low, grows to a peak when exists, but one that is much used is called the Gini
the household’s workers reach retirement age and coefficient. The Gini coefficient is based on the Lorenz
then falls after retirement. Also, a typical household’s curve and equals the ratio of the area between the
wealth changes over time. Like income, it starts out line of equality and the Lorenz curve to the entire
low, grows to a peak at the point of retirement, and area beneath the line of equality. The larger the
falls after retirement. Gini coefficient, the greater is the degree of income
Think about three households with identical inequality. If income is equally distributed, the Lorenz
lifetime incomes, one young, one middle-aged and curve is the same as the line of equality, so the Gini
one retired. The middle-aged household has the coefficient is zero. If one person has all the income
highest income, the retired household has the lowest and everyone else has none, the Gini coefficient is 1.
and the young household falls in the middle. The Figure 19.5 shows the South African Gini coef-
distributions of annual income and wealth in a given ficient from 1993 to 2011. The figure shows that the
year are unequal, but the distributions of lifetime Gini coefficient fluctuates within a very narrow band.
income and wealth are equal. Over the past 15 years the Gini coefficient has clearly
The data on inequality share the bias that you increased, which means on this measure, incomes
have just seen. Inequality in annual income and have become less equal.
R4 350 per month. When the breadwinner was aged the levels of income disparity in South Africa. There
between 15 and 24, average monthly household income are large differences in income between races when
was close to R3 860. And for breadwinners over 65, the the same level of education is observed. The average
average monthly household income was only R2 000. income for white individuals who have completed
high school is R9 000 per month, while African
Race and Ethnicity White households had an individuals with the same level of education earn on
average monthly income in 2011 of R19 000, while average R4 000. The difference is quite large for those
African households had an average income of R3 100. who have completed tertiary education where a white
Coloured households had an average monthly income individual earns R16 000 per month while an African
of R5 300 while Indian households had an average individual earns R9 500. The difference between the
income of R7 600. race groups by education, is substantial, and cause
for concern.
Race and Education Examining household income Figure 19.6 provides a quick visual summary of
by an interaction of race and education illustrates the numbers that we have just described.
11 000
Bachelor’s Coloured bachelor’s degree
10 000
degree
Income (rand per month)
The distribution of income varies significantly within each of Source of data: Southern African Labour and Development Research
the selected household characteristics displayed in the graph. Unit. National Income Dynamics Study 2010–2011, Wave 2 (dataset)
Despite the many years that have passed since the end of Version 1. Cape Town: Southern Africa Research and Development Unit
apartheid, education and race still appear to be the dominating [producer], 2012. Cape Town: DataFirst [distributor], 2012. Author’s
factors behind the distribution of income in South Africa. own calculations.
REVIEW QUIZ
1 Which is distributed more unequally, income or 3 What are the main characteristics of people
wealth? Why? Which is the better measure? who earn large incomes and those who earn
2 From 1993 to 2011 did the distribution of small incomes?
income become more equal or more unequal? 4 What is poverty and how does its incidence vary?
How did the richest quintile’s share change?
Inequality in the World Economy income while the highest 20 per cent receive 65 per
Which countries have the greatest economic inequality cent of total income. An average person in the highest
and which have the least and the greatest equality? quintile receives 32.5 times the income of an average
Where does South Africa rank? Is it one of the person in the lowest quintile.
most equal or most unequal or somewhere in the Contrast these numbers with those for Finland
middle? And how much inequality is there in the and Sweden. In these countries, the poorest 20 per
world as a whole when we consider the entire world as cent receive 8 per cent of total income and the highest
a single global economy? 20 per cent receive 35 per cent. So an average person
We will answer these questions by first looking at the in the highest quintile receives 4.4 times the income
income distribution in a selection of countries and then by of an average person in the lowest quintile.
examining features of the global distribution of income. The proportions for the United States lie between
these extremes with an average person in the highest
quintile receiving just under 10 times the amount
Income Distributions in Selected Countries received by an average person in the lowest quintile.
By inspecting the income distribution data for every Brazil and South Africa are extremes not
country, we can compare the degree of income matched in any other country or region for which
inequality and identify the countries with the most such calculations have been made. Inequality is
inequality and those with the least inequality. large in these countries because of unequal access to
Figure 19.7 summarises some extremes and opportunities, including education and the labour
shows where South Africa lies in the range of degrees market. Since the end of apartheid in South Africa,
of income inequality. the overall wealth distribution has not changed
Look first at the numbers in the table. They tell significantly. Finland and Sweden are extremes, but
us that in Brazil and South Africa, the poorest 20 per they are not unusual.
cent of households receive only 2 per cent of total We look next at the global income distribution.
Source of data: Deininger, Klaus and Squire, Lyn, ‘A New Data Set Measuring
Income Inequality’, The World Bank Economic Review. 10 (3): 565–91, 1996.
Global Inequality and Its Trends Despite greater inequality within countries, the
The global distribution of income is much more world is becoming less unequal. Figure 19.8 shows
unequal than the distribution within any one country. this trend toward less inequality as measured by the
The reason is that many countries, especially in Africa world Gini coefficient. How can the world income
and Asia, are in a pre-industrial stage of economic distribution become less unequal while individual
development and are poor, while industrial countries countries become more unequal? The answer is that
such as the United States are rich. When we look at average incomes in poorer countries are rising much
the distribution of income across the entire world faster than average incomes in rich countries. While
population that goes from the low income of the the gap between rich and poor is widening within
poorest African to the high income of the richest countries, it is narrowing across countries.
American, we observe a very large degree of inequality.
To put some raw numbers on this inequality, FIGURE 19.8 The World Gini Coefficient:
start with the poorest. Measured in the value of the 1970–2000
US dollar in 2005, a total of 3 billion people or 50 per 0.67
cent of the world population live on $2.50 a day or less.
Another 2 billion people or 30 per cent of the world
population live on more than $2.50 but less than 0.66
$10 a day. So 5 billion people or 80 per cent of the
world’s population live on $10 a day or less.
In contrast, in the rich United States, the average
person has an income of $115 per day and an average 0.65
The Sources of Economic Inequality forgone earnings during the years spent at university.
We have described some key facts about economic It might also include low earnings doing on-the-job
inequality and its trends and our task now is to explain training in a law firm during the holidays.
those facts. We began this task in Chapter 18 by Because the human capital needed to supply lawyer’s
learning about the forces that influence demand and services is costly to acquire, a person’s willingness to supply
supply in the markets for labour, capital and land. these services reflects this cost. The supply of lawyer’s
We are now going to deepen our understanding services is smaller than the supply of law-clerk services.
of these forces. The demand for and supply of each type of
Inequality arises from unequal labour market labour determine the wage rates that each type earns.
outcomes and from unequal ownership of capital. Lawyers earn a higher wage rate than law clerks
We will begin by looking at labour markets and three because the demand for lawyers is greater and the
features of them that contribute to differences in income: supply of lawyers is smaller. The gap between the wage
◆ Human capital rates reflects the higher value of marginal product of
◆ Discrimination a lawyer (demand) and the cost of acquiring human
◆ Contests among superstars capital (supply).
Trends in Inequality Explained by Technological in part (a) and that of high-skilled labour in part (b)
Change and Globalisation You have seen that are S, and initially, the demand in each market is
high-income households have earned an increasing D0. The low-skill wage rate is R50 an hour, and the
share of total income while low-income households high-skill wage rate is R100 an hour. The demand for
have earned a decreasing share: The distribution of low-skilled labour decreases to D1 in part (a) and the
income in South Africa has become more unequal. demand for high-skilled labour increases to D1 in part
Technological change and globalisation are two (b). The low-skill wage rate falls to R40 an hour and
possible sources of this increased inequality. the high-skill wage rate rises to R150 an hour.
employment. The supply of low-skilled labour skilled workers expand. Labour (thousands of hours per day)
(a) A decrease in demand for low-skilled labour
FIGURE 19.9 Explaining the Trend in Income Distribution
Wage rate (rand per hour)
Wage rate (rand per hour)
100 200
Information technology S
S
and low-skilled labour
80 are substitutes
150
60
D1
50 100
40
50
20 Information technology
D0 and high-skilled labour D0
are complements
D1
0 1 2 3 0 2 3 4
Labour (thousands of hours per day) Labour (thousands of hours per day)
(a)(a)
AAdecrease
decreaseinindemand
demand for low-skilled
for low-skilled labour
labour (b) An
(b)increase in demand
An increase for for
in demand high-skilled
high-skilledlabour
labour
Low-skilled labour in part (a) and information technologies are High-skilled labour in part (b) and information technologies are
Wage rate (rand per hour)
substitutes.
200 Advances in information technology decrease the complements. Advances in information technology increase the
demand for low-skilled labour and lower its wageS rate. demand for high-skilled labour and raise its wage rate.
150
D1
100 PART SIX Factor Markets, Inequality and Uncertainty
Discrimination
FIGURE 19.10 Discrimination
Human capital differences can explain some of the
economic inequality that we observe. Discrimination
Differences in the Degree of Specialisation Couples The runner-up in this event Agnieszka Radwanska,
must choose how to allocate their time between working received £500 000. So Serena earned double the
for a wage and doing jobs in the home, such as cooking, amount earned by Agnieszka. And she earned
cleaning, shopping, organising holidays and, most 88 times the amount received by the players who
importantly, bearing and raising children. lost in the first round of the tournament.
Let us look at the choices of Nathan and Arlene. It is true that Serena Williams has a lot of human
Nathan might specialise in earning an income capital. She practices hard and long and is a remarkable
and Arlene in taking care of the home. Or Arlene athlete. But anyone who is good enough to get into
might specialise in earning an income and Nathan in a tennis Grand Slam tournament is similarly well
taking care of the home. Or both of them might earn equipped with human capital and has spent a similar
an income and share home production jobs. number of long hours in training and practice. It is not
The allocation they choose depends on their human capital that explains the differences in earnings.
preferences and on their earning potential. The It is the tournament and the prize differences that
choice of an increasing number of households is for accounts for the large differences in earnings.
each person to diversify between earning an income But three questions jump out: First, why do we
and doing some household chores. But in most reward superstar tennis players (and golfers) with prizes
households, Nathan will specialise in earning an for winning a contest? Second, why are the prizes so
income and Arlene will both earn an income and bear different? And third, do the principles that apply on the
a larger share of the task of running the home. With tennis court (and golf course) apply more generally?
this allocation, Nathan will probably earn more than
Arlene. If Arlene devotes time and effort to ensuring Why Prizes for a Contest? The answer to this
Nathan’s mental and physical well-being, the quality question (which was noted in Chapter 5, see p. 101)
of Nathan’s market labour will be higher than it would is that contests with prizes do a good job of allocating
be if he were diversified. If the roles were reversed, scarce resources efficiently when the efforts of the
Arlene would be able to supply market labour that participants are hard to monitor and reward directly.
earns more than Nathan’s. There is only one winner, but many people work
To test whether the degree of specialisation hard in an attempt to be that person. So a great deal
accounts for earnings differences between the genders, of diligent effort is induced by a contest.
economists have compared the incomes of never-
married men and women. They have found that, on Why Are Prizes So Different? The prizes need to
average, with equal amounts of human capital, the be substantially different to induce enough effort.
wages of these two groups are the same. If the winner received 10 per cent more than the
runner up, the gain from being the winner would
be insufficient to encourage anyone to work hard
Contests Among Superstars enough. Someone would win but no one would put
The differences in income that arise from differences in in much effort. Tennis matches would be boring, golf
human capital are important and affect a large proportion scores would be high, and no one would be willing to
of the population. But human capital differences cannot pay to see these sports. Big differences are necessary to
account for some of the really large income differences. induce a big enough effort to generate the quality of
The super rich – those in the top one per cent of the performance that people are willing to pay to see.
income distribution whose income share has been rising
– earn vastly more than can be explained by human Does the Principle Apply More Generally?
capital differences. What makes a person super rich? Winner-takes-all is not confined to tennis and golf.
A clue to the answer is provided by thinking Movie stars, superstar athletes and top corporate
about the super rich in tennis and golf. What makes executives can all be viewed as participants in contests
tennis players and golfers special is that their earnings that decide the winners. The prize for the winner is
depend on where they finish in a tournament. When an income at least double that of the runner up and
Serena Williams won the Wimbledon Championship many multiples of the incomes of those who drop out
in 2012, she received £1 000 000 or $1 540 000. earlier in the tournament.
Do Contests Among Superstars Explain the Trend? way through post-graduate study might have lots
Contests among superstars can explain large differences of human capital and an outstanding student loan
in incomes. But can contests explain the trend toward of R300 000. This person has negative wealth.
greater inequality with an increasing share of total Gradually loans get paid off and a retirement fund is
income going to the super rich as shown on p. 411? accumulated. At the point of retiring from full-time
An idea first suggested by University of Chicago work, the family has maximum wealth. Then, during
economist Sherwin Rosen suggests that a winner- its retirement years, the family spends its wealth. This
takes-all contest can explain the trend. The key is that life-cycle pattern means that much of the wealth is
globalisation has increased the market reach of the owned by people in their sixties.
winner and increased the spread between the winner
and the runners-up. Intergenerational Transfers Some households
Global television audiences now watch all the inherit wealth from the previous generation.
world’s major sporting events and the total revenue Some save more than enough on which to live
generated by advertising spots during these events has during retirement and transfer wealth to the next
increased. Competition among networks and cable generation. But these intergenerational transfers of
and satellite television distributors has increased the wealth do not always increase wealth inequality.
fees that event organisers receive. And to attract the If a generation that has a high income saves a
top star performers, prize money has increased and large part of that income and leaves wealth to a
the winner gets the biggest share. succeeding generation that has a lower income,
So the prizes in sports have become bigger this transfer decreases the degree of inequality. But
and the share of income going to the ‘winner’ has one feature of intergenerational transfers of wealth
increased. A similar story can be told about superstars leads to increased inequality: wealth concentration
and the super rich in business. As the cost of doing through marriage.
business on a global scale has fallen, more and more
businesses have become global in their reach. Not Marriage and Wealth Concentration People tend
only are large multinational corporations sourcing to marry within their own socioeconomic class –
their inputs from far afield and selling in every a phenomenon called assortative mating. In everyday
country, they are also recruiting their top executives language, ‘like attracts like’. Although there is
from a global talent pool. a good deal of folklore that ‘opposites attract’,
With a larger source of talent, and larger total perhaps such Cinderella tales appeal to us because
revenue, firms must make the ‘prize’ – the reward they are so rare in reality. Wealthy people seek
for the top job – more attractive to compete for the wealthy partners.
best managers. Because of assortative mating, wealth becomes
We have examined some sources of inequality more concentrated in a small number of families and
in the labour market. Let us now look at the way the distribution of wealth becomes more unequal.
inequality arises from unequal ownership of capital.
REVIEW QUIZ
Unequal Wealth 1 What role does human capital play in
You have seen that wealth inequality – excluding accounting for income inequality?
human capital – is much greater than income 2 What role might discrimination play in
inequality. accounting for income inequality?
This greater wealth inequality arises from two 3 What role might contests among superstars
sources: life-cycle saving patterns and transfers of play in accounting for income inequality?
wealth from one generation to the next. 4 How might technological change and globali-
sation explain trends in the distribution of
Life-Cycle Saving Patterns Over a family’s life income?
cycle, wealth starts out at zero or perhaps less than 5 Does inherited wealth make the distribution
zero. A student who has financed education all the of income less equal or more equal?
Next, we are going to see how taxes and government Welfare Programmes The purpose of welfare is to
programmes redistribute income and decrease the provide incomes for people who do not qualify for
degree of economic inequality. unemployment insurance or cannot work. They are:
◆ The Old Age Pension (OAP) is designed to assist
females who are 60 years and older and males
who are 60 years and older who do not have
Income Redistribution
other forms of pensions.
The three main ways in which the government in ◆ The Child Support Grant (CSG) is designed to
South Africa redistributes income are: assist persons up to the age of 16 years of age,
◆ Income taxes provided they do not exceed some maximum
◆ Income maintenance programmes limit of income.
◆ Subsidised services ◆ Foster Care Grant (FCG) is designed to assist
persons who undertake the fostering of children.
◆ The Disability Grant (DG) is designed to assist
Income Taxes
persons who are unable to maintain full-time
Income taxes may be progressive, regressive, or employment.
proportional. A progressive income tax is one that taxes
income at an average rate that increases as income
increases. A regressive income tax is one that taxes The Big Trade-Off
income at an average rate that decreases as income The redistribution of income creates what has been
increases. A proportional income tax (also called a flat- called the big trade-off, a trade-off between equity and
rate income tax) is one that taxes income at a constant efficiency. The big trade-off arises because redistribution
average rate, regardless of the level of income. uses scarce resources and weakens incentives.
The tax system that applies in South Africa is A rand collected from a rich person does not
progressive. Successively higher-income households translate into a rand received by a poor person.
pay 25 per cent, 30 per cent, 38 per cent and 40 per Some of it gets used up in the process of
cent of each additional rand earned. redistribution. Tax-collecting agencies such as the
South African Revenue Service (SARS) and welfare-
administering agencies (as well as tax accountants
Income Maintenance Programmes
and lawyers) use skilled labour, computers and other
Two main types of programmes redistribute income scarce resources to do their work. The bigger the scale
by making direct payments (in cash, services or of redistribution, the greater is the opportunity cost of
vouchers) to people in the lower part of the income administering it.
distribution. They are: But the cost of collecting taxes and making
◆ Unemployment compensation welfare payments is a small part of the total cost of
◆ Welfare programmes redistribution. A bigger cost arises from the inefficiency
(deadweight loss) of taxes and benefits. Greater equality
Unemployment Compensation To provide an income can be achieved only by taxing productive activities
to unemployed workers, the South African government such as work and saving. Taxing people’s income from
has established the Unemployment Insurance Fund their work and saving lowers the after-tax income they
(UIF). Individuals are eligible to draw from the fund if receive. This lower after-tax income makes them work
they have been previously employed and lost their job and save less, which in turn results in smaller output
due to retrenchments, unpaid maternity leave or the and less consumption not only for the rich who pay the
death of an immediate relative. Individuals who earn a taxes but also for the poor who receive the benefits.
very low level of income can draw up to 60 per cent of It is not only taxpayers who face weaker incentives
their monthly salary while individuals who have much to work. Benefit recipients also face weaker incentives.
larger salaries are not entitled to as large a claim. The So the agencies that determine the scale and
only weakness of the system is that individuals who have methods of income redistribution must pay close
never been employed cannot draw from the fund. attention to the incentive effects of taxes and benefits.
In 2011, South Africa had more than 44 700 high net worth individuals, with a combined wealth of
$188 billion (R1.6 trillion), according to data provider WealthInsight. The group held 17.4 per cent
($33 billion) of their wealth outside South Africa, below the global average of about 30 per cent for
offshore wealth, the London-based wealth consultancy said.
High net worth individuals, who represent less than 0.1 per cent of the country’s population,
accounted for roughly 27 per cent of South Africa’s total individual wealth of $740 billion. Wealth
includes equities, bonds, cash and deposits, fixed-income products, real estate, alternative assets and
business interests.
The figures confirm that South Africa is one of the most unequal societies in the world.
People with assets worth more than $30 million are described as ultra-high net worth individuals.
Of these, 261 live in Johannesburg, 103 in Cape Town, 31 in Durban and 28 in Pretoria.
According to official estimates, WealthInsight said, South Africa’s wealth per capita amounted to
$14 234, the second-highest among the BRICS bloc of Brazil, Russia, India, China and South Africa:
above India ($2 863), Russia ($8 192) and China ($12 240) but below Brazil ($16 410).
‘This reflects the fact that the middle class in South Africa is larger [in percentage terms] than in
India, China and Russia,’ the data provider said.
But within BRICS, South Africa has the fewest high net worth individuals, while China has the most:
1.3 million.
In South Africa the number increased by 17.9 per cent between 2007 and 2011 while their wealth
grew 15.2 per cent, supported by a strong local property market, high savings rates and a significant
appreciation of the rand against the dollar over the review period.
This year, the currency has depreciated sharply, which will be reflected in the next set of data by WealthInsight.
However, the data provider said these individuals’ wealth and numbers ‘would continue to be
robust over the forecast period between 2011 and 2016, as more new businesses are developed
within the country’. It forecast the wealth of this group would grow 51 per cent, to reach $285 billion
in 2016. ‘However, there will be a smaller percentage increase, 41 per cent, in number to reach just
over 63 200 individuals in 2016.’
Key Terms
Big trade-off, 421 Market income, 408 Progressive income tax, 421 Regressive income tax, 421
Gini coefficient, 411 Money income, 408 Proportional income tax, 421 Wealth, 410
Lorenz curve, 410 Poverty, 412
The Sources of Economic Inequality perceived to be twice that of the workers who are
12. The following figure shows the market for discriminated against. Suppose also that the supply
low-skilled labour. of these other workers is 2 000 hours per day less
at each wage rate.
Wage rate (rand per hour)
12 S
12
8
D 8
4
4
D
0 1 2 3 4 5
Labour (thousands of hours per day) 0 2 4 6 8 10
Labour (thousands of hours per day)
29. Copy Figure 19.3. 30. Explain why tax cuts in a progressive income
a. Add a Lorenz curve that indicates a situation tax system are consistently criticised for favouring
where the lowest 40 per cent of the population the wealthy.
receive a cumulative income of 15 per cent and 31. How might the benefits of tax cuts ‘trickle down’
the highest quintile retains 30 per cent. to others whose taxes are not cut?
b. How does this affect the Gini coefficient?
Explain.
L
20
ife is like a lottery. You set up a summer business and work hard at
it. But will you make enough income to keep you in university next year
or will you get wiped out? How do people make a decision when they
do not know what its consequences will be?
As you drive across an intersection on a green light, you see a
car on your left that is still moving. Will it stop or will it run the red
light? You buy insurance against such a risk, and
Decisions in the Face of Uncertainty Bongiwe can now compare the expected wealth
Bongiwe, a student, is trying to decide which of two from each job – R3 000 for the risky job and R2 000
summer jobs to take. She can work as a house painter and for the non-risky job.
earn enough to save R2 000 by the end of the summer. So does Bongiwe prefer the risky job because
There is no uncertainty about the income from this job. it gives her a greater expected wealth? The answer is
If Bongiwe takes it, she will definitely have R2 000 in we do not know because we do not know how much
her bank account at the end of the summer. The other Bongiwe dislikes risk.
job, working as a telemarketer selling subscriptions to a
magazine, is risky. If Bongiwe takes this job, her bank
balance at the end of the summer will depend on her
Risk Aversion
success at selling. She will earn enough to save R5 000 if Risk aversion is the dislike of risk. Almost everyone
she is successful but only R1 000 if she turns out to be a is risk averse, but some more than others. In soccer,
poor salesperson. Bongiwe has never tried selling, so she passing is less risky than striking. Coach Pitso
does not know how successful she will be. But some of Mosimane of Bafana Bafana, who favours a cautious
her friends have done this job, and 50 per cent of them passing game, is risk averse.
do well and 50 per cent do poorly. Basing her expecta- Bafana Bafana striker Benny McCarthy, who
tions on this experience, Bongiwe thinks there is a 50 per favours a risky striking game, is less risk averse. But
cent chance that she will earn R5 000 and a 50 per cent almost everyone is risk averse to some degree.
chance that she will earn R1 000. We can measure the degree of risk aversion by the
Bongiwe is equally as happy to paint as she is to compensation needed to make a given amount of risk
make phone calls. She cares only about the money. acceptable.
Which job does she prefer: the one that provides her Returning to Bongiwe: If she needs to be paid
with R2 000 for sure or the one that offers her a 50 per more than R1 000 to take on the risk arising from the
cent chance of making R5 000 but a 50 per cent risk of telemarketing job, she will choose the safe painting
making only R1 000? job and take the R2 000 non-risky income. But if she
To answer this question, we need a way of thinks that the extra R1 000 of expected income is
comparing the two outcomes. One comparison is the enough to compensate her for the risk, she will take
expected wealth that each job creates. the risky job.
To make this idea concrete, we need a way of
thinking about how a person values different levels of
Expected Wealth wealth. The concept that we use is utility. We apply
Expected wealth is the money value of what a person the same idea that explains how people make expendi-
expects to own at a given point in time. An expecta- ture decisions (see Chapter 8) to explain risk aversion
tion is an average calculated by using a formula that and decisions in the face of risk.
weights each possible outcome with the probability
(chance) that it will occur.
For Bongiwe, the probability that she will have
Utility of Wealth
R5 000 is 0.5 (a 50 per cent chance). The probability Wealth (money in the bank and other assets of value)
that she will have R1 000 is also 0.5. Notice that the is like all good things. It yields utility. The more
probabilities sum to 1. Using these numbers, we can wealth a person has, the greater is that person’s total
calculate Bongiwe’s expected wealth, EW, which is utility. But each additional rand of wealth brings a
diminishing increment in total utility – the marginal
EW = (R5 000 × 0.5) + (R1 000 × 0.5) = R3 000. utility of wealth diminishes as wealth increases.
Diminishing marginal utility of wealth means
Notice that expected wealth decreases if the risk that the gain in utility from an increase in wealth is
of a poor outcome increases. For example, if Bongiwe smaller than the loss in utility from an equal decrease
has a 20 per cent chance of success (and 80 per cent in wealth. Stated differently, the pain from a loss is
chance of failure), her expected wealth falls to greater than the pleasure from a gain of equal size.
R1 800 – (R5 000 × 0.2) + (R1 000 × 0.8) = R1 800 Figure 20.1 illustrates Bongiwe’s utility of wealth.
45
20 ... and 50
per cent
chance of
Expected
A this outcome
20 (average)
0 1 2 3 4 5 wealth
Wealth (thousands of rand)
0 1 2 3 4 5
Wealth (thousands of rand)
Wealth Total utility Marginal utility
Bongiwe has a 50 per cent chance of having R5 000 of
(rands) (units) (units)
wealth and a total utility of 95 units. She also has a 50 per
A 0 0
45 cent chance of having R1 000 of wealth and a total utility of
B 1 000 45 45 units. Bongiwe’s expected wealth is R3 000 (the average
25 of R5 000 and R1 000) and her expected utility is 70 units
C 2 000 70 (the average of 95 and 45).
13 With a wealth of R3 000 and no uncertainty, Bongiwe’s
D 3 000 83 total utility is 83 units. For a given expected wealth, the
8 greater the range of uncertainty, the smaller is expected utility.
E 4 000 91
4
F 5 000 95
Expected utility decreases if the risk of a poor
The table shows Bongiwe’s utility of wealth schedule, and the outcome increases. For example, if Bongiwe has a
figure shows her utility of wealth curve. Utility increases as 20 per cent chance of success (and an 80 per cent
wealth increases, but the marginal utility of wealth diminishes. chance of failure), her expected utility is 55 units –
(95 × 0.2) + (45 × 0.8) = 55
Notice how the range of uncertainty affects FIGURE 20.3 Choice Under Uncertainty
expected utility. Figure 20.2 shows that with R3 000
of wealth and no uncertainty, total utility is 83 units.
Buying and Selling Risk Why People Buy Insurance People buy insurance
You have seen at many points in your study of and insurance companies earn a profit by selling insur-
markets how both buyers and sellers gain from trade. ance because people are risk averse. To see why people
Buyers gain because they value what they buy more buy insurance and why it is profitable, let us consider
highly than the price they must pay; they receive a an example. Bongani owns a car worth R10 000, which
consumer surplus. And sellers gain because they face is his only wealth. There is a 10 per cent chance that
costs that are less than the price at which they can sell; Bongani will have a serious accident that makes his car
they receive a producer surplus. worth nothing. So there is a 90 per cent chance that
Just as buyers and sellers gain from trading goods and Bongani’s wealth will remain at R10 000 and a 10 per
services, so they can also gain by trading risk. But risk is a cent chance that his wealth will be zero.
bad, not a good. The good that is traded is risk avoidance. Bongani’s expected wealth is
A buyer of risk avoidance can gain because the value of R9 000 – (R10 000 × 0.9) + (R0 × 0.1).
avoiding risk is greater than the price that must be paid Bongani is risk averse (just like Bongiwe in the
to someone else to get them to bear the risk. The seller of previous example). Because Bongani is risk averse,
risk avoidance faces a lower cost of risk than the price he will be better off by buying insurance to avoid
that people are willing to pay to avoid the risk. the risk that he faces, if the insurance premium is
We are going to put some flesh on the bare bones not too high.
of this brief account of how people can gain from Without knowing some details about just how
trading risk by looking at insurance markets. risk averse Bongani is, we do not know the most that
he would be willing to pay to avoid this risk. But we
do know that he would pay more than R1 000. If
Insurance Markets Bongani did pay R1 000 to avoid the risk, he would
Insurance plays a huge role in our economic lives. have R9 000 of wealth and face no uncertainty about
We will explain: his wealth. If he does not have an accident, his wealth
◆ How insurance reduces risk is the R10 000 value of his car minus the R1 000 he
◆ Why people buy insurance pays the insurance company. If he does lose his car,
◆ How insurance companies earn a profit the insurance company pays him R10 000, so he still
has R9 000. Being risk averse, Bongani’s expected
How Insurance Reduces Risk Insurance reduces the utility from R9 000 with no risk is greater than his
risk that people face by sharing or pooling the risks. expected utility from an expected R9 000 with risk.
When people buy insurance against the risk of So Bongani would be willing to pay more than
an unwanted event, they pay an insurance company a R1 000 to avoid this risk.
premium. If the unwanted event occurs, the insurance
company pays out the amount of the insured loss. How Insurance Companies Earn a Profit For the
Think about motor vehicle insurance. The prob- insurance company, R1 000 is the minimum amount
ability that any one person will have a serious motor at which it would be willing to insure Bongani and
vehicle accident is small. But a person who does have other people like him. With say 50 000 customers
a motor vehicle accident incurs a large loss. For a large all like Bongani, 5 000 customers (50 000 × 0.1)
population, the probability of one person having an acci- lose their cars and 45 000 do not. Premiums of
dent is the proportion of the population that has an acci- R1 000 give the insurance company a total revenue
dent. But this proportion is known, so the probability of of R50 000 000. With 5 000 claims of R10 000,
an accident occurring and the total cost of accidents can the insurance company pays out R50 000 000.
be predicted. An insurance company can pool the risks Thus a premium of R1 000 enables the insurance
of a large population and enable everyone to share the company to break even (make zero economic profit)
costs. It does so by collecting premiums from everyone on this business.
and paying out benefits to those who suffer a loss. An But Bongani (and everyone else) is willing to pay
insurance company that remains in business collects at more than R1 000, so insurance is a profitable busi-
least as much in premiums as it pays out in benefits. ness and there is a gain from trading risk.
The gain from trading risk is shared by Bongani for the loss of a vehicle, the insurance company can
(and the other people who buy insurance) and the provide insurance at a cost of R1 000 (10 per cent of
insurance company. The exact share of the gain R10 000). If Bongani pays only R1 000 for insur-
depends on the state of competition in the market ance, his wealth is R9 000 (the R10 000 value of his
for insurance. car minus the R1 000 he pays for insurance), and his
If the insurance market is a monopoly, the insur- utility from R9 000 of wealth with no uncertainty is
ance company can take all the gains from trading risk. about 98 units.
But if the insurance market is competitive, economic
profit will induce entry and profits will be competed Gains from Trade Because Bongani is willing to
away. In this case, Bongani (and the other buyers of pay up to R3 000 for insurance that costs the insur-
insurance) get the gain. ance company R1 000, there is a gain from trading
risk of R2 000 per insured person. How the gains are
shared depends on the nature of the market. If the
A Graphical Analysis of Insurance insurance market is competitive, entry will increase
We can illustrate the gains from insurance by using a supply and lower the price to R1 000 (plus normal
graph of Bongani’s utility of wealth curve. We begin, profit and operating costs). Bongani (and the other
in Figure 20.4, with the situation if Bongani does not buyers of insurance) enjoy a consumer surplus. If
buy insurance and decides to bear the risk he faces. the insurance market is a monopoly, the insurance
company takes the R2 000 per insured person as
Risk-Taking Without Insurance With no accident, economic profit.
Bongani’s wealth is R10 000 and his total utility is
100 units. If Bongani has an accident, his car is worthless;
he has no wealth and no utility. Because the chance of an FIGURE 20.4 Taking a Risk Without Insurance
accident is 10 per cent (or 0.1), the chance of not having
an accident is 90 per cent (or 0.9). Bongani’s expected
Utility of wealth (units)
110 Utility if
no crash Utility of wealth
wealth is R9 000 – (R10 000 × 0.9) + (R0 × 0.1) – and his 100
expected utility is 90 units – (100 × 0.9) + (0 × 0.1). 90
You have just seen that without insurance, Expected utility
80 with no insurance
Bongani gets 90 units of utility. But Bongani also gets
90 units of utility if he faces no uncertainty with a 70
Utility
smaller amount of wealth. 60
if crash
We are now going to see how much Bongani will 50
pay to avoid uncertainty. 40
30
The Value and Cost of Insurance Figure 20.5 Wealth
20 Expected if no
shows the situation when Bongani buys insurance. wealth crash
Wealth
You can see that for Bongani, having R7 000 with no 10 if crash
risk is just as good as facing a 90 per cent chance of
0 1 2 3 4 5 6 7 8 9 10 11 12
having R10 000 and a 10 per cent chance of having
Wealth (thousands of rand)
no wealth. So if Bongani pays R3 000 for insurance,
he has R7 000 of wealth, faces no uncertainty and Bongani’s wealth (the value of his car) is R10 000, which
gets 90 units of utility. gives him 100 units of utility.
The amount of R3 000 is the maximum that With no insurance, if Bongani has a crash, he has no
Bongani is willing to pay for insurance. It is the value wealth and no utility.
of insurance to Bongani. With a 10 per cent chance of a crash, Bongani’s
Figure 20.5 also shows the cost of insurance. expected wealth is R9 000 and his expected utility is
With a large number of customers each of whom 90 units.
has a 10 per cent chance of making a R10 000 claim
50
40 Private Information
30
In all the markets that you have studied so far, the
Wealth with Wealth with
20
insurance at insurance at
buyers and the sellers are well informed about the
10 price of R3 000 price of R1 000 good, service, or factor of production being traded.
But in some markets, either the buyers or the sellers
0 1 2 3 4 5 6 7 8 9 10 11 12 – usually the sellers – are better informed about the
Wealth (thousands of rand)
value of the item being traded than the person on
If Bongani pays R3 000 for insurance, his wealth is R7 000 and the other side of the market. Information about the
his utility is 90 units – the same utility as with no insurance – value of the item being traded that is possessed by
so R3 000 is the value of insurance for Bongani. only buyers or sellers is called private information. And
If Bongani pays R1 000 for insurance, which is the a market in which the buyers or sellers have private
insurance company’s cost of providing insurance, his wealth information has asymmetric information.
is R9 000 and his utility is about 98 units.
Bongani and the insurance company share the gain
from insurance. Asymmetric Information: Examples
and Problems
Asymmetric information affects many of your own
Risk That Cannot Be Insured economic transactions. One example is your knowl-
edge about your driving skills and temperament. You
The gains from motor vehicle collision insurance that know much more than your motor vehicle insurance
we have studied here apply to all types of insurance. company does about how carefully and defensively
Examples are property and casualty insurance, life you drive – about your personal risk of having an acci-
insurance and health-care insurance. One person’s dent that would cause the insurance company to pay
risks associated with driving, life and health are inde- a claim. Another example is your knowledge about
pendent of other persons’. That is why insurance is your work effort. You know more than your employer
possible. The risks are spread across a population. about how hard you are willing to work. Yet another
But not all risks can be insured. To be insurable, example is your knowledge about the quality of your
risks must be independent. If an event causes everyone car. You know whether it is a lemon, but the person
to be a loser, it is not possible to spread and pool the to whom you are about to sell it does not know and
risks. For example, flood insurance is often not avail- cannot find out until after he or she has bought it.
able for people who live on a floodplain because if one Asymmetric information creates two problems:
person incurs a loss, most likely all do. ◆ Adverse selection
Also, to be insurable, a risky event must be observ- ◆ Moral hazard
able to both the buyer and seller of insurance. But much
of the uncertainty that we face arises because we know Adverse Selection Adverse selection is the tendency
less (or more) than others with whom we do business. In for people to enter into agreements in which they can
the next section, we look at the way markets cope when use their private information to their own advantage
buyers and sellers have different information. and to the disadvantage of the uninformed party.
For example, if Jabu offers her To see how the used car market overcomes the
Adverse Selection
salespeople a fixed wage, she will lemon problem, we will look first at a used car market
attract lazy salespeople. Hardworking that has a lemon problem.
salespeople will prefer not to work
for Jabu because they can earn more The Lemon Problem in a Used Car Market
by working for someone who pays To explain the lemon problem as clearly as possible,
by results. The fixed-wage contract we will assume that there are only two kinds of cars:
adversely selects those with private defective cars – lemons – and cars without defects
information (knowledge about that we will call good cars. Whether or not a car is
www.quickto.mobi/ their work habits) who can use that a lemon is private information that is available only
PEA-ADVERSE knowledge to their own advantage to the current owner. The buyer of a used car cannot
and to the disadvantage of the tell whether he is buying a lemon until after he has
other party. bought the car and learned as much about it as its
current owner knows.
Moral Hazard Moral hazard is the tendency for Some people with low incomes and the time
people with private information, after entering into and ability to fix cars are willing to buy lemons as
an agreement, to use that information for their own long as they know what they are buying and pay
benefit and at the cost of the less-informed party. an appropriately low price. Suppose that a lemon is
For example, Jabu hires Moses as a salesperson worth R50 000 to a buyer. More people want to buy
and pays him a fixed wage regardless of how much he a good car and we will assume that a good car is worth
sells. Moses faces a moral hazard. He has an incentive R250 000 to a buyer.
to put in the least possible effort, benefitting himself But the buyer cannot tell the difference between
and lowering Jabu’s profits. For this reason, salespeople a lemon and a good car. Only the seller has this
are usually paid by a formula that makes their income information. And telling the buyer that a car is not a
higher, the greater is the volume (or value) of their sales. lemon does not help. The seller has no incentive to tell
A variety of devices have evolved that enable the truth.
markets to function in the face of moral hazard and So the most that the buyer knows is the prob-
adverse selection. ability of buying a lemon. If half of the used cars sold
We have just seen one; the use of incentive turn out to be lemons, the buyer knows that he has a
payments for salespeople. We are going to look at how 50 per cent chance of getting a good car and a 50 per
three markets cope with adverse selection and moral cent chance of getting a lemon.
hazard. They are: The price that a buyer is willing to pay for a car
◆ The market for used cars of unknown quality is more than the value of a lemon
◆ The market for loans because the car might be a good one. But the price is
◆ The market for insurance less than the value of a good car because it might turn
out to be a lemon.
Now think about the sellers of used cars, who
The Market for Used Cars know the quality of their cars. Someone who owns a
When a person buys a car, it might turn out to be good car is going to be offered a price that is less than
a lemon (a defective car). If the car is a lemon, it is the value of that car to the buyer. Many owners will
worth less to the buyer than if it has no defects. Does be reluctant to sell for such a low price. So the quan-
the used car market have two prices reflecting these tity of good used cars supplied will not be as large as it
two values – a low price for lemons and a higher price would be if people paid the price they are worth.
for cars without defects? It turns out that it does. In contrast, someone who owns a lemon is going
But it needs some help to do so and to overcome to be offered a price that is greater than the value of
what is called the lemon problem – the problem that that car to the buyer. So owners of lemons will be
in a market in which it is not possible to distinguish eager to sell and the quantity of lemons supplied will
reliable products from lemons – there are too many be greater than it would be if people paid the price
lemons and too few reliable products. that a lemon is worth.
Figure 20.6 illustrates the used car market that At the quantity of good cars supplied, buyers
we have just described. Part (a) shows the demand for are willing to pay R250 000 for a good car. They are
used cars, D, and the supply of used cars, S. willing to pay more than a good car is worth to its
Equilibrium occurs at a price of R100 000 per current owner for all good cars up to 400 cars a month.
car with 400 cars traded each month. The grey triangle shows the deadweight loss that
Some cars are good ones and some are lemons, results from there being too few good used cars.
but buyers cannot tell the difference until it is too late At the quantity of lemons supplied, buyers are
to influence their decision to buy. But buyers do know willing to pay R50 000 for a lemon. They are willing
what a good car and a lemon are worth to them, and to pay less than a lemon is worth to its current owner
sellers know the quality of the cars they are offering for all lemons above 150 cars a month. The grey
for sale. Figure 20.6(b) shows the demand curve for triangle shows the deadweight loss that results from
good cars, DG, and the supply curve of good cars, SG. there being too many lemons.
Figure 20.6(c) shows the demand curve for lemons, You can see adverse selection in this used car
DL, and the supply curve of lemons, SL. market because there is a greater incentive to offer
At the market price of R100 000, owners of a lemon for sale. You can also see moral hazard
good cars supply 200 cars a month for sale. Owners because the owner of a lemon has little incentive to
of lemons also supply 200 cars a month for sale. The take good care of the car, so it is likely to become an
used car market is inefficient because there are too even worse lemon. The market for used cars is not
many lemons and not enough good cars. Figure 20.6 working well.
makes this inefficiency clear by using the concept of Too many lemons and too few good used cars
deadweight loss (see Chapter 5, pp. 108–109). are traded.
0 200 400 600 800 0 200 400 600 800 0 150 200 300 400
Quantity (cars per month) Quantity (cars per month) Quantity (cars per month)
Buyers cannot tell a good used car from a lemon. Demand price, too few good cars are available, which brings a
and supply determine the price and quantity of used cars deadweight loss. In part (c), DL is the demand curve for
traded in part (a). In part (b), DG is the demand curve for lemons and SL is the supply curve. At the market price, too
good used cars and SG is the supply curve. At the market many lemons are available, which brings a deadweight loss.
A Used Car Market with Dealers’ Warranties Signalling occurs when an informed person takes
How can used car dealers convince buyers that a car actions that send information to uninformed persons.
is not a lemon? The answer is by giving a guarantee in The grades and degrees that a university awards
the form of a warranty. By providing warranties only students are signals. They inform potential (unin-
on good cars, dealers signal which cars are good ones formed) employers about the ability of the people
and which are lemons. they are considering hiring.
In the market for used cars, dealers send signals by So a car with a warranty is a good car; a car
giving warranties on the used cars they offer for sale. The without a warranty is a lemon. Warranties solve the
message in the signal is that the dealer agrees to pay the lemon problem and enable the used car market to
costs of repairing the car if it turns out to have a defect. function efficiently with two prices: one for lemons
Buyers believe the signal because the cost of sending and one for good cars.
a false signal is high. A dealer who gives a warranty on a Figure 20.7 illustrates this outcome. In part (a)
lemon ends up bearing a high cost of repairs – and gains the demand for and supply of good cars determine the
a bad reputation. A dealer who gives a warranty only on price of a good car. In part (b), the demand for and
good cars has no repair costs and a reputation that gets supply of lemons determine the price of a lemon.
better and better. It pays dealers to send an accurate Both markets are efficient.
signal, and it is rational for buyers to believe the signal.
Efficient outcome in
the market for lemons
100 000 100 000
D
66 670
50 000 50 000
Quantity of
Quantity of
good cars
lemons
D
With dealers’ warranties as signals, the equilibrium price of enables buyers to spot a lemon, the price of a lemon is
a good used car is R200 000 and 400 cars are traded. R66 670 and 150 lemons are traded. The market for lemons
The market for good used cars is efficient. Because the signal is efficient.
Interest rates and the price of credit risk are deter- borrowers. Signalling and screening in the market for
mined in the market for loans. The lower the interest loans works like warranties in the used car market and
rate, the greater is the quantity of loans demanded avoids the deadweight loss of a pooling equilibrium.
and for a given level of credit risk, the higher the
interest rate, the greater is the quantity of loans
supplied. Demand and supply determine the interest Economics in Action
rate and the price of credit risk. The Sub-Prime Credit Crisis
If lenders were unable to charge different interest A sub-prime mortgage is a loan to a homebuyer who has
rates to reflect different degrees of credit risk, there would a high risk of default. Figure 1 shows that between 2001
be a pooling equilibrium and an inefficient loans market. and 2005, the price of risk was low. Figure 2 shows why:
The supply of credit, S0, was large and so was the amount
Inefficient Pooling Equilibrium To see why a of risk taking. In 2007, the supply of credit decreased to S1.
pooling equilibrium would be inefficient, suppose The price of risk jumped and, faced with a higher interest
that banks cannot identify the individual credit risk rate, many sub-prime borrowers defaulted. Defaults in the
of their borrowers: they have no way of knowing how sub-prime mortgage market spread to other markets that
likely it is that a given loan will be repaid. supplied
1.5 the funds that financed mortgages.
In this situation, every borrower pays the same 1.5 Lehman crisis
1.5
interest rate and the market is in a pooling equilibrium. 1.5 Lehman
Lehman crisis
crisis
year)
Lehman crisis
If all borrowers pay the same interest rate, the 1.2
year)
year)
1.2
1.2 Sub-prime crisis
market for loans has the same problem as the used
year)
per
1.2 Sub-prime
and credit crisis
Sub-prime crunch
crisis
per
per
car market. Low-risk customers borrow less than they and credit crunch
cent
Sub-prime
and credit crisis
crunch
per
0.9
cent
would if they were offered the low interest rate appro- 0.9
(per
0.9
cent
0.9
(per
0.6
risk
0.6
risk
0.6
credit
Supply of credit
ofofcredit
Supply
Supply of
of credit
increased
for their high credit risk. So banks face an adverse 0.3 credit
Price
0.3 increased
Price
0.3
Price
S1 S0
providing lenders with relevant information. Signals might
year)
S
year)
S11 S
S0
year)
2.0 S1
per
S00
include information about the length of time a person has 2.0
per
2.0
per
cent
2.0
per
Sub-prime crisis:
risk
(per
Sub-prime crisis:
risk
of credit
as those who have failed to signal low risk. These Sub-prime crisis:
risk
1.2 supply
loans
supply of risky
risky
decreased
of
credit
supply of risky
credit
loans decreased
decreased
borrowers have an incentive to mislead lenders; and
ofofcredit
1.2
1.2 loans
loans decreased
1.2
1.0
lenders have an incentive to induce high-risk borrowers
Price
1.0
of
1.0
Price
1.0
Price
Grades as Signals
40
25
With grade inflation,
students get low-wage S
20 jobs before being
sorted by ability 30
… and low-grade
15
students get SL
20 low-wage jobs
10
10
5
D
DL
0 5 10 0 1 2 3 4 5 6
Quantity (thousands of workers) Quantity (thousands of workers)
Figure 1 Market with grade inflation Figure 3 The market for D students
Figure 1 Market with mark inflation Figure 3 The market for D students
Key Terms
Adverse selection, 434 Expected utility, 430 Pooling equilibrium, 437 Screening, 438
Asymmetric information, 434 Expected wealth, 429 Private information, 434 Separating equilibrium, 437
Credit risk, 437 Lemon problem, 435 Risk aversion, 429 Signalling, 436
Default risk, 437 Moral hazard, 435
6. High-Crime Auto Theft, an insurance company, we spend is somebody else’s money, and we do
offers to sell Gert insurance at R80 000 a year not have very good information about doctors or
and promises to provide Gert with a replacement hospitals. You can go online and find out your
car worth R200 000 if his car is stolen. Is Gert doctor’s fee before you make an appointment.
willing to buy this insurance? If not, is he willing But when you have a serious condition, you really
to pay R40 000 a year for such insurance? want to know about the doctor’s quality.
With the collaboration of doctors, agreeing
Private Information on quality standards and if all medical health
Use the following information to work out plans were willing to pool their data, consumers
Problems 7 and 8. could look at a set of performance indicators
that doctors think are appropriate, and be able to
Zuleika is a high-school teacher and is well known judge the quality of their doctors.
in her community for her honesty and integrity. She a. Explain how the adverse selection problem
is shopping for a used car and plans to borrow the applies to health care.
money from her local bank to pay for the car. b. How does the moral hazard problem apply
7. a. Does Zuleika create any moral hazard or to health insurance?
adverse selection problems for either the 11. You cannot buy insurance against the risk of being
bank or the car dealer? Explain your answer. sold a lemon. Why is there not a market in insur-
b. Does either the bank or the car dealer create ance against being sold a lemon? How does the
any moral hazard or adverse selection prob- market provide a buyer with some protection
lems for Zuleika? Explain your answer. against being sold a lemon? What are the main ways
8. What arrangements is Zuleika likely to encounter in which markets overcome the lemon problem?
that are designed to help her cope with the
moral hazard and adverse selection problems Uncertainty, Information, and the Invisible Hand
she encounters in her car buying and bank 12. In Problem 10, what role can better information
loan transactions? play in the health care market? Is it possible for
9. Suppose that there are three national soccer divi- there to be too much information in this market?
sions: Time Division, Goal Difference Division 13. In the Dark
and Bonus for Win Division. The divisions are of Employees often complain that they do not
equal quality, but the players are paid differently. know what their co-workers earn. Are businesses
In the Time Division, they are paid by the hour ‘keeping this private’ because employees want it
for time spent practising and time spent playing. that way or because transparency would lead to
In the Goal Difference division, they are paid an more people demanding a raise?
amount that depends on the points that the team Explain why a worker might be willing to pay for
scores minus the points scored against it. In the the salary information of other workers.
Bonus for Win Division, the players are paid one
wage for a loss, a higher wage for a tie and the Economics in the News
highest wage of all for a win. 14. Making the Grade
a. Briefly describe the predicted differences in Grade inflation is unfair to students who
the quality of the games played by each of truly deserve exceptional grades. It also is
the divisions. unfair to university graduate applicants who
b. Which division is the most attractive come from schools that do not inflate grades.
to players? What economic role do accurate grades play?
c. Which division will generate the largest Who benefits from grade inflation: students,
profits? academics, universities or future employers?
10. Paying Without Knowing Who bears the cost of grade inflation? How do
When paying for health care, most of us do not you think grade inflation might be controlled? Is
behave like good consumers: Most of the money grade inflation efficient?
21. If Chris cannot buy cold summer insurance, of this type would be valuable to workers but
what is her expected wealth and what is her unprofitable for an insurance provider and so
expected utility? would not work.
22. Business Loss Recovery, an insurance company,
is willing to sell Chris cold summer insurance at Uncertainty, Information and the Invisible Hand
a price of R3 000 a year and promises to pay her Use the following info byte to work out
R5 000 if the summer is cold and the business Problems 28 and 29.
fails. Is Chris willing to buy this loss insurance?
If she is, is she willing to pay R4 000 a year for it? Are We Worrying About the Right Things?
We humans have a strange habit of worrying
Private Information about mere possibilities while ignoring probabili-
Use the following info byte to work out ties, preparing for perceived dangers while leaving
Problems 23 to 25. ourselves exposed to real ones. Many people still
smoke. Others still do not buckle up in the car. We
Larry has a good car that he wants to sell; Harry has a build our houses on flood plains and when they are
lemon that he wants to sell. Each knows what type of washed away we go back and build them there again.
car he is selling. You are looking at used cars and plan 28. Explain how ‘worrying about mere possibilities
to buy one. while ignoring probabilities’ can result in people
23. If both Larry and Harry are offering their cars making decisions that not only fail to satisfy
for sale at the same price, from whom would you social interest, but also fail to satisfy self-interest.
most want to buy, Larry or Harry, and why? 29. How can information be used to improve
24 If you made an offer of the same price to Larry people’s decision making?
and Harry, who would sell to you and why?
Describe the adverse selection problem that arises Economics in the News
if you offer the same price to Larry and Harry. 30. How Much Am I Worth?
25. How can Larry signal that he is selling a good car Are you being paid fairly? In many instances, you
so that you are willing to pay Larry the price that do not know. Your employer has more and better
he knows his car is worth, and a higher price than information than you do about how your salary
what you are willing to offer Harry? and bonus compares to others in your field, to
26. Pam is a safe driver and Fran is a reckless others in your office and relative to the company’s
driver. Each knows what type of driver she is, profits in any given year. You can narrow the
but no one else knows. What might a motor information gap a bit if you are willing to buy
vehicle insurance company do to get Pam to salary reports from compensation sources.
signal that she is a safe driver so that it can offer a Explain the role that asymmetric informa-
her insurance at a lower premium than it offers tion can play in worker wages.
to Fran? b. What adverse selection problem exists if a
27. Why do you think it is not possible to buy insur- firm offers lower wages to existing workers?
ance against having to put up with a low-paying, c. What will determine how much a worker
miserable job? Explain why a market in insurance should actually pay for a detailed salary report?
Thomas Robert Malthus (1766–1834), an English Principle of Population. But it was also Malthus’s
clergyman and economist, was an extremely influ- gloomy predictions that led economics to be called
ential social scientist. the ‘dismal science’.
In his best-selling Essay on the Principle of
Population, published in 1798, he predicted that
population growth would outstrip food production ‘The passion between the sexes has appeared in
and said that wars, famine and disease were inevi- every age to be so nearly the same, that it may
table unless population growth was held in check always be considered, in algebraic language, as
by marrying at a late age and living a celibate life. a given quantity.’
(He married at 38 a wife of 27, marriage ages that
he recommended for others.)
THOMAS ROBERT MALTHUS
Malthus had a profound influence on Charles
Darwin, who got the key idea that led him to the An Essay on the Principle of Population
theory of natural selection from the Essay on the
as information technologies further shrank the globe, house painting, gardening and so on). It also excludes
the international dimension of macroeconomics production that people hide to avoid taxes or because
became more prominent. The result of these devel- the activity is illegal – the underground economy. But
opments is that modern macroeconomics is a broad despite its shortcomings, real GDP is the best measure
subject that studies all the issues we have just identi- of total production available. Let us see what it tells us
fied: economic growth, unemployment and inflation. about economic growth.
Macroeconomics also studies fluctuating currencies
and government budget and international deficits
and debts. Economic Growth in South Africa
Over the past 40 years, economists have devel- Figure 1 shows real GDP in South Africa from
oped a clearer understanding of the forces that deter- 1960 to 2012 and highlights two features of
mine macroeconomic performance and have devised economic growth:
policies that they hope will improve this performance. ◆ The growth of potential GDP
Your main goal is to become familiar with the theo- ◆ Fluctuations of real GDP around potential GDP
ries of macroeconomics and the policies that they
make possible. To set you on your path toward this The Growth of Potential GDP When all the
goal, we are going to take a look at economic growth, economy’s labour, capital, land and entrepreneurial
unemployment, inflation and the rand, and surpluses, ability are fully employed, the value of production is
deficits and debts and learn why these macroeconomic called potential GDP. Real GDP fluctuates around
phenomena merit our attention. potential GDP and the long-term economic growth
rate is measured by the growth rate of potential GDP.
It is shown by the steepness of the potential GDP line
(the red line) in Figure A20.1.
Economic Growth and Fluctuations During the 1960s, potential GDP grew at
Your parents are richer than your grandparents were an unusually rapid rate. But the growth rate of
when they were young. But are you going to be richer output per person slowed during the 1970s, a
than your parents are? And are your children going to phenomenon called productivity growth slowdown.
be richer than you? The answers depend on the rate of In other parts of the world, potential GDP began to
economic growth. grow more rapidly during the late 1980s and through
Economic growth is the expansion of the the 1990s and 2000s. In South Africa the policy of
economy’s production possibilities. It can be pictured apartheid and the subsequent economic sanctions
as an outward shift of the production possibilities kept the economy from reacting similarly to the
frontier (PPF ). changing economic conditions worldwide and we
We measure economic growth by the increase saw a decline in growth for most of the 1980s and
in real gross domestic product. We define real gross the early 1990s. After the democratic elections of
domestic product (also called real GDP) and how it is 1994, South Africa’s economic growth has recovered
measured in Chapter 21 but for now, you can think to a great extent. Yet, like most of the industrialised
of it as the value of the economy’s total production nations, South Africa has not been able to reach the
measured in the prices of a single year. Real GDP in high growth rate of the 1960s again.
South Africa is currently measured in the prices of Why did the productivity growth slowdown
2005 (called constant 2005 prices). We use the rand that influenced growth worldwide occur? The answer
price of a single year to eliminate the influence of to this question is controversial. One possible cause
inflation – the increase in the average level of prices – is a sharp rise in the relative price of energy. Whatever
and determine how much production has grown from its cause, a productivity growth slowdown means
one year to another. that we all have smaller incomes today than we
Real GDP is not a perfect measure of total would have had if the economy had continued
production because it does not include everything to grow at the rate it grew in the 1960s. In
that is produced. It excludes the things we produce for Chapter 23 we will take a look at what causes
ourselves at home (preparing meals, doing laundry, potential GDP to grow.
First
democratic
100 20
Strong WB series
Total non-agricultural
employment growing 15
period
IRL series
50 Private sector employment 10
0 0
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Year Year
(a) Employment in South Africa (b) Unemployment in South Africa
In part50(a) South Africa’s total employment index and to the Institute for Race Relations (IRL unemployment). Both
private sector employment index indicate that South Africa’s series indicate that unemployment is serious in South Africa.
45
employment stagnated during the 1980s. Employment Events that caused a surge in unemployment were the OPEC
Unemployment rate (percentage of labour force)
declined
40 steadily since 1990, but strong growth since oil price shock during the latter half of the 1970s (when the
2001 caused employment to increase sharply. The negative
Sanctions Organization of Petroleum Exporting Countries forced the
against SA First
35
influence of the 2008/9 recession ondemocratic
employment is also price of oil up by 70 per cent per barrel in 1973 and again
evident with a decline in both elections
employment indices. by 150 per cent in 1977) and sanctions against South Africa
30 OPEC
in the 1980s. The sanctions against South Africa entailed the
In part25(b) South Africa’s unemployment rate is shown and it is withdrawal of investments and companies from South Africa.
evident that unemployment is a persistent feature of economic With the closing down of international companies in the
20
life, but its rate varies. Two sources of unemployment
WB seriesrates are country, many people lost their jobs, increasing unemployment.
shown15– the official rate published by the World Bank since Sources of data: South African Reserve Bank, World Development Indicators
1994 (WB unemployment) and unemployment according
IRL series and the Institute for Race Relations.
10
Unemployment
0 more fully in Chapter 22.) The unemployment rate
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Not everyone who wants a job can find one. On any is not a perfect measure of the underutilisation of
Year
day in a normal or average year, there are people that labour for two main reasons. First, it excludes people
are unemployed and during a recession or depression, who are so discouraged that they have given up the
unemployment rises above this level. effort to find work. Second, the unemployment rate
To place the number of unemployed people in measures unemployed people rather than unemployed
perspective, we use a measure called the unemploy- labour hours. So the unemployment rate does not
ment rate. The unemployment rate is the number of tell us about the numbers of part-time workers who
unemployed people expressed as a percentage of all want full-time jobs. Despite these two limitations, the
the people who have jobs or are looking for one. (The unemployment rate is the best available measure of
concept of the unemployment rate, along with some underused labour resources.
other measures of the labour market, is explained
The Value of the Rand Abroad FIGURE A20.4 The Exchange Rate
When you spend money in South Africa, you pay 30 Sharp appreciation
in the currency
more when the prices in the shops rise. Inflation
20
Percentage change in the exchange rate
Why the Exchange Rate Matters The value of the South African rand fluctuates against other
major currencies on the foreign exchange market. The rand
When the South African rand depreciates, other things
depreciated sharply during the political instability of 1985
remaining the same, we must pay more for the things
and subsequent sanctions instated against the country
that we import. And when the rand appreciates, we
(indicated by a movement under the zero change line). The
pay less for the things that we import. So a weaker
rand continued the depreciating trend between 1990 and
rand hurts consumers; a stronger rand benefits them.
2002. It appreciated sharply between 2002 and 2005
But what is good for the consumer can make
(indicated by a movement above the zero change line), after
life tough for the producer. A stronger rand makes it
which it depreciated again and became very volatile.
harder for a South African producer to compete in
foreign markets and a weaker rand makes it easier Source of data: South African Reserve Bank.
to compete.
Chapter 26 explores these effects of the exchange government spends more than it collects in taxes, it
rate more fully and explains what determines the has a deficit – a government budget deficit.
exchange rate. Figure A20.5(a) shows the central government
budget surplus and deficit measured as a percentage of
GDP from 1963 to 2011.
Surpluses, Deficits and Debts We measure the budget surplus or deficit as
In 2006, for the first time in almost 30 years, the a percentage of GDP so that we can compare the
South African government had a budget surplus. surplus or deficit in one year with that in another year.
Mostly, the government’s budget is in a deficit. For You can think of this measure as the number of cents
most years since 1994, the country also has a large of surplus or deficit per rand of income earned by an
and growing international deficit. average person.
What happens when a government or a nation During this time period, the government had
spends more than it receives and has a deficit? Do a budget surplus for the first time in 2006. In every
governments and nations face the problem that you year from 1963 to 2005, the government had a deficit
and I would face if we spent more than we earned? that fluctuated and swelled during recessions. In the
Do governments and nations run out of funds? Let us 1990s, the deficit was never less than 2 per cent of
look at these questions. GDP and it reached a peak of almost 7 per cent of
GDP in 1993.
After 1993 the government budget deficit shrank
Government Budget Balance and in 2006, a budget surplus emerged. This was
If a government collects more in taxes than it spends, short-lived though and the budget deficit almost
it has a surplus – a government budget surplus. If a reached 5 per cent of GDP again in 2009.
FIGURE A20.5 Government Budget and International Surpluses and Deficits in South Africa
2 8
Sanction
Government budget balance
(percentage of GDP)
First budget
(percentage of GDP)
years
Current account balance
1 6 OPEC
surplus
recession
0
4 1996
–1 recession
2 Recession
–2
0
–3
Large –2
–4 budget
deficits –4
–5
... again Expansion Expansion
–6 since 2002
–6 First
OPEC 7% of GDP democratic Recession
–7 –8
recession deficit elections Expansion
–8 –10
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Year Year
In part (a), the central government budget deficit as a percentage sanction years (1985 to 1994) South Africa’s current
of GDP increased during recessions and shrank during the account was in a surplus. Since the democratic elections and
expansions. A budget surplus emerged in 2006 for the first time, the subsequent expansion, a large current account deficit
although this surplus quickly turned into a deficit again. emerged. During 2001–2002, the deficit was under control,
but it has escalated to more than 7 per cent of GDP again by
In part (b), South Africa’s current account shows the balance the year 2007.
of South Africa’s exports minus our imports. During the
Source of data: South African Reserve Bank.
International Deficit to reach 7.2 per cent of GDP in 2007 and remains a cause
When we import goods and services from the rest of for concern in the South African economy.
the world, we make payments to foreigners. When
we export goods and services to the rest of the world,
we receive payments from foreigners. If our imports Deficits Bring Debts
exceed our exports, we have an international deficit. A deficit is the amount by which spending exceeds
Figure A20.5(b) shows the history of South income during a given period. Suppose that you charge
Africa’s international balance from 1963 to 2011. The everything that you buy to your credit card and when you
graph shows the balance on the current account, which receive your monthly credit card statement, you pay only
includes South African exports minus South African the minimum balance. You have a personal budget deficit.
imports but also takes into account interest payments A debt is an amount that is owed. It is the total
paid to and received from the rest of the world. (Again, of all the past deficits minus the total of all past
to compare one year with another, the figure shows the surpluses. The total amount outstanding on your
current account as a percentage of GDP.) credit card account is a debt. It is the amount that
The South African current account has fluctuated you owe to the issuer of the card.
substantially between a surplus of almost 6 per cent of What happens to your credit card balance –
GDP and a deficit of more than 7 per cent of GDP. In your debt – if you charge more than you pay off?
the sanction years (1985 to 1994), South Africa’s current Your debt grows.
account was in a surplus. The surplus had to be obtained The government and the nation face the same
to sustain the outflow of capital caused by the sanctions. problem that you face. When a government or a
But since 1994, the current account has mostly been in nation has a deficit, its debt grows. The government’s
deficit. And since 2003, the deficit has grown substantially debt is called the national debt. It is the amount that
(percentage of GDP)
Government debt
International debt
32
30 Declining
First democratic budget deficits 28
and debt First democratic
elections
20 elections
24
10
20
0 16
1985 1990 1995 2000 2005 2010 1985 1990 1995 2000 2005 2010
Year Year
In part (a), budget deficits in the 1980s and early 1990s Part (b) shows that South Africa is a net borrower of
caused government debt to soar. Fiscal discipline and international funds. Increasing current account deficits have
economic growth decreased the government debt from more increased South Africa’s international debt.
than 50 per cent of GDP in 1995 to 23.9 per cent in 2008.
Source of data: South African Reserve Bank.
However, the budget deficit from 2008 onwards caused a
turnaround in the trend and by 2010 government debt had
surpassed 33 per cent of GDP again.
the government owes to all the people who have made Whether borrowing and paying out huge
loans to cover the government deficits. amounts of interest is a good idea depends on
Figure A20.6(b) shows South Africa’s international what the borrowed funds are used for. If you
debt. This debt is the amount that South African borrow to finance a holiday, you must eventually
residents owe to foreigners. When international debt is tighten your belt, cut spending and repay your
negative, foreigners owe South African residents. South debt, as well as pay interest on the debt. But if you
Africa is a net borrower from the rest of the world since borrow to invest in a business that earns a large
the national debt has not fallen to below zero. Due to profit, you might be able to repay your debt and pay
the debt standstill in 1985, where South Africa was the interest on it while continuing to increase your
forced to repay its debt to the rest of the world, the spending. It is the same with a government and a
official levels of foreign debt declined steadily during nation. A government or a nation that borrows to
the last part of the 1980s. The readmission of South increase its consumption might be heading for
Africa into the world economy led to an increase in trouble later. But a government or a nation that
foreign lending activity by South Africans and the borrows to buy assets that earn a profit might be
recent growth in the current account deficit shows a making a sound investment.
clear increase in demand for foreign funds. You will learn more about the government
budget in Chapter 30 and about the international
current account deficit in Chapter 26.
Why Deficits and Debts Matter With this background to the macroeconomic
What happens when a government cannot cover its history and challenges in South Africa, you are now
spending with taxes, or when a country buys more ready to analyse the macro economy in more detail.
from other countries than it sells to them?
W
21
ill our economy expand during the next three years? If so, will
the expansion be rapid or slow? Or are we going to swing into a
recession again? Many South African companies wanted to know
the answers to these questions at the beginning of the year. Vodacom
wanted to know whether to expand its server networks and introduce
new services or delay expansions for a while. Pick n Pay wanted to
know whether to increase its warehousing facilities.
MEASURING GDP To assess the state of the economy and to make big
decisions about business expansion, firms such as
AND ECONOMIC Vodacom and Pick n Pay use forecasts of GDP. What
exactly is GDP and what does it tell us about the
GROWTH state of the economy?
To reveal the rate of growth or shrinkage of
GDP, we must remove the effects of inflation and
assess how real GDP is changing. How do we remove the inflation
component of GDP to reveal real GDP?
How do we compare economic well-being in one country with that
in another? How can we make international comparisons of GDP?
In this chapter, you will find out how economic statisticians at
Statistics South Africa (StatsSA) measure GDP, real GDP and the
economic growth rate. You will also learn about the uses and the
limitations of these measures. In Reading Between the Lines at the end of
the chapter, we will look at the expenditure components responsible for
growth in real GDP in South Africa during 2011.
GDP and the Circular Flow of Expenditure Households and Firms Households own
factors of production (labour, capital, land and
and Income
entrepreneurship) and sell them to firms. Firms
Figure 21.1 illustrates the circular flow of expenditure buy the services of labour, capital and land in factor
and income. The economy consists of households, markets. For these factor services, firms pay income
firms, governments and the rest of the world (the to households: wages for labour services, interest for
rectangles), which trade in factor markets and goods the use of capital and rent for the use of land. The
(and services) markets. We focus first on households fourth factor of production, entrepreneurship,
and firms. receives profit.
HOUSEHOLDS
GOVERNMENTS
Y C
FACTOR GOODS
MARKETS MARKETS
X– M
I
C
Y REST
G OF
WORLD
X– M
FIRMS
Firms’ retained earnings, profits that are not GDP Equals Expenditure Equals Income Gross
distributed to households, are part of the household domestic product can be measured in two ways: by
sector’s income. the total expenditure on goods and services or by the
You can think of retained earnings as being total income earned producing goods and services.
income that households save and lend back to firms. The total expenditure – aggregate expenditure (AE )
Figure 21.1 shows the total income, aggregate income, – is the sum of the red flows in Fig. 21.1. Aggregate
received by households, including retained earnings, expenditure equals consumption expenditure (C ) plus
as the blue flow labelled Y. investment (I ) plus government expenditure (G) plus
Firms sell and households buy consumer goods net exports (X – M ).
and services, such as surfboards and haircuts, in the Aggregate income (Y ) is equal to the total
goods market. amount paid for the services of the factors of
The total payment for these goods and services is production used to produce final goods and services,
consumption expenditure, shown by the red flow labelled C. i.e. wages, interest, rent and profit. The blue flow in
Firms buy and sell new capital equipment, such Fig. 21.1 shows aggregate income. Because firms pay
as computer systems, aeroplanes, trucks and assembly out as incomes (including retained profits) everything
line equipment, in the goods market. Some of what received from the sale of its output, aggregate income
firms produce is not sold but is added to inventory. (the blue flow) equals aggregate expenditure (the sum
For example, if Toyota produces 1 000 cars and sells of the red flows). That is,
950 of them, the other 50 cars remain in Toyota’s
inventory of unsold cars, which increases by 50 cars. Y = AE
When a firm adds unsold output to inventory, we Y=C+I+G+X–M
can think of the firm as buying goods from itself. The
purchase of new plant, equipment and buildings and The table in Fig. 21.1 shows the values of the
the additions to inventories are investment, shown by expenditures for 2011 that in sum is R2 941 billion,
the red flow labelled I. which also equals aggregate income. Because aggregate
expenditure equals aggregate income, the two
Governments Governments buy goods and services methods of measuring GDP give the same answer. So
from firms and their expenditure on goods and GDP equals aggregate expenditure (AE ) and equals
services is called government expenditure. In Fig. 21.1, aggregate income (Y ).
government expenditure is shown as the red flow G. The circular flow model is the foundation on
Governments finance their expenditure with which the national economic accounts are built.
taxes. But taxes are not part of the circular flow of
expenditure and income. Governments also make
financial transfers to households, such as social grants Why Is Domestic Product ‘Gross’?
and unemployment benefits and pay subsidies to ‘Gross’ means before subtracting capital depreciation.
firms. These financial transfers, like taxes, are not part The opposite of ‘gross’ is ‘net’, which means after
of the circular flow of expenditure and income. subtracting capital depreciation.
Depreciation is the decrease in the value of a
Rest of the World Firms in South Africa sell goods and firm’s capital that results from wear and tear and
services to the rest of the world, exports and buy goods obsolescence. The total amount spent both buying new
and services from the rest of the world, imports. The capital and replacing depreciated capital is called gross
value of exports (X ) minus the value of imports (M ) is investment. The amount by which the value of capital
called net exports, the red flow X – M in Fig 21.1. If net increases is called net investment. Net investment equals
exports are positive, the net flow of goods and services is gross investment minus depreciation.
from South African firms to the rest of the world. This For example, if an airline buys 5 new aeroplanes
occurs when South Africa exports more than it imports. and retires 2 old aeroplanes from service, its gross
If net exports are negative the net flow of goods and investment is the value of the 5 new aeroplanes,
services is from the rest of the world to South African depreciation is the value of the 2 old aeroplanes retired
firms and our imports exceed our exports. and net investment is the value of 3 new aeroplanes.
Gross investment (I ) is one of the expenditures included produced in South Africa and in the rest of the
in the expenditure approach to measuring GDP. So the world. They include goods such as CDs and books
resulting value of total product is a gross measure. and services such as banking and legal advice. They
Gross profit, which is a firm’s profit before do not include the purchase of new houses, which is
subtracting depreciation, is one of the incomes counted as part of investment. But they do include
included in the income approach to measuring the purchase of consumer durable goods, which
GDP. So again, the resulting value of total product technically form part of capital as do houses.
is a gross measure. Gross private domestic investment (I ) is
expenditure on capital equipment and buildings by
REVIEW QUIZ firms and the additions to business inventories. It also
includes expenditure on new homes by households.
1 Define GDP and distinguish between a final Government expenditure (G ) on goods and
good and an intermediate good. Provide services is the expenditure by all levels of government
examples. on goods and services, such as national defence
2 Why does GDP equal both aggregate income and garbage collection. It does not include transfer
and aggregate expenditure? payments, such as unemployment benefits, because
3 What is the distinction between gross and net? they are not expenditures on goods and services.1
Net exports of goods and services (X – M ) are the
Now let us see how the ideas that you have value of exports minus the value of imports. This item
just studied are used in practice. We will see how includes the Volkswagens made in Uitenhage that
GDP and its components are measured in South are sold to Australians (a South African export) and
Africa today. Japanese DVD players that retailer Game buys from
Sony (a South African import).
Table 21.1 shows the relative magnitudes of the
four items of aggregate expenditure.
Measuring South Africa’s GDP
Statistics South Africa (StatsSA) uses the concepts
in the circular flow model to measure GDP and its The Income Approach
components in the National Income and Production The income approach measures GDP by summing the
Accounts. Because the value of aggregate output equals incomes that firms pay households for the services
aggregate expenditure and aggregate income, there of the factors of production they hire: wages for
are two approaches available for measuring GDP and labour, interest for capital, rent for land and profit for
both are used. They are: entrepreneurship. These incomes correspond to the
◆ The expenditure approach blue flow through the factor markets in the circular
◆ The income approach flow model in Fig. 21.1.
The National Income and Production Accounts
divide incomes into two big categories:
The Expenditure Approach 1. Compensation of employees
The expenditure approach measures GDP as the sum 2. Net operating surplus (which includes net interest,
of consumption expenditure (C ), investment (I ), rental income, dividends and proprietors’ income)
government expenditure on goods and services (G )
and net exports of goods and services (X –M ). These Compensation of employees is the payment for labour
expenditures correspond to the red flows through services. It includes net wages and salaries (called
the goods markets in the circular flow model in ‘take-home pay’) that workers receive plus taxes with-
Fig. 21.1. Table 21.1 shows these expenditures and held on earnings plus fringe benefits such as social
GDP for 2011. The table uses the terminology used in grants and pension fund contributions.
the National Income and Production Accounts.
1 Transfer payments are excluded because they are received without the
Personal consumption expenditures (C ) are the recipient having ‘produced’ a product or service. Therefore they do not
expenditures by households on goods and services contribute to GDP.
The expenditure approach measures GDP as the sum of measured by the expenditure approach was R2 941 billion.
personal consumption expenditures (C ), gross private Almost 60 per cent of aggregate expenditure is on personal
domestic investment (I), government expenditure on goods consumption goods and services.
and services (G), and net exports (X – M). In 2011, GDP Source of data: South African Reserve Bank.
Net operating surplus is the sum of all other factor final goods. When we sum the expenditures on final
incomes. goods, we arrive at a total called domestic product at
It has four components: net interest, rental income, market prices. Market prices and factor cost diverge
dividends and proprietors’ income. because of indirect taxes and subsidies.
Net interest is the interest households receive on An indirect tax is a tax paid by consumers
loans they grant minus the interest households pay on when they buy goods and services such as sales
their own borrowing. and excise taxes.
Rental income is the payment for the use of land Value-added tax (VAT) and taxes on alcohol,
and other subsoil assets.2 petrol and diesel and tobacco products are indirect
Dividends are the profits of companies, some taxes. Because of indirect taxes, consumers pay more
of which are paid to households in the form of for some goods and services than producers receive. So
dividends. Sometimes dividends paid exceed the market price exceeds the factor cost. For example,
dividends received, since shares can be held by if value-added tax is 14 per cent, you pay R1.14 when
foreigners. Therefore the income that households you buy a R1 toffee. The factor cost of the toffee
derive from dividends is less than the income paid out including profit is R1.00. The market price is R1.14.
by firms in a country. A subsidy is a payment that the government
Proprietors’ income, which is also referred to as mixed makes to a producer. Payments made to grain growers
income, is the income earned by the owner-operator of and dairy farmers are subsidies. Because of subsidies,
a business. It is the owner’s compensation for his/her consumers pay less for some goods and services than
labour, the use of the owner’s capital and profit. producers receive. So then the factor cost exceeds the
Table 21.2 shows these five factor incomes market price.
and their relative magnitudes. You can see that To get from factor cost to market price, we add
compensation of employees, labour income, is indirect taxes and subtract subsidies. Making this
approximately 1.5 times the magnitude of the other adjustment brings us to net domestic income at
factor incomes that make up the net operating market prices. We still must get from a net measure
surplus. to a gross measure.
The factor incomes sum to net domestic income at Total expenditure (AE ) is a gross number because
factor cost. The term ‘factor cost’ is used because it is it includes gross investment. Net domestic income
the cost of the factors of production used to produce at market prices is a net income measure because
2 Subsoil assets are mineral deposits below the earth and ownership of these
corporate profits are measured after deducting
deposits is often split from that of the land. Rent is then payable when these depreciation. To get from net income to gross income,
reserves are exploited. Examples include coal, oil, natural gas and mineral we must add depreciation.
reserves.
We have now arrived at GDP using the income an increase in production and higher prices. To isolate
approach. This number is not exactly the same as the increase in production from the increase in prices,
GDP using the expenditure approach. For example, we distinguish between real GDP and nominal GDP.
if a waiter does not report all his tips when he fills Real GDP is the value of final goods and services
out his income tax return, they get left out in the produced in a given year when valued at the prices
income approach but they show up in the expenditure of a reference base year. By comparing the value of
approach when he spends his income. Therefore, production in the two years at the same prices, we
the sum of expenditures might exceed the sum of reveal the change in production.
incomes. The sum of expenditures might also exceed Currently, the reference base year is 2005 and we
the sum of incomes because some expenditure items describe real GDP as measured in 2005 rand, thus in
are estimated rather than directly measured. terms of what the rand would buy in 2005.
The gap between the expenditure approach and Nominal GDP is the value of final goods and
the income approach is called the statistical discrepancy services produced in a given year when valued at the
and it is calculated as the GDP income total minus the prices of that year.
GDP expenditure total. The discrepancy is never large. Nominal GDP is just a more precise name for
In 2011, it was 0.8 per cent of South Africa’s GDP. GDP. Economists are more interested in real GDP as
they want to compare GDP over time.
Nominal GDP and Real GDP
Often, we want to compare GDP in two periods, say
Calculating Real GDP
2000 and 2010. In 2000, GDP was R922 billion and We will calculate real GDP for an economy that
in 2010, it was R2 661 billion, 189 per cent higher produces one consumption good, one capital good
than in 2000. This increase in GDP is a combination of and one government service. Net exports are zero.
The sum of all incomes equals net domestic income at factor The compensation of employees, labour income, was by far
cost. GDP equals net domestic income at factor cost plus the largest part of aggregate income.
indirect taxes less subsidies plus depreciation. In 2011,
Sources of data: South African Reserve Bank.
GDP measured by the income approach was R2 964 billion.
Table 21.3 shows the quantities produced and these expenditures to find real GDP in 2010, which is
the prices in 2005 (the base year) and in 2010. In part (a), R1 600 million (or R1.6 billion). This number is what
we calculate nominal GDP in 2005. For each item, total expenditure would have been in 2010 if prices
we multiply the quantity produced in 2005 by its price had remained the same as they were in 2005.
in 2005 to find the total expenditure on the item. We Nominal GDP in 2010 is three times its value
sum the expenditures to find nominal GDP, which in 2005, but real GDP in 2010 is only 1.6 times its
in 2005 is R1 000 million (which equals R1 billion). 2005 value, a 60 per cent increase in production.
Because 2005 is the base year, both real GDP and
nominal GDP equal R1 000 million (or R1 billion).
In Table 21.3(b), we calculate nominal GDP REVIEW QUIZ
in 2010, which is R3 000 million (or R3 billion). 1 What is the expenditure approach to
Nominal GDP in 2010 is three times its value in measuring GDP?
2005. But by how much has production increased? 2 What is the income approach to measuring
Real GDP will tell us. GDP?
In Table 21.3(c), we calculate real GDP in 2010. 3 What adjustments must be made to total
The quantities of the goods and services produced are income to make it equal GDP?
those of 2010, as in part (b). The prices are those in 4 What is the distinction between nominal
the reference base year, 2005, as in part (a). GDP and real GDP?
For each item, we multiply the quantity 5 How is real GDP calculated?
produced in 2010 by its price in 2005. We then sum
(a) In 2005
C T-shirts 10 50 500
I Computer chips 3 100 300
G Security services 1 200 200
Y Real and Nominal GDP in 2005 1 000
(b) In 2010
C T-shirts 4 50 200
I Computer chips 2 200 400
G Security services 6 400 2 400
Y Nominal GDP in 2010 3 000
In 2005, the reference base year, real GDP equals nominal which is calculated by using the quantities of 2010 in part (b)
GDP and was R1 000 million. In 2010, nominal GDP and the prices of 2005 in part (a), was only R1 600 million,
increased to R3 000 million. But real GDP in 2010 in part (c), a 60 per cent increase from 2005.
The Uses and Limitations of Real GDP FIGURE 21.2 Rising Standard of Living in
South Africa
Economists use estimates of real GDP for two main
40 000
purposes:
◆ To compare the standard of living over time
32 000
The Standard of Living Over Time
One method of comparing the standard of living over time 28 000
is to calculate real GDP per person in different years. Real
GDP per person is real GDP divided by the population. 24 000
Real GDP per person tells us the value of goods and Real GDP per Real GDP Real GDP per
person is 50% per person person is 30%
services that the average person can enjoy. By using real more in 20 years decline more in 16 years
20 000
GDP, we remove any influence that rising prices and a
rising cost of living might have had on our comparison. 1960 1970 1980 1990 2000 2010
We are interested in both the long-term trends and Year
the shorter-term cycles in the standard of living. Real GDP per person in South Africa grew steadily until
1980. By 1980, real GDP per capita was 1.5 times its
Long-Term Trend A handy way of comparing real 1960 level. The 1980s saw a decline in living standard in
GDP per person over time is to express it as a ratio of South Africa due to economic sanctions and real GDP per
some reference year. For example, in 1960, real GDP person only started to increase again after the first democratic
per person was R21 589 and in 2010, it was R36 695. elections in 1994. Real GDP per person, the red line,
So real GDP per person in 2010 was 1.7 times fluctuates around potential GDP per person, the black line.
its 1960 level – that is, R36 695 ÷ R21 589 = 1.7.
Source of data: World Bank Development Indicators.
To the extent that real GDP per person measures the
standard of living, people were 1.7 times as well off in
2010 as their grandparents had been in 1960. (They
could buy all their grandparents could plus 70 per the 1970s. Even a small change in the growth rate has
cent more than their grandparents could.) serious consequences for the standard of living.
Figure 21.2 shows the path of South Africa’s real
GDP per person for the 50 years from 1960 to 2010 and Fluctuations of Real GDP You can see that real GDP,
highlights two features of our expanding living standard: shown by the red line in Fig. 21.2, fluctuates around
◆ The growth of potential GDP per person potential GDP and sometimes real GDP shrinks.
◆ Fluctuations of real GDP per person
Real GDP Fluctuations – The Business Cycle
The Growth of Potential GDP Potential GDP is the We call the fluctuations in the pace of expansion of
maximum level of real GDP that can be produced real GDP the business cycle. The business cycle is a
while avoiding shortages of labour, capital, land and periodic but irregular up-and-down movement of total
entrepreneurial ability that would bring rising inflation. production and other measures of economic activity.
Potential GDP per person, the smoother black The business cycle is not a regular predictable
line in Fig. 21.2, grows at a steady pace because the cycle like the phases of the moon, but every cycle has
quantities of the factors of production and their two phases:
productivities grow at a steady pace. 1. Expansion
But potential GDP per person does not grow at a 2. Recession
constant pace.3 During the 1960s, it grew at 3.6 per cent and two turning points:
per year but slowed to only 1 per cent per year during 1. Peak
2. Trough
3 A constant pace would be indicated by a straight line, thus the slope of the
line would not change.
Figure 21.3 uses the most recent South African At the end of 2008, the South African economy
business cycle to illustrate these features. went into a recession sparked by the world financial
An expansion is a period during which real crisis. The recession was short-lived and a new
GDP increases. In the early stage of an expansion real expansion began in mid-2009. But the expenditure
GDP returns to potential GDP and as the expansion components driving the expansion are a cause
progresses, potential GDP grows and real GDP of concern (see Reading Between the Lines on
eventually exceeds potential GDP. In Figure 21.3 the pp. 470–471).
expansion starts in the fourth quarter of 2005.
A common definition of recession is a period
during which real GDP decreases, which means it The Standard of Living Across Countries
has a negative growth rate, for at least two successive Two problems arise in using real GDP to compare
quarters. The definition used by Statistics South living standards across countries. First, the real GDP
Africa, which dates the South African business cycle of one country must be converted into the same
phases and turning points, is a period of significant currency units as the real GDP of the other country.
decline in total output, income, employment and Second, the goods and services in both countries must
trade, usually lasting from six months to a year be valued at the same prices. Comparing the United
and marked by contractions in many sectors of States and South Africa provides a striking example of
the economy. these two problems.
An expansion ends and recession begins at a
business cycle peak (see mid-2008 in Figure 21.3), South Africa and the United States Compared
which is the highest level that real GDP has attained In 2010, GDP per person in the United States
up to that time. A recession ends at a trough, when was almost $38 000 in constant 2000 US$ terms.
real GDP reaches a temporary low point and from Taking into account the exchange rate, the World
which the next expansion begins (see second quarter Bank indicates that for the same year, the GDP per
2009 in Fig. 21.3). person in South Africa was less than $4 000 (again
in constant 2000 US$ terms). This comparison
FIGURE 21.3 The Most Recent SA Business Cycle of South Africa to the United States makes South
1 920 000 Africa look extremely poor. In 2010, GDP per
person in the United States was almost 10 times
Real GDP (in 2005 rand)
1 880 000
Peak Recession that in South Africa.
1 840 000
Real Figure 21.4 shows the story of real GDP in South
1 800 000 GDP
Africa from 1990 to 2010 based on converting the
1 760 000 rand to the US dollar at the rand-dollar exchange rate
1 720 000 Trough in 2000.
1 680 000
But if one looks at GDP using a Purchasing
Power Parity Comparison, also in Figure 21.4, it
1 640 000 Expansion
shows another estimate of South Africa’s real GDP
1 600 000
per person that is much larger than the measure we
1 560 000
Trough have just mentioned. Let us see how this alternative
1 520 000 measurement is made.
2005 2006 2007 2008 2009 2010 2011
GDP in the United States is measured by using
Year prices that prevail in the United States. South Africa’s
GDP is measured by using prices that prevail in
Source of data: South African Reserve Bank South Africa. However, the relative prices in the two
The business cycle expansion starts from a trough in the fourth countries are very different.
quarter of 2005 and ended in a peak in the third quarter of The prices of some goods are higher in the
2008. A deep but relatively quick recession followed and United States than in South Africa, so these items
a trough was reached in the second quarter of 2009 after get a smaller weight in South Africa’s real GDP than
which the economy started to expand again. they get in US real GDP. An example is a Big Mac
that costs $4.20 in New York. In Johannesburg, a calculate PPP estimates of GDP in all countries. The
Big Mac costs R19.95, which is the equivalent of PPP comparisons tell another story about South Africa.
$2.45. So in South Africa’s real GDP, a Big Mac gets According to the PPP comparisons, GDP
almost half the weight that it gets in US real GDP. per person in the United States in 2010 was only
Some prices in South Africa are higher than in 4.5 times that of South Africa, not the 10 times
the United States but more prices are lower, so South shown at the market exchange rate. Figure 21.4
African prices put a lower value on South Africa’s shows the PPP view of South Africa’s real GDP and
production than do US prices. compares it with the market exchange rate view.
If, instead of using South Africa’s prices, all the You have seen how real GDP is used to make
goods and services produced in South Africa are standard of living comparisons over time and across
valued at the prices prevailing in the United States, countries. But real GDP is not a perfect measure
then a more valid comparison can be made of GDP of the standard of living and we will now examine
in the two countries. Such a comparison uses prices its limitations.
called purchasing power parity prices, or PPP prices.
Alan Heston, Robert Summers and Bettina
Aten, economists at the Center for International Limitations of Real GDP
Comparisons at the University of Pennsylvania, have Real GDP measures the value of goods and services
used PPP prices to construct real GDP data for more that are bought, or traded, in markets. Some of the
than 100 countries. And the International Monetary factors that influence the standard of living and that
Fund (IMF) and World Bank now uses a method are not part of GDP are:
similar to that of Heston, Summers and Aten to ◆ Household production
◆ Underground economic activity
FIGURE 21.4 Two Views of Real GDP Per ◆ Health and life expectancy
Capita in South Africa ◆ Leisure time
.28
◆ Environmental quality
◆ Political freedom and social justice
.24
Household Production An enormous amount
Proportion of US GDP per person
Relative GDP
in PPP prices
.20
of production takes place every day in our homes.
Preparing meals, cleaning the kitchen, changing a
.16
light bulb, mowing the lawn, washing the car and
helping your younger brother with his homework
.12
are all examples of productive activities that do not
Relative GDP involve market transactions and therefore are not
in constant counted as part of GDP.
.08 US$ prices
If these activities grew at the same rate as real
.04 GDP, not measuring them would not be a problem.
But it is likely that market production, which is
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
part of GDP, is increasingly replacing household
Year
production, which is not part of GDP. This is the
When GDP is valued at the market exchange rate, South
case in the United States where the percentage of
Africa’s GDP per person in 2010 is only 9.9 per cent of the
people who have jobs (thus labour force participation)
US level. But when GDP is valued at purchasing power parity
has increased by 8 per cent from 1970 to 2006. In
prices, South Africa’s real GDP per person in 2010 is 22 per
these economies we also find that the purchase of
cent of the US level. The graph shows that if no adjustment is
traditionally home-produced goods and services now
made for price differences, living standards in South Africa
takes place in the market. For example, more and
are consistently underestimated.
more families now eat at restaurants, buy takeaways
Source of data: World Bank’s World Development Indicators. and use day-care services. This means that an
increasing proportion of food preparation and child
care that were part of household production are now of changes in economic welfare. But sometimes
measured as part of GDP. So real GDP grows more production shifts from the underground economy to
rapidly than real GDP plus home production does. the rest of the economy and sometimes it shifts the
In South Africa these two trends (outsourcing other way. The underground economy expands relative
of domestic chores and replacing home-made goods to the rest of the economy if taxes become especially
with market goods) are not so evident, pointing high or if regulations become especially restrictive. And
towards a large portion of household production still the underground economy shrinks relative to the rest of
taking place. The number of people who have formal the economy if the burdens of taxes and regulations are
employment has decreased from 70 per cent to 66 per eased. During the 1980s, when tax rates were cut in the
cent between 1980 and 2006. A closer look at these US, there was an increase in the reporting of previously
numbers reveals that male employment has actually hidden income and tax revenues increased. So some
increased, while female employment has decreased. part (but probably a very small part) of the expansion
The decline in female employment may partially of real GDP during the 1980s represented a shift from
be due to more females entering the labour force – the underground economy rather than an increase
thus women who used to stay at home that are now in production.
looking for a job contribute to a lower percentage of In developing countries, such as South Africa,
women with jobs. This supports the idea that home there are also informal economic activities, which
production is declining, also in South Africa. are not included in formal GDP measures. We have
all seen the informal traders along the roads selling
Underground Economic Activity The underground curios, fruit and various other products and home
economy is the part of the economy that is purposely produced goods. This informal part of the economy is
hidden from the view of the government to avoid also referred to as the ‘third economy’ and is not taken
taxes and regulations, or because the goods and into account when the GDP is calculated.
services produced are illegal. Because underground
economic activity is unreported, it does not get Health and Life Expectancy Good health and a
counted as part of GDP. long life – the hopes of everyone – do not show up in
The underground economy is easy to real GDP, at least not directly. A higher real GDP does
describe, even if it is hard to measure. It includes enable us to spend more on medical research, health
the production and distribution of illegal drugs, care, a good diet, gym membership and exercise
production that uses illegal labour that is paid less equipment. And as real GDP has increased, life
than the minimum wage and jobs done for cash to expectancy has lengthened in most countries. In the
avoid paying income taxes. This last category might US life expectancy increased from 70 years at the end
be quite large and includes tips earned by taxi drivers, of World War II to almost 80 years today. Worldwide,
hairdressers and wages earned by domestic workers. infant deaths and death in childbirth, two fearful
Estimates of the scale of the underground curses of the 19th century, have been greatly reduced.
economy in the United States range between 9 As a developing country, South Africa’s life
and 30 per cent of GDP ($1 200 billion to almost expectancy decreased from 53 years in 1970 to
$4 000 billion). The underground economy is much 50 years in 2006. Factors that contributed to this
larger in developing and transition countries than in include the increased crime rate, vehicle accidents
developed countries. It is estimated that in 2002/3 and HIV/Aids. In sub-Saharan Africa we face new
the underground economy in South Africa was health and life expectancy problems every year. The
29.5 per cent of GDP (so South Africa’s GDP could cholera outbreak in Zimbabwe in 2008/9 and the
be 1.3 times that which is recorded), which is the flooding and tropical cyclone in Mozambique in 2008
lowest on the African continent. Zimbabwe ranked are examples of the adverse conditions that Southern
first with an underground economy of 63.2 per cent Africans face. In addition to this, HIV/Aids has its
during the same time period. highest prevalence rates in sub-Saharan Africa. When
Provided that the underground economy is a we take these negative influences into account, we see
reasonably stable proportion of the total economy, the that real GDP growth overstates the improvements in
growth rate of real GDP still gives a useful estimate economic welfare.
Leisure Time Leisure time is an economic good Political Freedom and Social Justice Most
that adds to economic welfare. Other things being people in the world value political freedoms such as
equal, the more leisure we have, the better off we those provided by the Constitution of South Africa.
are. Our working time is valued as part of GDP, They value social justice and equity – equality of
but leisure time is not. Yet from the point of view opportunity and of access to social safety nets that
of economic welfare, that leisure time must be at protect people from the extremes of misfortune. The
least as valuable to us as the wage that we earn on latter is one aspect that still needs attention in the
the last hour worked. If it were not, we would work South African economy.
instead of taking the leisure. Over the years, leisure A country might have a very large real GDP
time has steadily increased. The workweek has per person but have limited political freedom and
become shorter, more people take early retirement equity. For example, a small elite might enjoy political
and the number of vacation days has increased. liberty and extreme wealth while the vast majority
These improvements in economic well-being are not are effectively enslaved and live in extreme poverty.
reflected in real GDP. Such an economy would generally be regarded as
having less economic welfare than one that had the
Environmental Quality Economic activity directly same amount of real GDP but in which everyone
influences the quality of the environment. The enjoyed political freedom. This was the case in South
burning of hydrocarbon fuels (CO2) is the most Africa under the apartheid policy, which reigned
visible activity that damages our environment, but it is prior to 1994 and is still evident in many of the social
not the only example. The depletion of non-renewable inequalities that continue to exist in the South African
natural resources, the mass clearing of forests and economy today.
the pollution of dams and rivers are other major Today, China has rapid real GDP growth but
environmental consequences of industrial production. limited political freedoms, while Russia has slow real
Resources that are used to protect the GDP growth and an emerging democratic political
environment are valued as part of GDP. For example, system. Economists have no easy way to determine
the value of catalytic converters that help to protect which of these countries is better off.
the atmosphere from vehicle emissions is part of
GDP. But if we did not use such pieces of equipment The Bottom Line Do we get the wrong message
and instead polluted the atmosphere, we would not about the level and growth in economic well-
count the deteriorating air that we were breathing as a being and the standard of living by looking at
negative part of GDP. the growth of real GDP? The influences that are
An industrial society possibly produces more omitted from real GDP are probably important
atmospheric pollution than an agricultural society and could be large. Developing countries have
does, but pollution does not always increase as we a larger amount of household production and a
become wealthier. Wealthy people value a clean larger underground economy than do developed
environment and are willing to pay for one. Compare countries, so the gap between their living standards
the pollution recorded in East Germany in the late is exaggerated. Also, as real GDP grows, part of the
1980s with pollution in the United States. East measured growth might reflect a switch from home
Germany, a poor country, polluted its rivers, lakes production to market production and underground
and atmosphere in a way that is unimaginable in the to regular production.
United States or in wealthy West Germany. This measurement error overstates the growth
Yet, the main culprits in environmental change in economic well-being and the improvement in the
are the industrialised countries. Environmental standard of living.
statistics reveal that the United States alone is Other influences on the standard of living
responsible for a quarter of the world’s CO2 emissions, include the amount of leisure time available, the
while a fast-growing developing nation such as India, quality of the environment, the security of jobs and
is only responsible for 4 per cent of CO2 emissions. homes and the safety of city streets.
South Africa lies 13th with its 1.5 per cent of total It is possible to construct broader measures that
world CO2 emissions. combine the many influences that contribute to
Economics in Action score. Namibia and Botswana rank slightly better than
South Africa in terms of HDI, but the Democratic
A Broader Indicator of Economic Well-Being Republic of Congo has the lowest real GDP per
The limitations of real GDP as a measure of the person and Niger has the lowest HDI.
standard of living and general well-being affects every
country. So to make international comparisons we
Human Development Index
1.200
must look at both real GDP and other indicators. Norway
The United Nations has constructed a broader Cuba
1.000
measure called the Human Development Index (HDI),
which combines real GDP, life expectancy, health and
0.800
education. Real GDP per person (measured on the PPP US Singapore
basis) is a major component of the HDI.
The dots in the figure show the relationship 0.600
between real GDP per person and the HDI. The
United States (along with a few other countries) has 0.400
South Africa
the highest real GDP per person, but the United
States has the thirteenth highest HDI. (Norway has
0.200
the highest HDI and Australia, Canada and Japan all Niger
have a higher HDI than the United States.)
African nations have the lowest levels of 0.000 0.2 0.4 0.6 0.8 1.0 1.2 1.4
economic well-being. With an HDI of 0.613, South Real GDP per person (PPP index)
Africa ranks 123rd in the world in terms of human The Human Development Index
development. The low life expectancy of South
Africans is one of the key contributors to this low Source of data: United Nations hdr.undp.org/en/statistics/data
‘Since the 2009 recession, growth has been driven primarily by household consumption expenditure,
which is clearly an undesirable and unsustainable growth path. Emphasis must be given to ensure
that growth is driven by investment. There are, however, signs that investment expenditure growth is
gathering pace and this will be reinforced if the proposals around increased infrastructure expenditure
are followed through.
‘… But the focus on infrastructure is not new and the plans have often not met expectations,
particularly since the 2010 World Cup. For example, in 2009/10, only 83 per cent of the amount
budgeted for infrastructure was spent. In 2010/11, this had declined further to 68 per cent.
‘Importantly, it is not only the government and state-owned enterprises that need to invest. … South
Africa’s gross fixed capital formation as a percentage of GDP averaged around 15.5 per cent in the
decade after 1994 and then accelerated to peak at around 23 per cent in 2008. … Since the crisis, this
investment to GDP ratio has declined and in 2011 averaged around 19 per cent. Between 1994 and
2007, government and public sector investment averaged 4.4 per cent of GDP, but since 2008 it has
averaged 8 per cent.
‘We can conclude from this that the lack of investment is not simply a problem of government failure
to invest. Private sector investment has also been lacking. But government does have an important
role to play in providing the environment conducive to private sector investment. For example, a
notable area where private sector investment has been severely lacking is in the mining sector. This
may be due in part to uncertainties created by the regulatory environment and lack of investment
in rail infrastructure which has impeded the
ability of the mines to get the ores to the ports.’
ESSENCE OF THE STORY
Source: Adapted from address by Gill Marcus, Governor of the South ◆ South Africa’s growth after the world recession is
African Reserve Bank, ‘Perspectives on the Global and Domestic still slow.
Economic Environment’, to the Volkswagen South Africa Strategic ◆ Growth is driven mainly by personal consumption
Conversation Dinner, Sandton, 15 March 2012. © Reserve Bank of expenditure (C ).
South Africa. ◆ Investment (I ) is a better source of sustainable
growth and should be stimulated.
◆ Government is investing, but investment by private
firms must be encouraged.
ECONOMIC ANALYSIS 8
Percentage
◆ After experiencing an upward phase in the 6
20 Investment
◆ Before the negative growth experienced during expenditure
late 2008 and the first half of 2009, the growth 15
in investment (I ) spending exceeded growth in
Consumption
consumer (C ) spending, indicating that growth 10
expenditure
was fuelled by business investment rather than
5
consumer spending.
◆ After the recession, the situation reversed and 0
consumer spending is now responsible for most
of the growth experienced in the South African –5
economy. –10
◆ In Chapter 23 we will revisit the sources of
growth and there you will see that capital –15
2006 2007 2008 2009 2010 2011
formation due to investment spending is a
Year
source of long-run growth for an economy,
Figure 2 Growth in private consumption and investment
while consumer spending only causes short-run
spending: 2006 to 2011
increases in GDP.
◆ Two ways in which to stimulate investment in the
economy are addressed by the Governor:
(i) creating an economic climate in which
businesses would feel comfortable investing and
(ii) providing businesses with the necessary
infrastructure to make their businesses more
successful.
10
Making a Time-Series Graph Falling
quickly
Rising
quickly
Rising
A time-series graph measures time (for example, years, 8
slowly
quarters, or months) on the x-axis and the variable or
variables in which we are interested on the y-axis. 6
200
A Time-Series with a Trend
Many macroeconomic variables, among them GDP 100
and the average level of prices, have an upward trend.
Figure A21.2 shows an example of such a variable: the 0
1970 1980 1990 2000 2010
average prices paid by consumers.
Year
In Fig. A21.2 (a), consumer prices since 1970 are
(a) Normal scale
graphed on a normal scale. In 1970 the level is 100.
In other years, the average level of prices is measured
as a percentage of the 1970 level. 600
The graph clearly shows the upward trend of 500
(per cent of 1970 level: ratio scale)
Key Terms
Business cycle, 464 Final good, 457 Intermediate good, 457 Real GDP per person,
Consumption expenditure, Government expenditure, Investment, 459 464
459 459 Net exports, 459 Recession, 465
Cycle, 473 Gross domestic product Net investment, 459 Time-series graph, 472
Depreciation, 459 (GDP), 457 Nominal GDP, 462 Trend, 473
Expansion, 465 Gross investment, 459 Potential GDP, 464
Exports, 459 Imports, 459 Real GDP, 462
Measuring South Africa’s GDP 12. Calculate nominal GDP in 2010 and 2012.
Use the following data to work out Problems 8 and 9. 13. Calculate real GDP in 2012 expressed in base-
The table lists some macroeconomic data for South year prices.
Africa for 2010.
Use the following data to work out Problems 14 and 15.
Item Billions of rand
In order to boost the local textile industry, the government
Wages paid to labour 1 202 imposes a ban on the import of cloth and imposes
Consumption expenditure 1 576 restrictions on the import of manufactured clothing.
Net operating surplus 822
14. Explain how this change will influence GDP and
Investment 517
Government expenditure 573 the components of aggregate expenditure.
Net exports –5 15. Explain how this change will influence the factor
Depreciation 351 incomes that contribute to GDP.
8. Calculate GDP in South Africa in 2010. The Uses and Limitations of Real GDP
9. Explain the approach (expenditure or income) 16. Use the following table to calculate in which year
that you used to calculate GDP. the US standard of living (i) increased and
(ii) decreased? Explain your answer.
Use the following data to work out Problems 10 and 11.
The national accounts of Parchment Paradise are kept Year Real GDP (trillion $) Population (million)
on (you guessed it) parchment. A fire destroys the 2006 13.0 300
statistics office. The accounts are now incomplete but 2007 13.2 302
2008 13.2 304
they contain the following data:
2009 12.8 307
◆ GDP (income approach): R2 900
◆ Consumption expenditure: R2 000
Measuring South Africa’s GDP 29. Calculate nominal GDP in 2009 and 2010.
Use the following data to work out Problems 27 and 30. Calculate real GDP in 2009 and 2010.
28. The table lists some macroeconomic data for
South Africa in 2009. The Uses and Limitations of Real GDP
31. The United Nations’ Human Development Index
Item Billions of rand
(HDI) is based on real GDP per person, life
Wages paid to labour 1 078 expectancy at birth and indicators of the quality
Consumption expenditure 1 461
and quantity of education.
Net operating surplus 731
Investment 471 a. Explain why the HDI might be better than
Government expenditure 503 real GDP as a measure of economic welfare.
Net exports –21 b. Which items in the HDI are part of real
GDP and which items are not in real GDP?
27. Calculate South Africa’s GDP in 2009. c. Do you think the HDI should be expanded
28. Explain the approach (expenditure or income) to include items such as pollution, resource
that you used to calculate GDP. depletion and political freedom? Explain.
d. What other influences on economic welfare
Use the following data to work out Problems 29 should be included in a comprehensive
and 30. measure?
An economy produces only apples and oranges. The 32. US GDP for 2011 is $15.06 trillion and the
base year is 2009 and the table gives the quantities estimated growth in real GDP for 2011 is
produced and the prices. 1.5 per cent. South Africa’s GDP for 2011 is
R2.94 trillion and when converted to US dollars
Quantities 2009 2010 via the market exchange rate, it is $422 billion.
Apples 60 160 The estimated growth in South Africa’s GDP for
Oranges 80 220 2011 is 3.4 per cent.
a. Are the real GDP growth rates for South
Prices (rand each) 2009 2010
Africa and the US comparable? Explain.
Apples R0.50 R1.00 b. Explain why it is complicated to use the real
Oranges R0.25 R2.00 GDP data to compare the standard of living
in South Africa and the US.
E
22
ach quarter, we chart the course of employment and unemployment
as measures of South African economic health. How do we count the
number of people working and the number unemployed? What do the
level of employment and the unemployment rate tell us? Are they reliable
vital signs for the economy?
Having a good job that pays a decent wage is only half of the
equation that translates into a good standard of
MONITORING JOBS living. The other half is the cost of living. We track
the cost of the items that we buy with another number
Economics in Action Interest, and Money and created what we now call
macroeconomics.
What Keeps Ben Bernanke Awake at Night Many economists have studied the Great Depression
The Great Depression began in October 1929, when and tried to determine why what started out as an ordi-
the US stock market crashed. It reached its deepest nary recession became so devastating. Among them is Ben
point in 1933, when 25 per cent of the labour force Bernanke, the Chairman of the Federal Reserve.
was unemployed and lasted until 1941, when the One of the reasons the Federal Reserve was so
United States entered World War II. aggressive in cutting interest rates, saving Bear Stearns
The depression quickly spread globally to envelop and propping up Fannie Mae and Freddie Mac is
most nations. because Ben Bernanke is so vividly aware of the
The 1930s were and remain the longest and worst horrors of total economic collapse and determined
period of high unemployment in history. Failed banks, to avoid any risk of a repeat of the Great Depression.
shops, farms and factories left millions of Americans Bear Stearns was a global investment bank and securi-
without jobs, homes and food. Without the support of ties trading company based in New York City. It was
government and charities, millions would have starved. the seventh-largest investment firm on Wall Street in
The Great Depression was an enormous political 2005. During the financial crisis the company became
event: It fostered the rise of the German and Japanese insolvent, leading the Federal Reserve to step in and
militarism that were to bring the most devastating facilitate a deal to save the company to prevent a
war humans have ever fought. It also led to President total financial collapse on Wall Street. On the other
Franklin D. Roosevelt’s ‘New Deal’, which enhanced hand, Fannie Mae and Freddie Mac were two United
the role of government in economic life and made States government-sponsored enterprises operating
government intervention in markets popular and the in the mortgage-loan sector. The financial losses from
market economy unpopular. mortgage-backed securities during the financial crises
The Great Depression also brought a revolu- were unprecedented and to prevent total economic
tion in economics. British economist John Maynard collapse and widespread bankruptcy, the Federal
Keynes published his General Theory of Employment, Reserve stepped in to save the two companies.
Think about a manager who loses his job when or official definition of unemployment. The broad or
his employer downsizes. The only work he can find is expanded definition of unemployment in South Africa
as a sales assistant at a retail store. After a year in this excludes the second criteria of pursuing active efforts
work, he discovers that he cannot compete with new to find a job in the four weeks prior to the interview.
MBA graduates. This enables statisticians and economists to separate
Eventually, he is hired as a manager but in a small out discouraged workers. Discouraged workers are
company at a lower wage than before. He has lost people who are available and willing to work but have
some of his human capital. not made specific active efforts to find a job within the
The cost of unemployment is spread unequally, previous four weeks. These workers often temporarily
which makes it a highly charged political problem as leave the labour force during a recession and re-enter
well as a serious economic problem. during an expansion and become active job seekers. In
Governments make strenuous efforts to measure South Africa’s case, the difference between the broad
unemployment accurately and to adopt policies to and official definitions of unemployment is quite large.
moderate its level and ease its pain. Here, we will learn how The decision to exclude non-searchers from the official
the South African government monitors unemployment. definition reduces the labour force participation rate,
as we will see later, as well as the unemployment rate.
Quarterly Labour Force Survey Every quarter, People who are narrowly unemployed are also broadly
Statistics South Africa (StatsSA) surveys 30 000 unemployed, although the opposite does not hold.
households and asks a series of questions about the Approximately 2.17 million people were classified
age and job market status of the members of each as discouraged workers in the third quarter of 2012.
household. This survey is called the Quarterly Labour People in the working-age population who are neither
Force Survey (QLFS). StatsSA uses the answers to employed nor unemployed are classified as not in the
describe the anatomy of the labour force. labour force (not economically active).
Figure 22.1 shows the population categories used
by StatsSA and the relationships among the categories. FIGURE 22.1 Population Labour Force Categories
The population is divided into two broad groups:
the working-age population and others who are too
Population
young to work or who live in institutions and are unable
to work. The working-age population is the total number
of people aged 15 years and over who are not in jail,
hospital or some other form of institutional care. Young and
Working-age population institutionalised
StatsSA then divides the working-age population
into two groups: those in the labour force and those not in
the labour force. It also divides the labour force into two Not in labour
Labour force
groups: the employed and the unemployed. So the labour force
Anyone surveyed who satisfies all of these three criteria Source of data: Statistics South Africa.
is counted as unemployed, according to the narrow
That is,
In the third quarter of 2012, the working-age
population of South Africa was 33.018 million; the Number of
people unemployed
labour force was 18.313 million and 14.705 million Unemployment rate = × 100
were not in the labour force. Of this number, most Labour force
were in school full time or had retired from work. and
Within the labour force, 4.667 million were Labour force = Number of people employed +
unemployed and 13.645 million were employed. Number of people unemployed
0.45
Expanded unemployment rate
Unemployment rate (percentage of labour force)
0.40
The average
unemployment rate
0.35 from 2000 to 2012
was 26.2 per cent.
The unemployment
0.30
Official unemployment rate
rate increases in a
recession, peaks after
0.25 Average unemployment rate the recession ends
and decreases in an
expansion.
0.20
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source of data: Statistics South
Year Africa.
0.60
The trend in the labour force
participation rate and the
Percentage of working-age population
0.55
Participation rate absorption rate is downward
in the early 2000s and fairly
flat thereafter.
0.50 The absorption rate
fluctuates more than the labour
force participation rate over
0.45
the business cycle and reflects
cyclical fluctuations in the
Labour absorption
0.40 unemployment rate.
0.35
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Year
unemployment rate. But StatsSA provides data on Also, people who are unemployed because they
two types of underutilised labour excluded from the voluntarily quit their jobs to find better ones or
official measure. They are: because they have just entered or re-entered the labour
◆ Marginally attached workers market bear some costs of unemployment. But these
◆ Part-time workers who want full-time jobs costs are lower than those borne by people who lose
their job and are forced back into the job market.
Marginally Attached Workers A marginally These costs include the loss of income and search costs
attached worker is a person who currently is neither for those seeking employment.
working nor looking for work but has indicated The unemployment rate does not distinguish
that he or she wants and is available for a job and among these different categories of unemployment. If
has looked for work sometime in the recent past. A most of the unemployed are long-term job losers, the
marginally attached worker who has stopped looking situation is much worse than if most are short-term
for a job because of repeated failure to find one is voluntary job searchers.
called a discouraged worker.
The official unemployment measure excludes
marginally attached workers because they have not REVIEW QUIZ
made specific efforts to find a job within the past 1 What determines if a person is in the
four weeks. In all other respects, they are unemployed. labour force?
South Africa does not distinguish between marginally 2 What distinguishes an unemployed person
attached workers and discouraged workers, both from one who is not in the labour force?
are excluded from the narrow definition of the 3 Describe the trends and fluctuations in the
labour force. South African unemployment rate from 2000
For South Africa, the issue of discouraged to 2012.
workers is highlighted given the long-term nature 4 Describe the trends and fluctuations in the
of much of unemployment in the country. This South African absorption rate and labour force
appears to be a characteristic we have in common participation rate from 2000 to 2012.
with many European economies. The United States
appears to have short-term unemployment rather You have seen how we measure employment and
than long-term unemployment: Workers in the US unemployment. Your next task is to see what we mean
economy who lose their jobs typically find new jobs by full employment and how unemployment and real
fairly quickly. GDP fluctuate over the business cycle.
There is also an unending process of job creation (ILO). Over the past few years we have observed
and job destruction as new firms are born, firms expand rising youth unemployment not only in South Africa,
or contract and some firms fail and go out of business. but all over the world. Rising youth unemployment
The flows into and out of the labour force and rates are a major concern in recession-hit countries
the processes of job creation and job destruction such as Greece, Spain and Portugal.
create the need for people to search for jobs and for In South Africa youth unemployment rose from
businesses to search for workers. Businesses do not less than 50 per cent in 2009 to about 52 per cent in
usually hire the first person who applies for a job and 2012, which is a large increase in a country where the
unemployed people do not usually take the first job majority of the unemployed are less than 34 years old.
that comes their way. Instead, both firms and workers
spend time searching for what they believe will be the
best available match. By this process of search, people Cyclical Unemployment
can match their own skills and interests with the avail- The higher than normal unemployment at a business
able jobs and find a satisfying job and a good income. cycle trough and the lower than normal unemployment
The unemployment that arises from the normal at a business cycle peak is called cyclical unemployment.
labour turnover we have just described – from people A worker who is laid off because the economy is in a
entering and leaving the labour force and from the recession and who is rehired some months later when the
ongoing creation and destruction of jobs – is called expansion begins has experienced cyclical unemployment.
frictional unemployment. Frictional unemployment is
a permanent and healthy phenomenon in a dynamic,
growing economy. ‘Natural’ Unemployment
Natural unemployment is the unemployment that
arises from frictions and structural change when there
Structural Unemployment
is no cyclical unemployment – when all the unem-
The unemployment that arises when changes in tech- ployment is frictional and structural. Natural unem-
nology or international competition change the skills ployment as a percentage of the labour force is called
needed to perform jobs or change the locations of jobs is the natural unemployment rate.
called structural unemployment. Structural unemployment Full employment is defined as a situation in which
usually lasts longer than frictional unemployment because the unemployment rate equals the natural unemploy-
workers must retrain and possibly relocate to find a job. ment rate.
When a mining company in Rustenburg, North West What determines the natural unemployment rate?
province, is automated, some jobs in that city disappear. Is it constant or does it change over time?
Meanwhile, new jobs for security guards, retail clerks and The natural unemployment rate is influenced by
life-insurance salespeople are created in Johannesburg and many factors but the most important ones are:
Pretoria. The unemployed former mineworkers remain ◆ The age distribution of the population
unemployed for several months or years until they move, ◆ The scale of structural change
retrain and get one of these jobs. Structural unemploy- ◆ The real wage rate
ment is painful, especially for older workers for whom ◆ Unemployment benefits
the best available option might be to retire early or
take a lower-skilled, lower-paying job. It is especially The Age Distribution of the Population An
difficult in South Africa as the opportunity to retrain economy with a young population has a large number
is limited and employment growth is particularly low. of new job seekers every year and has a high level of
frictional unemployment. An economy with an aging
population has fewer new job seekers and a low level
Youth Unemployment of frictional unemployment.
There is growing concern about youth unemploy-
ment, not only in South Africa but worldwide. Youth The Scale of Structural Change The scale of structural
are individuals between the ages of 15 and 24, as change is sometimes small. The same jobs using the same
classified by the International Labour Organization machines remain in place for many years. But sometimes
there is a technological upheaval. The old ways are swept is greater than potential GDP and the output gap is
aside and millions of jobs are lost and the skill to perform positive. And when the unemployment rate is greater
them loses value. The amount of structural unemploy- than the natural unemployment rate, real GDP is less
ment fluctuates with the pace and volume of techno- than potential GDP and the output gap is negative.
logical change and the change driven by fierce inter-
national competition, especially from fast-changing REVIEW QUIZ
Asian economies. A high level of structural unemploy-
ment is present in many parts of South Africa today. 1 Why does unemployment arise and what
makes some unemployment unavoidable?
The Real Wage Rate The natural unemploy- 2 Define frictional unemployment, structural
ment rate is influenced by the level of the real wage unemployment and cyclical unemployment.
rate. Real wage rates that bring unemployment are Give examples of each type of unemployment.
a minimum wage and an efficiency wage. Chapter 6 3 What is the natural unemployment rate?
(see pp. 124–126) explains how the minimum wage 4 How does the natural unemployment rate
creates unemployment. An efficiency wage is a wage set change and what factors might make it change?
above the going market wage to enable firms to attract 5 Why is the unemployment rate never zero,
the most productive workers, get them to work hard even at full employment?
and discourage them from quitting. 6 What is the output gap? How does it change
when the economy goes into recession?
Unemployment Benefits Unemployment benefits 7 How does the unemployment rate fluctuate
increase the natural unemployment rate by lowering over the business cycle?
the opportunity cost of job search. European coun-
tries have more generous unemployment benefits and Your next task is to see how we monitor the price
higher natural unemployment rates than the United level and the inflation rate. You will learn about the
States. Extending unemployment benefits increases Consumer Price Index (CPI), which is monitored
the natural unemployment rate. every month. You will also learn about other measures
There is no controversy about the existence of a of the price level and the inflation rate.
natural unemployment rate. Nor is there disagreement
that the natural unemployment rate changes.
But economists do not know its exact size or the
extent to which it fluctuates. Most economists agree
The Price Level, Inflation and Deflation
that the natural unemployment rate for South Africa What will it really cost you to pay off your student
is much higher than in many other countries and loan? What will your parent’s life savings buy when
could be in excess of 15 per cent – more than half the they retire? The answers depend on what happens to
current unemployment rate. the price level, the average level of prices and the value
of money. A persistently rising price level is called infla-
tion; a persistently falling price level is called deflation.
Real GDP and Unemployment Over the Cycle We are interested in the price level, inflation
The quantity of real GDP at full employment is potential and deflation for two main reasons. First, we want to
GDP (p. 506). Over the business cycle, real GDP fluctu- measure the annual percentage change of the price
ates around potential GDP. The gap between real GDP level – the inflation rate or deflation rate. Second, we
and potential GDP is called the output gap. As the output want to distinguish between the money values and
gap fluctuates over the business cycle, the unemployment real values of economic variables such as your student
rate fluctuates around the natural unemployment rate. loan and your parent’s savings.
When the economy is at full employment, the We begin by explaining why inflation and
unemployment rate equals the natural unemploy- deflation are problems. Then we will look at how we
ment rate and real GDP equals potential GDP so the measure the price level and the inflation rate. Finally,
output gap is zero. When the unemployment rate is we will return to the task of distinguishing real values
less than the natural unemployment rate, real GDP from money values.
Why Inflation and Deflation are Problems Diverts Resources from Production Unpredictable
Low, steady and anticipated inflation or deflation is inflation or deflation turns the economy into a casino
not a problem, but an unexpected burst of inflation or and diverts resources from productive activities to
period of deflation brings big problems and costs. forecasting inflation. It can become more profitable
Unexpected inflation or deflation: to forecast the inflation rate or deflation rate correctly
◆ Redistributes income than to invent a new product. Doctors, lawyers,
◆ Redistributes wealth accountants, farmers – just about everyone – can make
◆ Lowers real GDP and employment themselves better off, not by specialising in the profes-
◆ Diverts resources from production sion for which they have been trained but by spending
more of their time dabbling as amateur economists and
Redistribution of Income Workers and employers inflation forecasters and managing their investments.
sign wage contracts that last for a year or more. An From a social perspective, the diversion of
unexpected burst of inflation raises prices but does not talent that results from unpredictable inflation is like
immediately raise the wages. Workers are worse off throwing scarce resources onto a pile of rubbish. This
because their wages buy less than they bargained for waste of resources is a cost of inflation.
and employers are better off because their profits rise. At its worst, inflation becomes hyperinflation – an
An unexpected period of deflation has the oppo- inflation rate of 50 per cent a month or higher that
site effect. Wage rates do not fall but the prices fall. grinds the economy to a halt and causes a society to
Workers are better off because their fixed wages collapse. Hyperinflation is rare, but Zimbabwe in
buy more than they bargained for and employers are recent years and several European and Latin American
worse off with lower profits. countries have experienced it.
We pay close attention to the inflation rate,
Redistribution of Wealth People enter into loan even when its rate is low, to avoid its consequences.
contracts that are fixed in money terms and that pay We monitor the price level every month and devote
an interest rate agreed as a percentage of the money considerable resources to measuring it accurately. You
borrowed and lent. With an unexpected burst of infla- are now going to see how we do this.
tion, the money that the borrower repays to the lender
buys less than the money originally loaned.
The Consumer Price Index
The borrower wins and the lender loses. The interest
paid on the loan does not compensate the lender for the Every month, Statistics South Africa measures the
loss in the value of the money loaned. With an unex- price level by calculating the Consumer Price Index (CPI),
pected deflation, the money that the borrower repays to which is a measure of the average of the prices paid
the lender buys more than the money originally loaned. by urban consumers for a fixed basket of consumer
The borrower loses and the lender wins. goods and services. What you learn here will help you
to make sense of the CPI and relate it to your own
Lowers Real GDP and Employment Unexpected infla- economic life. The CPI tells you about the value of
tion that raises firms’ profits brings a rise in investment the money in your pocket.
and a boom in production and employment. Real GDP
rises above potential GDP and the unemployment rate
falls below the natural rate. But this situation is temporary.
Reading the CPI Numbers
Profitable investment dries up, spending falls, real GDP The CPI is defined to equal 100 for a period called
falls below potential GDP and the unemployment the reference base period. Currently, the reference
rate rises. Avoiding these swings in production and jobs base period is 2012. That is, for the average of the
means avoiding unexpected swings in the inflation rate. 12 months from January 2012 to December 2012,
Unexpected deflation has even greater conse- the CPI equals 100.
quences for real GDP and jobs. Businesses and house- Let us use an example to illustrate this idea.
holds that are in debt (borrowers) are worse off and Assume that CPI takes a value of 102.7 in January
they cut their spending. A fall in total spending brings 2013. The CPI for January 2012 was 97.2. The infla-
a recession and rising unemployment. tion rate of 5.7 per cent for January 2013 is calculated
as (102.7 minus 97.2, divided by 97.2, multiplied by Once the raw price data are in hand, the next
100). This number tells us that the average of the prices task is to calculate the CPI.
paid by urban consumers for a fixed market basket of
consumer goods and services was 5.7 per cent higher in Calculating the CPI To calculate the CPI, we:
January 2013 than it was in January 2012. 1. Find the cost of the CPI basket at base-period
prices.
2. Find the cost of the CPI basket at current-
Constructing the CPI period prices.
Constructing the CPI involves three stages: 3. Calculate the CPI for the base period and the
◆ Selecting the CPI basket current period.
◆ Conducting the monthly price survey
◆ Calculating the CPI We will work through these three steps for the
simple artificial economy in Table 22.1, which shows
The CPI Basket The first stage in constructing the the quantities in the CPI basket and the prices in the
CPI is to select what is called the CPI basket. This base period (2012) and current period (2013).
basket contains the goods and services represented in Part (a) contains the data for the base period.
the index, each weighted by its relative importance. In that period, consumers bought 10 oranges at
The idea is to make the relative importance of the R1 each and 5 haircuts at R30 each. To find the cost
items in the CPI basket the same as that in the budget of the CPI basket in the base-period prices, multiply
of an average urban household. For example, because the quantities in the CPI basket by the base-period
people spend more on housing than on clothing and prices. The cost of oranges is R10 (10 at R1 each)
footwear, the CPI places more weight on the price of and the cost of haircuts is R150 (5 at R30 each).
housing than on the price of clothing and footwear.
To determine the CPI basket, Statistics South
FIGURE 22.4 The CPI Basket
Africa conducts an Income and Expenditure Survey
(IES). This survey is costly and so is undertaken infre- 100 Health (1.5)
Education (3.0)
quently. Today’s CPI basket is based on data gathered
CPI weights (per cent)
So total cost of the CPI basket in the base period of rate as the annual percentage change in the CPI.
the CPI basket is R160 (R10 + R150). To calculate the inflation rate, we use the formula
Part (b) contains the price data for the current period.
The price of an orange increased from R1 to R2, CPI this year – CPI last year
which is a 100 per cent increase – (R1 ÷ R1) × 100 = 100. Inflation rate = × 100.
CPI last year
The price of a haircut increased from R30 to R40,
which is a 33 per cent increase – (R10 ÷ R30) × 100 = 33. We can use this formula to calculate the inflation
The CPI provides a way of averaging these price rate in January 2013.
increases by comparing the cost of the basket rather The CPI in January 2012 was 97.2 and the CPI
than the price of each item. To find the cost of the in January 2013 was 102.7. So the inflation rate
CPI basket in the current period, 2013, multiply the during the twelve months to January 2013 was
quantities in the basket by their 2012 prices. The
cost of oranges is R20 (10 at R2 each) and the cost Inflation rate = (102.7 – 97.2)/97.2 × 100 = 5.7%.
of haircuts is R200 (5 at R40 each). So total cost
of the fixed CPI basket at current-period prices is
R220 (R20 + R200). TABLE 22.1 The CPI: A Simplified Calculation
You have now taken the first two steps toward (a) The cost of the CPI basket at base-period prices: 2012
calculating the CPI: calculating the cost of the CPI CPI basket Cost of CPI
basket in the base period and the current period. The Basket
third step uses the numbers you have just calculated Item Quantity Price
to find the CPI for 2012 and 2013.
Oranges 10 R1.00 R10
The formula for the CPI is
Haircuts 5 R30.00 R150
Cost of CPI basket at
current prices Cost of CPI basket at base-period prices R160
CPI = × 100
Cost of CPI basket at
(b) The cost of the CPI basket at current-period prices: 2013
base-period prices
CPI basket Cost of CPI
In Table 22.1, you established that in 2012 (the Basket
base period), the cost of the CPI basket was R160 and Item Quantity Price
in 2013, it was R220.
Oranges 10 R2.00 R20
If we use these numbers in the CPI formula, we can
find the CPI for 2012 and 2013. For 2012, the CPI is Haircuts 5 R40.00 R200
A high inflation rate means that the price level is as Woolworths and instead shop at Shoprite, Pick n
rising rapidly. A high price level means that there has Pay, etc. This phenomenon is called outlet substitution.
been a sustained period of rising prices. The CPI surveys do not monitor outlet substitutions.
When the price level in part (a) falls, the inflation
rate in part (b) is negative – deflation. During the graphed FIGURE 22.5 The CPI and the Inflation Rate
period, South Africa did not experience deflation.
The CPI is not a perfect measure of the price level 140
140
and changes in the CPI probably overstates the infla-
tion rate. Let us look at the sources of bias. 120
120
scale)
100
ratioscale)
100
CPI
CPI (2008=100)
(2008=100)
The Biased CPI 80
100;ratio
80
The main sources of bias in the CPI are:
(1982–1984==100;
60
60
◆ New goods bias
◆ Quality change bias
CPI(1982–1984
40
40
◆ Commodity substitution bias
20
◆ Outlet substitution bias CPI 20
0
0
New Goods Bias If you want to compare the price 1984
1984 1988
1988 1992
1992 1996
1996 2000
2000 2004
2004 2008
2008 2012
2012
level in 2013 with that in 1969, you must somehow Year
Year
compare the price of a computer today with that of (a)
(a) CPI
CPI
a typewriter in 1969. Because a PC or tablet is more
expensive than a typewriter was, the arrival of the PC
or tablet puts an upward bias into the CPI and its 25
25
inflation rate.
20
Quality Change Bias Cars, CD players and many 20
10
10
inflation.
rate(per
5
Inflationrate
5
Commodity Substitution Bias Changes in relative
Inflation
The Magnitude of the Bias exports. These calculations are done in the same way
You have reviewed the sources of bias in the CPI. as that for real GDP described in simplified terms
But how big is the bias? This question was tackled on p. 499 and more technically on pp. 462–463 in
in 1996 by a Congressional Advisory Commission Chapter 21.
on the Consumer Price Index chaired by Michael To calculate the PCE deflator, we use the
Boskin, an economics professor at Stanford University. formula:
This commission concluded that for the United
States, CPI overstates inflation by 1.1 percentage PCE deflator (Nominal C ÷ Real C) × 100,
points a year. That is, if the CPI reports that inflation
is 3.1 per cent a year, most likely inflation is actually where C is personal consumption expenditure.
2 per cent a year. Recent research in South The basket of goods and services included in
Africa indicates that commodity substitution bias the PCE deflator is broader than that in the CPI
overstates inflation by between 0.2 per cent and because it includes all consumption expenditure,
1.5 per cent, on average. Also noted was the not only the items bought by a typical urban family.
fact that commodity substitution bias seems to The difference between the PCE deflator and
increase over time as the CPI basket becomes the CPI is small. Since 2000, the inflation rate
more outdated. measured by the PCE deflator is 6.23 per cent per
year, 0.3 percentage points higher than the CPI
inflation rate.
Some Consequences of the Bias
The bias in the CPI distorts private contracts and GDP Deflator The GDP deflator is a bit like the
increases government outlays. Many private agree- PCE deflator except that it includes all the goods
ments, such as wage contracts, are linked to the CPI. and services that are counted as part of GDP. So it
For example, a firm and its workers might agree to a is an index of the prices of the items in consumption,
three-year wage deal that increases the wage rate by investment, government expenditure and net exports.
the percentage increase in the CPI plus an additional
2 or 3 per cent. GDP deflator = (Nominal GDP ÷ Real GDP) × 100
Such a deal ends up giving the workers more real
income than the firm intended. This broader price index is appropriate for macro-
economics because it is a comprehensive measure of
the cost of the real GDP basket of goods and services.
Alternative Price Indexes Since 2000, the GDP deflator has increased
The CPI is just one of many alternative price level at an average rate of 6.7 per cent per year, only
index numbers and because of the bias in the CPI, 0.8 percentage points below the CPI inflation rate.
other measures are used for some purposes. We will
describe two alternatives to the CPI and explain when
Core CPI Inflation
and why they might be preferred to the CPI.
The alternatives are: No matter whether we calculate the inflation rate
◆ Personal consumption expenditure deflator using the CPI, the personal consumption expenditure
◆ GDP deflator deflator, or the GDP deflator, the number
may vary a good deal from month to month or
Personal Consumption Expenditure Deflator quarter to quarter. To determine the trend in the
The personal consumption expenditure deflator (or inflation rate, we need to strip the raw numbers of
PCE deflator) is calculated from data in the national their volatility. The core CPI inflation rate, which is
income accounts that you studied in Chapter 21. the CPI inflation rate excluding volatile elements,
When the South African Reserve Bank calculates real attempts to do just that and reveal the underlying
GDP, it also calculates the real values of its expendi- inflation trend.
ture components: real consumption expenditure, real As a practical matter, the core CPI inflation rate
investment, real government expenditure and real net is calculated as the percentage change in the CPI (or
other price index) excluding food and fuel. The prices the GDP deflator, we can deflate other nominal vari-
of these two items are among the most volatile. ables to find their real values. For example, the real
While the core CPI inflation rate removes the wage rate is the nominal wage rate divided by the
volatile elements in inflation, if the relative prices of GDP deflator.
the excluded items are changing, the core CPI infla- We can adjust any nominal quantity or price
tion rate will give a biased measure of the true under- variable for inflation by deflating it – by dividing it
lying inflation rate. by the price level.
Such a misleading account was given between There is one variable that is a bit different – an
2011 and 2012 when the relative prices of food and interest rate. A real interest rate is not a nominal
fuel were rising. The result was a core CPI inflation interest rate divided by the price level. You will learn
rate that was systematically below the CPI inflation how to adjust the nominal interest rate for inflation to
rate. Figure 22.6 shows the two series since 2009. find the real interest rate in Chapter 24.
More refined measures of core inflation have been But all the other real variables of macroeconomics
suggested that eliminate the bias. are calculated by dividing a nominal variable by the
price level.
The Real Variables in Macroeconomics
You saw in Chapter 21 how we measure real GDP.
REVIEW QUIZ
And you have seen in this chapter how we can 1 What is the price level?
use nominal GDP and real GDP to provide another 2 What is the CPI and how is it calculated?
measure of the price level – the GDP deflator. 3 How do we calculate the inflation rate and
But viewing real GDP as nominal GDP deflated, what is its relationship with the CPI?
opens up the idea of other real variables. By using 4 What are the four main ways in which the CPI
is an upward-biased measure of the price level?
FIGURE 22.6 Core Inflation 5 What problems arise from the CPI bias?
6 What are the alternative measures of the price
12
level and how do they address the problem of
bias in the CPI?
Inflation rate (per cent per year)
10
8
You have now completed your study of the meas-
Headline urement of macroeconomic performance. Your next
inflation
6
task is to learn what determines that performance and
how policy actions might improve it. But first, take a
close-up look at youth unemployment in South Africa
4
Core inflation in Reading Between the Lines on pp. 492–493.
2
0
2009 2010 2011 2012
Year
Xolile Blessing Bam is passionate about computers. The 20-year-old South African studied IT at a
business college in Johannesburg but he has not been able to find a job since. To get some experi-
ence he volunteers as a teaching assistant at a local school in Soweto. ‘I’ve tried looking for a job for a
year and a half now’, Bam said. ‘The challenges are experience and the level of education that I have
because I only have a certificate, not a diploma or degree.’
Bam’s story is typical. Out of a population of 49 million, 7.5 million South Africans are out of work.
Young people are worst affected, with over half of 18- to 25-year-olds unemployed.
According to the labour federation, Congress of South African Trade Unions (Cosatu), there’s no
other middle-income country in the world with such a high rate of unemployment. ‘This is a crisis.
We call it a ticking bomb’, said Zwelinzima Vavi, Cosatu’s general secretary. ‘We think that one day
there may be an explosion. Seventy-three per cent of people who are unemployed in South Africa are
below the age of 35 and a lot of them have been to universities.’
Protests
Demonstrations have exploded in poor areas, with the number of protests rising eight-fold in the last
seven years, peaking at 111 in 2010.
In an attempt to pacify this growing anger, President Zuma has promised to create five million jobs
by 2020. In his 2012 State of the Nation address, he put forward an ambitious job creation plan,
underpinned by R300 billion in spending to upgrade the nation’s railways and ports.
A new story
South Africa’s economy has begun creating ESSENCE OF THE STORY
jobs again, with unemployment at 23.9% in
the last quarter of 2011 – still very high but at ◆ The majority of the unemployed are youth between
the lowest level since the 2008 global financial the ages of 15 and 24.
crisis. But South Africa still has not replaced the ◆ When the age bracket is extended to include indi-
one million jobs lost during the global recession viduals up to 34 years of age, the youth unemploy-
and the part of the population living in poverty ment rate increases to 73%.
– nearly 40% – has hardly budged since white- ◆ The lack of jobs has sparked protests country wide.
minority rule ended in 1994. ◆ Young people with degrees, diplomas and certifi-
cates are all struggling to find jobs.
◆ No other middle income country has higher unem-
ployment rates than South Africa.
◆ The government seeks to create five million jobs
by 2020.
‘The work done last year indicates that if we continue to grow reasonably well, we will begin to write
a new story about South Africa – the story of how, working together, we drove back unemployment
and reduced economic inequality and poverty’, Zuma said.
The job creation drive might seem a long way off but politicians trust it is enough to give young
people hope in order to avoid more social unrest. Despite the increase in protests, many young people
do not want revolution.
Source: © Mail & Guardian.
Key Terms
Absorption rate, 482 Discouraged worker, 483 Labour force participation Price level, 485
Consumer Price Index Frictional unemployment, rate, 482 Structural unemployment,
(CPI), 486 484 Marginally attached 484
Core CPI inflation rate, 490 Full employment, 484 worker, 483 Unemployment rate, 481
Cyclical unemployment, Hyperinflation, 486 Natural unemployment Working-age population,
484 Inflation, 485 rate, 484 480
Deflation, 485 Labour force, 480 Output gap, 485
◆ Promise used to earn R460 000 a year and a. In which region was the inflation rate
she turned down a low-paid job to search for highest in 2007 and in 2008?
one that pays at least R380 000 a year. b. Describe the path of the price level in Japan.
◆ David turned down a temporary full-time
job paying R50 an hour because it was an Use the following info byte to work out Problem 19.
hour’s drive away and the transport costs
would be high. The largest contributions to overall inflation came
from housing and utilities, followed by food and
The Price Level, Inflation and Deflation transport. Food price inflation has moderated after
Use the following information to work out Problems 18 months of sustained increases, as meat and vege-
12 and 13. table price inflation has eased markedly. Core inflation
trended upwards within the target range, suggesting
The people on Coral Island buy only juice and cloth. more generalised inflation pressures although still
The CPI basket contains the quantities bought in 2010. remaining well contained. Administered prices
The average household spent $60 on juice and $30 on continued to increase at rates well above the upper
cloth in 2009 when the price of juice was $2 a bottle band of the target range, driven by electricity, petrol
and the price of cloth was $5 a metre. In the current and assessment rates.
year, 2010, juice is $4 a bottle and cloth is $6 a metre.
Source: Monetary Policy Review May 2012.
12. Calculate the CPI basket and the percentage of
the household’s budget spent on juice in 2010. 19. Distinguish between the CPI and the core CPI.
13. Calculate the CPI and the inflation rate in 2011. Why might the core CPI be a useful measure-
ment and why might it be misleading?
Use the following data to work out Problems 14 to 16.
Use the following info byte to work out Problem 20.
Statistics South Africa reported the following CPI data:
2007 112.1 The year-on-year inflation rate as measured by the
2008 125.0 consumer price index (CPI) for all urban areas was
2009 133.9 5.5 per cent in June 2012, down from 5.7 per cent
14. Calculate the inflation rates for 2008 and 2009. in May. The categories of food, housing and utilities
How did the inflation rate change in 2009? and transport together accounted for 3.5 percentage
15. Why might these CPI numbers be biased? points of the inflation outcome. Food prices increased
16. How do alternative price indexes help to avoid by 6.0 per cent, petrol by 14.2 per cent and electricity
the bias in the CPI numbers? by 17.1 per cent on a year-on-year basis. Core infla-
17. Explain why inflation influences a worker’s real tion, as measured by the exclusion of food, petrol and
wage rate. Do workers prefer a real wage cut that electricity from CPI, increased in line with expecta-
arises from an increase in the price level or from a tions from 4.4 per cent in May to 4.6 per cent in
cut in their nominal wage? June. Administered prices, excluding petrol, increased
18. The IMF World Economic Outlook reported the at a year-on-year rate of 8.7 per cent in both May
following price level data (2000 = 100): and June.
Source: Statement of the Monetary Policy Committee Date: 2012-07-19.
Region 2006 2007 2008
United States 117.1 120.4 124.0 20. Explain why the categories of food, housing
and utilities and transport contribute the most
Euro area 113.6 117.1 119.6
to the CPI.
Japan 98.1 98.1 98.8
The Big Picture First, in Chapters 23 to 26, you will study long-
term trends. This material is central to the oldest
Macroeconomics is a large and controversial subject question in macroeconomics that Adam Smith tried
that is interlaced with political ideological disputes. to answer: What are the causes of the wealth of
And it is a field in which charlatans, as well as serious nations? You will also study three other old questions
thinkers have much to say. that Adam Smith’s contemporary and friend David
You have just learned in Chapters 21 and 22 how to Hume first addressed: What causes inflation? What
monitor and measure the main macroeconomic variables. causes international deficits and surpluses? And why
We use real GDP to calculate the rate of economic growth do exchange rates fluctuate?
and business cycle fluctuations. And we use the CPI and In Chapters 27 to 29, you will study macroeco-
other measures of the price level to calculate the inflation nomic fluctuations.
rate and to ‘deflate’ nominal values to find real values. Finally, in Chapters 30 and 31, you will study
In the chapters that lie ahead, you will learn the the policies that the government and South African
theories that economists have developed to explain Reserve Bank might adopt to make the economy
economic growth, fluctuations and inflation. perform well.
David Hume, a Scot who lived from 1711 He repeatedly appealed to experience and
to 1776, did not call himself an economist. evidence as the ultimate judge of the validity of
‘Philosophy and general learning’ is how he an argument. Hume’s fundamentally empirical
described the subject of his life’s work. approach dominates macroeconomics today.
Hume was an extraordinary thinker and
writer. Published in 1742, his Essays, Moral and
Political, range across economics, political science, ‘... in every kingdom into which money begins
moral philosophy, history, literature, ethics and to flow in greater abundance than formerly,
religion and explore such topics as love, marriage, everything takes a new face: labour and
divorce, suicide, death and the immortality of
industry gain life; the merchant becomes more
the soul!
His economic essays provide astonishing enterprising, the manufacturer more diligent
insights into the forces that cause inflation, busi- and skilful, and even the farmer follows his
ness cycle fluctuations, balance of payments deficits plow with greater alacrity and attention.’
and interest rate fluctuations; and they explain the
effects of taxes and government deficits and debts. DAVID HUME
Data were scarce in Hume’s day, so he was not
Essays, Moral and Political
able to draw on detailed evidence to support his
analysis. But he was empirical.
R
23
eal GDP per person in South Africa doubled between 1950 and
2010. If you live in a residence that was built during the 1960s, it is
likely to have just two power outlets: one for a desk lamp and one for
a bedside lamp. Today, your room may be equipped with a personal
computer, television and DVD player, microwave, refrigerator and more,
all connected to their own outlets. Economic growth has brought about
this improvement in living standards.
The answer is provided by a formula called the growth rate of the variable. Using the Rule of 70,
Rule of 70, which states that the number of years you can now calculate how many years it takes your
it takes for the level of any variable to double is R1 000 to become R2 000. It is 70 divided by 5,
approximately 70 divided by the annual percentage which is 14 years.
60
1 70.0
2 35.0
50 2 per cent growth
doubles in 35 years 3 23.3
40
4 17.5
35
30 5 14.0
7 per cent growth
doubles in 10 years 6 11.7
20
7 10.0
10
8 8.8
9 7.8
0 1 2 3 4 5 6 7 8 9 10 11 12
Growth rate (per cent per year)
10 7.0
The number of years it takes for the level of a variable to 11 6.4
double is approximately 70 divided by the annual percentage
growth rate of the variable. 12 5.8
40 000
Recession
GDP per capita (constant 2005 rand)
of 2008/2009
36 000
14 000 50 000
Real GDP p.c. (PPP, 2005 US$)
12 000
40 000 United States
Botswana
10 000
30 000
South Africa Euro area
8 000 OECD countries
20 000
Mauritius
6 000
South Africa
10 000
4 000 Namibia
World Sub-Saharan Africa
2 000 0
1980 1990 2000 2010 1980 1990 2000 2010
Year Year
Real GDP per person has grown at different rates throughout Among various regions of the world in part (b), growth rates
the world. Among the sub-Saharan African countries in have been lower in sub-Saharan African countries and the
part (a), real GDP per person has grown faster in Botswana world on average than in the developed countries (the United
and Mauritius than in South Africa and Namibia. This has States, OECD countries and Euro area).
caused the GDP per person in Botswana and Mauritius The gap between the real GDP per person in sub-Saharan
to surpass that of South Africa since 1996. Slow growth Africa, including South Africa and that in the United States
in Namibia means that it is not catching up with its has widened.
neighbouring countries.
Source of data: World Bank Development indicators.
The real wage rate is the money wage rate Figure 23.5 illustrates labour market equilibrium.
divided by the price level. The real wage rate is the The demand for labour curve is LD and the supply
quantity of goods and services that an hour of labour of labour curve is LS. This labour market is in
earns. It contrasts with the money wage rate, which is equilibrium at a real wage rate of R35 an hour and
the number of rand that an hour of labour earns. 20 billion hours a year are employed.
The real wage rate influences the quantity of If the real wage rate exceeds R35 an hour, the
labour demanded because what matters to firms is not quantity of labour supplied exceeds the quantity
the number of rand they pay (money wage rate) but demanded and there is a surplus of labour. When
how much output they must sell to earn those rand. there is a surplus of labour, the real wage rate falls
The quantity of labour demanded increases as the toward the equilibrium real wage rate where the
real wage rate decreases – the demand for labour curve surplus is eliminated.
slopes downward. Why? The answer lies in the shape If the real wage rate is less than R35 an hour, the
of the production function. quantity of labour demanded exceeds the quantity
You have seen that along the production function, supplied and there is a shortage of labour. When there
each additional hour of labour increases real GDP is a shortage of labour, the real wage rate rises toward
by successively smaller amounts, another example of the equilibrium real wage rate where the shortage is
the law of diminishing (marginal) returns. Because of eliminated.
diminishing returns, firms will hire more labour only If the real wage rate is R35 an hour, the quantity
up to the point where the additional cost of labour (the of labour demanded equals the quantity supplied and
real wage rate) equals the additional benefit it receives there is neither a shortage nor a surplus of labour.
(the extra output produced by that labour).
FIGURE 23.5 Labour Market Equilibrium
The Supply of Labour The supply of labour is the
relationship between the quantity of labour supplied
Real wage rate (2005 rand per hour)
LS
and the real wage rate. The quantity of labour supplied 60 Labour surplus
forces the real
is the number of labour hours that all the households in wage rate down
the economy plan to work during a given period. This 50
quantity depends on the real wage rate.
The real wage rate influences the quantity of Labour market
equilibrium
labour supplied because what matters to households is
35
not the amount of rand earned (money wage rate) but
what they can buy with those rand.
The quantity of labour supplied increases as the
20
real wage rate increases – the supply of labour curve
slopes upward. At a higher real wage rate, more people Labour shortage LD
choose to work and more people choose to work 10 forces the real
wage rate up
longer hours if they can earn more per hour.
0 10 20 30 40 50
Labour Market Equilibrium The price of labour is Labour (billions of hours per year)
the real wage rate. The forces of supply and demand
Labour market equilibrium occurs when the quantity of labour
operate in labour markets just as it does in the
demanded equals the quantity of labour supplied. The
markets for goods and services to eliminate a shortage
equilibrium real wage rate is R35 an hour and equilibrium
or a surplus. But a shortage or a surplus of labour
employment is 20 billion hours per year.
brings only a gradual change in the real wage rate. If
At a wage rate above R35 an hour, there is a surplus of
there is a shortage of labour, the real wage rate rises to
labour and the real wage rate falls to eliminate the surplus. At
eliminate it; and if there is a surplus of labour, the real
a wage rate below R35 an hour, there is a shortage of labour
wage rate eventually falls to eliminate it. When there
and the real wage rate rises to eliminate the shortage.
is neither a shortage nor a surplus, the labour market
is in equilibrium – a full-employment equilibrium.
We can divide all the forces that make potential GDP Potential
grow into two categories: 1 500 GDP
LS
productive and more labour is employed. 60
Real GDP
Physical capital growth growth
Human capital growth Labour
Education and training productivity Real GDP per
Job experience growth person growth
Technological advances
Labour supply growth and labour productivity growth combine depends on real GDP growth and population growth.
to determine real GDP growth. Real GDP per person growth
Technological Change and Diminishing to save and invest, saving decreases and the rate of
Returns In neoclassical growth theory, the pace capital accumulation slows. Eventually, the pace of
of technological change influences the economic capital accumulation slows so that it is only keeping
growth rate but economic growth does not influence up with population growth. Capital per worker
the pace of technological change. It is assumed that remains constant.
technological change results from chance. When we
are lucky, we have rapid technological change and A Problem with Neoclassical Growth Theory
when bad luck strikes, the pace of technological All economies have access to the same technologies
advance slows. and capital is free to roam the globe, seeking the
To understand neoclassical growth theory, highest available real interest rate. Capital will flow
imagine the world of the mid-1950s, when Robert until rates of return are equal and rates of return will
Solow is explaining his idea. Income per person in the be equal when capital per hour of labour are equal. Real
United States was around $12 000 a year in today’s GDP growth rates and income levels per person around
money. The population was growing at about 1 per the world will converge. Figure 23.3 on p. 502 shows
cent a year. Saving and investment are about 20 per that while there is some sign of convergence among
cent of GDP, enough to keep the quantity of capital some African countries in part (a), convergence is
per hour of labour constant. Income per person is slow and part (b) shows that it does not appear to
growing but not very fast. be imminent for all regions. New growth theory
Then technology begins to advance at a more overcomes this shortcoming of neoclassical growth
rapid pace across a range of activities. The transistor theory. It also explains what determines the pace of
revolutionises an emerging electronics industry. technological change.
New plastics revolutionise the manufacture
of household appliances. The highway system
New Growth Theory
revolutionises road transportation. Jet airliners start
to replace piston-engine aeroplanes and speed air New growth theory holds that real GDP per
transportation. person grows because of the choices people make
These technological advances bring new profit in the pursuit of profit and that growth will persist
opportunities. Businesses expand and new businesses indefinitely. Paul Romer of Stanford University
are created to exploit the newly available profitable developed this theory during the 1980s, based
technologies. Investment and savings increase. The on ideas of Joseph Schumpeter during the 1930s
economy enjoys new levels of prosperity and growth. and 1940s.
But will the prosperity last? And will the growth last? According to the new growth theory, the pace
Neoclassical growth theory says that the prosperity at which new discoveries are made – and at which
will last but the growth will not last unless technology technology advances – is not determined by chance.
keeps advancing. It depends on how many people are looking for
According to neoclassical growth theory, a new technology and how intensively they are
the prosperity will persist because there is no looking. The search for new technologies is driven
classical population growth to induce the wage by incentives.
rate to fall. So the gains in income per person are Profit is the spur to technological change. The
permanent. forces of competition squeeze profits, so to increase
But growth will eventually stop if technology profit, people constantly seek either lower-cost
stops advancing because of diminishing marginal methods of production or new and better products
returns to capital. The high profit rates that result for which people are willing to pay a higher price.
from technological change bring increased saving Inventors can maintain a profit for several years by
and capital accumulation. But as more capital is taking out a patent or a copyright, but eventually,
accumulated, more and more projects are undertaken a new discovery is copied and profits disappear. So
that have lower rates of return – diminishing marginal more research and development is undertaken in the
returns. As the return on capital falls, the incentive hope of creating a new burst of profitable investment
to keep investing weakens. With weaker incentives and growth.
Two facts about discoveries and technological capital has relentlessly increased. In 1990, it cost
knowledge play a key role in the new growth theory: about R50 to sequence one DNA base pair. That
Discoveries are (at least eventually) a public capital cost had fallen to R7 by 2000 and to 1/10 000th of a
good; and knowledge is capital that is not subject to penny (less than 1 cent) by 2010.
diminishing marginal returns. The implication of this simple and appealing
Economists call a good a public good when no one observation is astonishing. Unlike the other two
can be excluded from using it and when one person’s use theories, new growth theory has no growth-stopping
does not prevent others from using it. National defence is mechanism. As physical capital accumulates, the
the classic example of a public good. The programming return to capital – the real interest rate – falls. But the
language used to write apps for the iPhone is another. incentive to innovate and earn a higher profit becomes
Because knowledge is a public good, as the stronger. So innovation occurs, capital becomes more
benefits of a new discovery spread, free resources productive, the demand for capital increases and the
become available. Nothing is given up when they real interest rate rises again.
are used: They have a zero opportunity cost. When a Labour productivity grows indefinitely as people
student in Cape Town writes a new iPhone app, his discover new technologies that yield a higher real
use of the programming language does not prevent interest rate. The growth rate depends only on people’s
another student in Johannesburg from using it. incentives and ability to innovate.
Knowledge is even more special because it is not
subject to diminishing returns. But increasing the A Perpetual Motion Economy New growth theory
stock of knowledge makes both labour and machines sees the economy as a perpetual motion machine,
more productive. Knowledge capital does not bring which Fig. 23.10 illustrates.
diminishing returns. Biotech knowledge illustrates No matter how rich we become, our wants
this idea well. Biologists have spent a lot of time exceed our ability to satisfy them. We always want
developing DNA sequencing technology. As more has a higher standard of living. In the pursuit of a higher
been discovered, the productivity of this knowledge standard of living, human societies have developed
incentive systems – markets, property rights and Neoclassical growth theory reaches the same
money – that enable people to profit from innovation. conclusion but not because of a population explosion.
Innovation leads to the development of new and Instead, it emphasises diminishing returns to capital
better techniques of production and new and better and reminds us that we cannot keep growth going
products. To take advantage of new techniques and just by accumulating physical capital. We must
to produce new products, new firms start up and old also advance technology and accumulate human
firms go out of business – firms are born and die. As capital. We must become more creative in our use
old firms die and new firms are born, some jobs are of scarce resources. New growth theory emphasises
destroyed and others are created. The new jobs created the capacity of human resources to innovate at a pace
are better than the old ones and they pay higher real that offsets diminishing returns. New growth theory
wage rates. Also, with higher wage rates and more fits the facts of today’s world more closely than does
productive techniques, leisure increases. New and either of the other two theories. But that does not
better jobs and new and better products lead to more make it correct.
consumption goods and services and, combined with
increased leisure, bring a higher standard of living.
But our insatiable wants are still there, so the
The Empirical Evidence on the Causes of
process continues: Wants and incentives create Economic Growth
innovation, new and better products and a yet Economics makes progress by the interplay between
higher standard of living. theory and empirical evidence. A theory makes
predictions about what we will observe if the theory
is correct. Empirical evidence, the data generated by
New Growth Theory Versus Malthusian
history and the natural experiments that it performs,
Theory
provide the data for testing the theory.
The contrast between the Malthusian theory and new Economists have done an enormous amount
growth theory could not be more sharp. Malthusians of research confronting theories of growth with the
see the end of prosperity as we know it today and new empirical evidence. The way in which this research has
growth theorists see unending plenty. The contrast been conducted has changed over the years.
becomes clearest by thinking about the differing views In 1776, when Adam Smith wrote about ‘the
about population growth. nature and causes of the Wealth of Nations’ in his
To a Malthusian, population growth is part of celebrated book, empirical evidence took the form
the problem. To a new growth theorist, population of carefully selected facts described in words and
growth is part of the solution. People are the ultimate stories. Today, large databases, sophisticated statistical
economic resource. A larger population brings forth methods and fast computers provide numerical
more wants, but it also brings a greater amount of measurements of the causes of economic growth.
scientific discovery and technological advance. So Economists have looked at the growth rate data
rather than being the source of falling real GDP per for more than 100 countries for the period since 1960
person, population growth generates faster labour and explored the correlations between the growth
productivity growth and rising real GDP per person. rate and more than 60 possible influences on it. The
Resources are limited, but the human imagination conclusion of this data crunching is that most of these
and ability to increase productivity are unlimited. possible influences have variable and unpredictable
effects, but a few of them have strong and clear effects.
Table 23.1 summarises these more robust influences.
Sorting Out the Theories They are arranged in order of difficulty (or in the case
Which theory is correct? None of them tells us the of region, impossibility) of changing. Political and
whole story, but each teaches us something of value. economic systems are hard to change, but market
Classical growth theory reminds us that our distortions, investment and openness to international
physical resources are limited and that without trade are features of a nation’s economy that can be
advances in technology, we must eventually hit influenced by policy.
diminishing returns. Let us now look at growth policies.
Policies for Achieving Faster Growth is limited and the market allocates too few resources
Growth theory supported by empirical evidence tells to this activity. Governments can direct public funds
us that to achieve faster economic growth, we must toward financing basic research, but this solution is
increase the growth rate of physical capital, the pace not foolproof. It requires a mechanism for allocating
of technological advance, or the growth rate of human the public funds to their highest-valued use.
capital and openness to international trade.
The main suggestions for achieving these Improve the Quality of Education The free
objectives are: market produces too little education because its
◆ Stimulate saving benefits extend beyond those valued by the people
◆ Stimulate research and development who receive the education. By funding basic education
◆ Improve the quality of education and by ensuring high standards in basic skills such as
◆ Provide international aid to developing nations language, mathematics and science, governments can
◆ Encourage international trade contribute to a nation’s growth potential. Education
can also be stimulated and improved by using tax
Stimulate Saving Saving finances investment, so incentives to encourage improved private provision.
stimulating saving increases economic growth. The East
Asian economies have the highest growth rates and the Provide International Aid to Developing Nations
highest saving rates. Some African economies have the It seems obvious that if rich countries give financial
lowest growth rates and the lowest saving rates. aid to developing countries, investment and growth
Tax incentives can increase saving. Economists will increase in the recipient countries. Unfortunately,
claim that a tax on consumption rather than income the obvious does not routinely happen. A large amount
provides the best saving incentive. of data-driven research on the effects of aid on
growth has turned up a zero and even negative effect.
TABLE 23.1 The Influences on Economic Growth Aid often gets diverted and spent on consumption.
Influence Good for Bad for
Economic Growth Economic Growth Encourage International Trade Trade, not aid,
Region • Far from equator • Sub-Saharan stimulates economic growth. It works by extracting
Africa the available gains from specialisation and trade.
Politics • Rule of law • Revolutions The fastest-growing nations are those most open to
• Civil liberties • Military coups trade. If the rich nations truly want to aid economic
• Wars
development, they will lower their trade barriers
Economic • Capitalist
against developing nations, especially in farm
system
products. The World Trade Organization’s efforts to
Market • Exchange rate
distortions distortions achieve more open trade are being resisted by the
• Price controls and richer nations.
black markets
Investment • Human capital
• Physical capital REVIEW QUIZ
International • Open to trade 1 What is the key idea of classical growth theory
trade
that leads to the dismal outcome?
Source of information: Xavier Sala-i-Martin, ‘I Just Ran Two Million Regressions’, The 2 What, according to neoclassical growth theory,
American Economic Review, Vol. 87, No 2, (May 1997), pp. 178–183. © The is the fundamental cause of economic growth?
American Economic Review. Used with permission of the author Xavier Sala-i-Martin. 3 What is the key proposition of new growth
theory that makes economic growth persist?
Stimulate Research and Development Everyone
can use the fruits of basic research and development To complete your study of economic growth, take
efforts. For example, all biotechnology firms can a look at Reading Between the Lines on pp. 517–519
use advances in gene-splicing technology. Because and see how the return of skilled labours to Africa has
basic inventions can be copied, the inventor’s profit a positive effect on growth on the continent.
‘Africa has steadily gained positive press due to strong economic growth, a favourable demographic
profile and seemingly endless opportunities. Such is the enthusiasm for Africa that comparisons have
been drawn between the growing opportunities in Africa and the initial stages of China’s economic
growth. Consequently, a new trend has arisen – that of Africans living abroad, returning home to the
opportunities offered to them.
‘… Traditionally, Africa has always suffered from bad press in the international media, to the extent
that it was once dubbed the “hopeless continent” in a May 2000 issue of The Economist magazine.
However, the magazine has in recent times changed its negative tone to a more optimistic one with
its December 2011 issue, ‘Africa Rising’. In this issue it was stated that “After decades of slow growth,
Africa has a real chance to follow in the footsteps of Asia.” …
‘Reverse migration is not a new trend; other developing countries have experienced former expatriates
returning to their home countries in great numbers. The most notable country to experience such a
phenomenon is China, where former expatriates have returned home to contribute to a burgeoning
society. Many returning expatriates in China provided skills and experiences, found to be lacking in
their country. …
‘With surging growth in Africa, many Africans abroad, with professional expertise, are being recruited
for and enticed by opportunities at home. … Fortunately for Africans educated abroad, their options
are favourable compared to those educated at home, as there is a skills shortage in Africa and the
demand for talent is high. … Many of the Africans
featured have recently returned to their home countries
after time spent living and working abroad and have ESSENCE OF THE STORY
embarked on starting their own businesses in sectors ◆ There is agreement that the future of Africa
such as manufacturing, hospitality and education. …’ is looking brighter.
Source: © Consultancy Africa Intelligence www.consultancyafrica.com ◆ After decades of slow growth, the continent
is now being compared to China.
◆ Reverse migration is taking place, which
replenishes skills that Africa lost.
◆ Not only are they bringing skills, they are
also starting businesses in Africa.
24 000 1 900 C
1 800 B
PF0
20 000
16 000 A
1 300
12 000
1 000
8 000
4 000
500
0
1990 1995 2000 2005 2010
Year
LS
60
6
50
Percentage growth in GDP per person
4
OECD members 45
40
2
35
30
0
Euro area
20 LD1
–2
LD0
Sub-Saharan Africa
10
–4
Figure 2 Changing growth picture in sub-Saharan Africa Figure 3 The effect of an increase in human capital on
potential output
◆ The article talks with great optimism about ◆ It therefore represents an increase in output that
Africa’s prospects and one reason for this can be produced with the same levels of input, as
optimism is the return of skilled labourers to the illustrated in Figure 3(a).
continent – called reverse migration. ◆ This increases the demand for labour in the
◆ Why is reverse migration so important? In the economy, illustrated in Figure 3(b).
chapter we saw that a growth in labour is not ◆ What makes the return of skilled labourers even
necessarily a good thing, but that a growth in more noteworthy is the fact that many of them
human capital is a source of economic growth. turn out to be entrepreneurs – thereby providing
◆ Human capital increases output in a similar way job opportunities in a variety of sectors in the
as an increase in productivity. economy.
Key Terms
Aggregate production Economic growth rate, 499 New growth theory, 513 Real wage rate, 505
function, 504 Labour productivity, 508 Real GDP per person, 499 Rule of 70, 500
Classical growth theory, Neoclassical growth
512 theory, 512
Growth Theories, Evidence and Policies Initially, the population of Cape Despair is constant
17. Explain the processes that will bring the growth and real GDP per hour of labour is at the subsistence
of real GDP per person to a stop according to: level of R15. Then a technological advance shifts the
a. Classical growth theory. production function upward by 50 per cent at each
b. Neoclassical growth theory. level of labour.
c. New growth theory. a. What are the initial levels of real GDP and
18. In the economy of Cape Despair, the subsistence labour productivity?
real wage rate is R15 an hour. Whenever real b. What happens to labour productivity
GDP per hour rises above R15, the population immediately following the technological
grows and whenever real GDP per hour of labour advance?
falls below this level, the population falls. The c. What happens to the population growth rate
table shows Cape Despair’s production function. following the technological advance?
d. What are the eventual levels of real GDP
Labour Real GDP and real GDP per hour of labour?
(billions of hours per year) (billions of 2000 rand)
0.5 8
1.0 15
1.5 21
2.0 26
2.5 30
3.0 33
3.5 35
How Potential GDP Grows 27. Suppose that labour productivity increases in
23. If a large increase in investment increases labour 2010. What effect does the increased labour
productivity, explain what happens to: productivity have on the demand for labour, the
a. Potential GDP. supply of labour, potential GDP and real GDP
b. Employment. per person?
c. The real wage rate.
24. If a severe drought decreases labour productivity, Why Labour Productivity Grows
explain what happens to: 28. Explain five potential sources for faster
a. Potential GDP. economic growth.
b. Employment.
c. The real wage rate. Growth Theories, Evidence and Policies
29. Is faster economic growth always a good thing?
Use the following tables to work out Problems 25 Argue the case for faster growth and the case
to 27. The first table describes an economy’s labour for slower growth. Then reach a conclusion on
market in 2010 and the second table describes its whether growth should be increased or slowed.
production function in 2010.
30. New Wind Blowing
Real wage rate Labour hours Labour hours Green energy solutions are becoming more
(rand per hour) supplied demanded
important in view of depleted resources such as
80 55 15 fossil fuels and higher energy demands. One
70 50 20
company intends to harness high altitude wind
to generate power. This differs from wind turbines
60 45 25 that operate near the surface. They plan to adapt
50 40 30 old technology, kites, to tap into this potentially
lucrative source.
40 35 35 Explain which growth theory best describes this
30 30 40 company’s method of exploiting existing sources.
20 25 45
Economics in the News
31. In China, the one-child policy reduces
Labour Real GDP population growth to around 0.5 per cent per
(hours) (2005 rand) year. India also boasts a large population but
15 1 425
does not have a one-child policy restriction on its
population growth. Both economies had similar
20 1 800 economic growth rates in 2005.
25 2 125 a. Given the expected population changes,
do you think China or India will have the
30 2 400 greater economic growth rate? Why?
35 2 625 b. Would China’s growth rate remain at 9 per
cent a year without the restriction on its
40 2 800
population growth rate?
45 2 925 c. India’s population growth rate is 1.6 per
cent a year and in 2005 its economic growth
50 3 000
rate was 8 per cent a year. China’s population
growth rate is 0.6 per cent a year and in 2005
25. What is the equilibrium real wage rate and the
its economic growth rate was 9 per cent a
quantity of labour employed in 2010?
year. In what year will real GDP per person
26. What are labour productivity and potential GDP
double in each country?
in 2010?
D
24
uring September 2008, Wall Street put on a spectacular show.
To prevent the collapse of Fannie Mae and Freddie Mac, the two largest
lenders to home-buyers, the US government took over their risky debts.
When Lehman Brothers, a venerable Wall Street investment bank, was
on the verge of bankruptcy, secure phone lines and limousines worked
overtime as the Federal Reserve Bank of New York, the US Treasury and
senior officials of Bank of America and Barclays Bank
FINANCE, SAVING (a British bank) tried to find ways to save the bank. The
effort failed. On the same weekend, Bank of America
AND INVESTMENT bought Merrill Lynch, another big Wall Street investment
bank. And a few days later, the US government bought
insurance giant AIG and tried to persuade the US
Congress to provide $700 billion to buy just about
every risky debt that anyone wanted to unload.
Behind such drama, Wall Street plays a crucial unseen role
funnelling funds from savers and lenders to investors and borrowers.
This chapter explains how financial markets work and their place in
the economy.
In Reading Between the Lines at the end of the chapter, we will look
at the effects of government budget deficits and apply what you have
learned to better understand what is happening in South African and
global financial markets today.
railway locomotives to Transnet, CSR Zhuzhou Electric Financial institutions also stand ready to trade
Locomotive wants to be paid when the items are so that households with funds to lend and firms or
shipped. But Transnet does not want to pay until the households seeking funds can always find someone on
locomotives are earning an income. In this situation, the other side of the market with whom to trade.
Transnet might promise to pay CSR Zhuzhou Electric The key financial institutions are:
Locomotive R2.7 billion three months in the future. ◆ Commercial banks
A bank would be willing to buy this promise for (say) ◆ Pension funds
R2.6 billion. CSR Zhuzhou Electric Locomotive gets ◆ Insurance companies
R2.6 billion immediately and the bank gets R2.7
billion in three months when Transnet honours its Commercial Banks Commercial banks are financial
promise. The South African National Treasury issues institutions that accept deposits, provide payment
promises of this type, called Treasury bills. services and make loans to firms and households.
Another type of bond is a mortgage-backed The bank that you use for your own banking services
security, which entitles its holder to the income from and that issues your credit card is a commercial bank.
a package of mortgages. Mortgage lenders create These institutions play a central role in the monetary
mortgage-backed securities. They make mortgage system and we study them in detail in Chapter 25.
loans to homebuyers and then create securities that
are sold to obtain more funds to make more mortgage
loans. The holder of a mortgage-backed security is Economics in Action
entitled to receive payments that derive from the The Financial Crisis
payments received by the mortgage lender from the
homebuyer–borrower. Bear Stearns: absorbed by JPMorgan Chase with help
Mortgage-backed securities were at the centre of from the US Federal Reserve. Lehman Brothers: gone.
the storm in the financial markets in 2007–2008. Fannie Mae and Freddie Mac: taken into government
oversight. Merrill Lynch: absorbed by Bank of
Stock Markets When Boeing wants finance to America. AIG: given an $85 billion lifeline by the
expand its aeroplane building business, it issues stock. US Federal Reserve and sold off in pieces to financial
A stock is a certificate of ownership and claim on the institutions around the world. Wachovia: taken over
firm’s profits. Boeing has issued about 900 million by Wells Fargo. Washington Mutual: taken over
shares of its stock. So if you owned 900 Boeing shares, by JPMorgan Chase. Morgan Stanley: 20 per cent
you would own one millionth of Boeing and be bought by Mitsubishi, a large Japanese bank. These
entitled to receive one millionth of its profits. are some of the events in the financial crisis of 2008.
Unlike a stockholder, a bondholder does not own What was going on and how can a repeat
part of the firm that issued the bond. situation be avoided?
A stock market is a financial market in which Between 2002 and 2005, mortgage lending
shares of stocks of corporations are traded. The New exploded and home prices rocketed. Mortgage lenders
York Stock Exchange, the London Stock Exchange (in bundled their loans into mortgage-backed securities and
England), the Tokyo Stock Exchange (in Japan) and sold them to eager buyers around the world.
the Johannesburg Stock Exchange (in South Africa) When interest rates began to rise in 2006
are all examples of stock markets. and asset prices fell, financial institutions took
big losses. Some losses were too big to bear and
big-name institutions failed.
Financial Institutions
Financial markets are highly competitive because
of the role played by financial institutions in those Pension Funds Pension funds are financial
markets. A financial institution is a firm that operates institutions that use the pension contributions of
on both sides of the markets for financial capital. The firms and workers to buy bonds and stocks. Some
financial institution is a borrower in one market and a pension funds are very large and play an active role in
lender in another. the firms whose stock they hold.
Insurance Companies Insurance companies enable Because the interest rate is a percentage of the
households and firms to cope with risks such as accident, price of an asset, if the asset price rises, other things
theft, fire, ill-health and a host of other misfortunes. remaining the same, the interest rate falls. Conversely,
They receive premiums from their customers and pay if the asset price falls, other things remaining the
claims. Insurance companies use the funds they have same, the interest rate rises.
received but not paid out as claims to buy bonds and To see this inverse relationship between an asset
stocks on which they earn interest income. price and the interest rate, let us look at an example.
In normal times, insurance companies have a We will consider a bond that promises to pay its
steady flow of funds coming in from premiums and holder R500 a year forever. What is the rate of return
interest on the financial assets they hold and a steady, but – the interest rate – on this bond? The answer depends
smaller, flow of funds paying claims. Their profit is the on the price of the bond. If you could buy this bond
gap between the two flows. But in unusual times, when for R5 000, the interest rate would be 10 per cent
large and widespread losses are being incurred, insurance per year:
companies can run into difficulty in meeting their
obligations. Such a situation arose in 2008 for one of the Interest rate = (R500 ÷ R5 000) × 100 = 10 per cent
biggest insurers in the world, AIG and the firm was taken
into public ownership by the United States government. But if the price of this bond increased to
R20 000, its rate of return or interest rate would be
only 2.5 per cent per year. That is,
Insolvency and Illiquidity
A financial institution’s net worth is the market value Interest rate = (R500 ÷ R20 000) × 100 = 2.5 per cent
of what it has lent minus the market value of what it
has borrowed. If net worth is positive, the institution This relationship means that the price of an asset
is solvent. But if net worth is negative, the institution and the interest rate on that asset are determined
is insolvent and must go out of business. The owners simultaneously – one implies the other.
of an insolvent financial institution – usually its This relationship also means that if the interest
stockholders – bear the loss. rate on the asset rises, the price of the asset falls,
A financial institution both borrows and debts become harder to pay and the net worth of
lends, so it is exposed to the risk that its net worth the financial institution falls. Insolvency can arise
might become negative. To limit that risk, financial from a previously unexpected large rise in the
institutions are regulated and a minimum amount of interest rate.
their lending must be backed by their net worth. In the next part of this chapter, we learn how
Sometimes, a financial institution is solvent but interest rates and asset prices are determined in the
illiquid. A firm is illiquid if it has made long-term financial markets.
loans with borrowed funds and is faced with a sudden
demand to repay more of what it has borrowed than its REVIEW QUIZ
available cash. In normal times, a financial institution
that is illiquid can borrow from another institution. 1 Distinguish between physical capital and
But if all the financial institutions are short of cash, the financial capital and give two examples
market for loans among financial institutions dries up. of each.
Insolvency and illiquidity were at the core of the 2 What is the distinction between gross
financial meltdown of 2007–2008. investment and net investment?
3 What are the three main types of markets for
financial capital?
Interest Rates and Asset Prices 4 Explain the connection between the price of a
Stocks, bonds, short-term securities and loans are financial asset and its interest rate.
collectively called financial assets. The interest rate on
a financial asset is the interest received expressed as a
percentage of the price of the asset.
Y=C+I+G+X–M
Funds that Finance Investment
Figure 24.2 shows the flows of funds that finance By using these two equations, you can see that
investment. They come from three sources:
1. Household saving I+G+X=M+S+T
2. Government budget surplus
3. Borrowing from the rest of the world Subtract G and X from both sides of the last
equation to obtain
Households’ income, Y, is spent on consumption
goods and services, C, saved, S, or paid in net taxes, T. I = S + (T – G) + (M – X )
Net taxes are the taxes paid to governments minus the
cash transfers received from governments (such as the This equation tells us that investment, I, is
child support grant and unemployment benefits). financed by household saving, S, the government
FIGURE 24.2 Financial Flows and the Circular Flow of Expenditure and Income
S Households’ saving
T
HOUSEHOLDS Government
borrowing
(deficit)
GOVERNMENTS
Y C
Government
debt
G repayment
(surplus)
budget surplus, (T – G ), and borrowing from the rest 5 per cent nominal interest rate minus the 2 per cent
of the world, (M – X ). inflation rate.1
A government budget surplus (T > G ) contributes The real interest rate is the opportunity cost of
funds to finance investment, but a government budget loanable funds. The real interest paid on borrowed
deficit (T < G ) competes with investment for funds. funds is the opportunity cost of borrowing. And the
If we export less than we import, we borrow real interest rate forgone when funds are used either
(M – X ) from the rest of the world to finance some of to buy consumption goods and services or to invest
our investment. If we export more than we import, we in new capital goods is the opportunity cost of not
lend (X – M ) to the rest of the world and part of South saving or not lending those funds.
African saving finances investment in other countries. We are now going to see how the loanable funds
The sum of private saving, S, and government market determines the real interest rate, the quantity
saving, (T – G ), is called national saving. National of funds loaned, saving and investment. In the rest of
saving and foreign borrowing finance investment. this section, we will ignore the government and the
You are going to see how investment and saving rest of the world and focus on households and firms
and the flows of loanable funds – all measured in in the loanable funds market. We will study:
constant 2010 rand – are determined. The price in ◆ The demand for loanable funds
the loanable funds market that achieves equilibrium is ◆ The supply of loanable funds
an interest rate, which we also measure in real terms ◆ Equilibrium in the loanable funds market
as the real interest rate. In the loanable funds market,
there is just one interest rate, which is an average of
the interest rates on all the different types of financial The Demand for Loanable Funds
securities that we described earlier. Let us see what we The quantity of loanable funds demanded is the total
mean by the real interest rate. quantity of funds demanded to finance investment,
the government budget deficit and international
investment or lending during a given period.
The Real Interest Rate Our focus here is on investment. We will bring the
The nominal interest rate is the number of rand that other two items into the picture in later sections
a borrower pays and a lender receives in interest in a of this chapter.
year expressed as a percentage of the number of rand What determines investment and the demand for
borrowed and lent. For example, if the annual interest loanable funds to finance it? Many details influence
paid on a R5 000 loan is R250, the nominal interest this decision, but we can summarise them in two
rate is 5 per cent per year: R250 ÷ R5 000 × 100 or factors:
5 per cent. 1. The real interest rate
The real interest rate is the nominal interest 2. Expected profit
rate adjusted to remove the effects of inflation on
the buying power of money. The real interest rate Firms invest in capital only if they expect to earn
is approximately equal to the nominal interest rate a profit and fewer projects are profitable at a high real
minus the inflation rate. interest rate than at a low real interest rate, so
You can see why if you suppose that you have
Other things remaining the same, the higher
put R5 000 in a savings account that earns 5 per cent
a year. At the end of a year, you have R5 250 in your the real interest rate, the smaller is the
savings account. Suppose that the inflation rate is 2 per quantity of loanable funds demanded; and
cent per year – during the year, all prices increased by the lower the real interest rate, the greater
2 per cent. Now, at the end of the year, it costs R5 100 the quantity of loanable funds demanded.
to buy what R5 000 would have bought one year ago.
Your money in the bank has really only increased 1 The exact real interest rate formula, which allows for the change in the
by R150, from R5 100 to R5 250. That R150 is purchasing power of both the interest and the loan is: Real interest rate
= (Nominal interest rate – Inflation rate) ÷ (1 + Inflation rate/100). If the
equivalent to a real interest rate of 3 per cent a year on nominal interest rate is 5 per cent a year and the inflation rate is 2 per cent
your original R5 000. So the real interest rate is the a year, the real interest rate is (5 – 2) ÷ (1 + 0.02) = 2.94 per cent a year.
Demand for Loanable Funds Curve The demand Expected profit rises during a business cycle
for loanable funds is the relationship between the expansion and falls during a recession; rises when
quantity of loanable funds demanded and the real technological change creates profitable new products;
interest rate, when all other influences on borrowing rises as a growing population brings increased demand for
plans remain the same. The demand curve DLF in goods and services; and fluctuates with contagious swings
Fig. 24.3 is a demand for loanable funds curve. of optimism and pessimism, called ‘animal spirits’ by
To understand the demand for loanable funds, Keynes and ‘irrational exuberance’ by Alan Greenspan.
think about kalahari.com’s decision to borrow When expected profit changes, the demand for
R100 million to build some new warehouses. If loanable funds curve shifts.
Kalahari expects to earn a return of R5 million a year
from this investment before paying interest costs and The Supply of Loanable Funds
the interest rate is less than 5 per cent a year, Kalahari The quantity of loanable funds supplied is the total
would make a profit, so it builds the warehouses. But funds available from private saving, the government
if the interest rate were more than 5 per cent a year, budget surplus and international borrowing during
Kalahari would incur a loss, so it does not build the a given period. Our focus here is on saving. We will
warehouses. The quantity of loanable funds demanded bring the other two items into the picture later.
is greater the lower is the real interest rate. How do you decide how much of your income
to save and supply in the loanable funds market?
Changes in the Demand for Loanable Funds Your decision is influenced by many factors, but chief
When the expected profit changes, the demand for among them are:
loanable funds changes. Other things remaining the 1. The real interest rate
same, the greater the expected profit from new capital, 2. Disposable income
the greater is the amount of investment and the 3. Expected future income
greater the demand for loanable funds. 4. Wealth
5. Default risk
FIGURE 24.3 The Demand for Loanable Funds We begin by focusing on the real interest rate.
Real interest rate (per cent per year)
Changes in the Supply of Loanable Funds A change Shifts of the Supply of Loanable Funds Curve
in disposable income, expected future income, wealth, or When any of the four influences on the supply of
default risk changes the supply of loanable funds. loanable funds changes, the supply of loanable funds
changes and the supply curve shifts. An increase in
Disposable Income A household’s disposable income is disposable income, a decrease in expected future income,
the income earned minus net taxes. When disposable a decrease in wealth, or a fall in default risk increases
income increases, other things remaining the same, saving and increases the supply of loanable funds.
consumption expenditure increases but by less than the
increase in income. Some of the increase in income is
saved. So the greater a household’s disposable income, Equilibrium in the Loanable Funds Market
other things remaining the same, the greater is its saving. You have seen that, other things remaining the same,
the higher the real interest rate, the greater is the
Expected Future Income The higher a household’s quantity of loanable funds supplied and the smaller
expected future income, other things remaining the is the quantity of loanable funds demanded. There
same, the smaller is its saving today. is one real interest rate at which the quantities of
loanable funds demanded and supplied are equal and
Wealth The higher a household’s wealth, other things that interest rate is the equilibrium real interest rate.
remaining the same, the smaller is its saving. If a Figure 24.5 shows how the demand for and supply
person’s wealth increases because of a capital gain, the of loanable funds determine the real interest rate.
person sees less need to save. The DLF curve is the demand curve and the SLF curve
is the supply curve. If the real interest rate exceeds 6 per
Default Risk Default risk is the risk that a loan will cent a year, the quantity of loanable funds supplied
not be repaid. The greater that risk, the higher is the exceeds the quantity demanded – a surplus of funds.
interest rate needed to induce a person to lend and the
smaller is the supply of loanable funds. FIGURE 24.5 Equilibrium in the Loanable
Funds Market
FIGURE 24.4 The Supply of Loanable Funds
Real interest rate (per cent per year)
Real interest rate (per cent per year)
5
5
4
A fall in the real interest
4 Equilibrium quantity
rate decreases saving DLF
of loanable funds
and the quantity of
loanable funds supplied
0 1.0 1.5 2.0 2.5 3.0 3.5
0 1.0 1.5 2.0 2.5 3.0 3.5 Loanable funds (billions of 2010 rand)
Loanable funds (billions of 2010 rand)
A surplus of funds lowers the real interest rate and a shortage
A change in the real interest rate changes the quantity of of funds raises it. At an interest rate of 6 per cent a year, the
loanable funds supplied and brings a movement along the quantity of funds demanded equals the quantity supplied and
supply of loanable funds curve. the market is in equilibrium.
Borrowers find it easy to obtain funds, but lenders are Changes in Demand and Supply
unable to lend all the funds they have available. The Financial markets are highly volatile in the short run
real interest rate falls and continues to fall until the but remarkably stable in the long run. Volatility in the
quantity of funds supplied equals the quantity market comes from fluctuations in either the demand
of funds demanded. for loanable funds or the supply of loanable funds.
If the real interest rate is less than 6 per cent These fluctuations bring fluctuations in the real
a year, the quantity of loanable funds supplied is interest rate and in the equilibrium quantity of funds
less than the quantity demanded – a shortage of lent and borrowed. They also bring fluctuations in
funds. Borrowers cannot obtain the funds they want,
7 6
6 5
DLF1
5 4
DLF0 DLF
0 1.0 1.5 2.0 2.5 3.0 3.5 0 1.0 1.5 2.0 2.5 3.0 3.5
Loanable funds (billions of 2010 rand) Loanable funds (billions of 2010 rand)
In part (a), the demand for loanable funds increases and In part (b), the supply of loanable funds increases and
supply does not change. The real interest rate rises (financial demand does not change. The real interest rate falls (financial
interest rate (per cent per year)
SLF1
7
PART EIGHT Macroeconomic Trends
6
9781775785026_gsp_eco_stb_ter_eng_za.indb 532 2014/03/14 7:13 AM
The Loanable Funds Market 533
With no change in the supply of loanable funds, Long-Run Growth of Demand and Supply Over
there is a shortage of funds at a real interest rate of time, both demand and supply in the loanable funds
6 per cent a year. The real interest rate rises until it market fluctuate and the real interest rate rises and
is 7 per cent a year. Equilibrium is restored and the falls. Both the supply of loanable funds and the
equilibrium quantity of funds has increased. demand for loanable funds tend to increase over
time. On average, they increase at a similar pace,
An Increase in Supply If one of the influences on so although demand and supply trend upward, the
saving plans changes and increases saving, the supply real interest rate has no trend. It fluctuates around a
of loanable funds increases. constant average level.
With no change in the demand for loanable
funds, the market has a large amount of loanable
REVIEW QUIZ
funds available. Borrowers find bargains and
lenders find themselves accepting a lower interest 1 What is the loanable funds market?
rate. At the lower interest rate, borrowers find 2 Why is the real interest rate the opportunity
additional investment projects profitable and cost of loanable funds?
increase the quantity of loanable funds that 3 How do firms make investment decisions?
they borrow. 4 What determines the demand for loanable
Figure 24.6(b) illustrates these changes. An increase funds and what makes it change?
in supply shifts the supply curve rightward from SLF0 to 5 How do households make saving decisions?
SLF1. With no change in demand, there is a surplus of 6 What determines the supply of loanable funds
funds at a real interest rate of 6 per cent a year. The real and what makes it change?
interest rate falls until it is 5 per cent a year. 7 How do changes in the demand for and
Equilibrium is restored and the equilibrium supply of loanable funds change the real
quantity of funds has increased. interest rate and quantity of loanable funds?
Economics in Action funds curve to DLF05. The real interest rate fell to
1 per cent a year and the quantity of loanable funds
Loanable Funds Fuel Home Price Bubble increased to $36 trillion – a 24 per cent increase in
The financial crisis that gripped the US and global just four years.
economies in 2007 and cascaded through the financial With this large increase in available funds, much
markets in 2008 had its origins much earlier in events of it in the form of mortgage loans to homebuyers,
taking place in the loanable funds market. the demand for homes increased by more than the
Between 2001 and 2005, a massive injection of increase in the supply of homes. Home prices rose
loanable funds occurred. Some funds came from the and the expectation of further increases fuelled the
rest of the world, but that source of supply has been demand for loanable funds.
stable. The US Federal Reserve provided funds to keep By 2006, the expectation of continued rapidly
interest rates low and that was a major source of the rising home prices brought a very large increase in the
increase in the supply of funds. demand for loanable funds.
Figure 1 illustrates the loanable funds market At the same time, the US Federal Reserve began
starting in 2001. In that year, the demand for loanable to tighten credit. (You will learn how this is done in
funds in the US was DLF01 and the supply of loanable the next chapter). The result of the Fed’s tighter credit
funds was SLF01. The equilibrium real interest rate policy was a slowdown in the pace of increase in the
was 4 per cent a year and the equilibrium quantity of supply of loanable funds.
loanable funds was $29 trillion (in 2005 dollars). Figure 2 illustrates these events. In 2006, the
During the ensuing four years, a massive demand for loanable funds increased from DLF05 to
increase in the supply of loanable funds shifted DLF06 and the supply of loanable funds increased by a
the supply curve rightward to SLF05. A smaller smaller amount from SLF05 to SLF06. The real interest
increase in demand shifted the demand for loanable rate increased to 3 per cent a year.
The rise in the real interest rate (and a much constant but decreased the quantity of new business.
higher rise in the nominal interest rate) put many The total quantity of loanable funds did not
homeowners in financial difficulty. decrease, but the rate of increase slowed to a snail’s
Mortgage payments increased and some pace and financial institutions most exposed to the
borrowers stopped repaying their loans. bad mortgage debts and the securities that they
By August 2007, the damage from mortgage backed began to fail.
default and foreclosure was so large that the credit These events illustrate the crucial role played by
market began to dry up. A large decrease in both the loanable funds market in economies.
demand and supply kept interest rates roughly
Real interest rate (per cent per year)
4 4
Smaller increase
in demand for
loanable funds
Slower increase
3 3
in supply of
loanable funds
Real
2 interest 2
rate falls Real
interest
rate rises
1 1
DLF05 DLF06
DLF01 DLF05
0 29 31 33 35 36 37 39 0 35 36 37 38 39 40
Loanable funds (trillions of 2005 dollars) Loanable funds (trillions of 2005 dollars)
Figure 1 The Foundation of the Crisis: 2001–2005 Figure 2 The Start of the Crisis: 2005–2006
8
Government budget deficit Rational taxpayers
PSLF increases the demand for increase saving
8 SLF0
loanable funds
SLF
7 SLF1
… lowers the
real interest 7
rate
6
5
DLF
4
… decreases … increases
saving investment 4 DLF
PDLF
0 1.0 1.5 2.0 2.5 3.0 3.5
Loanable funds (billions of 2010 rand)
0 1.5 2.0 2.5 3.0 3.5 4.0
Loanable funds (billions of 2010 rand)
A government budget surplus of R1 billion is added to private
saving and the private supply of loanable funds (PSLF ) to A budget deficit increases the demand for loanable funds.
determine the supply of loanable funds, SLF. The real interest Rational taxpayers increase saving, which increases the
rate falls to 5 per cent a year, private saving decreases, but supply of loanable funds curve from SLF0 to SLF1. Crowding
investment increases to R2.5 billion. out is avoided: Increased saving finances the budget deficit.
The rise in the real interest rate increases private The Global Loanable Funds Market
saving to R2.5 billion, but investment decreases to
The loanable funds market is global, not national.
R1.5 billion because R1 billion of private saving must
Lenders on the supply side of the market want
finance the government budget deficit.
to earn the highest possible real interest rate and they
will seek it by looking everywhere in the world.
The Crowding-Out Effect The tendency for
Borrowers on the demand side of the market
a government budget deficit to raise the real
want to pay the lowest possible real interest rate and
interest rate and decrease investment is called the
they will seek it by looking everywhere in the world.
crowding-out effect. The budget deficit crowds out
Financial capital is mobile: it moves to the best
investment by competing with businesses for scarce
advantage of lenders and borrowers.
financial capital.
The crowding-out effect does not decrease
investment by the full amount of the government International Capital Mobility
budget deficit because the higher real interest rate If a South African supplier of loanable funds can earn
induces an increase in private saving that partly a higher interest rate in Tokyo than in Johannesburg,
contributes toward financing the deficit. funds supplied in Japan will increase and funds
supplied in South Africa will decrease – funds will
The Ricardo-Barro Effect First suggested by the flow from South Africa to Japan.
English economist David Ricardo in the eighteenth If a South African demander of loanable funds can
century and refined by Robert J. Barro of Harvard pay a lower interest rate in Paris than in Johannesburg,
University, the Ricardo-Barro effect holds that both the demand for funds in France will increase and the
of the effects we have just shown are wrong and demand for funds in South Africa will decrease – funds
the government budget, whether in surplus or will flow from France to South Africa.
deficit, has no effect on either the real interest rate Because lenders are free to seek the highest real
or investment. interest rate and borrowers are free to seek the lowest
Barro says that taxpayers are rational. They can real interest rate, the loanable funds market is a single,
see that a budget deficit today means that future taxes integrated, global market. Funds flow into the country
will be higher and future disposable incomes will in which the interest rate is highest and out of the
be smaller. With smaller expected future disposable country in which the interest rate is lowest.
incomes, saving increases today. Private saving and When funds leave the country with the lowest
the private supply of loanable funds increase to match interest rate, a shortage of funds raises the real interest
the quantity of loanable funds demanded by the rate. When funds move into the country with the highest
government. So the budget deficit has no effect on interest rate, a surplus of funds lowers the real interest
either the real interest rate or investment. Figure 24.9 rate. The free international mobility of financial capital
shows this outcome. pulls real interest rates around the world toward equality.
Most economists regard the Ricardo-Barro Only when the real interest rates in Johannesburg,
view as extreme. But there might be some change Tokyo and Paris are equal does the incentive to move
in private saving that goes in the direction suggested funds from one country to another stop.
by the Ricardo-Barro effect that lessens the crowding- Equality of real interest rates does not mean that if
out effect. you calculate the average real interest rate in Johannesburg,
Tokyo and Paris, you will get the same number.
REVIEW QUIZ To compare real interest rates, we must compare
1 How does a government budget surplus or financial assets of equal risk.
deficit influence the loanable funds market? Lending is risky. A loan might not be repaid. Or
2 What is the crowding-out effect and how does the price of a stock or bond might fall. Interest rates
it work? include a risk premium – the riskier the loan, other
3 What is the Ricardo-Barro effect and how does things remaining the same, the higher is the interest
it modify the crowding-out effect? rate. The interest rate on a risky loan minus that on a
safe loan is called the risk premium.
International capital mobility brings real interest does not make the quantity of funds demanded and
rates in all parts of the world to equality except for supplied equal in each national economy. The demand
differences that reflect differences in risk – differences for and supply of funds in a national economy
in the risk premium. determine whether the country is a lender to or a
borrower from the rest of the world.
International Borrowing and Lending The Global Loanable Funds Market Figure 24.10(a)
A country’s loanable funds market connects with the illustrates the global market. The demand for loanable
global market through net exports. If a country’s net funds, DLFW is the sum of the demands in all countries.
exports are negative (X < M ), the rest of the world Similarly, the supply of loanable funds, SLFW is the sum
supplies funds to that country and the quantity of of the supplies in all countries. The world equilibrium
loanable funds in that country is greater than national real interest rate makes the quantity of funds supplied in
saving. If a country’s net exports are positive (X > M ), the world as a whole equal to the quantity demanded.
the country is a net supplier of funds to the rest of In this example, the equilibrium real interest rate is 5 per
the world and the quantity of loanable funds in that cent a year and the quantity of funds is R10 trillion.
country is less than national saving.
An International Borrower Figure 24.10(b) shows
the loanable funds market in a country that borrows
Demand and Supply in the Global and from the rest of the world.
National Markets The country’s demand for loanable funds, DLF,
The demand for and supply of funds in the global is part of the world demand in Fig. 24.10(a). The
loanable funds market determines the world country’s supply of loanable funds, SLFD, is part of the
equilibrium real interest rate. This interest rate makes world supply.
the quantity of loanable funds demanded equal If this country were isolated from the global
the quantity supplied in the world economy. But it market, the real interest rate would be 6 per cent
a year (where the DLF and SLFD curves intersect).
FIGURE 24.10 Borrowing and Lending in the Global Loanable Funds Market
Real interest rate (per cent per year)
Net foreign
6 6 6
lending
SLFD
5 5 SLF 5 SLF
0 9.0 9.5 10.0 10.5 11.0 11.5 0 1.0 1.5 2.0 2.5 3.0 3.5 0 1.0 1.5 2.0 2.5 3.0 3.5
Loanable funds (trillions of 2010 rand) Loanable funds (billions of 2010 rand) Loanable funds (billions of 2010 rand)
(a) The global market (b) An international borrower (c) An international lender
In the global loanable funds market in part (a), the demand At the world real interest rate, borrowers in part (b) want more
for loanable funds, DLFW, and the supply of funds, SLFW, funds than the quantity supplied by domestic lenders (SLFD).
determine the world real interest rate. Each country can get The shortage is made up by international borrowing.
funds at the world real interest rate and faces the (horizontal) Domestic suppliers of funds in part (c) want to lend more
supply curve SLF in parts (b) and (c). than domestic borrowers demand. The excess quantity
supplied goes to foreign borrowers.
But if the country were integrated into the global rate of 5 per cent a year in the rest of the world,
economy, with an interest rate of 6 per cent a year, domestic suppliers of loanable funds would seek the
funds would flood into it. With a real interest rate of higher return in other countries. Again, the country
5 per cent a year in the rest of the world, suppliers of faces the supply of loanable funds curve SLF, which is
loanable funds would seek the higher return in this horizontal at the world equilibrium real interest rate.
country. In effect, the country faces the supply of The country’s demand for loanable funds and the
loanable funds curve SLF, which is horizontal at the world interest rate determine the equilibrium quantity
world equilibrium real interest rate. of loanable funds – R1.5 billion in Fig. 24.10(c).
The country’s demand for loanable funds and the
world interest rate determine the equilibrium quantity Changes in Demand and Supply A change in the
of loanable funds – R2.5 billion in Fig. 24.10(b). demand or supply in the global loanable funds market
changes the real interest rate in the way shown in Fig. 24.6
An International Lender Figure 24.10(c) shows (see p. 532). The effect of a change in demand or supply
the situation in a country that lends to the rest of the in a national market depends on the size of the country.
world. As before, the country’s demand for loanable A change in demand or supply in a small country has
funds, DLF, is part of the world demand and the no significant effect on global demand or supply, so
country’s supply of loanable funds, SLFD, is part of the it leaves the world real interest rate, unchanged and
world supply in Fig. 24.10(a). changes only the country’s net exports and international
If this country were isolated from the global borrowing or lending. A change in demand or supply in a
economy, the real interest rate would be 4 per cent large country has a significant effect on global demand
a year (where the DLF and SLFD curves intersect). or supply, so it changes the world real interest rate, as
But if this country were integrated into the global well as the country’s net exports and international
economy, with an interest rate of 4 per cent a year, borrowing or lending. Every country feels some of the
funds would quickly flow out of it. With a real interest effect of a large country’s change in demand or supply.
Economics in Action
Real interest rate (per cent per year)
10.0 SLF01
SLF05
Greenspan’s Interest Rate Puzzle
8.0
The real interest rate paid by big corporations in the
United States fell from 5.5 per cent a year in 2001 to
2.5 per cent a year in 2005.
Alan Greenspan, then the Chairman of the 5.5
The figure illustrates these events. The supply of quantity of loanable funds increased.
loanable funds increased from SLF01 in 2001 to SLF05 In the United States, borrowing from the rest
in 2005. (In the figure, we ignore the change in the of the world increased to finance the increased
global demand for loanable funds because it was small government budget deficit.
relative to the increase in supply.) The interest rate puzzle illustrates the important
With the increase in supply, the real interest rate fact that the loanable funds market is a global market,
fell from 5.5 per cent to 2.5 per cent a year and the not a national market.
REVIEW QUIZ
1 Why do loanable funds flow among countries? 4 What happens if a country has a surplus of
2 What determines the demand for and supply of loanable funds at the world real interest rate?
loanable funds in an individual economy? 5 How is a government budget deficit financed in
3 What happens if a country has a shortage of an open economy?
loanable funds at the world real interest rate?
To complete your study of financial markets, take funds market to understand the saving and borrowing
a look at Reading Between the Lines on pp. 539–541 behaviour of South Africans.
and see how you can use the model of the loanable
... South Africa has seen a steady increase in household indebtedness over the last few years. We did
not double the size of the economy. And that’s the problem. ...
The average household debt to disposable income ratio is about 75% at the moment, significantly
higher than the 40-year national average of 56%, but slightly lower than the all-time highs of 82%
in 2008. Government also seems to be on a borrowing spree. Government debt has risen from 27%
of GDP in 2008/09 to 41% of GDP in 2012/13 and is projected to increase further in the next
few years.
Increase in
5 Increase in 5 government
government deficit
deficits ...
4 4
3 3
Crowding out
2 2
Figure 1 The global loanable funds market Figure 2 The South African loanable funds market
Key Terms
Bond, 525 Financial institution, 526 National saving, 529 Saving, 524
Bond market, 525 Gross investment, 524 Net investment, 524 Stock, 526
Crowding-out effect, 536 Loanable funds market, 528 Net taxes, 528 Stock market, 526
Demand for loanable Mortgage, 525 Net worth, 527 Supply of loanable funds,
funds, 530 Mortgage-backed Nominal interest rate, 529 530
Financial capital, 524 security, 526 Real interest rate, 529 Wealth, 524
b. Equities reap a capital gain in the same rate is 7 per cent a year, First Call will build a smaller
way that houses reap a capital gain. Does factory that costs R8 million.
this mean that the purchase of equities is 6. Draw a graph of First Call’s demand for loanable
investment? If not, explain why it is not. funds curve.
5. After the 2008/2009 financial crisis, countries 7. First Call expects its profit from the sale of
belonging to the G20 decided that it would cellular phones to double next year. If other
be prudent for financial institutions to hold things remain the same, explain how this increase
more capital. in expected profit influences First Call’s demand
What are the financial institutions that the G20 for loanable funds.
might require to hold more capital? What exactly 8. Draw a graph to illustrate how an increase in the
is the ‘capital’ referred to in the info byte? How supply of loanable funds and a decrease in the
might the requirement to hold more capital make demand for loanable funds can lower the real
financial institutions safer? interest rate and leave the equilibrium quantity of
loanable funds unchanged.
The Loanable Funds Market 9. Explain why households prefer to buy corporate
Use the following information to work out equities rather than bonds.
Problems 6 and 7.
Government in the Loanable Funds Market
First Call (Pty) Ltd is a cellular phone company. It Use the following table to work out Problems 10
plans to build a factory that costs R10 million if the to 12. The table shows an economy’s demand
real interest rate is 6 per cent a year. If the real interest for loanable funds and the supply of loanable
rate is 5 per cent a year, First Call will build a larger funds schedules, when the government’s budget
factory that costs R12 million. And if the real interest is balanced.
10. Suppose that the government has a budget Use the table in Problem 10 to work out
surplus of $1 trillion. What are the real interest Problems 13 to 15.
rate, the quantity of investment and the quantity Suppose that the quantity of loanable funds
of private saving? Is there any crowding out in demanded increases by $1 trillion at each real
this situation? interest rate and the quantity of loanable funds
11. Suppose that the government has a budget deficit supplied increases by $2 trillion at each interest rate.
of $1 trillion. What are the real interest rate, 13. If the government budget is balanced, what are
the quantity of investment and the quantity the real interest rate, the quantity of loanable
of private saving? Is there any crowding out in funds, investment and private saving? Does any
this situation? crowding out occur?
12. Suppose that the government has a budget deficit 14. If the government budget becomes a deficit of
of $1 trillion and the Ricardo-Barro effect occurs. $1 trillion, what are the real interest rate, the
What are the real interest rate and the quantity of quantity of loanable funds, investment and
investment? private saving? Does any crowding out occur?
15. If the government wants to stimulate investment 18. IMF Says It Battled Crisis Well
and increase it to $9 trillion, what must it do? In order to combat the effect of the financial crisis
of 2008/2009, the IMF provided funding to
The Global Loanable Funds Market developing countries and asked major economic
16. Why is the United States, with the world’s largest players, like China, to employ expansionary fiscal
economy, borrowing heavily on international policies to stimulate their economies even if this
capital markets – rather than lending, as would meant running a deficit. On the other hand,
seem more natural? developing countries with large deficits were asked
17. a. What implications do the US current to reign in expenditure and reduce their deficits.
account deficit (negative net exports) and a. Explain how increased government budget
US reliance on foreign credit have for deficits change the loanable funds market.
economic performance in the United States? b. Would the global recession have been less
b. What policies, if any, should be used to severe had the IMF made larger loans to
address this situation? developing countries?
and expectations of an economic slowdown were 27. With economic growth forecasted to slow, future
keeping the interest rates on bonds relatively low. incomes are expected to fall. If other things
a. Explain how ‘unusual buying’ might lead to remain the same, how will the demand or supply
a low real interest rate. of loanable funds in India change?
b. Explain how ‘expectations of an economic 28. Government finances deficits through debt. What
slowdown’ might lead to a lower real is the effect of a continued and rising government
interest rate. deficit on economic growth?
Government in the Loanable Funds Market The Global Loanable Funds Market
Use the following information to work out Problems 29. The Global Savings Glut and Its Consequences
26 and 27. Growth leads to higher levels of disposable
income and higher savings rates. India has seen
India’s Economy Hits the Wall the average savings rate increase from 23% to
India, one of the BRICS, seemed poised for economic 33% over a decade and China has an average
success in 2008. Annual growth was 9%, consumer savings rate of around 55%. These savings are
demand was high and foreign direct investment mainly put into US bonds, resulting in Asia
was increasing. However, there was also inflation of effectively lending to the US.
11.4%, rising interest rates and a large government a. Graphically illustrate and explain the impact
deficit, with expectations of growth slowing to 7% of the higher savings rate on the real interest
by year end. In order to correct this imbalance, it rate and the quantity of loanable funds.
was suggested that India moderate inflation and the b. How do the high saving rates in Asia impact
government deficit and employ procedures to boost investment in the United States?
education and liberate financial markets.
26. If the Indian government reduces its deficit and
returns to a balanced budget, how will the demand
or supply of loanable funds in India change?
M
25
oney, like fire and the wheel, has been around for a long time
and it has taken many forms. Money was wampum (beads made from
shells) for North American Indians, whale’s teeth for Fijians and tobacco
for early American colonists. Cakes of salt served as money in Ethiopia
and Tibet. Today, when we want to buy something, we use coins or
rand notes, write a cheque, or swipe a debit card or a credit card. We
already make payments over the internet or by using
MONEY, THE
a cellphone. Are all these things money?
The quantity of money in our economy is regulated
PRICE LEVEL AND by the central bank – the South African Reserve Bank.
How does the Reserve Bank influence the quantity of
Are M1, M2 and M3 Really Money? Money money. There was not an extra R500 of money while
is the means of payment. So the test of whether an the transaction was waiting for settlement. The card
asset is money: Does it serve as a means of payment? transaction only instructs the bank to transfer money
Currency passes the test. But what about deposits? from Anaïs to Totalsports.
Cheque deposits are money because they can be trans- If Anaïs and Totalsports use different banks,
ferred from one person to another by writing a cheque the process remains exactly the same. Totalsports’
or using a debit card. Such a transfer of ownership bank credits the card amount to their account and
is equivalent to handing over currency. Because M1 Anaïs’s bank debits Anaïs’ account by R500. Again,
consists of currency plus cheque deposits and each of settlement between the two accounts takes place
these is a means of payment, M1 is money. electronically.
But what about M2 and M3? Some of the savings
deposits in M2 are just as much a means of payment Credit Cards Are Not Money You have just seen
as the cheque deposits in M1. You can use the ATM that cheques and debit cards are not money. What
at the supermarket till or petrol station and transfer about credit cards? Is having a credit card in your
funds directly from your savings account to pay for your wallet and presenting the card to pay for your running
purchase. But some savings and longer-term deposits are shoes not the same thing as using money? Why are
not means of payment. These deposits are known as liquid credit cards not somehow valued and counted as part
assets. Liquidity is the property that a certain asset has of the quantity of money?
which makes it easy to convert into a means of payment When you pay by cheque, you are frequently
without loss in value. Because the deposits in M2 and asked to prove your identity by showing your driver’s
M3 that are not means of payment are quickly and easily license or ID book. It would never occur to you to
converted into a means of payment – into currency or think of your driver’s license as money. It is just an
cheque deposits – they are counted as money. ID card. A credit card is also an ID card, but one that
lets you take out a loan at the instant you buy some-
Deposits Are Money but Debit Cards and thing. When you sign a credit card sales slip, you are
Cheques Are Not In defining money, we include, saying, ‘I agree to pay for these goods when the credit
along with currency, deposits at banks and other depos- card company bills me’. Once you get your statement
itory institutions. But we do not count the cheques that from the credit card company, you must make at least
people write or debit card payments as money. the minimum payment due. To make that payment,
Why are deposits money but cheques and debit you need money – you need to have currency or a
cards not? cheque deposit to pay the credit card company. So
To see why deposits are money but cheques although you use a credit card when you buy some-
and debit cards are not, think about what happens thing, the credit card is not the means of payment and
when Anaïs buys running shoes for R500 from it is not money.
Totalsports. When Anaïs goes to Totalsports, she has
R1 000 in her deposit account at First National Bank. REVIEW QUIZ
Totalsports has R10 000 in their deposit account – at
the same bank, as it happens. The total deposits of 1 What makes something money? What
these two people are R11 000. Anaïs pays R500 for functions does money perform? Why do
the shoes using a debit card. The settlement takes you think packs of chewing gum do not
place electronically. Totalsports’ bank balance rises serve as money?
from R10 000 to R10 500 and Anaïs’s balance falls 2 What are the problems that arise when a
from R1 000 to R500. The total deposits of Anaïs commodity is used as money?
and Totalsports are still the same as before: R11 000. 3 What are the main components of money in
Totalsports now has R500 more than before and Anaïs South Africa today?
has R500 less. 4 What are the official measures of money? Are
This transaction has transferred money from all the measures really money?
Anaïs to Totalsports. The debit card itself was never 5 Why are cheques and credit cards not money?
We have seen that the main component of money At the beginning of 2012, 16 registered commercial
in South Africa is deposits at banks and other deposi- banks, of which 10 were controlled locally and 6
tory institutions. Let us take a closer look at these from foreign countries, operated in South Africa.1 An
institutions. additional 11 branches of international banks also operate
in South Africa. Besides channelling funds from surplus
to deficit units, commercial banks perform another very
important task in the economy, since they receive the
Depository Institutions savings of the population for safekeeping. Therefore they
A firm that takes deposits from households and firms are also the custodians of the community’s wealth.
and makes loans to other households and firms is called
a depository institution. The deposits of four types of
depository institutions make up the nation’s money: Profit and Prudence: A Balancing Act
◆ Commercial banks The aim of a bank is to maximise the net worth of its
◆ Mutual banks shareholders. To achieve this objective, the interest
◆ The Postbank rate at which a bank lends exceeds the interest rate it
◆ The Land and Agricultural Bank pays out to its depositors. But a bank must perform a
delicate balancing act. Lending is risky and the more a
The purpose of the Land and Agricultural Bank is bank ties up its deposits in high risk, high-interest-rate
to provide financing for agricultural activities in South loans, the bigger the chance of not being able to repay
Africa. The main aim of the Postbank is to offer savings its depositors. And if depositors perceive a high risk of
facilities to promote a culture of saving in South Africa, not being repaid, they withdraw their funds and create
especially to rural areas and small communities, which a crisis for the bank. Therefore a bank must be prudent
cannot be served profitably by commercial banks. in the way it uses its deposits, balancing security for the
While there is a separate act for mutual banks, there depositors against profit for its shareholders.
are not many such banks left in South Africa, since a
mutual bank operates like a commercial bank, but with
a limited amount of assets. Therefore, mutual banks What Depository Institutions Do
that grow turn into commercial banks. The current Depository institutions provide services such as
movement in South Africa is to pool mutual banks and cheque clearing, account management, credit cards
all the informal savings institutions, such as stokvels, and internet banking, all of which provide an income
under a co-operative banks act. from service fees.
Having said this, it is evident that commercial But depository institutions earn most of their
banks are by far the most important private depository income by using the funds they receive from deposi-
institutions in South Africa and therefore the remainder tors to make loans and to buy securities that earn a
of this section only focuses on commercial banks. higher interest rate than that paid to depositors. In
this activity, a depository institution must perform a
balancing act weighing return against risk. To see this
Commercial Banks
balancing act, we will focus on the commercial banks.
A commercial bank is a firm that is licensed by A commercial bank places the funds it receives
the Registrar of Banks (at the South African from depositors and other funds that it borrows into
Reserve Bank) to receive deposits and make loans. four types of assets:
Commercial banks act as intermediaries between 1. A bank’s reserves are notes and coins in the
people with excess money (surplus units) and those bank’s vault or in a deposit account at the South
that are in need of money (deficit units). When African Reserve Bank. (We will study the South
people lend money from a bank, it is referred to as African Reserve Bank later in this chapter.)
indirect lending. Direct lending, on the other hand, is
when one person lends money directly from another 1 For a complete list of banks in South Africa visit the South African Reserve
person, without a depository institution acting as Bank website (www.resbank.co.za). You will find the heading ‘South
African Registered Banks and Representative Office’ under the ‘Regulation
an intermediary. and Supervision’ link.
These funds are used to meet depositors’ currency TABLE 25.2 Commercial Banks: Sources and
withdrawals and to make payments to other Uses of Funds
banks. In normal times, a bank keeps about a half Funds Percentage
of one per cent of deposits as reserves. (billions of rand) of deposits
2. Liquid assets are Treasury bills issued by
Total funds 3 404.1 136.2
government to finance current spending, as
Sources
well as commercial paper. These assets are the Deposits 2 499.8 100.0
bank’s first line of defence if they need cash. Other liabilities to the 307.6 12.3
Liquid assets can be sold and instantly converted public
into cash with virtually no risk of loss. Because Own capital and other 596.7 23.9
they are virtually risk free, they have a low liabilities
interest rate. Uses
3. Investment securities are longer-term government Central bank money 87.6 3.5
bonds and other bonds. These assets can be sold and gold
and converted into cash but at prices that fluc- Loans 2 515.8 100.6
tuate. Because their prices fluctuate, these assets Investments 719.9 28.8
are riskier than liquid assets and have a higher Non-financial and other 80.8 3.2
assets
interest rate.
4. Loans are commitments of fixed amounts Commercial banks get most of their funds from depositors
of money for agreed-upon periods of time. and use most of them to make loans. South African banks are
Most bank loans are made to firms to finance well-capitalised with capital representing 23.9% of deposits –
the purchase of capital equipment and invento- much higher than the international norm.
ries and to households – personal loans –
Source of data: South African Reserve Bank. Data for December, 2011.
to finance consumer durable goods, such as
houses, cars or boats. The outstanding balances Depository institutions provide four benefits:
on credit card accounts are also bank loans. ◆ Create liquidity
Loans are the riskiest asset of a bank because ◆ Pool risk
they cannot be converted into cash until they ◆ Lower the cost of borrowing
are due to be repaid. And some borrowers ◆ Lower the cost of monitoring borrowers
default and never repay. Because they are the
riskiest of the bank’s assets, loans carry the Create Liquidity Depository institutions create
highest interest rate. liquidity by borrowing short and lending long – taking
deposits and standing ready to repay them on short
Table 25.2 provides a snapshot of the sources and notice or on demand and making loan commitments
uses of funds of all the commercial banks in that run for terms of many years.
December 2011 that serves as a summary of the
above account. Pool Risk A loan might not be repaid – a default.
If you lend to one person who defaults, you lose the
entire amount loaned. If you lend to 1 000 people
Economic Benefits Provided by Depository
(through a bank) and one person defaults, you lose
Institutions almost nothing. Depository institutions pool risk.
You have seen that a depository institution earns part
of its profit because it pays a lower interest rate on Lower the Cost of Borrowing Imagine there are no
deposits than what it earns on loans. What benefits do depository institutions and a firm is looking for
these institutions provide that make depositors willing R1 million to buy a new machine. It hunts around for
to put up with a low interest rate and borrowers several dozen people from whom to borrow the funds.
willing to pay a higher one? Depository institutions lower the cost of this search.
The firm obtains its R1 million from a single institution
that receives deposits from a large number of people but surpass ratios laid down by regulation. The Bank
spreads the cost of this activity over many borrowers. Supervision Department at the South African Reserve
Bank makes sure that banks in South Africa have
Lower the Cost of Monitoring Borrowers By moni- sufficient capital and reserves to serve as a buffer in
toring borrowers, a lender can encourage good decisions times of financial turmoil.
that prevent defaults. But this activity is costly.
Imagine how costly it would be if each household
that lent money to a firm incurred the costs of moni- Financial Innovation
Innovation
toring that firm directly. Depository institutions can In the pursuit of larger profit,
perform this task at a much lower cost. depository institutions are
constantly seeking ways to
improve their products in
How Depository Institutions Are Regulated
a process called financial
Depository institutions are engaged in a risky innovation. The development
business and a failure, especially of a large bank, of low-cost computing and
would have damaging effects on the entire financial communication brought financial
system and economy. To make the risk of failure innovations such as credit www.quickto.mobi/
small, depository institutions are required to hold cards, internet payments and PEA-INNOVATION
levels of reserves and owners’ capital that equal or cellphone banking.
Economics
Year
in Action Year
bank in the US, the Fed, created and the banks
Commercial Banks Flush with Reserves
2008 willingly
2008 held reserves at the unheard of level of
When Lehman Brothers (a New York investment $1 trillion or14 per cent of deposits.
bank) failed in October 2008, panic spread through Throughout 2009 and 2010, bank reserves
financial
2010
markets. Banks that are normally happy to remained at this extraordinary level. And despite
2010
lend to each other overnight for an interest rate barely having plenty of funds to lend, the level of bank
above the rate they can earn on safe Treasury bills lost loans
0 barely changed4 000
2 000 over 2009 and 2010.
6 000 8 000 10 000
0 2 000 4 000 6 000 8 000 10 000
confidence and the interest rate in this market shot
Sources (billions of dollars) The figure
Sources (billions compares
of dollars) the commercial banks’
up to 3 percentage
Deposits
points above
Borrowing
the Treasury bill rate.
Own capital and other
sourcesDeposits
and uses Borrowing
of funds (sources areand
Own capital liabilities
other and
Banks wanted to be safe and to hold cash. The central uses are assets) in 2008
(a) Sources of commercial bank funds
with those in 2010.
(a) Sources of commercial bank funds
Year
Year Year
Year
2008
2008 2008
2008
2010
2010 2010
2010
00 2
2 000
000 44 000
000 6
6 000
000 88 000
000 10
10 000
000 0 2 000 4 000 6 000 8 000 10 000
Sources
Uses (billions
(billions of of dollars)
dollars) Uses (billions of dollars)
0 2 000 4 000 6 000 8 000 10 000
Deposits
Sources Borrowing
(billions ofReserves
dollars) Own capital and other Reserves Securities
Securities
(a) SourcesDeposits
of commercial Liquid bank
assets funds
Borrowing Own capital
Loansand other Liquid assets Loans
(a)
(b) Sources of commercial
Uses of commercial bank
bank funds
funds (b) Uses of commercial bank funds
Year
Changes in the Sources and Uses of Commercial Bank Funds Changes in the Sources and Uses of Commercial Bank Funds
Year
2008
Source of data: The Federal Reserve Board.
2008
2010
2010
0 2 000 4 000 6 000 8 000 10 000
PART EIGHT Macroeconomic Trends
Uses (billions of dollars)
0 2 000 4 000 6 000 8 000 10 000
9781775785026_gsp_eco_stb_ter_eng_za.indb 551 2014/03/14 7:14 AM
Uses (billions of dollars)
Reserves Securities
552 CHAPTER 25 Money, the Price Level and Inflation
Financial innovation in the US house market The independence of the monetary authority from
was one of the main causes of the recent financial politics is the key to successful central banking.
crises. The following describes the development in the A central bank is not a people’s bank. That is, the
US mortgage market that led to this innovation and Reserve Bank does not provide general banking
preceded the crisis. services for businesses and individual citizens.
During the late 1970s, a high inflation rate sent
the interest rate on home-purchase loans to 15 per
cent a year. Traditional fixed interest rate mortgages
The Reserve Bank’s Goals and Targets
became unprofitable and variable interest rate mort- The Reserve Bank conducts the nation’s monetary
gages were introduced. policy, which means that it adjusts the quantity of
During the 2000s, when interest rates were low money in circulation. The Reserve Bank’s vision is to
and depository institutions were flush with funds, foster a stable financial environment that will allow
sub-prime mortgages2 were developed. To avoid the the economy to thrive. In line with its vision, the
risk of carrying these mortgages, mortgage-backed Reserve Bank’s primary goal is to achieve and main-
securities were developed. The original lending institu- tain price stability in South Africa’s economic system.
tion sold these securities, lowered their own exposure It is therefore committed to achieve price stability in
to risk and obtained funds to make more loans. order to promote balanced and sustainable growth in
It is therefore not surprising that financial innova- the South African economy. In pursuit of its primary
tion has brought changes in the composition of money. goal, the Reserve Bank takes responsibility, among
others, to:
REVIEW QUIZ ◆ Formulate and implement monetary policy
◆ Issue banknotes and coins
1 What are depository institutions? ◆ Supervise the banking sector
2 What are the functions of depository institutions? ◆ Ensure the effective functioning of the payment
3 How do depository institutions balance risk system in South Africa
and return? ◆ Act as banker for the government
4 How do depository institutions create liquidity, ◆ Act as lender of the last resort
pool risks and lower the cost of borrowing?
The Reserve Bank uses a formal inflation
You now know what money is. Your next task targeting framework to reach its goal of price stability.
is to learn about the South African Reserve Bank The framework, used since 2000, will be discussed in
and the ways in which it can influence the quantity Chapter 31.
of money. In the next section we examine the Reserve
Bank’s policy tools. Later in this chapter, we look
at the long-run effects of the Reserve Bank’s actions
and in Chapter 31, we look at the short- run effects
The South African Reserve Bank when the Reserve Bank implements monetary policy.
The central bank of South Africa is the South African But firstly we begin by describing the structure of the
Reserve Bank3 (abbreviated as SARB). A central bank Reserve Bank.
is a bank’s bank that regulates a nation’s depository
institutions and controls the quantity of money.
The Structure of the Reserve Bank
The South African Reserve Bank is a public company
that is owned by shareholders. Yet the government is The Constitution of South Africa presents the Reserve
the majority shareholder in the Reserve Bank. Bank with a certain degree of autonomy for executing
its duties. The Reserve Bank is not owned by govern-
2 A sub-prime mortgage is a home loan that is given to a person who is not
creditworthy and does not really qualify for a loan. This person will then pay ment, but by shareholders. Yet, in terms of the
a higher interest rate than other borrowers on the mortgage loan, since he/ South African Reserve Bank Act, Act 90 of 1989,
she is more likely not to be able to repay the loan (i.e. a high credit risk).
3 The website of the South African Reserve Bank is a wonderful source of
the Bank must submit an annual report to Parliament.
information and is always worth a visit (www.resbank.co.za). The Reserve Bank is thus accountable to Parliament,
but government cannot influence the decisions The Governor’s power and influence stem from
taken by the Reserve Bank to promote any party- three sources. First, he/she is the chairman who
political agenda. controls the agenda and who dominates the meetings
The South African Reserve Bank is managed by of the Monetary Policy Committee. Second, day-to-
a Board of Directors with 15 members: day contact with a large staff of economists and other
◆ The Governor of the Reserve Bank, who is technical experts provides the Governor with detailed
appointed by the President of the Republic of background briefings on monetary policy issues. Third,
South Africa the Governor is the spokesperson for the Reserve Bank
◆ Three deputy governors, also appointed by the and the main point of contact with the Minister of
President of the Republic of South Africa Finance, the President of South Africa and government
◆ Four other directors, again appointed by the and with foreign central banks and governments.
President
◆ Seven directors who are chosen by the share-
holders of the bank. These directors must repre- The Reserve Bank’s Policy Tools
sent agriculture, labour, industry and commerce The Reserve Bank has many responsibilities, but we
or finance will examine its single most important one: influ-
encing the amount of money in circulation in South
On a day-to-day basis, the Reserve Bank is Africa in order to create price stability. How does the
managed by the Governor and deputy governors. Reserve Bank control the quantity of money? It does
There are 15 departments in the Reserve Bank so by influencing the reserves of the banking system.
that report to the Governor and deputy governors, The Reserve Bank is also lender of last resort for
which include Bank Supervision, Financial Stability, commercial banks, which means that banks that face
Exchange Controls, Research and Financial Markets, failure can ask the Reserve Bank for assistance. Yet,
to name a few. assistance to prevent bank failures is only given at the
discretion of the Reserve Bank and only when they
The Monetary Policy Committee The Monetary perceive that the failing bank will cause instability in
Policy Committee (MPC) is the main policy-making the country’s financial system. The Reserve Bank uses
organ of the South African Reserve Bank. The MPC three main policy tools to achieve its objectives:
consists of the following members: ◆ Required reserve ratios
◆ The Governor ◆ Repo rate
◆ The three deputy governors ◆ Open-market operations
◆ Three senior officials of the Reserve Bank
Required Reserve Ratios All depository institu-
The MPC meets every two months to review the tions are required to hold a minimum percentage
state of the domestic and international economy and of deposits as reserves. This minimum percentage is
to decide the monetary policy actions to be carried known as a required reserve ratio. The Reserve Bank
out by the Reserve Bank. The monetary policy action has two requirements that banks have to adhere to,
decided on, is explained in a statement and released to namely the cash reserve requirement and the liquid
the press to inform the nation. asset requirement. The cash reserve ratio requires banks
The Governor is also the chairman of the to hold a minimum of 2.5 per cent of its deposits in
Monetary Policy Committee and therefore has a large cash. Additionally banks are required to hold 5 per cent
influence on the Reserve Bank’s monetary policy of its deposits in liquid assets according to the liquid
actions. Some remarkable individuals have held this asset requirement. These liquid assets include Treasury
position. The current (2012) Governor is Gill Marcus, bills issued by government, government bonds and
who took over from Tito Mboweni after 10 years as securities issued by the Reserve Bank and Land Bank.
Governor (1999–2009). Mboweni’s predecessors were If the banks have to hold more reserves, they have
Dr Chris Stals (1987–1998) and Dr Gerhard de Kock less money to lend to customers and the quantity of
(1979–1987), who followed in the footsteps of his money in circulation declines. This causes the price of
father, Dr M.H. de Kock. money (i.e. the interest rate) to increase.
Repo Rate The main mechanism that the Reserve The bank now has more reserves to lend out again and
Bank uses to implement monetary policy, is the refi- the money supply increases. When the Reserve Bank
nancing system. According to this system, the Reserve sells securities, banks have to pay for them and they do
Bank provides finance to banks to meet their require- so with the reserves held at the Reserve Bank. Thus,
ments, explained above, at an interest rate, called banks now have a shortage of reserves and they have to
the repo rate. The repo rate is thus the interest rate make up for this by borrowing from the Reserve Bank
at which the Reserve Bank stands ready to provide at the repo rate. Let us look at some examples.
liquidity to depository institutions against the security
of a qualifying asset (such as a government bond). A An Open-Market Purchase To see how an open
change in the repo rate is proposed by the MPC. market operation changes bank reserves, suppose the
Reserve Bank buys R100 million of government secu-
Open-Market Operations An open-market opera- rities from Nedbank. When the Reserve Bank makes
tion is the purchase or sale of Treasury bills issued this transaction, two things happen:
by government and government bonds, as well as 1. Nedbank has R100 million less securities and the
Reserve Bank debentures, by the Reserve Bank in the Reserve Bank has R100 million more securities.
open market. When the Reserve Bank conducts an 2. The Reserve Bank pays for the securities by
open market operation, it makes a transaction with placing R100 million in Nedbank’s deposit
a bank or some other business but it does not account at the Reserve Bank.
transact with the government. By selling bonds
and debentures in the market, the Reserve Bank Figure 25.1 shows the effects of these actions on
withdraws money from the market. With less money the balance sheets of the Reserve Bank and Nedbank.
in circulation, the price of money (i.e. the interest Ownership of the securities passes from Nedbank to
rate) increases. the Reserve Bank, so Nedbank’s assets decrease by
When the Reserve Bank buys securities from a R100 million and the Reserve Bank’s assets increase by
bank, the Reserve Bank pays for them by increasing R100 million, as shown by the green arrow running
the cash reserves held by the bank at the Reserve Bank. from Nedbank to the Reserve Bank.
FIGURE 25.1 The Reserve Bank Buys Securities FIGURE 25.2 The Reserve Bank Sells Securities
in the Open Market in the Open Market
Reserve Bank Reserve Bank
Nedbank Nedbank
Assets Liabilities Assets Liabilities
(millions) (millions) (millions) (millions)
When the Reserve Bank buys securities in the open market, When the Reserve Bank sells securities in the open market,
it creates bank reserves. Reserve Bank assets and liabilities it reduces bank reserves. Reserve Bank assets and liabilities
increase and the selling bank exchanges securities for reserves. decrease and the buying bank exchanges reserves or securities.
The Reserve Bank pays for the securities by Creating Deposits by Making Loans
placing R100 million in Nedbank’s reserve account at The easiest way to see that banks create deposits is to
the Reserve Bank, as shown by the blue arrow running think about what happens when Musheera, who has
from the Reserve Bank to Nedbank. a Visa credit card issued by Nedbank, uses her card
The Reserve Bank’s assets and liabilities to buy a DVD from Musica. When Musheera signs
increase by R100 million. Nedbank’s total assets are the card sales slip, she takes a loan from Nedbank
unchanged: It sold securities to increase its reserves – and obligates herself to repay the loan at a later date.
both assets on the bank’s statements. For now, let us assume that Musica also banks at
Nedbank. Electronic settlement of the transaction
An Open-Market Sale If the Reserve Bank sells takes place and the bank credits Musica’s account with
R100 million of government securities in the the value of the slips (minus the bank’s commission).
open market: You can see that these transactions have created a
1. Nedbank has R100 million more securities and bank deposit and a loan. Musheera has increased the
the Reserve Bank has R100 million less securities. size of her loan (her credit card balance) and Musica
2. Nedbank pays for the securities by using has increased the size of its bank deposit. And because
R100 million of its reserves deposit account at deposits are money, Nedbank has created money.
the Reserve Bank. If, as we have just assumed, Musheera and
Musica use the same bank, no further transactions
Figure 25.2 shows the effects of these actions take place. But the outcome is essentially the same
on the balance sheets of the Reserve Bank and when two banks are involved. If Musica’s bank is
Nedbank. Ownership of the securities passes from Investec Bank, then Nedbank uses its deposit at the
the Reserve Bank to Nedbank, so the Reserve Bank’s Reserve Bank to pay Investec Bank. Nedbank has an
assets decrease by R100 million and Nedbank’s assets increase in loans and a decrease in its deposit at the
increase by R100 million, as shown by the blue arrow Reserve Bank; Investec Bank has an increase in its
running from the Reserve Bank to Nedbank. deposit at the Reserve Bank. And the banking system
In Chapter 31, these policy tools are further as a whole has an increase in loans and deposits and
discussed. no change in reserves.
Thus, when Musheera swiped her card through
an automatic payment system, all these transactions
REVIEW QUIZ
occurred at the time she bought her new DVD and
1 What is the central bank of South Africa and the quantity of money increased by the amount
what functions does it perform? of her purchase (minus the bank’s commission for
2 What are the Reserve Bank’s three policy tools? conducting the transactions).
3 What is the Monetary Policy Committee and Three factors limit the quantity of deposits that
what are its main functions? the banking system can create:
4 How does an open market operation change ◆ The monetary base
the money in circulation? ◆ Desired reserves
◆ Desired cash holdings
Next, we are going to see how the banking system
– the banks and the Reserve Bank – creates money. The Monetary Base The monetary base is the sum
of banknotes and coins in circulation in the economy,
as well as deposits that banks keep at the Reserve
Bank. The size of the monetary base limits the total
How Banks Create Money quantity of money that the banking system can create
Banks create money. But this does not mean that they because banks have a desired level of reserves, house-
have sophisticated computer software and specialised holds and firms have a desired level of cash holding
printers with scores of counterfeiters anxiously working. and both of these desired holdings of the monetary
Remember, most money is deposits, not cash. What banks base depend on the quantity of money available in
create are deposits and they do so by making loans. the economy.
Desired Reserves A bank’s actual reserves consist of the Desired Cash Holdings We hold our money in
banknotes and coins in its vaults and its deposit at the the form of cash (banknotes and coins) and bank
Reserve Bank. A bank uses its reserves to meet depositors’ deposits. The proportion of money held as cash is not
demand for cash and to make payments to constant but at any given time, people have a definite
other banks. view as to how much they want to hold in each form
You have also seen that banks do not have R100 of cash.
of reserves for every R100 that people have deposited Because households and firms want to hold
with them. If the banks did behave that way, they some proportion of their money in the form of cash,
would not earn any profit. when the total quantity of bank deposits increases,
Banks today have reserves of R7.50 for every so does the quantity of cash that they want to hold.
R100 of deposits. R2.50 of these reserves is currency Thus, a portion of the monetary base is in the hands
and the other R5 is liquid assets. You might think that of ordinary citizens and not in the banking system.
the cash reserves that are held in the form of deposits Because desired cash holding increases when deposits
at the Reserve Bank are tiny. But there is no need for increase, there is always cash that leaves the banking
panic. These reserve levels are adequate for ordinary system when loans are made and deposits increase.
business needs. We call the leakage of cash from the banking system
The fraction of a bank’s total deposits that are the currency drain. And we call the ratio of currency to
held in reserves is called the reserve ratio. So with deposits the currency drain ratio.
reserves of R7.50 for every R100 of deposits, the The greater the currency drain ratio, the greater
reserve ratio is 7.5 per cent. the amount of cash that citizens hold and thus the
A bank’s desired reserves are the reserves that smaller is the quantity of deposits in the banking
it wishes to hold. The banks are required to hold a system. Therefore a greater currency drain ratio means
level of reserves that does not fall below a specified that less money can be created by the banking system
percentage of total deposits. This percentage is the from a given monetary base.
required reserve ratio – the 7.5 per cent explained We have sketched the way that a loan creates a
above. deposit and described the three factors that limit the
The desired reserve ratio is the ratio of reserves to amount of loans and deposits that can be created. We
deposits that a bank wants to hold. This ratio exceeds are now going to examine the money creation process
the required reserve ratio by an amount that the banks more closely and discover a money multiplier.
determine to be prudent on the basis of their daily
business requirements.
A bank’s reserve ratio changes when its customers The Money Creation Process
make a deposit or a withdrawal. If a bank’s customer The money creation process begins with an increase
makes a deposit, reserves and deposits increase by the in the monetary base, which occurs if the Reserve
same amount, so the bank’s reserve ratio increases. Bank conducts an open market operation in which
Similarly, if a bank’s customer makes a withdrawal, it buys securities from banks and other institutions.
reserves and deposits decrease by the same amount, so The Reserve Bank pays for the securities it buys with
the bank’s reserve ratio decreases. newly created bank reserves.
A bank’s excess reserves are its actual reserves When the Reserve Bank buys securities from a
minus its desired reserves. Whenever the banking bank, the bank’s reserves increase but its deposits do
system as a whole has excess reserves, the banks are not change.
able to create money. Banks increase their loans when So the bank has excess reserves. When a bank has
they have excess reserves and they decrease their excess reserves, it makes loans and creates deposits.
loans when they are short of reserves – when desired When the entire banking system has excess reserves,
reserves exceed actual reserves. total loans and deposits increase and the quantity of
But the greater the desired reserve ratio, the money increases.
smaller is the quantity of loans and, therefore, money One bank can make a loan and get rid of excess
that the banking system can create from a given reserves. But the banking system as a whole cannot get
monetary base. rid of excess reserves so easily. When the banks make
loans and create deposits, the extra deposits lower If the Reserve Bank sells securities in an open market
excess reserves for two reasons. First, the increase in operation, then banks have negative excess reserves –
deposits increases desired reserves. Second, a currency they are short of reserves.
drain decreases total reserves. But excess reserves do When the banks are short of reserves, loans and
not completely disappear. deposits decrease and the process we have described
So the banks lend some more and the process repeats. above works in a downward direction until desired
As the process of making loans and increasing reserves plus desired currency holding has decreased
deposits repeats, desired reserves increase, total by an amount equal to the decrease in monetary base.
reserves decrease through the currency drain and even- A money multiplier determines the change in the
tually enough new deposits have been created to use quantity of money that results from a change in the
all the new monetary base. monetary base.
Figure 25.3 summarises one round in the
process we have just described. The sequence has the
following eight steps: The Money Multiplier
1. Banks have excess reserves. The money multiplier is the ratio of the change in the
2. Banks lend excess reserves. quantity of money to the change in monetary base.
3. The quantity of money increases. For example, if a R1 million increase in the monetary
4. New money is used to make payments. base increases the quantity of money by R2.5 million,
5. Some of the new money remains on deposit. then the money multiplier is 2.5.
6. Some of the new money is a currency drain. The smaller the banks’ desired reserve ratio and
7. Desired reserves increase because deposits have the smaller the currency drain ratio, the larger is the
increased. money multiplier. (See the Mathematical Note on
8. Excess reserves decrease. pp. 568–569 for details on the money multiplier).
FIGURE 25.3 How the Banking System Creates Money by Making Loans
Increase in
monetary
base
The Reserve Bank increases the monetary base, which banks and some leaves the banks in a currency drain.
increases bank reserves and creates excess reserves. Banks The increase in bank deposits increases banks’ desired
lend the excess reserves, which creates new deposits. The reserves. But the banks still have excess reserves, though
quantity of money increases. New deposits are used to make less than before. The process repeats until excess reserves
payments. Some of the new money remains on deposit at have been eliminated.
By holding money instead, you forgo the interest decreases – there is a movement up along the demand
that you otherwise would have received. for money curve. Similarly, when the interest rate falls,
Money loses value because of inflation, so why the opportunity cost of holding money falls and the
is the inflation rate not part of the cost of holding quantity of real money demanded increases – there is a
money? It is. Other things remaining the same, the movement down along the demand for money curve.
higher the expected inflation rate, the higher is the When any influence on money holding other
nominal interest rate. than the interest rate changes, there is a change in the
demand for money and the demand for money curve
Real GDP The quantity of money that households shifts. Let us study these shifts.
and firms plan to hold depends on the amount they
are spending. The quantity of money demanded in the
economy as a whole depends on aggregate expenditure
Shifts in the Demand for Money Curve
– real GDP. A change in real GDP or financial innovation changes
Again, suppose that you hold an average of the demand for money and shifts the demand for
R100 to finance your weekly purchases of movies and money curve.
popcorn. Now imagine that the prices of these goods Figure 25.5 illustrates the change in the demand
and of all other goods remain constant but that your for money. A decrease in real GDP decreases the
income increases. As a consequence, you now buy demand for money and shifts the demand for money
more goods and services and you also keep a larger curve leftward from MD0 to MD1. An increase in real
amount of money on hand to finance your higher GDP has the opposite effect: It increases the demand
volume of expenditure. for money and shifts the demand for money curve
rightward from MD0 to MD2.
Financial Innovation Technological change and the
arrival of new financial products influence the quan-
tity of money held. Financial innovations include: FIGURE 25.4 The Demand for Money
1. Daily interest cheque deposits
2. Automatic transfers between cheque and
Interest rate (per cent per year)
6
saving deposits Effect of an
increase in
3. Automatic teller machines (ATMs) the interest
4. Credit cards and debit cards rate
FIGURE 25.6 The Supply of Money Curve FIGURE 25.7 Money Market Equilibrium
Interest rate (per cent per year)
6 6
Effect of a decrease
in the interest rate
5 5
Effect of an increase
in the interest rate
4 4
MD
Shortage of money
people sell bonds and
3 3 interest rate rises
0 0.8 0.9 1.0 1.1 1.2 0 0.8 0.9 1.0 1.1 1.2
Real money (trillions of 2005 rand) Real money (trillions of 2005 rand)
The supply of money curve, MS, shows the relationship Money market equilibrium occurs when the quantity of money
between the quantity of real money that the banking system demanded equals the quantity supplied. In the short run,
supplies and the interest rate, other things remaining the real GDP determines the demand for money curve, MD and
same. A rise in the interest rate – a rise in the opportunity the banking system determines the quantity of real money
cost of reserves – brings a lower desired reserve ratio and a supplied and the supply of money curve, MS. The interest rate
greater quantity of money supplied. adjusts to achieve equilibrium, here 5 per cent a year.
You have seen that the quantity of money supplied is The Effect of Monetary Policy If the Reserve
positively related to the nominal interest rate, while Bank increases the monetary base, the supply of
the quantity of money demanded is negatively related money curve MS will move to the right. This is
to the interest rate. Money market equilibrium occurs show in Figure 25.8 with the money supply
when the quantity of money demanded equals the curve moving from MS0 to MS1. At an interest
quantity of money supplied. The interest rate adjusts rate of 5 per cent, people find themselves holding
to ensure that the market is in equilibrium. more money than they would like to hold.
With a surplus of money holding, people enter What Happens in the Long Run? You have just
the loanable funds market and buy bonds in an seen how the nominal interest rate is determined in the
attempt to get rid of the extra money they are money market at the level that makes the quantity of
holding. The increase in demand for bonds raises the money demanded equal the quantity supplied by the
price of a bond and lowers the interest rate. banking sector. You learned in Chapter 24 (on p. 531)
This process will continue until the interest rate that the real interest rate is determined in the loanable
declines to 4 per cent where the demand for money funds market at the level that makes the quantity of
equals the supply of money and where the money loanable funds demanded equal the quantity of loan-
market is in equilibrium. able funds supplied. You also learned in Chapter 24
If the Reserve Bank decreases the monetary (on p. 529) that the real interest rate equals the
base, the supply of money curve MS will move to nominal interest rate minus the inflation rate.
the left. This is shown in Figure 25.8 with the money When the inflation rate equals the expected (or fore-
supply curve from MS0 to MS2. At an interest rate casted) inflation rate and when real GDP equals poten-
of 5 per cent, people find themselves holding less tial GDP, the money market, the loanable funds market,
money than they would like to hold. They now the goods market and the labour market are in long-run
enter the loanable funds market to sell bonds. The equilibrium – the economy is in long-run equilibrium.
decrease in the demand for bonds lowers their price If in long-run equilibrium, the Reserve Bank
and raises the interest rate. When the interest rate increases the quantity of money, eventually a new
reaches 6 per cent, the demand for money equals long-run equilibrium is reached in which nothing real
the supply of money and the money market is in has changed. Real GDP, employment, the real quan-
equilibrium again. tity of money and the real interest rate all return to
their original levels. But something does change: the
price level. The price level rises by the same percentage
FIGURE 25.8 A Change in the Supply of Money as the rise in the quantity of money. Why does this
outcome occur in the long run?
The reason is that real GDP and employment are
Interest rate (per cent per year)
An increase in the
8
supply of money determined by the demand for labour, the supply of labour
lowers the interest
rate and increases and the production function – the real forces described
MS 2 the quantity of money
7 in Chapter 23 (pp. 504–507); and the real interest rate is
MS 0 MS 1 determined by the demand for and supply of (real) loan-
6
able funds – the real forces described in Chapter 24
(pp. 529–531). The only variable that is free to respond
5
to a change in the supply of money in the long run is the
4 price level. The price level adjusts to make the quantity of
A decrease in real money supplied equal to the quantity demanded.
the supply of
3 money raises the So when the Reserve Bank changes the nominal
interest rate and
decreases the
quantity of money, in the long run the price level
2 quantity of money MD 0 changes by a percentage equal to the percentage
0 change in the quantity of nominal money. In the long
0.8 0.9 1.0 1.1 1.2
Real money (trillions of 2005 rand)
run, the change in the price level is proportional to
the change in the quantity of money.
Fluctuations in the demand for money bring fluctuations in the
interest rate and the quantity of money. When the demand for The Transition from the Short Run to the Long
money fluctuates, the interest rate and the quantity of money Run How does the economy move from the first
fluctuate in the same direction. Fluctuations in the supply of short-run response to an increase in the quantity of
money bring fluctuations in the interest rate and the quantity of money to the long-run response? The adjustment
money. When the supply of money fluctuates, the interest rate process is lengthy and complex. Here, we will only
and the quantity of money fluctuate in opposite directions. provide a sketch of the process. A more thorough
account must wait until you have studied Chapter 26.
We start out in long-run equilibrium and the The quantity theory of money is the proposition
Reserve Bank increases the monetary base, which allows that in the long run, an increase in the quantity of
the supply of money by the banking sector to increase by money brings an equal percentage increase in the
10 per cent. Here are the steps in what happens next. price level.
First, the nominal interest rate falls (just like you To explain the quantity theory of money, we first
saw on p. 561 and in Fig. 25.8). The real interest rate need to define the velocity of circulation.
falls too, as people try to get rid of their excess money The velocity of circulation is the average number of
holdings and buy bonds. With a lower real interest rate, times a specific rand is used annually to buy the goods
people want to borrow and spend more. Firms want and services that make up GDP. But GDP equals the
to borrow to invest and households want to borrow to price level (P) multiplied by real GDP (Y ). That is,
invest in bigger homes or to buy more consumer goods.
The increase in the demand for goods cannot be GDP = PY
met by an increase in supply because the economy Call the quantity of money M. The velocity of
is already at full employment. So there is a general circulation, V, is determined by the equation
shortage of all kinds of goods and services.
The shortage of goods and services forces the price V = PY/M
level to rise. As the price level rises, the real quantity of
money decreases. The decrease in the quantity of real For example, if GDP is R1 000 billion (GDP = PY =
money raises the nominal interest rate and the real interest R1 000 billion) and the quantity of money is
rate. As the interest rate rises, planned spending is cut back R250 billion, then the velocity of circulation is 4.
and eventually the original full-employment equilibrium is From the definition of the velocity of circulation,
restored. At the new long-run equilibrium, the price level the equation of exchange tells us how M, V, P and Y
has risen by 10 per cent and nothing real has changed. are connected. This equation is
MV = PY
REVIEW QUIZ Given the definition of the velocity of circulation, the
1 What are the main influences on the quantity equation of exchange is always true – it is true by defi-
of real money that people and businesses plan nition. It becomes the quantity theory of money if the
to hold? quantity of money does not influence the velocity of
2 Show the effects of a change in the nominal circulation or real GDP. In this case, the equation of
interest rate and a change in real GDP using exchange tells us that in the long run, the price level is
the demand for money curve. determined by the quantity of money. That is,
3 How is money market equilibrium determined?
P = M × (V/Y )
4 How does a change in the supply of money
change the interest rate in the short run? where (V/Y ) is independent of M. So a change in
5 How does a change in the supply of money M brings a proportional change in P.
change the interest rate in the long run? We can also express the equation of exchange in
growth rates,4 in which form it states that:
Let us explore the long-run link between money
and the price level a bit further. Money growth rate + Rate of velocity = Inflation
rate + Real GDP growth rate
tion – the quantity theory of money – explains this ∆ M/M + ∆V/V = ∆P/P + ∆Y/Y
The term ∆ M/M is the money growth rate, ∆V/V is the rate of velocity
long-run adjustment of the price level. change, ∆P/P is the inflation rate and ∆Y/Y is the real GDP growth rate.
Solving this equation for the inflation rate gives: In the long run, fluctuations in the money growth rate
minus the real GDP growth rate bring equal fluctua-
Inflation rate = Money growth rate + Rate of tions in the inflation rate.
velocity change – Real GDP growth rate Also, in the long run, with the economy at full
employment, real GDP equals potential GDP, so
In the long run, the rate of velocity change is not the real GDP growth rate equals the potential GDP
influenced by the money growth rate. More strongly, growth rate. This growth rate might be influenced by
in the long run, the rate of velocity change is approxi- inflation, but the influence is likely to be small and
mately zero. With this assumption, the inflation rate the quantity theory assumes that it is zero. So the real
in the long run is determined as GDP growth rate is given and does not change when
the money growth rate changes – inflation is corre-
Inflation rate = Money growth rate – Real GDP lated with money growth.
growth rate
Economics in Action
Does the Quantity Theory Work? International data also support the quantity
On average, as predicted by the quantity theory theory.
of money, the inflation rate fluctuates in line with Figure 2 shows a scatter diagram of the
fluctuations in the money growth rate minus the real inflation rate and the money growth rate in
GDP growth rate. Figure 1 shows the relationship 134 countries and Figure 3 shows the inflation rate
between money growth (M2 definition) and inflation and money growth rate in countries with inflation
(as measured by the producer price index) in South rates below 20 per cent a year. You can see a general
Africa. You can see a relationship between the two tendency for money growth and inflation to be
variables and it is evident that a change in inflation is correlated, but the quantity theory (the red line)
often preceded by a change in real money growth. does not predict inflation precisely.
250
Inflation rate (per cent per year)
1 600 Quantity
Inflation rate and money growth rate
(per cent per year)
theory
M2 growth rate prediction
1 400 200 Belarus
1 200
1 000 150
800 Ukraine
100
600 Azerbaijan
Armenia
400
50
Inflation
200
rate
0
95 96 97 98 99 00 01 02 03 04 05 06 0 50 100 150 200 250
Year Money growth rate (per cent per year)
25 Quantity
theory
prediction
20
15
10
0 5 10 15 20 25
Money growth rate (per cent per year)
Zimbabwe’s out-of-control hyperinflation has become the symbol of its unprecedented economic
decline and most people simply treat the two local currencies (original and ‘revalued’) as beyond
salvation.
The monthly inflation rate passed the 50 per cent mark – the threshold for defining ‘hyperinflation’
– in March 2007; in January 2009 the RBZ (Reserve Bank of Zimbabwe) issued the world’s first
100-trillion-dollar note.
‘Since then, it has gotten much worse’, said Steve Hanke, professor of Applied Economics at Johns
Hopkins University, Baltimore, in the US and a senior fellow at the Cato Institute, a Washington-
based think-tank. The latest official RBZ figure, dating back to July 2008, put year-on-year inflation
at more than 231 million per cent.
In the absence of credible official statistics, Hanke developed a hyperinflation index for Zimbabwe
and in an article in the December 2008 issue of the financial magazine, Forbes Asia, put the annual
inflation rate at around 6.5 quindecillion novemdecillion per cent – 65 followed by 107 zeros. ‘Prices
double every 24.7 hours’, he noted. ‘Shops have simply stopped accepting Zimbabwean dollars.’
MATHEMATICAL NOTE R33 333 drains out of the banks as currency and
R66 667 remains in the banks as deposits. The increase in
the quantity of money of R100 000 equals the increase
The Money Multiplier in deposits plus the increase in currency holdings.
This note explains the basic maths of the money multiplier The increased bank deposits of R66 667 generate an
and shows how the value of the multiplier depends on the increase in desired reserves of 10 per cent of that amount,
banks’ desired reserve ratio and the currency drain ratio. which is R6 667. Actual reserves have increased by the
To make the process of money creation concrete, same amount as the increase in deposits: R66 667. So the
we work through an example for a banking system in banks now have excess reserves of R60 000.
which each bank has a desired reserve ratio of 10 per The process we have just described repeats but
cent of deposits and the currency drain ratio is 50 per begins with excess reserves of R60 000. The figure
cent of deposits. (Although these ratios are larger than shows the next two rounds.
the ones in a real economy, they make the process end At the end of the process, the quantity of money
more quickly and enable you to see more clearly the has increased by a multiple of the increase in the
principles at work.) monetary base. In this case, the increase is R250 000,
The figure keeps track of the numbers. Before the which is 2.5 times the increase in the monetary base.
process begins, all the banks have no excess reserves. The sequence in the figure shows the first stages
Then the monetary base increases by R100 000 and of the process that finally reaches the total shown in
one bank has excess reserves of this amount. the final row of the ‘money’ column.
The bank lends the R100 000 of excess reserves. To calculate what happens at the later stages in
When this loan is made, new money increases by the process and the final increase in the quantity of
R100 000. money, look closely at the numbers in the figure.
Some of the new money will be held as currency and The initial increase in reserves is R100 000 (call it A).
some as deposits. With a currency drain ratio of 50 per At each stage, the loan is 60 per cent (0.6) of the previous
cent of deposits, one third of the new money will be held loan and the quantity of money increases by 0.6 of the
as currency and two thirds will be held as deposits. That is, previous increase. Call that proportion L(L = 0.6).
Money
Initial increase in monetary base Money
R100
Initial increase in 000
monetary base
R100 000
Loan
R100 000
Loan R100 000 loan creates R100 000 of money.
R100 000 With currency
R100 000 loandrain equal
creates to 50
R100 perofcent
000 of
money.
Currency Deposit deposits,
With deposits
currency drainincrease
equal toby50
R66
per667
centand
of
R100 000 currency increases
deposits, by R33 333.
deposits increase by R66 667 and
R33 333
Currency R66 667
Deposit
R100 000 currency increases by R33 333.
R33 333 R66 667
With R66 667 increase in deposits,
Reserve Loan desired
With reserves
R66 increaseinby
667 increase R6 667
deposits,
R6 667
Reserve R60 000
Loan and R60reserves
desired 000 is loaned.
increase by R6 667
R6 667 R60 000 and R60 000 is loaned.
Currency Deposit R60 000 loan creates R60 000 of money.
R160 000
R20 000
Currency R40 000
Deposit With000
R60 currency
loan drain equal
creates R60 to 50of
000 per cent of
money.
R160 000
R20 000 R40 000 deposits,
With deposits
currency drainincrease
equal toby50
R40
per000
centand
of
currency increases
deposits, by R20 000.
deposits increase The000
by R40 quantity
and
and so
of moneyincreases
currency has now increased
by R20 000.by R160 000.
The quantity
on ...so
and
of money has now increased by R160 000.
on ...
We can write down the complete sequence for the The money multiplier is the ratio of money to the
increase in the quantity of money as monetary base. Call the money multiplier mm, the
quantity of money M and the monetary base MB.
A + AL + AL2 + AL3 + AL4 + AL5 + ... Then
The magnitude of the money multiplier depends Now divide all the variables on the right side of the
on the desired reserve ratio and the currency drain equation by D to give
ratio. Let us explore this relationship.
mm = M/MB = (1 + C/D)/(R/D + C/D)
5 The sequence of values is called a convergent geometric series. To find the
sum of a series such as this, begin by calling the sum S. Then write the sum as
S = A + AL + AL2+ AL3+ AL4+ AL5+ ... In this equation, C/D is the currency drain ratio and
Multiply by L to get R/D is the banks’ reserve ratio. If we use the values in
LS = AL + AL2+ AL3+ AL4+ AL5+ ... the example on the previous page, C/D is 0.5 and R/D
and then subtract the second equation from the first to get is 0.1 and
S(1 – L) = A
or mm = (1 + 0.5)/(0.1 + 0.5)
S = A/(1 – L)
= 1.5/0.6 = 2.5
Key Terms
Central bank, 552 M1, 547 Monetary Policy Reserve ratio, 556
Currency, 547 M2, 547 Committee, 553 Reserves, 549
Currency drain ratio, 556 M3, 547 Open market operation, 554 South African Reserve
Demand for money, 559 Means of payment, 546 Quantity theory of money, Bank, 552
Depository institution, 549 Monetary base, 555 563 Velocity of circulation, 563
Desired reserve ratio, 556 Money, 546 Repo rate, 554
Excess reserves, 556 Money multiplier, 557 Required reserve ratio, 553
The following table indicates the amounts held in In the economy of Nocoin, banks have deposits
various components of money. Use the information to of $300 billion. Their reserves are $15 billion, two
answer Problems 2 and 3. thirds of which is in deposits with the central bank.
Households and firms hold $30 billion in bank notes.
Item R million There are no coins!
Home loans 400 11. Calculate the monetary base and the quantity
Currency 300 of money.
12. Calculate the banks’ desired reserve ratio and the
Pension funds 200
currency drain ratio (as percentages).
M3 1 500 13. Explain how increasing the required reserve ratio
Medium term deposits 500 influences banks’ money creation process.
14. Why might a higher required reserve ratio
2. Calculate the value of M2. decrease bank profits?
3. Under which official measure of money do home
loans fall? Why? The Money Market
4. If people can use their cellphones to make 15. The spreadsheet provides information about the
payments, will currency disappear? How will the demand for money in Minland.
components of M1 change? A B C
1 r Y0 Y1
Depository Institutions 2 7 1.0 1.5
5. Explain a bank’s ‘balancing act’ and how the 3 6 1.5 2.0
over-pursuit of profit or underestimation of risk 4 5 2.0 2.5
can lead to a bank failure. 5 4 2.5 3.0
6. During a time of uncertainty, why might it be 6 3 3.0 3.5
necessary for a bank to build up its liquidity? 7 2 3.5 4.0
8 1 4 4.5
The South African Reserve Bank
7. Explain how the SARB can be both independent Column A is the nominal interest rate, r. Columns B
from and accountable to government. and C show the quantity of money demanded at two
8. Which tools can the SARB use to reach its objec- values of real GDP: Y0 is $10 billion and Y1 is $20
tives and how are these used? billion. The quantity of money supplied is $3 billion.
9. How do the members of the MPC differ from Initially, real GDP is $20 billion. What happens in
the Board of Directors of the SARB? Minland if the interest rate (i) exceeds 4 per cent a
year and (ii) is less than 4 per cent a year?
16. The figure shows the demand for money curve. is at full employment and real GDP is $400
million, the price level is 200 and the velocity
of circulation is 20. In year 2, the quantity of
Nominal interest rate (per cent per year)
8
money increases by 20 per cent. Calculate the
quantity of money, the price level, real GDP and
the velocity of circulation in year 2.
6
Mathematical Note
4 18. In Problem 11, the banks have no excess reserves.
Suppose that the Bank of Nocoin, the central
2
bank, increases bank reserves by $0.5 billion.
MD a. What happens to the quantity of money?
b. Explain why the change in the quantity of
0 3.9 4.0 4.1 4.2 money is not equal to the change in the
Real money (trillions of 2005 rand) monetary base.
c. Calculate the money multiplier.
If the central bank decreases the quantity of real
money supplied from R4 trillion to R3.9 trillion, 19. In Problem 11, the banks have no excess reserves.
explain how the price of a bond will change. Suppose that the Bank of Nocoin, the central
bank, decreases bank reserves by $0.5 billion.
The Quantity Theory of Money a. Calculate the money multiplier.
17. Quantecon is a country in which the quantity b. What happens to the quantity of money,
theory of money operates. In year 1, the economy deposits and currency?
T
26
he dollar ($), the euro (€) and the yen (¥) are three of the world’s
monies and most international payments are made using one of them.
But the world has more than 100 different monies, of which the South
African rand (ZAR or R) is one.
The South African rand was introduced after South Africa became a
Republic (1961). One of the new currencies is the euro – the currency of
22 members of the European Union which
AND THE BALANCE OF for one US dollar, but since then, the rand
weakened to more than R10 for a US dollar.
PAYMENTS Why did the rand fall against the dollar?
Before 1994, foreign ownership of
assets in South Africa was limited due
to economic sanctions. But since then foreigners have seized the
opportunity to invest in a variety of South African assets ranging from
private properties to banks to telecommunication companies. Why have
foreigners been buying South African businesses?
In this chapter, you are going to discover the answers to these
questions. In Reading Between the Lines at the end of the chapter, we
will look at the Chinese currency and international events that has had
an influence on South African currency.
Another Money
10
When people who are holding the money of some
other country want to exchange it for South African
8
rand, they demand South African rand and supply
US Dollar that other country’s money. And when people who are
6 holding South African rand want to exchange them for
the money of some other country, they supply South
4 African rand and demand that other country’s money.
So the factors that influence the demand for South
2
Yuan African rand also influence the supply of US dollars or
European euro, or Japanese yen, or Chinese yuan. And the
0 factors that influence the demand for that other country’s
00 01 02 03 04 05 06 07 08 09 10 11 12 13 money also influence the supply of South African rand.
Year
We will first look at the influences on the demand
for South African rand in the foreign exchange market.
The South African Rand Against Three Currencies
They also buy South African rand so that they can buy same), the quantity of South African rand demanded in
South African assets such as bonds, shares, businesses the foreign exchange market increases.
and property or so that they can keep part of their To see this effect at work, think about orders for
money holding in a South African rand bank account. Denel’s new Rooivalk helicopters. If the price of a
The quantity of South African rand demanded Rooivalk is R10 million rand and the exchange rate is
in the foreign exchange market is the amount that 10 euro cents per South African rand, the price of this
traders plan to buy during a given time period at a helicopter to the French army is €1 million. The French
given exchange rate. This quantity depends on many army decides this price is too high, so it does not buy a
factors, but the main ones are: new Rooivalk. If the exchange rate weakens to 8 euro
1. The exchange rate cents per South African rand and other things remain
2. World demand for South African exports the same, the price of a Rooivalk falls to €800 000. The
3. Interest rates in South Africa and other countries French now decide to buy a Rooivalk and buy South
4. The expected future exchange rate African rand in the foreign exchange market.
We look first at the relationship between the Expected Profit Effect The larger the expected profit
quantity of South African rand demanded in the from holding South African rand, the greater is the
foreign exchange market and the exchange rate when quantity of South African rand demanded in the foreign
the other three influences remain the same. exchange market. But expected profit depends on the
exchange rate. For a given expected future exchange
Foreign Exchange
The Law of Demand for Foreign rate, the lower the exchange rate today, the larger is the
Exchange The law of demand expected profit from buying South African rand today
applies to South African rand just as and holding them, so the greater is the quantity of
it does to anything else that people South African rand demanded in the foreign exchange
value. Other things remaining the market today. Let us look at an example.
same, the higher the exchange rate, To see this effect at work, suppose that Citibank, a
the smaller is the quantity of South US bank, expects the exchange rate to be R8 per US dollar.
African rand demanded in the foreign Citibank expects no profit from buying South African
exchange market. For example, if the rand and holding them until the end of the year. But if the
www.quickto.mobi price of the South African rand rises exchange rate is R9 per one US dollar and Citibank buys
/PEA-FOREIGN- from 10 yen to 12 yen but nothing South African rand, that is sells a dollar and gets R9, it
EXCHANGE
else changes, the quantity of South expects to sell those rand at the end of the year for R8 per
African rand that people plan to buy US dollar and make a profit of R1 per US dollar.
in the foreign exchange market decreases. The exchange The weaker the exchange rate today, other things
rate influences the quantity of South African rand remaining the same, the greater is the expected profit
demanded for two reasons: from holding South African rand and the greater is
◆ Exports effect the quantity of South African rand demanded in the
◆ Expected profit effect foreign exchange market today.
FIGURE 26.1 The Demand for South African Let us look at the law of supply in the foreign
Rand exchange market – the relationship between the
quantity of South African rand supplied in the foreign
exchange market and the exchange rate when the
Exchange rate (yen per South African rand)
Other things remaining the other three influences remain the same.
same, a rise in the exchange
rate decreases the quantity
15
of South African rand The Law of Supply of Foreign Exchange Other
demanded ... things remaining the same, the higher the exchange
rate, the greater is the quantity of South African rand
supplied in the foreign exchange market. For example,
10
if the exchange rate strengthens from 10 yen to 12 yen
... and a fall in the per South African rand and other things remain the
exchange rate increases same, the quantity of South African rand that people
the quantity of South
5
African rand demanded
plan to sell in the foreign exchange market increases.
The exchange rate influences the quantity of rand
D
supplied for two reasons:
◆ Imports effect
0 1.3 1.4 1.5 1.6 1.7 ◆ Expected profit effect
Quantity (billions of South African rand per day)
FIGURE 26.2 The Supply of South African Rand FIGURE 26.3 Equilibrium Exchange Rate
Exchange rate (yen per South African rand)
10 10 Equilibrium at 10 yen
per South African rand
0 1.3 1.4 1.5 1.6 1.7 0 1.3 1.4 1.5 1.6 1.7
Quantity (billions of South African rand per day) Quantity (billions of South African rand per day)
The quantity of South African rand supplied depends on The demand curve for South African rand is D and the supply
the exchange rate. Other things remaining the same, if the curve of South African rand is S. If the exchange rate is 15 yen
exchange rate strengthens, the quantity of South African per South African rand, there is a surplus of South African rand
rand supplied increases and there is a movement up along and the exchange rate weakens. If the exchange rate is 5 yen
the supply curve of South African rand. If the exchange per South African rand, there is a shortage of South African
rate weakens, the quantity of South African rand supplied rand and the exchange rate strengthens. If the exchange rate is
decreases and there is a movement down along the supply 10 yen per South African rand, there is neither a shortage nor
curve of South African rand. a surplus of South African rand and the exchange rate remains
constant. The foreign exchange market is in equilibrium.
South African exports, a fall in the South African interest South African Demand for Imports An increase
rate differential, or a fall in the expected future exchange in the South African demand for imports increases
rate decreases the demand for South African rand today the supply of South African rand in the foreign
and shifts the demand curve leftward from D0 to D2. exchange market. To see why, think about Makro’s
purchase of DVD players. An increase in the
FIGURE 26.4 Changes in the Demand for demand for DVD players sends Makro out on a
South African Rand global shopping spree. Makro decides that Panasonic
DVD players produced in Japan are the best buy, so
Makro increases its purchases of these players. The
Exchange rate (yen per South African rand)
Changes in the Exchange Rate exchange rate strengthens (the currency appreciates).
If the demand for South African rand increases If the supply of South African rand increases and the
and the supply does not change, the exchange rate demand does not change, the exchange rate weakens
strengthens (the currency appreciates). If the demand (the currency depreciates).
for South African rand decreases and the supply does These predictions are exactly the same as
not change, the exchange rate weakens (the currency those for any other market. Two episodes in the
depreciates). Similarly, if the supply of South African life of the South African rand (box below) illustrate
rand decreases and the demand does not change, the these predictions.
A Depreciating South African Rand: 2006–2008 The situation worsened during 2008, with more
Between April 2006 and December 2008, the South uncertainty in the international markets, which
African rand depreciated against the euro. It fell from caused non-locals selling their South African rand
€0.13 to €0.07 per South African rand. Part (b) of assets (increasing the supply of rand) and the
the figure provides a possible explanation for this demand for South African assets decreased further.
depreciation. The demand and supply curves labelled Therefore the demand for South African rand
D06 and S06 are the same as in part (a). decreased and the supply of South African rand
Since 2006 South African imports grew increased during this period.
strongly, causing the supply of rand to increase during In part (b) of the figure, the demand curve
2007, financial turmoil in international markets led shifted leftward from D06 to D08, the supply curve
to uncertainty in the future of the rand exchange shifted rightward from S06 to S08 and the exchange
rate and the demand for rand started to decrease. rate weakened to €0.07 per South African rand.
Exchange rate (euro per South African rand)
0.13 0.13
Exchange Exchange
rate rate weakens
strengthens
0.07
0.07
D06 D 06
D 02 D 08
0 Q0 0 Q0
Quantity (billions of South African rand per day) Quantity (billions of South African rand per day)
Arbitrage also removes profit from borrowing $25 or R250. Money buys more in South Africa than
in one currency and lending in another and buying in the United States. Money is not of equal value in
goods in one currency and selling them in another. the two countries.
These arbitrage activities bring about: If all (or most) prices have increased in the
◆ Interest rate parity United States and not increased in South Africa,
◆ Purchasing power parity then people will generally expect that the value of the
South African rand in the foreign exchange market
Interest Rate Parity Suppose a US bank deposit in must increase. In this situation, the exchange rate is
New York earns 3 per cent a year and a South African expected to strengthen.
rand bank deposit earns 8 per cent a year. Why would The demand for South African rand increases
people not move their funds to Cape Town and even and the supply of South African rand decreases. The
borrow in New York to do so? The answer is that some exchange rate strengthens, as expected. If the exchange
would, in an activity called the ‘carry trade’. rate strengthens to R8 per dollar and there are no
The New York deposit is in dollars and the Cape further price changes, purchasing power parity is
Town deposit is in rand. So a change in the exchange rate restored. A memory stick that costs $25 in New York
brings risk to borrowing in one currency and lending also costs the equivalent of $25 (25 × 8 = 200) in
in another. Suppose people expect the US dollar to Port Elizabeth.
appreciate by 5 per cent a year. South African investors If prices increase in South Africa but remain
that buy and hold US dollars for a year will earn 3 per constant in the United States and other countries,
cent interest and they expect a 5 per cent return from then people will generally expect that the value of the
the higher dollar (lower rand). This gives a total expected South African rand in the foreign exchange market is
return of 8 per cent. So the interest rate in terms of South too high and that it is going to weaken.
African rand is the same in Cape Town and New York. In this situation the exchange rate is expected to
This situation is one of interest rate parity, which weaken (fall).
means equal rates of return. Adjusted for risk, interest The demand for South African rand decreases
rate parity always prevails. Funds move to receive the and the supply of South African rand increases. The
highest expected return available. If for a few seconds a exchange rate weakens, as expected.
higher return is available in Cape Town than in New So far we have been looking at the forces that
York, the demand for South African rand increases determine the nominal exchange rate – the amount
and the exchange rate strengthens until the expected of one money that another money buys. We are now
rates of return are equal. going to study the real exchange rate.
that the exchange rate E is 10 yen per rand. South of money applies to all countries, so the quantity of
Africa produces only wine priced at R500 a case, money in Japan determines the price level in Japan
Japan produces only DVD players priced at and the quantity of money in South Africa determines
10 000 yen each, so P* equals 10 000 yen and the price level in South Africa.
E × P equals 10 × 500 = 5 000 yen. Then the real For a given real exchange rate, a change in the
exchange rate is quantity of money brings a change in the price level
and a change in the exchange rate.
RER = (10 × 500)/10 000 = 0.5 DVD player per Suppose that the quantity of money doubles
case of wine. in Japan. The rand appreciates (the yen depreciates)
from 10 yen per rand to 20 yen per rand and all prices
In our example wine represents South Africa’s real double, so the price of a DVD player rises from
GDP and DVD players represent Japan’s real GDP. So 10 000 yen to 20 000 yen.
the price of a DVD player in Japan and the price of a At the new price in Japan and the new exchange
case of wine in South Africa represent the price levels rate, a DVD player still costs R1 000 (20 000 yen ÷
in the two countries. The real exchange rate is 2 cases 20 yen per rand = R1 000). The real exchange rate
of wine for one DVD player (or half a DVD player remains at 2 cases of wine per DVD player.
for a case of wine). If Japan and South Africa produced identical
goods (if GDP in both countries consisted only of
The Short Run In the short run, if the nominal wine production), the real exchange rate in the long
exchange rate changes, the real exchange rate also run would equal 1.
changes. The reason is that prices and the price levels In reality, although there is overlap in what
in South Africa and Japan do not change every time each country produces, South Africa’s real GDP is a
the exchange rate changes. Sticking with the wine different bundle of goods and services from Japan’s
and DVD player example, if the rand appreciates to real GDP. So the relative price of the Japanese and the
20 yen per rand and prices do not change, the real South African real GDP – the real exchange rate – is
exchange rate rises to 1 case of wine per DVD player. not 1 and it changes over time. The forces of demand
The price of a DVD player in South Africa falls to and supply in the markets for the millions of goods
R500 (10 000 yen ÷ 20 yen per rand = R500). and services that make up real GDP determine the
Changes in the real exchange rate bring short-run relative price of the Japanese and the South African
changes in the quantity of imports demanded and the real GDP and changes in these forces change the real
quantity of exports supplied. exchange rate.
0.09
Economics in Action
D1
0.08
D0 The People’s Bank of China in the Foreign
D2
Exchange Market
0 1.3 1.4 1.5 1.6 1.7
The exchange rate between the US dollar and the
Quantity (millions of rand per day)
Chinese yuan was constant for several years. The
Initially, the demand for South African rand is D0, the supply reason for this near constant exchange rate is that
of South African rand is S and the exchange rate is R10 per China’s central bank, the People’s Bank of China,
euro (or €0.10 per rand). intervened to operate a fixed exchange rate policy.
The Reserve Bank can intervene in the foreign exchange From 1997 until 2005, the yuan was pegged at
market to keep the exchange rate close to its target rate (€0.10 8.28 yuan per US dollar. Since 2005, the yuan has
per rand). If demand increases from D0 to D1, the Reserve Bank appreciated slightly but it has not been permitted to
sells rand to increase supply. If the demand decreases from D0 fluctuate freely. Since 2005, the yuan has been on a
to D2, the Reserve Bank buys rand to decrease supply. Persistent crawling peg.
intervention on one side of the market cannot be sustained.
Why Does China Manage Its Exchange Rate? The consequence of the fixed (and crawling peg)
The popular story is that China manages its exchange yuan exchange rate is that China has piled up
rate to keep its export prices low and to make it easier US dollar reserves on a huge scale. By mid-2006,
to compete in world markets. You have seen that this China’s official foreign currency reserves approached
story is correct only in the short run. With prices in $1 trillion and by the end of 2009, they exceeded
China unchanged, a lower yuan–US dollar exchange $2 trillion!
rate brings lower US dollar prices for China’s exports. If the People’s Bank stopped buying US dollars,
But the yuan–US dollar exchange rate was fixed for the US dollar would depreciate and the yuan would
almost 10 years and has been managed for five more appreciate – the yuan–US dollar exchange rate would
years. This long period of a fixed exchange rate has fall – and China would stop piling up US dollar
long-run, not short-run, effects. In the long run, the reserves.
exchange rate has no effect on competitiveness. The In the example in the figure, the dollar would
reason is that prices adjust to reflect the exchange depreciate to 5 yuan per dollar.
rate and the real exchange rate is unaffected by the
nominal exchange rate. 500
So why does China fix its exchange rate? The Increase in reserves
(billions of US dollars) 400
most convincing answer is that China sees a fixed
exchange rate as a way of controlling its inflation
300
rate. By making the yuan crawl against the US dollar,
China’s inflation rate is anchored to the US inflation
200
rate and will depart from US inflation by an amount
determined by the speed of the crawl.
100
The bottom line is that in the long run, exchange
rate policy is monetary policy, not foreign trade 0
policy. To change its exports and imports, a country 00 01 02 03 04 05 06 07 08 09
Year
must change its comparative advantage (Chapter 2).
(a) Increase in US dollar reserves
TABLE 26.1 South African Balance of gold and other foreign reserves of R32.704 billion in
Payments in 2011 2011. Our official reserves decreased in 2011
by R32.704 billion. When our reserves decrease,
Current account Billions of rand
we record this as a positive number in our
Merchandise exports +671.330 international accounts because a decrease in our
reserves is like borrowing from the rest of the world
Net gold exports +75.298
– the government decreases its deposits in foreign
Service receipts +107.825 central banks.
To see more clearly what the nation’s balance
Income receipts +38.118
of payments accounts mean, think about your own
Less merchandise imports –730.128 balance of payments accounts. They are similar to the
nation’s accounts.
Less payments of services –142.230
Financial
account
6 balance
–2
–4 Current
account
balance
–6
–8
1980 1985 1990 1995 2000 2005 2011
Year
Borrowers and Lenders 1993, South Africa had to repay its foreign debt and
A country that is borrowing more from the rest of was therefore a net lender to the rest of the world
the world than it is lending to the rest of the world – South Africa had a current account surplus and a
is called a net borrower. Similarly, a net lender is a financial account deficit. Since 1994 South Africa has
country that is lending more to the rest of the world become a net borrower, with the exception of only a
than it is borrowing from the rest of the world. single year, 2001. And during the years since 2001, the
South Africa is a net borrower, but it has not scale of South African borrowing has grown.
always been in this situation. Throughout the height Most countries are net borrowers like South
of economic sanctions against South Africa, 1985 to Africa. But a few countries, including China, Japan
and oil-rich Saudi Arabia, are net lenders. In 2010, economic growth and higher income, borrowing is
when the United States borrowed more than $400 not a problem. It earns a return that more than pays
billion from the rest of the world, most of it came the interest. But if borrowed money is used to finance
from China. consumption, to pay the interest and repay the loan,
consumption will eventually have to be reduced. In
this case, the greater the borrowing and the longer it
Debtors and Creditors goes on, the greater is the reduction in consumption
A net borrower might be decreasing its net assets held that will eventually be necessary.
in the rest of the world, or it might be going deeper
into debt. A nation’s total stock of foreign investment
determines whether it is a debtor or a creditor. A debtor
Current Account Balance
nation is a country that during its entire history has What determines a country’s current account balance
borrowed more from the rest of the world than it has and net foreign borrowing? You have seen that net
lent to it. It has a stock of outstanding debt to the rest exports (NX ) is the main item in the current account.
of the world that exceeds the stock of its own claims on We can define the current account balance (CAB) as
the rest of the world. A creditor nation is a country that
during its entire history has invested more in the rest of CAB = NX + Net interest income + Net transfers
the world than other countries have invested in it.
South Africa has always been a debtor nation, We can study the current account balance by
which is normal for a developing country. looking at what determines net exports because the
The United States was a debtor nation through other two items are small and do not fluctuate much.
the nineteenth century as they borrowed from Europe
to finance their westward expansion, railroads and
industrialisation. They paid off their debt and became Net Exports
a creditor nation for most of the twentieth century. Net exports are determined by the government budget
But following a string of current account deficits, they and private saving and investment. To see how net
became a debtor nation again in 1986. exports are determined, we need to recall some of the
Since 1986, the total stock of US borrowing things that we learned in Chapter 24 about the flows
from the rest of the world has exceeded US lending of funds that finance investment. Table 26.2 refreshes
to the rest of the world. The largest debtor nations your memory and summarises some calculations.
are the capital-hungry developing countries (such as Part (a) lists the national income variables that
the United States was during the nineteenth century). are needed, with their symbols. Part (b) defines three
The international debt of these countries grew from balances: net exports, the government sector balance
less than a third to more than a half of their gross and the private sector balance.
domestic product during the 1980s and created what Net exports is exports of goods and services minus
was called the ‘Third World debt crisis’. The debt of imports of goods and services.
these countries is crippling their development and The government sector balance is equal to net
in 2005 it was reported that the developing world taxes minus government expenditures on goods and
spends US$13 on repaying its debts, for every US$1 services. If that number is positive, a government
it receives from grants. There have been widespread sector surplus is lent to other sectors; if that number
calls for the cancellation of the debt of many of the is negative, a government deficit must be financed by
poor countries, but opponents to this argue that it borrowing from other sectors. The government sector
will motivate countries to borrow recklessly and never deficit is the sum of the deficits of the central and
repay their debt. local governments.
Should we be concerned that South Africa is The private sector balance is saving minus
a net borrower and a debtor? The answer to this investment. If saving exceeds investment, a private
question depends mainly on what the net borrower sector surplus is lent to other sectors. If investment
is doing with the borrowed money. If borrowing exceeds saving, a private sector deficit is financed by
is financing investment that in turn is generating borrowing from other sectors.
Part (b) also shows the values of these balances sum of consumption expenditure (C ), investment (I ),
for South Africa in 2011. As you can see, net exports government expenditure (G ) and net exports
were –R18.015 billion. The government sector’s (X – M ). Real GDP also equals the sum of
revenue from net taxes was R545.836 billion and its consumption expenditure, saving and net taxes.
expenditure was R636.446 billion, so the government Rearranging these equations tells us that net
sector balance was –R90.607 billion. The private exports is the sum of the government sector balance
sector saved R281.128 billion and invested R208.533 and the private sector balance. In South Africa in
billion, so its balance was R72.595 billion – a surplus 2011, the government sector balance was –R90.607
of R72.595 billion. billion and the private sector balance was R72.595
Part (c) shows the relationship among the three billion. The government sector balance plus the
balances. From the National Income and Product private sector balance equalled net exports of
Accounts, we know that real GDP, Y, is the –R18.015 billion.
TABLE 26.2 Net Exports, the Government Budget, Saving and Investment
Symbols and equations South Africa in 2011 (billions of rand)
(a) Variables
Exports* X 854.343
Imports* M 872.355
Investment I 208.533
Saving S 281.128
(b) Balances
=C+S+T
Rearranging: X–M=S–I+T–G
Source of data: South African Reserve Bank. The data is for the year 2011.
* Note that Saving is the sum of household saving (R–1.411 billion), corporate saving (R201.769 billion) and the difference between international income payments
and receipts plus current transfers (R80.770 billion) as reported in the balance of payments Table 26.1.
–2
Government
sector
–4
–6
2000 2002 2004 2006 2008 2010
Year
The Three Sector Balances
‘The Chinese currency is undoubtedly deliberately undervalued. China’s capital account remains
closed, despite recent experimentation with Renminbi internationalisation via Hong Kong and,
recently, South Korea and Japan. The latter has been partly responsible for the recent substantial
reduction of China’s current account surplus, from over 10 per cent of GDP at its peak in 2007 to
less than 3 per cent now. But the slowdown in China’s Western export markets must take some of the
“credit” and suggests a reversal once those markets revive.
‘… Until such time as China’s domestic financial system is opened up and the RMB floated, currency
“manipulation” will remain the practice in China. Both may take a long time.
‘… However, since growth in the developed world remains stagnant, in contrast to relatively rapid
growth in developing countries, the low interest rate environment has driven a wall of capital into
certain emerging countries with liquid financial
markets such as Brazil and South Africa. This
ESSENCE OF THE STORY
led to currency appreciation in some cases,
thus undermining manufacturing exports. … ◆ The Chinese keep their currency, the Renminbi (or
the rand has still weakened against the dollar, yuan), below its equilibrium value.
so it is not obvious that the policy has been ◆ This causes the Chinese to keep their current
particularly damaging to us.’ account balance in a surplus and their capital
(financial) account in a deficit.
Source: A version of this article first appeared in the Business Day on ◆ The low interest rate environment has caused
6 June 2012. Edited by: South African Institute of International Affairs. capital to flow to South Africa.
© Times media, Business Day. ◆ But the South African rand has depreciated rather
than appreciated.
◆ Figure 1 illustrates that the demand for rand increases ◆ One factor that caused the supply of rand to
due to the increasing interest rate differential. increase is the increase in imports, which is
◆ An increase in demand would cause the rand evident from the large and increasing, current
to appreciate, as Fig. 1 shows, but the rand did account deficit that we have.
not appreciate. ◆ The increase in South Africa’s imports caused the
◆ Therefore the supply of rand had to exceed supply of rand to increase more than the demand
the demand of rand in order to cause the for rand, causing the rand to depreciate rather
depreciation of the currency. than appreciate. See Figure 2.
Exchange rate (US dollar per South African rand)
S1
0.14 0.14
0.13
0.125
D1 D1
D0 D0
Key Terms
Balance of payments Current account, 588 Foreign exchange market, Private sector balance, 591
accounts, 588 Debtor nation, 591 574 Purchasing power parity,
Capital transfer account, Exchange rate, 574 Government sector 583
588 Financial account, 588 balance, 591 Real exchange rate, 583
Change in net gold and Fixed exchange rate, 585 Interest rate parity, 583 South African interest rate
other foreign reserves 588 Flexible exchange rate, Net borrower, 590 differential, 579
Crawling peg, 586 585 Net exports, 591
Creditor nation, 591 Foreign currency, 574 Net lender, 590
Date Price of pula Date Price of euro Date Price of rand in metical
(Botswana) (Eurozone) (Mozambique)
27 April 2012 R1.055 15 November 2011 R11.065 30 June 2011 M4200.984
30 May 2012 R1.134 15 May 2012 R10.548 31 May 2012 M3251.227
Consider the exchange rate between South Africa and b. The supply of pesos?
Botswana and the Eurozone as provided in the above c. The quantity of pesos demanded?
table to work out Problems 1 to 3. d. The quantity of pesos supplied?
1. Did the rand appreciate or depreciate against e. The exchange rate of the peso against the
the Botswana pula? Did the rand appreciate or South African rand?
depreciate against the euro? 9. If a euro deposit in a bank in Paris, France, earns
2. What was the value of the rand in terms of interest of 4 per cent a year and a yen deposit in
Botswana pula on 27 April 2012 and Tokyo, Japan, earns 0.5 per cent a year, everything
30 May 2012? Did the Botswana pula else remaining the same and adjusted for risk, what
appreciate or depreciate against the rand? is the exchange rate expectation of the Japanese yen?
3. What was the value of one rand in terms of the 10. The UK pound is trading at 1.54 US dollars per
euro on 15 November 2011 and 15 May 2012? UK pound. There is purchasing power parity at
Did the euro appreciate or depreciate against this exchange rate. The interest rate in the United
the rand in 2009? States is 2 per cent a year and the interest rate in
the United Kingdom is 4 per cent a year.
Consider the exchange rate between South Africa and a. Calculate the US interest rate differential.
Mozambique as provided in the above table to work b. What is the UK pound expected to be worth
out Problems 4 to 6. in terms of US dollars one year from now?
4. Explain the export effect of this change in the c. Which country more likely has the lower
exchange rate. inflation rate? How can you tell?
5. Explain the import effect of this change in the 11. In Maputo, Mozambique, one can buy a lamp
exchange rate. for 900 000 metical and the exchange rate is
6. Explain the expected profit effect of this change 3256.741 metical per rand. If purchasing power
in the exchange rate. parity holds, what would one pay for an identical
lamp in Cape Town?
Exchange Rate Fluctuations 12. The Big Mac Index, as created by the Economist
7. The exchange rate between the rand and the euro magazine, is a fun way of determining whether
strengthens from R13 per euro to R11.50 per euro. a currency is under- or overvalued. Consider
a. Discuss the events that might have played a a situation where a Big Mac costs $3.73 in
role in this strengthening. Washington, 13.2 yuan in Beijing and 6.50 Swiss
b. Did the events change the demand or supply francs in Basel and the exchange rates to the US
of rand, or both demand and supply in the dollar are 6.78 yuan and 1.05 Swiss francs.
foreign exchange market? a. Is the yuan undervalued or overvalued
8. Colombia is the world’s biggest producer of relative to purchasing power parity?
roses. The global demand for roses increases and b. Is the Swiss franc undervalued or overvalued
at the same time, the central bank in Colombia relative to purchasing power parity?
increases the interest rate. In the foreign exchange c. Do you think the price of a Big Mac in
market for Colombian pesos, what happens to: different countries provides a valid test of
a. The demand for pesos? purchasing power parity?
13. The price level in the Eurozone is 112.4, the price b. What did the unions want the exchange rate
level in South Africa is 135.8 and the nominal policy to be in the short run? Why would
exchange rate is 0.099 euro cents per rand. What such a policy have no effect on the exchange
is the real exchange rate expressed as Eurozone rate in the long run?
real GDP per unit of South African real GDP? 17. Curious Currency
14. The US price level is 106.3, the South African Theory would have one believe that a currency
price level is 133.4 and the real exchange rate is is rather predictable, reflecting its economy’s
7.96 South African real GDP per unit of US real fundamentals (e.g. productivity, inflation, resource
GDP. What is the nominal exchange rate? allocation). Reality reflects a less predictable case
15. On a graph of the foreign exchange market show as these fundamentals are difficult to value. Many
the effects of: countries try to manipulate their currency values in
a. Japanese exports becoming more expensive. the foreign exchange market, despite the futility of
b. Investors stepping up the sale of rand. trying to influence such a huge market. Even the US
was active in trading currencies to influence dollar
Exchange Rate Policy values. In the 1970s and 1980s it traded often,
16. With the strengthening of the rand against the slowing down in the 1990s to only a few trades and
US dollar in 2010, the South African Reserve then stopping trading from 2000.
Bank did not take any action. Unions called on a. How has US exchange rate policy evolved since
the Reserve Bank to take action to weaken the the early 1970s?
rand, saying it will help exporters in the short run b. Explain why ‘trying to manipulate the dollar is
and leave no long-term effects. largely futile’, especially in the long run.
a. What is South Africa’s current exchange rate c. Explain why a currency can experience short-run
policy? fluctuations that seem to have little to do with
fundamentals. Illustrate with a graph.
24. On 1 May 2012 the exchange rate was R7.727 per cent against the dollar over three years. But America
US dollar. Over the month, the demand for US manufacturers still feel they are competing in an unfair
dollars increased and by 1 June 2012 the exchange market as the yuan is still heavily undervalued.
rate was R8.627 per US dollar. What happened 29. What was the exchange rate policy adopted by
to the quantity of US dollars that South Africans China until July 2005? Explain how it worked.
planned to sell in the foreign exchange market? Draw a graph to illustrate your answer.
30. What was the exchange rate policy adopted by
Use the following info byte to work out Problems 25 China after July 2005? Explain how it works.
and 26. 31. Explain how fixed and crawling peg exchange
rates can be used to manipulate trade balances in
Top SA Real Estate Markets for Investment the short run, but not the long run.
Foreigners are buying up properties around Cape 32. Explain the long-run effect of China’s current
Town. The buying spree is fuelled by a weaker rand exchange rate policy.
and a belief that the South African economy is 33. Interest Rates Down Under
basically stable and that the rand may recover. Suppose the Australian dollar depreciates against
25. Explain why foreigners are buying up properties the US dollar and the market reports that the
around Cape Town as an investment. latest inflation data meets with expectations.
26. Explain what would happen if South African Investors still predict that the Australian central
properties became even more popular with foreign bank will increase interest rates at their next
investors. Would expectations become self-fulfilling? meeting but not as much as expected.
a. What is Australia’s exchange rate policy?
Use the following information to work out Problems Explain why expectations about the
27 and 28. Australian interest rate lowered the value of
the Australian dollar against the US dollar.
The Rise and Fall b. To avoid the fall in the value of the
The South African rand appreciates 33 per cent against the Australian dollar against the US dollar, what
US dollar and the South African interest rate is 10.5 per action could the central bank of Australia
cent as opposed to the US interest rate of 4.25 per cent. have taken? Would such an action signal a
South Africa is also enjoying an influx of foreign change in Australia’s exchange rate policy?
funds. The Big Mac Index prices a burger in South
Africa at $4.60 as opposed to $3.99 in the US. Financing International Trade
27. Does purchasing power parity hold? If not, does Use the following table to work out Problems 34 to
PPP predict that the rand will appreciate or 36. The table gives some data about the UK economy.
depreciate against the US dollar? Explain.
28. Does interest rate parity hold? If not, why not? Item Billions of
UK pounds
Will the rand appreciate further or depreciate
against the US dollar if the US Central Bank Consumption expenditure 721
raises the interest rate while the South African Exports of goods and services 277
interest rate remains at 10.5 per cent a year? Government expenditures 230
Net taxes 217
Exchange Rate Policy
Use the following info byte to work out Problems 29 Investment 181
to 32. Saving 162
Joseph Schumpeter, the son of a textile factory entrepreneurs as the source of economic progress.
owner, was born in Austria in 1883. He moved But he saw economic progress as a process of
from Austria to Germany during the tumultuous creative destruction – the creation of new profit
1920s when those two countries experienced opportunities and the destruction of currently
hyperinflation. In 1932, in the depths of the profitable businesses. For Schumpeter, economic
Great Depression, he came to the United States growth and the business cycle were a single
and became a professor of economics at Harvard phenomenon.
University.
This creative economic thinker wrote about
economic growth and development, business ‘Economic progress, in capitalist
cycles, political systems and economic biography.
society, means turmoil.’
He was a person of strong opinions who expressed
them forcefully and delighted in verbal battles.
Schumpeter saw the development and JOSEPH SCHUMPETER
diffusion of new technologies by profit-seeking Capitalism, Socialism, and Democracy
Z
27
olani Mahola of Freshlyground sings into a microphone in a barely
audible whisper and through the magic of electronic amplification, her
voice fills the stadium.
Pravin Gordhan, the Minister of Finance, and an assistant are
being driven to a business meeting along one of Johannesburg’s streets
where potholes have not been repaired.
The car’s wheels bounce and vibrate over some
though disposable income is zero. This consumption expenditure exceeds disposable income, between D
expenditure is called autonomous consumption and it and F consumption expenditure is less than disposable
is the amount of consumption expenditure that would income and at point D, consumption expenditure
take place in the short run even if people had no equals disposable income.
current income. Consumption expenditure in excess
of this amount is called induced consumption, which Saving Function Figure 27.1(b) shows a saving
is the consumption expenditure that is induced by an function. Again, the points A to F correspond to
increase in disposable income. the rows of the table. For example, point E shows
that when disposable income is R8 trillion, saving is
45° Line Figure 27.1(a) also contains a 45° line, the R0.5 trillion. As disposable income increases, saving
height of which measures disposable income. At each increases. Notice that when consumption expenditure
point on this line, consumption expenditure equals exceeds disposable income in part (a), saving is
disposable income. Between A and D, consumption negative, called dissaving, in part (b).
E 8 7.5 0.5
A
2
F 10 9.0 1.0
0 2 4 6 8 10
The table shows planned consumption expenditure and saving
Disposable income at various levels of disposable income. Part (a) of the figure
(trillions of 2005 rand) shows the relationship between consumption expenditure and
(a) Consumption function disposable income (the consumption function). The height of
the consumption function measures consumption expenditure at
each level of disposble income. Part (b) shows the relationship
between saving and disposable income (the saving function).
Saving (trillions of 2005 rand)
increase in real GDP of R1 trillion increases imports by Investment depends on the real interest rate
R0.25 trillion, the marginal propensity to import is 0.25. and the expected profit (see Chapter 24, p. 530). At
a given point in time, these factors generate a given
level of investment. Suppose this level of investment
REVIEW QUIZ is R2.0 trillion. Also, suppose that government
1 Which components of aggregate expenditure expenditure is R2.5 trillion.
are influenced by real GDP? The next two columns show exports and imports.
2 Define and explain how to calculate the Exports are influenced by events in the rest of
marginal propensity to consume and the the world, prices of foreign-produced goods and
marginal propensity to save. services relative to the prices of similar South African-
3 How do we calculate the effects of real GDP produced goods and services and exchange rates.
on consumption expenditure and imports by But they are not directly affected by South Africa’s
using the marginal propensity to consume and real GDP. Exports are a constant R2.0 trillion.
the marginal propensity to import? Imports increase as South Africa’s real GDP increases.
A R1 trillion increase in South Africa’s real GDP
Real GDP influences consumption expenditure generates a 0.2 trillion increase in imports – the
and imports, which in turn influence real GDP. Your marginal propensity to import is 0.2.
next task is to study this second piece of the two-way The final column shows aggregate planned
link between aggregate expenditure and real GDP expenditure – the sum of planned consumption
and see how all the components of aggregate planned expenditure, investment, government expenditure on
expenditure interact to determine real GDP. goods and services and exports minus imports.
Figure 27.3 plots an aggregate expenditure curve.
Real GDP is shown on the x-axis and aggregate
planned expenditure is shown on the y-axis. The
Real GDP with a Fixed Price Level aggregate expenditure curve is the red line AE. Points
You are now going to see how, at a given price level, A to F on that curve correspond to the rows of the
aggregate planned expenditure determines real GDP. table. The AE curve is a graph of aggregate planned
We start by looking at the relationship between expenditure (the last column) plotted against real
aggregate planned expenditure and real GDP. GDP (the first column).
This relationship can be described by an aggregate Figure 27.3 also shows the components of
expenditure schedule or an aggregate expenditure aggregate expenditure. The constant components –
curve. The aggregate expenditure schedule lists aggregate investment (I ), government expenditure on goods
planned expenditure generated at each level of real and services (G ) and exports (X ) – are shown by
GDP. The aggregate expenditure curve is a graph of the the horizontal lines in the figure. Consumption
aggregate expenditure schedule. expenditure (C ) is the vertical gap between the lines
labelled I + G + X and I + G + X + C.
To construct the AE curve, subtract imports (M )
Aggregate Planned Expenditure from the I + G + X + C line. Aggregate expenditure is
The table in Figure 27.3 sets out an aggregate expenditure on SA produced goods and services. But
expenditure schedule. To calculate aggregate planned the components of aggregate expenditure – C, I and G –
expenditure at a given real GDP, we add the expenditure include expenditure on imported goods and services. For
components together. The first column of the table example, if you buy a new cellphone, your expenditure
shows real GDP and the second column shows the is part of consumption expenditure. But if the cellphone
planned consumption at each level of real GDP. A is a Nokia made in Finland, your expenditure on it must
R1 trillion increase in real GDP increases consumption be subtracted from consumption expenditure to find out
expenditure by R0.7 trillion – the MPC is 0.7. how much is spent on goods and services produced
The next two columns show investment and in South Africa – on South Africa’s real GDP. Money
government expenditure on goods and services, both paid to Nokia for cellphone imports from Finland
of which are independent of the level of real GDP. does not add to aggregate expenditure in South Africa.
Because imports are only a part of aggregate expenditure is that it would be the level of aggregate
expenditure, when we subtract imports from the planned expenditure if real GDP were zero.
other components of aggregate expenditure, aggregate In Fig. 27.3, autonomous expenditure is
planned expenditure still increases as real GDP R6.5 trillion – aggregate planned expenditure when
increases, as you can see in Fig. 27.3. real GDP is zero (point A). For each R1 trillion
Consumption expenditure minus imports, which increase in real GDP, induced expenditure increases
varies with real GDP, is called induced expenditure. by R0.5 trillion.
The sum of investment, government expenditure and The aggregate expenditure curve summarises the
exports, which does not vary with real GDP, is called relationship between aggregate planned expenditure
autonomous expenditure. Consumption expenditure and real GDP. But what determines the point
and imports can also have an autonomous component on the aggregate expenditure curve at which the
– a component that does not vary with real GDP. economy operates? What determines actual aggregate
Another way of thinking about autonomous expenditure?
I +G +X +C
20 expenditure, investment, government expenditure on goods and
Imports services and exports minus imports. For example, in row C of
AE the table, when real GDP is R11 trillion, planned consumption
15 expenditure is R7.7 trillion, planned investment is R2.0 trillion,
F planned government expenditure is R2.5 trillion, planned exports
E
C
D are R2.0 trillion and planned imports are R2.2 trillion. So when
10 real GDP is R11 trillion, aggregate planned expenditure is
Consumption
B R12 trillion (R7.7 + R2.0 + R2.5 + R2.0 – R2.2). The schedule
A expenditure
I +G +X shows that aggregate planned expenditure increases as real
5 GDP increases. This relationship is graphed as the aggregate
I +G
expenditure curve AE. The components of aggregate expenditure
I that increase with real GDP are consumption expenditure
and imports. The other components – investment, government
0 5 10 15 20 expenditure and exports – do not vary with real GDP.
Real GDP (trillions of 2005 rand)
Planned expenditure
Real Consumption Government Aggregate planned
Investment Exports Imports
GDP expenditure expenditure expenditure
(AE = C + I + G +
(Y) (C) (I) (G) (X) (M)
X – M)
(trillions of 2005 rand)
A 0 0 2.0 2.5 2.0 0.0 6.5
B 5 3.5 2.0 2.5 2.0 1.0 9.0
C 11 7.7 2.0 2.5 2.0 2.2 12.0
D 12 8.4 2.0 2.5 2.0 2.4 12.5
E 13 9.1 2.0 2.5 2.0 2.6 13.0
F 14 9.8 2.0 2.5 2.0 2.8 13.5
16 45º line
GDP (Y ) planned inventory change
15
expenditure (AE) (Y – AE)
Real GDP exceeds AE
planned expenditure (trillions of 2005 rand)
14 F A 10 11.5 –1.5
D E
13 B 11 12.0 –1.0
C
B Equilibrium C 12 12.5 –0.5
12 expenditure
A D 13 13.0 0
11
Planned E 14 13.5 0.5
expenditure
10 exceeds F 15 14.0 1.0
real GDP
0 10 11 12 13 14 15 16
Real GDP (trillions of 2005 rand) The table shows expenditure plans at different levels of
(a) Equilibrium expenditure real GDP. When real GDP is R13 trillion, aggregate planned
expenditure equals real GDP.
Part (a) of the figure illustrates equilibrium expenditure,
which occurs when aggregate planned expenditure equals
Unplanned inventory change (trillions of 2005 rand)
From Above Equilibrium If in Fig. 27.4, real GDP firms’ inventories rise by R1 trillion, point F in
is R15 trillion, the process that we have just described Fig. 27.4(b). Now, real GDP begins to fall. As long
works in reverse. With real GDP at R15 trillion, as actual expenditure exceeds planned expenditure,
actual aggregate expenditure is also R15 trillion. But inventories rise and production decreases. Again, the
aggregate planned expenditure is R14 trillion, point process ends when real GDP has reached R13 trillion,
F in Fig. 27.4(a). Actual expenditure exceeds planned the equilibrium at which unplanned inventory
expenditure. When people spend R14 trillion and changes are zero and firms do not change their
firms produce goods and services worth R15 trillion, production.
The producers of cars, flat-screen TVs, holidays But the change in induced expenditure is determined by
and other goods and services now have increased the change in real GDP and the slope of the AE curve. To
incomes and they, in turn, spend part of the increase see why, begin with the fact that the slope of the AE curve
in their incomes on consumption goods and services. equals the ‘rise’, ∆N, divided by the ‘run’, ∆Y. That is,
Additional income induces additional
∆N
expenditure, which creates additional income. Slope of AE curve =
∆Y
How big is the multiplier effect?
So
∆N = Slope of AE curve × ∆Y
The Size of the Multiplier
Suppose that the economy is in a recession. Profit Now, use this equation to replace ∆N in the first
prospects start to look better and firms are planning equation above to give
a large increase in investment. The world economy
is also heading toward expansion. The question on ∆Y = Slope of AE curve × ∆Y + ∆ A
everyone’s lips is: How strong will the expansion be?
This is a hard question to answer, but an Now, solve for ∆Y as
important ingredient in the answer is the size of the
multiplier. (1 – Slope of AE curve) × ∆Y = ∆ A
The multiplier is the amount by which a change
in autonomous expenditure is multiplied to determine and rearrange to give
the change in equilibrium expenditure that it
∆A
generates. To calculate the multiplier, we divide the ∆Y=
(1 – Slope of AE curve)
change in equilibrium expenditure by the change in
autonomous expenditure. Finally, divide both sides of this equation by ∆ A to give
Let us calculate the multiplier for the example ∆Y 1
in Fig. 27.5. Initially, equilibrium expenditure is Multiplier = =
∆ A 1– Slope of AE curve
R13 trillion. Then autonomous expenditure increases
by R0.5 trillion and equilibrium expenditure increases If we use the example in Fig. 27.5, the slope of the AE
by R2 trillion, to R15 trillion. Then curve is 0.75, so
Change in equilibrium expenditure 1 1
Multiplier = Multiplier = = =4
Change in autonomous expenditure (1 – 0.75) 0.25
Where there are no income taxes and no imports, the
R2 trillion
Multiplier = =4 slope of the AE curve equals the marginal propensity
R0.5 trillion
to consume (MPC ). So
The Multiplier and the Slope of the AE Curve Multiplier =
1
1 – MPC
The magnitude of the multiplier depends on the
slope of the AE curve. In Figure 27.6, the AE curve But (1 – MPC) equals MPS. So another formula is
in part (a) is steeper than the AE curve in part (b)
1
and the multiplier is larger in part (a) than in part (b). Multiplier =
MPS
To see why, let us do a calculation.
Aggregate expenditure and real GDP change Again using the numbers in Fig. 27.5, we have
because induced expenditure and autonomous
1
expenditure change. The change in real GDP (∆Y ) Multiplier = =4
0.25
equals the change in induced expenditure (∆ N) plus
the change in autonomous expenditure (∆ A). That is, Because the marginal propensity to save (MPS ) is a
fraction – a number between 0 and 1 – the multiplier
∆Y = ∆ N + ∆ A is greater than 1.
Aggregate expenditure
The multiplier is 45º line The multiplier is 45º line curve less steep and reduce the value of
16 1 16 1
=4 AE1 =2 the multiplier. In part (a), with no imports
1 – 0.75 1 – 0.5
B
15 AE0 15 AE1 and no income taxes, the slope of the AE
AE0
B curve is 0.75 (the marginal propensity
14 14
to consume) and the multiplier is 4. But
13 A 13 with imports and income taxes, the slope
A
of the AE curve is less than the marginal
12 12
propensity to consume. In part (b), the slope
of the AE curve is 0.5. In this case, the
0 12 13 14 15 16 0 12 13 14 15 16
Real GDP (trillions of 2005 rand) Real GDP (trillions of 2005 rand) multiplier is 2.
Imports and Income Taxes Over time, the value of the multiplier changes
Imports and income taxes influence the size of the as tax rates change and as the marginal propensity
multiplier and make it smaller than it otherwise to consume and the marginal propensity to
would be. import change. These ongoing changes make the
To see why imports make the multiplier smaller, multiplier hard to predict. But they do not change
think about what happens following an increase in the fundamental fact that an initial change in
investment. The increase in investment increases autonomous expenditure leads to a magnified change
real GDP, which in turn increases consumption in aggregate expenditure and real GDP.
expenditure. But part of the increase in expenditure is
on imported goods and services. Only expenditure on
South African-produced goods and services increases
The Multiplier Process
South Africa’s real GDP. The larger the marginal The multiplier effect is not a one-shot event. It is a
propensity to import, the smaller is the change in process that plays out over a few months. Figure 27.7
South Africa’s real GDP. The Mathematical Note on illustrates the multiplier process. Autonomous
pp. 621–627 shows the effects of imports and income expenditure increases by R0.5 trillion and real GDP
taxes on the multiplier. increases by R0.5 trillion (the green bar in round 1).
Income taxes also make the multiplier smaller This increase in real GDP increases induced
than it otherwise would be. Again, think about what expenditure in round 2. With the slope of the AE
happens following an increase in investment. The curve equal to 0.75, induced expenditure increases by
increase in investment increases real GDP. Income tax 0.75 times the increase in real GDP, so the increase in
payments increase so disposable income increases by real GDP of R0.5 trillion induces a further increase
less than the increase in real GDP and consumption in expenditure of R0.375 trillion. This change in
expenditure increases by less than it would if taxes induced expenditure (the green bar in round 2) when
had not changed. The larger the income tax rate, the added to the previous increase in expenditure
smaller is the change in real GDP. (the blue bar in round 2) increases real GDP by
The marginal propensity to import and the R0.875 trillion. The round 2 increase in real GDP
income tax rate together with the marginal propensity induces a round 3 increase in induced expenditure.
to consume determine the multiplier. And their The process repeats through successive rounds. Each
combined influence determines the slope of the increase in real GDP is 0.75 times the previous increase
AE curve. and eventually real GDP increases by R2 trillion.
Economics in Action that many people drew parallels between the recent
crisis and the Great Depression of the 1930s.
The Multiplier in the Great Depression In 1929, the US and global economies were
The aggregate expenditure model and its multiplier booming. US real GDP and real GDP per person had
were developed during the 1930s by John Maynard never been higher. By 1933, real GDP had fallen to
Keynes to understand the most traumatic event in 73 per cent of its 1929 level and more than a quarter
economic history, the Great Depression. Although of the labour force was unemployed.
a number of factors contributed to the Great The table shows the GDP numbers and
Depression, it is widely accepted that it started with components of aggregate expenditure in 1929
the stock market crash of October 1929 in the US. and 1933.
This led to large-scale bankruptcies of investors Autonomous expenditure collapsed as investment
and banks, much like we have seen with the recent fell from $17 billion to $3 billion and exports fell by a
financial crisis, which started in 2007/8. No wonder large amount. Government expenditure held steady.
1929 1933
Aggregate expenditure (billions of 1929 dollars)
45º line
150 A $17 billion fall in
(billions of autonomous expenditure
1929 dollars) (mainly investment) ...
AE29
A Induced consumption 47 34
AE33
B Induced imports –6 –4 104
Wealth Effect Other things remaining the same, the R13 trillion – point B on the AD curve. If the price
higher the price level, the smaller is the purchasing level rises to 130, the aggregate quantity of goods and
power of wealth. For example, suppose you have services demanded decreases to R12 trillion. There is
R1 000 in the bank and the price level is 105. If a movement up along the aggregate demand curve to
the price level rises to 125, your R1 000 buys fewer point A.
goods and services. If the price level falls to 90, the aggregate
You are less wealthy. With less wealth, you will quantity of goods and services demanded increases
probably want to try to spend a bit less and save a to R14 trillion. There is a movement down along the
bit more. The higher the price level, other things aggregate demand curve to point C.
remaining the same, the lower is aggregate planned Each point on the aggregate demand curve corre-
expenditure. sponds to a point of equilibrium expenditure. The
equilibrium expenditure points A, B and C in
Substitution Effects For a given expected future Fig. 27.8(a) correspond to the points A, B and C on
price level, a rise in the price level today makes current the aggregate demand curve in Fig. 27.8(b).
goods and services more expensive relative to future
goods and services and results in a delay in purchases
Changes in Aggregate Expenditure and
– an intertemporal substitution. A rise in South Africa’s
price level, other things remaining the same, makes
Aggregate Demand
South African-produced goods and services more When any influence on aggregate planned expenditure
expensive relative to foreign-produced goods other than the price level changes, both the aggregate
and services. As a result, South Africa’s imports expenditure curve and the aggregate demand curve
increase and South Africa’s exports decrease – an shift. For example, an increase in investment or
international substitution. exports increases both aggregate planned expenditure
When the price level rises, each of these effects and aggregate demand and shifts both the AE curve
reduces aggregate planned expenditure at each level and the AD curve. Figure 27.9 illustrates the effect of
of real GDP. As a result, when the price level rises, the such an increase.
aggregate expenditure curve shifts downward. A fall in Initially, the aggregate expenditure curve is
the price level has the opposite effect. When the price AE0 in part (a) and the aggregate demand curve is
level falls, the aggregate expenditure curve shifts upward. AD0 in part (b). The price level is 110, real GDP is
Figure 27.8(a) shows the shifts of the AE curve. R13 trillion and the economy is at point A in both
When the price level is 110, the aggregate parts of Fig. 27.9. Now suppose that investment
expenditure curve is AE0, which intersects the 45° line increases by R1 trillion. At a constant price level of
at point B. Equilibrium expenditure is R13 trillion. 110, the aggregate expenditure curve shifts upward
If the price level increases to 130, the aggregate to AE1. This curve intersects the 45° line at an
expenditure curve shifts downward to AE1, which equilibrium expenditure of R15 trillion (point B).
intersects the 45° line at point A. Equilibrium This equilibrium expenditure of R15 trillion is the
expenditure decreases to R12 trillion. If the price level aggregate quantity of goods and services demanded at
decreases to 90, the aggregate expenditure curve shifts a price level of 110, as shown by point B in part (b).
upward to AE2, which intersects the 45° line at point C. Point B lies on a new aggregate demand curve. The
Equilibrium expenditure increases to R14 trillion. aggregate demand curve has shifted rightward to AD1.
We have just seen that when the price level But how do we know by how much the AD
changes, other things remaining the same, the curve shifts? The multiplier determines the answer.
aggregate expenditure curve shifts and the equilibrium The larger the multiplier, the larger is the shift in
expenditure changes. But when the price level the aggregate demand curve that results from a
changes, other things remaining the same, there is a given change in autonomous expenditure. In this
movement along the aggregate demand curve. example, the multiplier is 2. A R1 trillion increase
Figure 27.8(b) shows the movements along the in investment produces a R2 trillion increase in the
aggregate demand curve. At a price level of 110, the aggregate quantity of goods and services demanded
aggregate quantity of goods and services demanded is at each price level. That is, a R1 trillion increase in
autonomous expenditure shifts the aggregate demand FIGURE 27.8 Equilibrium Expenditure and
curve rightward by R2 trillion. Aggregate Demand
A decrease in autonomous expenditure shifts the
aggregate expenditure curve downward and shifts the
aggregate demand curve leftward. You can see these effects
run. First we will see what happens in the short run. (b) Aggregate demand
An Increase in Aggregate Demand in the Short A change in the price level shifts the AE curve and results in a
Run Figure 27.10 describes the economy. Initially, in movement along the AD curve. When the price level is 110,
part (a), the aggregate expenditure curve is AE0 and the AE curve is AE0 and equilibrium expenditure is
equilibrium expenditure is R13 trillion – point A. In R13 trillion at point B. When the price level rises to 130, the
part (b), aggregate demand is AD0 and the short-run AE curve is AE1 and equilibrium expenditure is R12 trillion at
aggregate supply curve is SAS. (Chapter 28, pp. 633–635, point A. When the price level falls to 90, the AE curve is AE2
explains the SAS curve.) Equilibrium is at point A in and equilibrium expenditure is R14 trillion at point C. Points
part (b), where the aggregate demand and short-run A, B and C on the AD curve in part (b) correspond to the
aggregate supply curves intersect. The price level is equilibrium expenditure points A, B and C in part (a).
110 and real GDP is R13 trillion.
FIGURE 27.9 A Change in Aggregate Demand Now suppose that investment increases by
R1 trillion. With the price level fixed at 110, the
aggregate expenditure curve shifts upward to AE1.
16 Equilibrium expenditure increases to R15 trillion – point
Aggregate expenditure (trillions of 2005 rand)
140
An Increase in Aggregate Demand in the Long
Run Figure 27.11 illustrates the long-run effect of
130 an increase in aggregate demand. In the long run,
120 real GDP equals potential GDP and there is full
B employment. Potential GDP is R3 trillion and the
110
A long-run aggregate supply curve is LAS. Initially, the
AD0
100 economy is at point A in parts (a) and (b).
... and increases Investment increases by R1 trillion. In Fig. 27.11,
90 aggregate demand.
The multiplier in this the aggregate expenditure curve shifts to AE1 and
example is 2 AD1 the aggregate demand curve shifts to AD1. With no
change in the price level, the economy would move to
0 13 14 15 16
point B and real GDP would increase to R15 trillion.
Real GDP (trillions of 2005 rand) But in the short run, the price level rises to 123 and
real GDP increases to only R14.3 trillion. With the
(b) Aggregate demand
higher price level, the AE curve shifts from AE1 to
AE2. The economy is now in a short-run equilibrium
The price level is 110. When the aggregate expenditure
at point C in both part (a) and part (b).
curve is AE0 in part (a), the aggregate demand curve is AD0
Real GDP now exceeds potential GDP. The labour
in part (b). An increase in autonomous expenditure shifts the
force is more than fully employed and in the long run,
AE curve upward to AE1. In the new equilibrium, real GDP
shortages of labour increase the money wage rate.
is R15 trillion (at point B). Because the quantity of real GDP
The higher money wage rate increases firms’
demanded at a price level of 110 increases to R15 trillion,
costs, which decreases short-run aggregate supply
the AD curve shifts rightward to AD1.
and shifts the SAS curve leftward to SAS1. The
price level rises further and real GDP decreases.
There is a movement along AD1 and the AE curve by the same percentage, real GDP is again equal to
shifts downward from AE2 toward AE0. When the potential GDP and the economy is at point A’. In the
money wage rate and the price level have increased long run, the multiplier is zero.
FIGURE 27.10 The Multiplier in the Short Run FIGURE 27.11 The Multiplier in the Long Run
Aggregate expenditure (trillions of 2005 rand)
A'
... but the 13 A
price level
rises, which
13 A decreases
aggregate
planned 12
expenditure
0 13 14.3 15 16 0 12 13 14.3 15
Real GDP (trillions of 2005 rand) Real GDP (trillions of 2005 rand)
LAS
Price level (GDP deflator, 2005 = 100)
SAS1
150 150
A'
SAS
140
130 SAS0
130
C
123 C 123
110 B 110 B
A A
100 AD1
AD1 AD0
90 90
AD0
0 13 14.3 15 16 0 12 13 14.3 15
Real GDP (trillions of 2005 rand) Real GDP (trillions of 2005 rand)
An increase in investment shifts the AE curve from AE0 to AE1 Starting from point A, an increase in investment shifts the AE
and the AD curve from AD0 to AD1. The price level rises and curve to AE1 and the AD curve to AD1. In the short run, the
the higher price level shifts the AE curve downward from economy moves to point C. In the long run, the money wage
AE1 to AE2. The economy moves to point C in both parts. In rate rises and the SAS curve shifts to SAS1. As the price level
the short run, when prices are flexible, the multiplier effect is rises, the AE curve shifts back to AE0 and the economy moves
smaller than when the price level is fixed. to point A’. In the long run, the multiplier is zero.
REVIEW QUIZ You are now ready to build on what you have
learned about aggregate expenditure fluctuations.
1 How does a change in the price level influence
We will study the business cycle and the roles of
the AE curve and the AD curve?
fiscal policy and monetary policy in smoothing the
2 If autonomous expenditure increases with no
cycle while achieving price stability and sustained
change in the price level, what happens to
economic growth. In Chapter 29 we study the South
the AE curve and the AD curve? Which curve
African business cycle and inflation and in Chapters 30
shifts by an amount that is determined by the
and 31 we study fiscal policy and monetary policy,
multiplier and why?
respectively. But before you leave the current topic,
3 How does an increase in autonomous expenditure
look at Reading Between the Lines on pp. 619–620
change real GDP in the short run? Does real GDP
and see the aggregate expenditure model in action
change by the same amount as the change in
in the South African economy during the fourth
aggregate demand? Why or why not?
quarter of 2011.
4 How does real GDP change in the long run
when autonomous expenditure increases? Does
real GDP change by the same amount as the
change in aggregate demand? Why or why not?
AE1 AE1
AE0 AE0
C
B
B
A A
Figure 1 An increase in government spending and investment Figure 2 An increase in planned inventories
AE = C + I + G + X – M
Aggregate planned expenditure (trillions of 2005 rand)
Disposable income (YD) equals real GDP minus net 10 Slope equals
taxes (Y – T ). So if we replace YD with (Y – T ), the b(1 – t ) – m
C = a + b(Y – T )
13 A
A 11
1
Y = _______________ A
1 – [b(1 – t ) – m]
0 5 13 20 0 11 13 15 17 19
Real GDP (trillions of 2005 rand) Real GDP (trillions of 2005 rand)
A = a – bTa + I + G + X, A = a – bTa + I + G + X,
the change in autonomous expenditure equals the the change in autonomous expenditure equals minus b
change in government expenditure. That is, multiplied by the change in autonomous taxes.
That is,
∆ A = ∆G
∆ A = –b∆Ta
You can see from the solution for equilibrium
expenditure Y that You can see from the solution for equilibrium
expenditure Y that
1
∆Y = ∆G
1 –[b(1 – t) – m] –b
∆Y = ∆T
1 –[b(1 – t) – m] a
The government expenditure multiplier equals
The autonomous tax multiplier equals
1
1 –[b(1 – t) – m] –b
=
1 –[b(1 – t) – m]
In an economy in which t = 0 and m = 0, the
government expenditure multiplier is 1/(1 – b). With In an economy in which t = 0 and m = 0, the
b = 0.75, the government expenditure multiplier is 4, autonomous tax multiplier is b/(1 – b). In this special
as Figure 4 shows. Make up some examples and use case, with b = 0.75, the autonomous tax multiplier
the above formula to show how b, m and t influence equals 3, as Figure 5 shows. Make up some examples
the government expenditure multiplier. and use the above formula to show how b, m and t
influence the autonomous tax multiplier.
45º line 45º line
Aggregate expenditure (trillions of 2005 rand)
AE1
17 B 15
AE0
16 14
AE0
AE1
A
15 13
14 12
13 A 11
12 10 B
0 12 13 14 15 16 17 0 10 11 12 13 14 15
Real GDP (trillions of 2005 rand) Real GDP (trillions of 2005 rand)
Notice that
Balanced Budget Multiplier
1
The balanced budget multiplier equals the change in
1 –[b(1 – t) – m]
equilibrium expenditure and real GDP (Y ) that results
from equal changes in government expenditure and is common to both terms on the right side. So we can
lump-sum taxes divided by the change in government rewrite the equation as
expenditure. Because government expenditure and
autonomous taxes change by the same amount, the 1
∆Y = (∆G –b∆Ta)
budget balance does not change. 1 –[b(1 – t) – m]
The change in equilibrium expenditure that
results from the change in government expenditure is The AE curve shifts upward by ∆G – b∆Ta as shown
in Fig. 6.
1 But the change in government expenditure equals
∆Y = ∆G
1 –[b(1 – t) – m] the change in autonomous taxes. That is,
And the change in equilibrium expenditure that
results from the change in autonomous taxes is ∆G = ∆Ta
–b So we can write the equation as
∆Y = ∆T
1 –[b(1 – t) – m] a
1–b
So the change in equilibrium expenditure ∆Y = ∆G
1 –[b(1 – t) – m]
resulting from the changes in government expenditure
and autonomous taxes is The balanced budget multiplier equals
1 –b 1–b
∆Y = ∆G + ∆T 1 –[b(1 – t) – m]
1 –[b(1 – t) – m] 1 –[b(1 – t) – m] a
In an economy in which t = 0 and m = 0, the
45º line balanced budget multiplier is (1 – b)/(1 – b), which
Aggregate expenditure (trillions of 2005 rand)
15 AE1
equals 1, as Figure 6 shows. Make up some examples
AE0
and use the above formula to show how b, m and t
influence the balanced budget multiplier.
B
14
_
If we assume that I is 150 then we add I to C Let Us Bring it Together to Find an
to calculate total _autonomous
_ spending, which in this Equilibrium (Y€)
case will read as C + I = 100 + 150 = 250.
Within the Keynesian model, we will be considering
changes in two different multipliers: one that
Time to Introduce Government Spending (G) influences C and I and one that influences G and
(X – M). This is because the tax rate will change the
When we looked at investment spending we assumed
shape of the multiplier. (Increased tax rates reduce our
it to be autonomous to the economy. This meant that
ability to spend and tax collected by the government
investment spending would have an impact on our
is not automatically spent immediately by the
lives, but we cannot influence investment spending.
government back into the economy.)
Now government spending (G ) in the economy works
When we apply the numbers calculated from our
in the same way. Government spending influences our
example, then_for _the model with Consumption and
lives, but we cannot influence how much government
Investment ( C + I ) the equilibrium national income
chooses to spend. Therefore, government spending
level will be :
is considered to be an autonomous_ function in the
Keynesian model. If we assume G to be 50 then 1 1 5
First the multiplier is = × =5
aggregate_ total 1 – 15 1 1
_ autonomous
_ spending in our example
will be C + I + G which now means that if we add Then the formula
the values used in the previous example, then we get _ _
1
100 + 150 + 50 = 300. Y€ = ( C + I ).
1–b
Now insert the numbers.
Time to Introduce the Foreign Sector
1
Y€ = (100 + 150)
Trade is also considered to be an autonomous 1 – 45
function in
_ the Keynesian model. If _ we assume = 5 (250) = 1 250
exports ( X ) to be 80 and imports M_to be
_ 30_then the
total
_ autonomous
_ spending will be C + I + G+
The total private consumption at this Y€ level will be:
( X – M) = 100 + 150 + 50 + (80 – 30) = 350.
_
C = C + bY€ = 100 + 45 (1 250) = 1 100
Consider Very Briefly: The Multiplier
Total aggregate spending in the economy will be
Within the Keynesian model, the overall impact of _
the multiplier can be considered. The multiplier C + I = 100 + 150 + 45 (1 250) = 1 250 (at the
suggests that when some component of spending point of equilibrium aggregate spending will be equal
changes, it will have an impact on the total economy. to national income).
This change in spending may be due to changes For a closed economic model with a govern-
in consumption spending by household or ment sector, the equilibrium national income (for our
government, or maybe a change in investment, or example), with a tax rate of 25%, will be
a growth in exports of goods and services. The impact 1 _ _ _
that you see in the economy is far greater than just Y€ = ( C + I +G )
1 –[b(1 – t)]
the amount by which consumption spending or
the investment changes. The reason could be traced thus when we substitute it into the equation
back to the fact that as money enters the economy, 1
it is passed from hand to hand. Your spending is Y€ = (100 + 150 + 50)
1 – (1 – 14)
4
someone else’s income and that income is spent again 5
and becomes someone else’s income and spending. = 2.5 (300) = 750
Thus the impact created will be far greater than the
initial amount spent.
Private consumption expenditure will be We now place the numbers into the equation
_
C = C + b (1 – t) Y€ 1
Y€ = (100 + 150 + 50 + (80 – 30))
1 – (1 – 14)
4
= 100 + 45 (34) 750 5
Y€ = 2.50 (350) = 875
= 100 + 450 = 550
(Equilibrium of aggregate spending will be equal to From this example we can see the effect that
national income). additional spending has on the economy. Compare
the different values that we derived for Y€ C, I, G and
For an open economic model the equilibrium national
then finally (X – M). Think about these values and
income (for our example) will be
consider how spending within our own economy
1 _ _ _ _ _ could influence our own lives.
Y€ = ( C + I + G + X – M)
1 –b(1 – t)
Key Terms
Aggregate planned Balanced budget Government expenditure Marginal propensity to
expenditure, 601 multiplier, 624 multiplier, 623 import, 604
Autonomous expenditure, Consumption function, 601 Induced expenditure, 606 Marginal propensity to
606 Disposable income, 601 Marginal propensity to save, 603
Autonomous tax multiplier, Equilibrium expenditure, consume, 603 Multiplier, 609
623 607 Saving function, 601
8.0
400 420
AE
500 500
600 580 6.0
5.6
700 660
4.0
1. Calculate the marginal propensity to consume.
2. Calculate saving at each level of disposable income
and calculate the marginal propensity to save. 2.0 I+G
3. In China households save about 30 per cent 1.5 I
5. a. What is aggregate planned expenditure when 15. a. In the long run, does real GDP increase by
real GDP is $6 billion? more than, less than, or the same amount
b. If real GDP is $4 billion, what is happening as the immediate increase in the quantity of
to inventories? real GDP demanded?
c. If real GDP is $6 billion, what is happening b. Explain how the price level changes in the
to inventories? long run.
6. Explain the difference between induced 16. Are the values of the multipliers in the short run
consumption ependiture and autonomous and the long run larger or smaller than 2?
consumption ependiture. Why is not all 17. Will R10 billion of tax rebates to South African
consumption expenditure induced expenditure? consumers increase aggregate expenditure by more
7. Explain how an increase in business investment than, less than, or exactly R10 billion? Explain.
at a constant price level changes equilibrium 18. Explain and draw a graph to illustrate how
expenditure. this fiscal stimulus will influence aggregate
expenditure and aggregate demand in both the
The Multiplier short run and the long run.
Use the following data to work out Problems 8 and 9.
An economy has a fixed price level, no imports and Working Poor More Pinched as Rich Cut Back
no income taxes. MPC is 0.80 and real GDP is R150 Some economists believe that spending by the rich
billion. Businesses increase investment by R5 billion. has a trickle down effect on the poor. So when the
8. Calculate the multiplier and the change in rich cut back on spending, this results in less income
real GDP. trickling down the poor.
9. Calculate the new real GDP and explain why real 19. Why would reduced spending by the wealthiest
GDP increases by more than R5 billion. decile (i.e. the wealthiest 10 per cent) of the
population impact on the poorer population?
Use the following data to work out Problems 10 and Explain and draw a graph to illustrate the process.
11. An economy has a fixed price level, no imports 20. Explain and draw a graph to illustrate how real
and no income taxes. GDP will be driven back to potential GDP in the
An increase in autonomous expenditure of R2 trillion long run.
increases equilibrium expenditure by R8 trillion. 21. Why is the multiplier only a short-run influence
10. Calculate the multiplier and the marginal on real GDP?
propensity to consume.
11. What happens to the multiplier if an income tax Mathematical Note
is introduced? 22. In the Canadian economy, autonomous
consumption expenditure is $50 billion,
The Multiplier and the Price Level investment is $200 billion and government
Use the following data to work out Problems 12 to 16. expenditure is $250 billion. The marginal
Suppose that the economy is at full employment, the propensity to consume is 0.7 and net taxes are
price level is 100 and the multiplier is 2. Investment $250 billion. Exports are $500 billion and imports
increases by R100 billion. are $450 billion. Assume that net taxes and imports
12. What is the change in equilibrium expenditure if are autonomous and the price level is fixed.
the price level remains at 100? a. What is the consumption function?
13. a. What is the immediate change in the b. What is the equation of the AE curve?
quantity of real GDP demanded? c. Calculate equilibrium expenditure.
b. In the short run, does real GDP increase by d. Calculate the multiplier.
more than, less than, or the same amount as e. If investment decreases to $150 billion, what
the immediate change in the quantity of real is the change in equilibrium expenditure?
GDP demanded? f. Describe the process in part (e) that moves
14. In the short run, does the price level remain at the economy to its new equilibrium
100? Explain why or why not. expenditure.
T
28
he pace at which production grows and prices rise is uneven. In
2006, South Africa’s real GDP grew by 5.6 per cent, but growth has
slowed down to 3.6 per cent in 2008 and 2009 saw real GDP shrink
by 1.5 per cent.
Similarly, during recent years, prices have increased at rates
ranging from -0.9 per cent in 2004, to 2.1 per cent in 2005 and to
9.9 per cent in 2008.
AND AGGREGATE this chapter and the one that follows it.
This chapter explains a model of real
DEMAND GDP and the price level – the aggregate
supply–aggregate demand model or AS–AD
model. This model represents the consensus view of macroeconomists on
how real GDP and the price level are determined. The model provides a
framework for understanding the forces that make an economy expand,
that bring inflation and that cause business cycle fluctuations. The
AS–AD model also provides a framework within which we can see the
range of views of macroeconomists in different schools of thought.
In Reading Between the Lines at the end of the chapter, we use the
AS–AD model to interpret the factors that influence South Africa’s growth
and inflation outlook from 2012 to 2014.
R1.2 trillion.1 In the short run, a rise in the price level 110 C
B 105 1.25
Back at the South African Breweries Plant You
can see why the short-run aggregate supply curve C 110 1.30
slopes upward by returning to the South African D 115 1.35
Breweries (SAB) bottling plant. If production
E 120 1.4
increases, marginal cost rises and if production
decreases, marginal cost falls (see Chapter 2, p. 32).
If the price of beer rises with no change in the In the long run, the quantity of real GDP supplied is potential
money wage rate and other costs, SAB can increase GDP and the LAS curve is vertical at potential GDP. In the
profit by increasing production. SAB is in business to short run, the quantity of real GDP supplied increases if the
maximise its profit, so it increases production. price level rises, while all other influences on supply plans
Similarly, if the price of beer falls while the money remain the same.
wage rate and other costs remain constant, SAB can avoid The short-run aggregate supply curve, SAS, slopes upward.
a loss by decreasing production. The lower price weakens The short-run aggregate supply curve is based on the aggregate
the incentive to produce, so SAB decreases production. supply schedule in the table. Each point A to E on the curve
What is true for SAB bottlers is true for the producers corresponds to the row in the table identified by the same letter.
of all goods and services. When all prices rise, the price When the price level is 110, the quantity of real GDP
level rises. If the price level rises and the money wage rate supplied is R1.3 trillion, which is potential GDP. If the price
and other factor prices remain constant, all firms increase level rises above 110, the quantity of real GDP supplied
production and the quantity of real GDP supplied increases and exceeds potential GDP; if the price level falls
increases. A fall in the price level has the opposite effect below 110, the quantity of real GDP supplied decreases
and decreases the quantity of real GDP supplied. below potential GDP.
An Advance in Technology A South African Breweries An expected rise in the inflation rate makes the money
(SAB) plant that has pre-computer age machines produces wage rate rise faster and an expected fall in the inflation
less than one that uses the latest robot technology. rate slows the rate at which the money wage rate rises.
Technological change enables firms to produce more from
any given amount of factors of production. So even with FIGURE 28.3 A Change in the Money
fixed quantities of labour and capital, improvements in Wage Rate
technology increase potential GDP.
Technological advances are by far the most
supply does not change. A rise in the money wage rate decreases short-run aggregate
Figure 28.3 shows the effect of an increase in the supply and shifts the short-run aggregate supply curve leftward
money wage rate. Initially, the short-run aggregate from SAS0 to SAS2. A rise in the money wage rate does not
supply curve is SAS0. A rise in the money wage rate change potential GDP, so the long-run aggregate supply
decreases short-run aggregate supply and shifts the curve does not shift.
short-run aggregate supply curve leftward to SAS2.
A rise in the money wage rate decreases short-run
aggregate supply because it increases firms’ costs. REVIEW QUIZ
With increased costs, the quantity that firms are
1 If the price level and the money wage rate
willing to supply at each price level decreases, which is
rise by the same percentage, what happens
shown by a leftward shift of the SAS curve.
to the quantity of real GDP supplied? Along
A change in the money wage rate does not
which aggregate supply curve does the
change long-run aggregate supply because on the
economy move?
LAS curve, the change in the money wage rate is
2 If the price level rises and the money wage
accompanied by an equal percentage change in the
rate remains constant, what happens to the
price level. With no change in relative prices, firms
quantity of real GDP supplied? Along
have no incentive to change production and real GDP
which aggregate supply curve does the
remains constant at potential GDP. With no change
economy move?
in potential GDP, the long-run aggregate supply curve
3 If potential GDP increases, what happens
LAS does not shift.
to aggregate supply? Does the LAS curve
shift or is there a movement along the LAS
What Makes the Money Wage Rate Change? The
curve? Does the SAS curve shift or is there a
money wage rate can change for two reasons: departures
movement along the SAS curve?
from full employment and expectations about inflation.
4 If the money wage rate rises and potential
Unemployment above the natural rate puts downward
GDP remains the same, does the LAS curve
pressure on the money wage rate and unemployment
or the SAS curve shift or is there a movement
below the natural rate puts upward pressure on it.
along the LAS curve or the SAS curve?
Aggregate Demand Wealth Effect When the price level rises but other
things remain the same, real wealth decreases. Real
The quantity of real GDP demanded (Y ) is the sum wealth is the amount of money in the bank, bonds,
of real consumption expenditure (C ), investment (I ), shares and other assets that people own, measured not
government expenditure (G ) and exports (X ) minus in rand but in terms of the goods and services that the
imports (M ). That is, money, bonds and shares will buy.
Y=C+I+G+X-M
FIGURE 28.4 Aggregate Demand
The quantity of real GDP demanded is the total
People save and hold money, bonds and shares But at an interest rate of 10 per cent a year, you
for many reasons. One reason is to build up funds for might decide that the payments would be too high.
education expenses. You do not abandon your plan to buy the computer,
Another reason is to build up enough funds to but you decide to delay your purchase.
meet possible medical expenses or other big bills. A second substitution effect works through
But the biggest reason is to build up enough funds to international prices. When the South African price
provide a retirement income. level increases and other things remain the same,
If the price level rises, real wealth decreases. locally-produced goods and services become more
People then try to restore their wealth. To do so, expensive relative to foreign-produced goods and
they must increase saving and, equivalently, decrease services. This change in relative prices encourages
current consumption. Such a decrease in consumption people to spend less on locally-produced items and
is a decrease in aggregate demand. more on foreign produced items. For example, if
South Africa’s price level increases relative to Britain’s
Gloria’s Wealth Effect You can see how the wealth price level, Britons buy fewer South African Mercedes
effect works by thinking about Gloria’s planned (South Africa’s exports decrease) and South Africans
expenditure. Gloria lives in Maputo, Mozambique. buy more British-made Bentleys (British exports
She has worked hard all summer and saved 20 000 increase). Thus South Africa’s GDP decreases.
meticais (metical is the currency of Mozambique),
which she plans to spend attending graduate school Gloria’s Substitution Effects In Maputo, Mozambique,
when she has finished her economics degree. So Gloria makes some substitutions. She was planning to
Gloria’s wealth is 20 000 meticais. Gloria has a part- trade in her old scooter and buy a new one. But with a
time job and her income from this job pays her higher price level and higher interest rates, she decides
current expenses. The price level in Mozambique to make her old scooter last one more year. Also, with
increases by 100 per cent and now Gloria needs the prices of Mozambican goods sharply increasing,
40 000 meticais to buy what 20 000 once bought. Gloria buys a low-cost dress made in China rather
To try to make up some of the fall in value of her than the traditional Mozambican-made dress she had
savings, Gloria saves even more and cuts her current originally planned to buy. She thus substitutes locally
spending to the bare minimum. produced goods in favour of imported goods.
Substitution Effects When the price level rises and Changes in the Quantity of Real GDP Demanded
other things remain the same, interest rates rise. When the price level rises and other things remain the
The reason is related to the wealth effect that you same, the quantity of real GDP demanded decreases –
have just studied. A rise in the price level decreases a movement up along the AD curve as shown by the
the real value of the money in people’s pockets and arrow in Figure 28.4. When the price level falls and
bank accounts. With a smaller amount of real money other things remain the same, the quantity of real
around, banks and other lenders can get a higher GDP demanded increases – a movement down along
interest rate on loans. But faced with a higher interest the AD curve.
rate, people and businesses delay plans to buy new We have now seen how the quantity of real GDP
capital and consumer durable goods and cut back demanded changes when the price level changes. How do
on spending. other influences on buying plans affect aggregate demand?
This substitution effect involves changing the
timing of purchases of capital and consumer durable
goods and is called an intertemporal substitution Changes in Aggregate Demand
effect – a substitution across time. Saving increases to A change in any factor that influences planned
increase future consumption. expenditure other than the price level brings a change
To see this intertemporal substitution effect in aggregate demand. The main factors are:
more clearly, think about your own plan to buy a new ◆ Expectations
computer. At an interest rate of 5 per cent a year, you ◆ Fiscal policy and monetary policy
might borrow R10 000 and buy the new computer. ◆ The world economy
Expectations An increase in expected future The World Economy Two main influences that
income increases the amount of consumption goods the world economy has on aggregate demand are the
(especially big-ticket items such as cars) that people exchange rate and foreign income. The exchange rate is
plan to buy today and increases aggregate demand. the amount of a foreign currency that you can buy with
An increase in the expected future inflation rate a South African rand. Other things remaining the same,
increases aggregate demand today because people a rise in the exchange rate decreases aggregate demand.
decide to buy more goods and services at today’s To see how the exchange rate influences aggregate
relatively lower prices. demand, suppose that the exchange rate is R10 for
An increase in expected future profits increases one euro. A Nokia cellphone made in Finland costs
the investment that firms plan to undertake today and 120 euros and an equivalent Samsung phone made in
increases aggregate demand. South Africa costs R1 300. In South African rand, the
Nokia phone costs R1 200, so people around the world
Fiscal Policy and Monetary Policy The buy the cheaper phone from Finland. Now suppose
government’s attempt to influence the economy by the exchange rate falls to R12 per 1 euro. The Nokia
setting and changing taxes, making transfer payments phone now costs R1 440 and is more expensive than
and purchasing goods and services is called fiscal policy. the Samsung phone. People will switch from the Nokia
A tax cut or an increase in transfer payments – for phone to the Samsung phone. South Africa’s exports
example, unemployment benefits or welfare payments will increase and South Africa’s imports will decrease,
– increases aggregate demand. Both of these influences so South Africa’s aggregate demand will increase.
operate by increasing households’ disposable income. An increase in foreign income increases South Africa’s
Disposable income is aggregate income minus exports and increases South Africa’s aggregate demand. For
taxes plus transfer payments. The greater the example, an increase in income in Japan and Germany
disposable income, the greater is the quantity of increase Japanese and German consumers’ and producers’
consumption goods and services that households plan planned expenditures on South African-produced
to buy and the greater is aggregate demand. goods and services causing our exports to increase.
Government expenditure on goods and services
is one component of aggregate demand. So if the
government spends more on anti-retroviral medication, Economics in Action
schools and highways, aggregate demand increases.
The South African Reserve Bank’s (SARB’s) Monetary Policy to Fight Recession
attempt to influence the economy by changing In October 2008 and the months that followed, the
interest rates and the quantity of money is called central bank of the US, the Federal Reserve, together
monetary policy. The Reserve Bank influences the with the European Central Bank, the Bank of Canada
quantity of money and interest rates by using the tools and the Bank of England, cut the interest rate and took
and methods described in Chapter 25. other measures to ease credit and encourage banks and
An increase in the quantity of money increases other financial institutions to increase their lending.
aggregate demand through two main channels: It The US interest rate was the lowest with Ben Bernanke
lowers interest rates and makes it easier to get a loan. lowering the interest rate to 0.20%. Mark Carney of
With lower interest rates, businesses plan the Bank of Canada reduced the Canadian interest rate
a greater level of investment in new capital and to 0.25%, while Mervin King of the Bank of England
households plan greater expenditure on new homes, cut interest rates in Great Britain to 0.50%. In Europe,
on home improvements, on vehicles and a host of Claude Trichet of the European Central Bank lowered
other consumer durable goods. Banks and others interest rates to 1.75%. Tito Mboweni and the South
eager to lend lower their standards for making loans African Reserve Bank followed a similar strategy and
and more people are able to obtain home loans and interest rates declined from 12% to 7%.
consumer loans. The idea of these interest rate cuts and easier credit
A decrease in the quantity of money has the was to stimulate business investment and consumption
opposite effects and lowers aggregate demand. expenditure and increase aggregate demand.
Shifts of the Aggregate Demand Curve When quantity of money increases and the interest rate falls;
aggregate demand changes, the aggregate demand the exchange rate falls; or foreign income increases.
curve shifts. Figure 28.5 shows two changes in Aggregate demand decreases and the AD curve
aggregate demand and summarises the factors that shifts leftward from AD0 to AD2 when expected
bring about such changes. future income, inflation, or profit decreases;
Aggregate demand increases and the AD curve government expenditure on goods and services
shifts rightward from AD0 to AD1 when expected decreases; taxes increase; transfer payments
future income, inflation, or profit increases; decrease; the quantity of money decreases and
government expenditure on goods and services the interest rate rises; the exchange rate rises; or
increases; taxes are cut; transfer payments increase; the foreign income decreases.
Aggregate demand
Price level (GDP deflator, 2005 = 100)
140
wage rate is too low, short-run equilibrium is above
E'
potential GDP and the unemployment rate is below
130 Firms cut
production
the natural rate.
and prices SAS With an excess demand for labour, the money
D'
120 E wage rate rises.
D
Figure 28.7 shows the long-run equilibrium and
C'
110
Short-run how it comes about. If short-run aggregate supply
macroeconomic
C
equilibrium curve is SAS1, the money wage rate is too high to
B achieve full employment. A fall in the money wage
B'
100
A
rate shifts the SAS curve to SAS* and brings full
Firms increase A' employment. If short-run aggregate supply curve
90 production
and prices
is SAS2, the money wage rate is too low to achieve
AD
full employment. Now, a rise in the money wage
0 1.20 1.25 1.30 1.35 1.40 1.45
rate shifts the SAS curve to SAS* and brings full
Real GDP (trillions of 2005 rand) employment.
Short-run macroeconomic equilibrium occurs when real GDP
In long-run equilibrium, potential GDP
demanded equals real GDP supplied – at the intersection
determines real GDP and potential GDP and
of the aggregate demand curve (AD) and the short-run
aggregate demand together determine the price
aggregate supply curve (SAS).
level. The money wage rate adjusts until the SAS
curve passes through the long-run equilibrium point.
LAS
140 In the long run, SAS1
money wage
rate adjusts
The figure is a scatter diagram of US real GDP and
130 the price level. The graph has the same axes as those of
the AS–AD model.
SAS*
Each dot represents a year between 1960 and
120
2010. The red dots are recession years. The pattern
formed by the dots shows the combination of
110 SAS2 economic growth and inflation.
Economic growth was fastest during the 1960s;
100 inflation was fastest during the 1970s.
The AS–AD model interprets each dot as being at
90 the intersection of the SAS and AD curves.
AD
Price level (GDP deflator, 2005 = 100)
0 1.20 1.25 1.30 1.35 1.40 1.45 SAS10
120.0
Real GDP (trillions of 2005 rand)
110.5
100.0
In long-run macroeconomic equilibrium, real GDP equals AD10
potential GDP. So long-run equilibrium occurs where the Inflation
80.0
aggregate demand curve, AD, intersects the long-run
aggregate supply curve, LAS. In the long run, aggregate
demand determines the price level and has no effect on 60.0
real GDP. The money wage rate adjusts in the long run, so
that the SAS curve intersects the LAS curve at the long-run 40.0
SAS60 Economic
equilibrium price level.
growth
18.6
AD60
Let us now see how the AS–AD model helps us to 0 2.8 6 9 13.2 15
Real GDP (trillions of 2005 dollars)
understand economic growth and inflation.
The Path of Real GDP and the Price Level
Economic Growth and Inflation in the Source of data: Bureau of Economic Analysis.
AS–AD Model
Economic growth results from a growing labour
force and increasing labour productivity, which
together make potential GDP grow (Chapter 23, Figure 28.8 illustrates this explanation in terms of
pp. 506–509). Inflation results from a growing the shifting LAS and AD curves.
quantity of money that outpaces the growth of When the LAS curve shifts rightward from LAS0
potential GDP (Chapter 25, pp. 563–564). to LAS1, potential GDP grows from R1.3 trillion to
The AS–AD model explains and illustrates R1.4 trillion and in long-run equilibrium, real GDP
economic growth and inflation. It explains economic also grows to R1.4 trillion.
growth as increasing long-run aggregate supply and it When the AD curve shifts rightward from AD0
explains inflation as a persistent increase in aggregate to AD1, which is a growth of aggregate demand that
demand at a faster pace than that of the increase in outpaces the growth of potential GDP, the price level
potential GDP. rises from 110 to 120.
If aggregate demand were to increase at the same is the output gap. When real GDP exceeds potential
pace as long-run aggregate supply, real GDP would GDP, the output gap is called an inflationary gap.
grow with no inflation. The above full-employment equilibrium shown
Our economy experiences periods of growth and in Fig. 28.9(a) occurs where the aggregate demand
inflation, like those shown in Fig. 28.8, but it does curve AD0 intersects the short run aggregate supply
not experience steady growth and steady inflation. curve SAS0 at a real GDP of R1.32 trillion. There is an
Real GDP fluctuates around potential GDP in a inflationary gap of R0.2 trillion.
business cycle. When we study the business cycle, we
ignore economic growth and focus on the fluctuations
around the trend. By doing so, we see the business
cycle more clearly. Let us now see how the AS-AD
Economics in Action
model explains the business cycle. The US Business Cycle
The US economy had an inflationary gap in 2006
FIGURE 28.8 Economic Growth and Inflation (at A in the figure), full employment in 2006
(at B) and a recessionary gap in 2009 (at C ). The
fluctuating output gap in the figure is the real-
Price level (GDP deflator, 2005 = 100)
LAS0 LAS1
140
world version of Fig. 28.9(d) and is generated by
Increase in LAS
brings economic
fluctuations in aggregate demand and short-run
130 growth aggregate supply.
120 6
Inflation Inflationary
A
gap
110 4
Output gap (per cent of potential GDP)
AD1 Full
2 employment
100 Bigger increase Real
in AD than in LAS GDP
brings inflation 0
90 Economic B
growth
AD0
–2
0 1.30 1.40
Real GDP (trillions of 2005 rand) –4 Recessionary
gap
Economic growth results from a persistent increase in potential
–6
GDP – a rightward shift of the LAS curve. Inflation results
from persistent growth in the quantity of money that shifts the AD C
–8
curve rightward at a faster pace than the real GDP growth rate. 2000 2002 2004 2006 2008 2010
Year
In part (c), there is a below full-employment The economy moves from one type of
equilibrium. A below full-employment equilibrium is macroeconomic equilibrium to another as a result of
an equilibrium in which potential GDP exceeds real fluctuations in aggregate demand and in short-run
GDP. When potential GDP exceeds real GDP, the aggregate supply. These fluctuations produce
output gap is called a recessionary gap. fluctuations in real GDP. Figure 28.9(d) shows how
The below full-employment equilibrium shown in real GDP fluctuates around potential GDP.
Fig. 28.9(c) occurs where the aggregate demand curve Let us now look at some of the sources of these
AD2 intersects the short-run aggregate supply curve fluctuations around potential GDP.
SAS2 at a real GDP of R1.28 trillion. Potential GDP is
R1.3 trillion, so the recessionary gap is R0.2 trillion.
100)
100)
100)
100)
100)
100)
100)
LAS LAS LAS
LAS
LAS LAS
LAS LAS
===
LAS
===
===
2005
2005
2005
2005
2005
2005
2005
2005
2005
130 130 Full 130 Recessionary
130 130 Full
Full 130 Recessionary SAS 2
employment Recessionary SAS
deflator,
SAS 22
deflator,
employment gap
deflator,
deflator,
employment
deflator,
gap
deflator,
deflator,
deflator,
gap
deflator,
120 Inflationary 120 SAS 1 120
120 Inflationary
Inflationary 120 SAS 1 120
120 gap SAS 0 120 SAS 1 120
gap
gap SAS
SAS 00
(GDP
C
(GDP
(GDP
(GDP
C
(GDP
(GDP
(GDP
A C
(GDP
level
level
level
level
level
level
level
AD
Price
0
Price
Price
Price
Price
AD 1
AD 1
AD 1
AD
AD 22
AD
0 0 0 2
0
0 1.30 1.32 0
0 1.28 1.30 1.32 0
0 1.28 1.30 1.32
1.30
1.30 1.32 1.28
1.28 1.30
1.30 1.32 1.28
1.28 1.30
1.30 1.32
Real GDP (trillions of1.32
2005 rand) Real GDP (trillions of 20051.32
rand) Real GDP (trillions of 20051.32
rand)
Real
Real GDP (trillions of 2005
GDP (trillions of 2005 rand)
rand) Real
Real GDP (trillions of 2005 rand)
GDP (trillions of 2005 rand) Real
Real GDP (trillions of 2005 rand)
GDP (trillions of 2005 rand)
(a) Above full-employment equilibrium (b) Full-employment equilibrium (c) Below full-employment equilibrium
(a) Above
(a) Above full-employment equilibrium
full-employment equilibrium (b)
(b) Full-employment
Full-employment equilibrium
equilibrium (c) Below
(c) Below full-employment equilibrium
full-employment equilibrium
rand)
rand)
rand)
1.32 Inflationary
Inflationary A Actual part (b) shows a full employment equilibrium in year 2;
2005
gap A Actual
2005
1.32
1.32 gap
gap real GDP
real
real GDP
GDP and part (c) shows a below full-employment equilibrium
ofof
Full
of
(trillions
Full
Full in year 3. Part (d) shows how real GDP fluctuates around
(trillions
employment
(trillions
employment
employment
1.30 potential GDP in a business cycle.
1.30
1.30 Potential B
GDP
Potential B
GDP
GDP
GDP
GDP is at point A in parts (a) and (d). In year 2, the economy
Real
Real
Real
LAS
Price level (GDP deflator, 2005 = 100)
The
140increase in aggregate demand has increased the 140
SAS1
prices of all goods and services. Faced with higher prices,
firms increased
130 their output rates. At this stage, prices of 130
SAS0 SAS0
goods and services have increased but the money wage 125
rate has not changed. (Recall that as we move along the
SAS curve,
115 the money wage rate is constant.) 115
The
110 economy cannot produce in excess of
potential GDP forever. Why not? What are the forces
at work100that bring real GDP back to potential GDP? 100
Because the price level has increased and AD
1
the money
90 wage rate is unchanged, workers have 90
AD1
not raise the money wage rate, they will either lose An increase in aggregate demand shifts the aggregate demand
workers or have to hire less productive ones. curve from AD0 to AD1. In short-run equilibrium, real GDP
As the money wage rate rises, the short-run increases to R1.35 trillion and the price level rises to 115. In this
aggregate supply begins to decrease. In Fig. 28.10(b), situation, an inflationary gap exists. In the long run in part (b),
the short-run aggregate supply curve begins to shift the money wage rate rises and the short-run aggregate supply
from SAS0 toward SAS1. The rise in the money wage curve shifts leftward. As short-run aggregate supply decreases,
rate and the shift in the SAS curve produce a sequence the SAS curve shifts from SAS0 to SAS1 and intersects the
of new equilibrium positions. Along the adjustment aggregate demand curve AD1 at higher price levels and real
path, real GDP decreases and the price level rises. The GDP decreases. Eventually, the price level rises to 125 and real
economy moves up along its aggregate demand curve GDP decreases to R1.3 trillion – potential GDP.
as shown by the arrows in the figure.
Eventually, the money wage rate rises by the South Africa caused a withdrawal of foreign firms and
same percentage as the price level. At this time, the investment from the country. Since the 1970s most of
aggregate demand curve AD1 intersects SAS1 at a new the developed countries have, however, not struggled
full-employment equilibrium. The price level has with stagflation.
risen to 125 and real GDP is back where it started, In the analysis, when the price of oil returns to its
at potential GDP. original level, the economy returns to full employment.
A decrease in aggregate demand has effects
similar but opposite to those of an increase in
aggregate demand. That is, a decrease in aggregate FIGURE 28.11 A Decrease in Aggregate
demand shifts the aggregate demand curve leftward. Supply
Real GDP decreases to less than potential GDP and
100
Fluctuations in Aggregate Supply
Fluctuations in short-run aggregate supply can bring 90
fluctuations in real GDP around potential GDP. AD 0
We can use the AS–AD model to explain and Aggregate Demand Fluctuations In the classical
illustrate the views of the alternative schools of view, technological change is the most significant
thought in macroeconomics. That is your next task. influence on both aggregate demand and aggregate
supply. For this reason, classical macroeconomists do
not use the AS–AD framework. But their views can be
Macroeconomic Schools of Thought interpreted in this framework. A technological change
Macroeconomics is an active field of research and that increases the productivity of capital brings an
much remains to be learned about the forces that increase in aggregate demand because firms increase
make our economy grow and fluctuate. There is their expenditure on new plant and equipment. A
a greater degree of consensus and certainty about technological change that lengthens the useful life of
economic growth and inflation – the longer-term existing capital decreases the demand for new capital,
trends in real GDP and the price level – than there is which decreases aggregate demand.
about the business cycle – the short-term fluctuations
in these variables. Here, we will look only at Aggregate Supply Response In the classical view,
differences of view about short-term fluctuations. the money wage rate that lies behind the short-run
The AS–AD model that you have studied in this aggregate supply curve is instantly and completely
chapter provides a good foundation for understanding flexible. The money wage rate adjusts so quickly to
the range of views that macroeconomists hold about maintain equilibrium in the labour market that real
this topic. But what you will learn here is just a first GDP always adjusts to equal potential GDP.
glimpse at the scientific controversy and debate. Potential GDP itself fluctuates for the same
We will return to these issues at various points reasons that aggregate demand fluctuates: technological
later in the text and deepen your appreciation of the change. When the pace of technological change is
alternative views. rapid, potential GDP increases quickly and so does
Classification usually requires simplification real GDP. And when the pace of technological change
and classifying macroeconomists is no exception to slows, so does the growth rate of potential GDP.
this general rule. The classification that we will use
here is simple, but it is not misleading. We divide Classical Policy The classical view of policy
macroeconomists into three broad schools of thought emphasises the potential for taxes to hamper incentives
and examine the views of each group in turn. The and create inefficiency. By minimising the disincentive
groups are: effects of taxes, employment, investment and
◆ Classical technological advance are at their efficient levels and
◆ Keynesian the economy expands at an appropriate and rapid pace.
◆ Monetarist
The Keynesian View
The Classical View A Keynesian macroeconomist believes that left alone, the
A classical macroeconomist believes that the economy economy would rarely operate at full employment and
is self-regulating and always at full employment. The that to achieve and maintain full employment, active
term ‘classical’ derives from the name of the founding help from fiscal policy and monetary policy is required.
school of economics that includes Adam Smith, David The term ‘Keynesian’ derives from the name
Ricardo and John Stuart Mill. of one of the twentieth century’s most famous
A new classical view is that business cycle economists, John Maynard Keynes (see p. 672).
fluctuations are the efficient responses of a well- The Keynesian view is based on beliefs about the
functioning market economy that is bombarded forces that determine aggregate demand and short-run
by shocks that arise from the uneven pace of aggregate supply.
technological change.
The classical view can be understood in terms of Aggregate Demand Fluctuations In the Keynesian
beliefs about aggregate demand and aggregate supply. view, expectations are the most significant influence
on aggregate demand. Those expectations are based on
herd instinct, or what Keynes himself called ‘animal But if the SARB decreases the quantity of money
spirits’. A wave of pessimism about future profit or even just slows its growth rate too abruptly, the
prospects can lead to a fall in aggregate demand and economy will go into recession. In the monetarist view,
plunge the economy into recession. all recessions result from inappropriate monetary policy.
Aggregate Supply Response In the Keynesian Aggregate Supply Response The monetarist
view, the money wage rate that lies behind the view of short-run aggregate supply is the same as the
short-run aggregate supply curve is extremely sticky Keynesian view: the money wage rate is sticky. If the
in the downward direction. Basically, the money wage economy is in recession, it will take an unnecessarily
rate does not fall. So if there is a recessionary gap, long time for it to return unaided to full employment.
there is no automatic mechanism for getting rid of
it. If it were to happen, a fall in the money wage rate Monetarist Policy The monetarist view of policy is the
would increase short-run aggregate supply and restore same as the classical view on fiscal policy. Taxes should
full employment. But the money wage rate does not be kept low to avoid disincentive effects that decrease
fall, so the economy remains stuck in recession. potential GDP. Provided that the quantity of money is
A modern version of the Keynesian view, known as kept on a steady growth path, no active stabilisation is
the new Keynesian view, holds not only that the money needed to offset changes in aggregate demand.
wage rate is sticky, but also that prices of goods and
services are sticky. With a sticky price level, the short-run
aggregate supply curve is horizontal at a fixed price level. The Way Ahead
In the chapters that follow, you are going to encounter
Policy Response Needed The Keynesian view calls Keynesian, classical and monetarist views again. In the
for fiscal policy and monetary policy to actively offset last chapter, we studied the original Keynesian model
changes in aggregate demand that bring recession. of aggregate demand. This model remains useful today
By stimulating aggregate demand in a recession, because it explains how expenditure fluctuations are
full employment can be restored. magnified and bring changes in aggregate demand
that are larger than the changes in expenditure. We
then went on to apply the AS–AD model for a deeper
The Monetarist View look at South Africa’s inflation and business cycles.
A monetarist is a macroeconomist who believes Our attention now turns to short-run
that the economy is self-regulating and that it will macroeconomic policy – the fiscal policy of the
normally operate at full employment, provided that Treasury and the monetary policy of the SARB.
monetary policy is not erratic and that the pace of
money growth is kept steady.
REVIEW QUIZ
The term ‘monetarist’ was coined by an outstanding
twentieth-century economist, Karl Brunner, to describe 1 What are the defining features of classical
his own views and those of Milton Friedman. macroeconomics and what policies do classical
The monetarist view can be interpreted in terms macroeconomists recommend?
of beliefs about the forces that determine aggregate 2 What are the defining features of Keynesian
demand and short-run aggregate supply. macroeconomics and what policies do
Keynesian macroeconomists recommend?
Aggregate Demand Fluctuations In the monetarist 3 What are the defining features of monetarist
view, the quantity of money is the most significant macroeconomics and what policies do
influence on aggregate demand. monetarist macroeconomists recommend?
The quantity of money is determined by the
central bank (the South African Reserve Bank – SARB). To complete your study of the AS–AD model,
If the SARB keeps money growing at a steady pace, Reading Between the Lines on pp. 648–649 analyses the
aggregate demand fluctuations will be minimised and factors that influence South Africa’s growth and inflation
the economy will operate close to full employment. outlook from 2012 to 2014, using the AS–AD model.
‘The global uncertainties impart a downside risk to the domestic economic growth outlook, which
remains relatively subdued. The turbulence in the financial markets has caused the rand to depreciate,
but the associated risk to the inflation outlook is offset to some extent by the lower international oil
prices and depends on how sustained the depreciation
will be. Inflation is nevertheless expected to remain
within the target range over the medium term. ESSENCE OF THE STORY
‘… The Bank’s central forecast for GDP growth is more ◆ Economic growth in South Africa is still
or less unchanged since the previous MPC at 2.9 per cent low, although it is expected to increase.
for 2012 and 3.9 per cent for 2013. Growth is expected ◆ The main risk to achieving higher
to average 4.1 per cent in 2014. … However the possible growth rates in South Africa is the crisis
contagion effects from a further slowdown in Europe will experienced in Europe.
impact on domestic growth through the trade channel, ◆ The inflation outlook for South Africa is
imparting a downside risk to this forecast.’ stable.
◆ The depreciation of the rand may cause
Source: Statement of the Monetary Policy Committee 2012-05-24, issued by Gill inflationary pressures.
Marcus, Governor of the SARB. © South African Reserve Bank (www.resbank.co.za).
ECONOMIC ANALYSIS ◆ The article further explores the factors that might
impact on inflation.
◆ The South African economy recovered to positive ◆ The depreciation of the currency is seen as the
growth rates after the recession experienced at main threat to inflation.
the end of 2009 and beginning of 2010. ◆ In the chapter we showed that a depreciation of the
◆ The growth rate was still low in 2012, but is currency means that South African products are
expected to increase over the next two years. cheaper and that this results in an increase in exports.
◆ The main threat to growth in South Africa is ◆ The increase in exports causes the AD curve to
caused by the instability experienced in Europe. shift rightward (see Figure 2).
◆ Why does Europe influence growth in South ◆ Additionally, the depreciation of the currency
Africa? The article highlights that the influence influences the cost of production, since inputs
is via the ‘trade channel’. in the production process that are imported, are
◆ This implies that South African exports to now more expensive. This causes the short-run
Europe are lower because of the crisis, (because AS curve to move to the left (see Fig. 2).
Europeans have less disposable income during ◆ The influence on price levels in the economy
the crisis) which is equivalent to a leftward shift due to a depreciation of the rand is illustrated
of the AD curve in South Africa (see Figure 1). in Fig. 2.
SRAS 0 SRAS 1
SRAS 0
120 125
110 110
AD2
AD0
AD1 AD1
Figure 1 Declining exports in the AS–AD model Figure 2 The influence of a depreciating currency
Figure 1 Declining exports in the AS–AD model Figure 2 The
in influence
the AS–ADofmodel
a depreciating currency in the
AS–AD model
Key Terms
Above full-employment Fiscal policy, 638 Long-run macroeconomic Recessionary gap, 643
equilibrium, 642 Full-employment equilibrium, 640 Short-run aggregate
Aggregate demand, 636 equilibrium, 642 Monetarist, 647 supply, 633
Below full-employment Inflationary gap, 642 Monetary policy, 638 Short-run macroeconomic
equilibrium, 643 Keynesian, 646 New classical, 646 equilibrium, 640
Classical, 646 Long-run aggregate New Keynesian, 647 Stagflation, 645
Disposable income, 638 supply, 632 Output gap, 642
5. The South African Reserve Bank (SARB) cuts the 10. Some events change aggregate demand from AD0
quantity of money and all other things remain the to AD1 and aggregate supply from SAS0 to SAS1.
same. Explain the effect of the cut in the quantity What is the new macroeconomic equilibrium?
of money on aggregate demand in the short run.
6. Mozambique trades with South Africa. Explain Use the following data to work out Problems 11 to 13.
the effect of each of the following events on the
quantity of real GDP demanded and aggregate The following events have occurred in the history of
demand in Mozambique. South Africa:
◆ South Africa goes into a recession. ◆ A deep recession hits the world economy.
◆ The price level in Mozambique rises. ◆ The world oil price rises sharply.
◆ Mozambique increases the quantity of money. ◆ South African businesses expect future
7. Explain how an increase in demand for durable profits to fall.
goods, a decrease in new home sales and a 11. Explain for each event whether it changes
decrease in exports each influence South African short-run aggregate supply, long-run aggregate
aggregate demand. supply, aggregate demand, or some combination
of them.
Explaining Macroeconomic Trends and 12. Explain the separate effects of each event on
Fluctuations South African real GDP and the price level,
Use the following graph to work out Problems 8 to 10. starting from a position of long-run equilibrium.
Initially, the short-run aggregate supply curve is SAS0 13. Explain the combined effects of these events
and the aggregate demand curve is AD0. on South African real GDP and the price level,
starting from a position of long-run equilibrium.
Price level
LAS SAS 1
Use the following data to work out Problems 14 and 15.
115 SAS 0
Use the following information to work out Problems 29. Explain the effect of a rise in consumption
27 and 28. In Japan, potential GDP is 600 trillion expenditure on real GDP and the price level in
yen and the table shows the aggregate demand and the short run.
short-run aggregate supply schedules. 30. If the economy had been operating at full-
employment equilibrium:
Price Real GDP demanded Real GDP supplied in a. Describe the macroeconomic equilibrium
level the short run after a rise in consumer spending.
(trillions of 2012 yen) b. Explain and draw a graph to illustrate how
the economy can adjust in the long run to
75 600 400
restore full-employment equilibrium.
85 550 450 31. Why do changes in consumer spending play a
95 500 500 large role in the business cycle?
32. Explain and draw a graph to illustrate how
105 450 550
inflation and inflation expectations ‘become
115 400 600
self-fulfilling’.
125 350 650
135 300 700 Macroeconomic Schools of Thought
33. In times of economic crises, it is accepted
27. a. Draw a graph of the aggregate demand curve policy to stimulate aggregate demand. From
and the short-run aggregate supply curve. the government’s side this can be done either
b. What is the short-run equilibrium real GDP by increasing government expenditure or by
and price level? decreasing taxes. Economists from which
28. Does Japan have an inflationary gap or a macroeconomic school of thought would
recessionary gap and what is its magnitude? recommend a second spending stimulus and
which a permanent tax cut?
29
ack in the 1970s, when inflation was raging at a double-digit rate
in most economies of the world, economist Arthur M. Okun proposed
what he called the ‘misery index’. Misery, he suggested, could be
measured as the sum of the inflation rate and the unemployment rate.
At its peak, in 1980, the misery index hit 22 in the United States. At its
lowest, in 1953, the misery index was 3 in the US.
Inflation and unemployment make us miserable for good reasons.
We care about inflation because it raises
LAS LAS
Price level (GDP deflator, 2005 = 100)
Price level (GDP deflator, 2005 = 100)
113 113
110 110
0 1.20 1.25 1.30 1.35 1.40 1.45 0 1.20 1.25 1.30 1.35 1.40 1.45
Real GDP (trillions of 2005 rand) Real GDP (trillions of 2005 rand)
(a) Initial effect (b) The money wage adjusts
In part (a), the aggregate demand curve is AD0, the short-run In part (b), starting from the above full-employment
aggregate supply curve is SAS0 and the long-run aggregate equilibrium, the money wage rate begins to rise and the
supply curve is LAS. The price level is 110 and real GDP is short-run aggregate supply curve shifts leftward toward
R1.3 trillion, which equals potential GDP. Aggregate demand SAS1. The price level rises further and real GDP returns to
increases to AD1. The price level rises to 113 and real GDP potential GDP.
increases to R1.35 trillion.
Money Wage Rate Response Real GDP to AD2. The price level rises further to 125 and real
cannot remain above potential GDP forever. With GDP again exceeds potential GDP at R1.35 trillion.
unemployment below its natural rate, there is a Yet again, the money wage rate rises and decreases
shortage of labour. In this situation, the money wage short-run aggregate supply. The SAS curve shifts
rate begins to rise. As it does so, short-run aggregate to SAS2 and the price level rises further, to 133. As
supply decreases and the SAS curve starts to shift the quantity of money continues to grow, aggregate
leftward. The price level rises further and real GDP demand increases and the price level rises in an
begins to decrease. ongoing demand-pull inflation process.
With no further change in aggregate demand – The process you have just studied generates
that is, the aggregate demand curve remains at AD1 – inflation, an ongoing process of a rising price level.
this process ends when the short-run aggregate supply
curve has shifted to SAS1 in Fig. 29.1(b). At this time,
the price level has increased to 121 and real GDP has FIGURE 29.2 A Demand-Pull Inflation Spiral
returned to potential GDP of R1.3 trillion, the level LAS
and the beverage plant finds it hard to hang on to its best At a given price level, the higher the cost of
people. To do so, it offers a higher money wage rate. As production, the smaller is the amount that firms
the wage rate rises, so do the beverage plant’s costs. are willing to produce. So if the money wage rate
What happens next depends on aggregate rises or if the prices of raw materials (for example,
demand. If aggregate demand remains constant, the oil) rise, firms decrease their supply of goods and
firm’s costs increase but the price of beverages do not services. Aggregate supply decreases and the short-run
increase as quickly as its costs. In this case, the firm aggregate supply curve shifts leftward.1 Let us trace
cuts production. Eventually, the money wage rate and the effects of such a decrease in short-run aggregate
costs increase by the same percentage as the rise in the supply on the price level and real GDP.
price of beverages. In real terms, the bottling plant
is in the same situation as it was initially. It produces Initial Effect of a Decrease in Aggregate Supply
the same amount of beverages and employs the same Suppose that last year the price level was 110 and real
amount of labour as before the increase in demand. GDP was R1.3 trillion. Potential real GDP was also
But if aggregate demand continues to increase, so R1.3 trillion. Figure 29.3(a) illustrates this situation.
does the demand for beverages and the price of beverages The aggregate demand curve was AD0, the short-run
rises at the same rate as wages. The beverage-bottling plant aggregate supply curve was SAS0 and the long-run
continues to operate at above full employment and there is aggregate supply curve was LAS. In the current year, the
a persistent shortage of labour. Prices and wages chase each world’s oil producers form a price-fixing organisation
other upward in a demand-pull inflation spiral. that strengthens their market power and increases the
relative price of oil. They raise the price of oil, which
Demand-Pull Inflation in South Africa A demand- causes input cost in all production processes to increase,
pull inflation like the one you have just studied and this action therefore decreases short-run aggregate
occurred in South Africa during the late 1960s and supply for the economy as a whole. The short-run
early 1970s. In 1963, inflation was a low 1.4 per cent aggregate supply curve shifts leftward to SAS1. The
a year, but its rate increased slowly to 5.7 per cent price level rises to 117 and real GDP decreases to
by 1970. High economic growth rates in the 1960s R1.25 trillion. The economy is at a below full-
caused aggregate demand to increase more rapidly. employment equilibrium and there is a recessionary gap.
Consequently, the rightward shift of the aggregate This event is a one-time rise in the price level. It
demand curve speeded up and the price level increased is not inflation. In fact, a supply shock on its own
more quickly. Real GDP moved above potential GDP cannot cause inflation. Something more must happen
and the unemployment rate fell to its lowest level ever to enable a one-time supply shock, which causes a
in South Africa (between 9 and 10 per cent). one-time rise in the price level, to be converted into a
With unemployment below its natural rate, the process of ongoing inflation. The quantity of money
money wage rate started to rise more quickly and the must persistently increase. Sometimes it does increase,
short-run aggregate supply curve shifted leftward. The as you will now see.
Reserve Bank responded with a further increase in the
money growth rate and a demand-pull inflation spiral Aggregate Demand Response When real GDP
unfolded. By 1975, the inflation rate had reached decreases, unemployment rises above its natural rate.
12.5 per cent a year. In such a situation, there is often an outcry of concern
Next, let us see how shocks to aggregate supply and a call for action to restore full employment.
can create cost-push inflation. Suppose that the Reserve Bank cuts the interest rate
and increases the quantity of money. Aggregate demand
increases. In Fig. 29.3(b), the aggregate demand
Cost-Push Inflation curve shifts rightward to AD1 and full employment is
Inflation that is kicked-off by an increase in costs is restored. But the price level rises further to 121.
called cost-push inflation. The two main sources of cost
1 Some cost-push forces, such as an increase in the price of oil accompanied
increases are: by a decrease in the availability of oil, can also decrease long-run
1. An increase in the money wage rate aggregate supply. We will ignore such effects here and examine cost-push
factors that change only short-run aggregate supply. Later in the chapter, we
2. An increase in the money prices of raw materials study the effects of shocks to long-run aggregate supply.
FIGURE 29.3 A Cost-Push Rise in the Price Level A Cost-Push Inflation Process The oil producers
now see the prices of everything they buy increasing,
LAS so oil producers increase theLAS price of oil again to
Price level (GDP deflator, 2005 = 100)
SAS1
AD to restore full SAS1 price, the economy remains below full employment.
130 employment and the
price level rises again
SAS0 SAS0
FIGURE 29.4 A Cost-Push Inflation Spiral
121
LAS
Price level (GDP deflator, 2005 = 100)
SAS2
117
133
129 SAS1
110
AD 1
121
100 SAS0
117
AD 0 AD 0
AD 2
1.40 1.45 0 1.20 1.25 1.30 1.35 1.40 1.45 110
(trillions of 2005 rand) Real GDP (trillions of 2005 rand) AD 0 AD 1
(b) The Reserve Bank responds Oil producers and
(b) The SARB responds 100
the SARB feed a cost-
Initially, the aggregate demand curve is AD0, the short-run push inflation spiral
If the Reserve Bank increases the quantity of money rates only affects the economy with a considerable time
to restore full employment, it invites another oil price lag, and the result was a huge increase in the inflation
hike that will call forth yet a further increase in the rate of South Africa from 2006 to 2008. By 2008, the
quantity of money. growth in the money supply slowed down and so did
If the Reserve Bank responds to each oil price the inflation rate.
hike by increasing the quantity of money, inflation
will rage along at a rate decided by oil producers. But
if the Reserve Bank keeps the lid on money growth,
Expected Inflation
the economy remains below full employment. If inflation is expected, the fluctuations in real GDP
that accompany demand-pull and cost-push inflation
Cost-Push Inflation in Midrand What is going that you have just studied do not occur. Instead,
on in the Midrand beverage-bottling plant when the inflation proceeds as it does in the long run, with real
economy is experiencing cost-push inflation? GDP equal to potential GDP and unemployment at
When the oil price increases, so do the costs its natural rate. Figure 29.5 explains why.
of bottling beverages. These higher costs decrease Suppose that last year the aggregate demand
the supply of beverages, increasing their price and curve was AD0, the aggregate supply curve was SAS0
decreasing the quantity produced. The bottling plant and the long-run aggregate supply curve was LAS. The
lays off some workers. price level was 110 and real GDP was R1.3 trillion,
This situation persists until either the Reserve which is also potential GDP.
Bank increases aggregate demand or the price of oil To keep things as simple as possible, suppose that
falls. If the Reserve Bank increases aggregate demand, potential GDP does not change, so the LAS curve
the demand for beverages increases and so does its does not shift. Also suppose that aggregate demand is
price. The higher price of beverages brings higher expected to increase to AD1.
profits and the bottling plant increases its production. In anticipation of this increase in aggregate
The plant rehires the laid-off workers. demand, the money wage rate rises and the short-run
aggregate supply curve shifts leftward. If the money
Cost-Push Inflation in South Africa Cost-push wage rate rises by the same percentage as the price
inflation like the one you have just studied occurred level is expected to rise, the short-run aggregate supply
in South Africa during the 1970s and during recent curve for next year is SAS1.
inflationary pressures from 2006 to 2008. The first oil If aggregate demand turns out to be the same
crisis began in 1974 when OPEC raised the price of as expected, the aggregate demand curve is AD1.
oil fourfold. The higher oil price decreased aggregate The short-run aggregate supply curve, SAS1 and AD1
supply, which caused the price level to rise more determine the actual price level at 121. Between last
quickly and real GDP to shrink. The Reserve Bank year and this year, the price level increased from 110
then faced a dilemma: Would it increase the quantity to 121 and the economy experienced an inflation rate
of money and accommodate the cost-push forces, or equal to that expected. If this inflation is ongoing,
would it keep aggregate demand growth in check by aggregate demand increases (as expected) in the
limiting money growth? In 1974 and 1975, the Reserve following year and the aggregate demand curve shifts
Bank allowed the quantity of money to grow quickly to AD2. The money wage rate rises to reflect the
and inflation proceeded at a rapid rate. In 1976 money expected inflation and the short-run aggregate supply
growth slowed down and so did the inflation rate. In curve shifts to SAS2. The price level rises, as expected,
1980, OPEC was again able to push oil prices higher. to 133.
On that occasion, the Reserve Bank again allowed the What caused this inflation? The immediate
quantity of money to grow rapidly and high inflation answer is that because people expected inflation,
rates quickly returned to South Africa. Even during the money wage rate increased and the price level
the last oil price crisis (2006–2008), the South African increased. But the expectation was correct. Aggregate
Reserve Bank could not succeed in curtailing growth in demand was expected to increase and it did increase.
the quantity of money in time. Although the Reserve It is the actual and expected increase in aggregate
Bank increased the interest rate, the increase in interest demand that caused the inflation.
An expected inflation at full employment is its short-run effects show why the quantity theory of
exactly the process that the quantity theory of money money does not explain the fluctuations in inflation.
predicts. To review the quantity theory of money, see The economy follows the course described in
Chapter 25, pp. 563–565. Fig. 29.5, but as predicted by the quantity theory,
This broader account of the inflation process and only if aggregate demand growth is forecasted correctly.
SAS2
133 was SAS0. The actual price level was the same as the
SAS1 expected price level: 110. This year, aggregate demand is
expected to increase to AD1 and the price level is expected to
rise from 110 to 121. As a result, the money wage rate rises
121
SAS0 and the short-run aggregate supply curve shifts to SAS1. If
aggregate demand actually increases as expected, the actual
AD 2 aggregate demand curve AD1 is the same as the expected
110 aggregate demand curve. Real GDP is R1.3 trillion and the
Anticipated increases actual price level rises to 121. The inflation is expected.
in AD bring inflation
AD 1 Next year, the process continues with aggregate demand
but no change in
real GDP AD 0 increasing as expected to AD2 and the money wage rate
rising to shift the short-run aggregate supply curve to SAS2.
0 1.20 1.25 1.30 1.35 1.40 1.45 Again, real GDP remains at R1.3 trillion and the price level
Real GDP (trillions of 2005 rand)
rises, as expected, to 133.
Inflation and Unemployment: case, there is movement down along the short-run
The Phillips Curve Phillips curve from point A to point C.
The short-run Phillips curve is like the short-run
Another way of studying inflation cycles focuses on aggregate supply curve. A movement along the SAS
the relationship and the short-run trade-off between curve that brings a higher price level and an increase
inflation and unemployment, a relationship called the in real GDP is equivalent to a movement along the
Phillips curve – so named because it was first suggested short-run Phillips curve from A to B that brings an
by New Zealand economist A.W. Phillips. increase in the inflation rate and a decrease in the
Why do we need another way of studying unemployment rate.
inflation? What is wrong with the AS–AD explanation Similarly, a movement along the SAS curve
of the fluctuations in inflation and real GDP? The that brings a lower price level and a decrease in
first answer to both questions is that we often want real GDP is equivalent to a movement along the
to study changes in both the expected and actual short-run Phillips curve from A to C that brings a
inflation rates and for this purpose, the Phillips curve decrease in the inflation rate and an increase in the
provides a simpler tool and clearer insights than the unemployment rate.
AS–AD model provides. The second answer to both
questions is that we often want to study changes in
the short-run trade-off between inflation and real FIGURE 29.6 A Short-Run Phillips Curve
economic activity (real GDP and unemployment) and
again, the Phillips curve serves this purpose well.
To begin our explanation of the Phillips curve,
Inflation rate (per cent per year)
20
we distinguish between two time frames (similar to
the two aggregate supply time frames). We study:
◆ The short-run Phillips curve 15
◆ The long-run Phillips curve Expected
B
inflation
rate
A
10
The Short-Run Phillips Curve
C
The short-run Phillips curve shows the relationship
SRPC
between inflation and unemployment, holding 5
constant: Natural
unemployment
1. The expected inflation rate rate
2. The natural unemployment rate
0 3 6 9 12
Unemployment rate (percentage of labour force)
You have just seen what determines the expected
inflation rate. The natural unemployment rate and the
factors that influence it are explained in Chapter 22, The short-run Phillips curve (SRPC) shows the relationship
pp. 483–485. between inflation and unemployment at a given expected
Figure 29.6 shows a short-run Phillips curve, inflation rate and a given natural unemployment rate. With an
SRPC. Suppose that the expected inflation rate is expected inflation rate of 10 per cent a year and a natural
10 per cent a year and the natural unemployment rate unemployment rate of 6 per cent, the short-run Phillips curve
is 6 per cent, point A in the figure. A short-run Phillips passes through point A.
curve passes through this point. If inflation rises above An unexpected increase in aggregate demand lowers
its expected rate, unemployment falls below its natural unemployment and increases the inflation rate – a movement
rate. This joint movement in the inflation rate and up along the short-run Phillips curve to point B.
the unemployment rate is illustrated as a movement An unexpected decrease in aggregate demand increases
up along the short-run Phillips curve from point A to unemployment and lowers the inflation rate – a movement
point B. Similarly, if inflation falls below its expected down along the short-run Phillips curve to point C.
rate, unemployment rises above its natural rate. In this
FIGURE 29.7 Short-Run and Long-Run Phillips FIGURE 29.8 A Change in the Natural
Curves Unemployment Rate
Inflation rate (per cent per year)
20 20 LRPC0 LRPC1
LRPC
Decrease in expected
15 inflation shifts short-run 15
Phillips curve downward
A A E
10 10
SRPC 1
Increase in natural
6 SRPC 0 SRPC 0
D unemployment rate
5 shifts LRPC and
SRPC rightward
SRPC 1
0 3 6 9 12 0 3 6 9 12
Unemployment rate (percentage of labour force) Unemployment rate (percentage of labour force)
The long-run Phillips curve is LRPC. A fall in expected inflation from A change in the natural unemployment rate shifts both the
10 per cent a year to 6 per cent a year shifts the short-run Phillips short-run and long-run Phillips curves. An increase in the
curve downward from SRPC0 to SRPC1. The long-run Phillips curve natural unemployment rate from 6 per cent to 9 per cent shifts
does not shift. The new short-run Phillips curve intersects the long-run the Phillips curves rightward to SRPC1 and LRPC1. The new
Phillips curve at the new expected inflation rate – point D. long-run Phillips curve intersects the new short-run Phillips curve
at the expected inflation rate – point E.
The US Phillips Curve of 5 per cent and an expected inflation rate of 6 per
cent a year (point B).
The Shifting Short-Run Trade-Off During the late 1970s, the natural
Figure 1 is a scatter diagram of the US inflation rate unemployment rate increased to 8 per cent (point C )
(measured by the GDP deflator) and the unemployment and the short-run Phillips curve shifted to SRPC2.
rate since 1961. We can interpret the data in terms of the Briefly in 1975 and again in 1981, the expected
shifting short-run Phillips curve in Figure 2. inflation rate surged to 9 per cent a year (point D)
During the 1960s, the short-run Phillips curve and the short-run Phillips curve shifted to SRPC3.
was SRPC0, with a natural unemployment rate of During the 1980s and 1990s, the expected
4.5 per cent and an expected inflation rate of 2 per inflation rate and the natural unemployment rate
cent a year (point A). decreased and the short-run Phillips curve shifted
During the early 1970s, the short-run Phillips leftward back to SRPC1 and, by the mid-1990s, back
curve was SRPC1, with a natural unemployment rate to SRPC0, where it remained into the 2000s.
Inflation rate (per cent per year)
Inflation rate (per cent per year)
89 72 68 89 72 84
68 84 4 83
4 91 83 05 91
05 90 06 90
06 85
67 87 67 07
07 08 04 85 66 04 87
01 08 03 93
66 03 93 92 00 96 92 SRPC1
96
2 00 01 94 86 2 A 94 86
99 99 97 09 10
9764 09 61
61 64
98 63 10 98 63
SRPC0
Figure11Phillips
Figure Phillips Curve
Curve Data
Data in in
the the United
United The Time SequenceFigure
States:
States: 2 The
Figure Shifting
2 The Phillips
Shifting Curves
Phillips Curves
The Time Sequence
Source of data: Bureau of Labour Statistics.
100 A
AD0 AD1
In a business cycle expansion, potential GDP increases and the LAS curve shifts rightward from
LAS0 to LAS1. A greater than expected increase in aggregate demand brings inflation.
If the aggregate demand curve shifts to AD1, the economy remains at full employment. If the
aggregate demand curve shifts to AD2, a recessionary gap arises. If the aggregate demand
curve shifts to AD3, an inflationary gap arises.
Real GDP
6 growth
–2
Productivity
growth
–4
1964 1969 1974 1979 1984 1989 1994 1999 2004 2009
Year
The real business cycle is caused by changes in technology that bring fluctuations in the growth rate of
productivity*. Productivity fluctuations are correlated with real GDP fluctuations and most recessions are
associated with a slowdown in productivity growth. The 2008–2009 recession is an exception and
occurred at a time when productivity growth increased.
*Productivity growth calculations are based on assumptions about the aggregate production function.
Source of data: Bureau of Economic Analysis.
Before we can determine the new level of RBC theory says that workers behave like you.
employment and real wage rate, we need to take a ripple They work fewer hours, sometimes zero hours, when
effect into account – the key effect in RBC theory. the real wage rate is temporarily low and they work
more hours when the real wage rate is temporarily
The Key Decision: When to Work? According to high. But to properly compare the current wage rate
RBC theory, people decide when to work by doing with the expected future wage rate, workers must use
a cost-benefit calculation. They compare the return the real interest rate. If the real interest rate is 6 per
from working in the current period with the expected cent a year, a real wage of R10 an hour earned this
return from working in a later period. You make such week will become R10.60 a year from now. If the
a comparison every day in school. Suppose your goal real wage rate is expected to be R10.50 an hour next
in this module is to get an A. To achieve this goal, year, today’s real wage of R10 looks good. By working
you work hard most of the time. But during the longer hours now and shorter hours a year from now,
few days before the final exams, you work especially a person can get a 1 per cent higher real wage. But
hard. Why? Because you believe that the return from suppose the real interest rate is 4 per cent a year. In
studying close to the exam is greater than the return this case, R10 earned now is worth R10.40 next year.
from studying when the exam is a long time away. So Working fewer hours now and more next year is the
during the term, you take time off for the movies and way to get a 1 per cent higher real wage.
other leisure pursuits, but at exam time, you study So the when-to-work decision depends on the
every evening and weekend. real interest rate. The lower the real interest rate,
FIGURE 29.11 Loanable Funds and Labour Markets in a Real Business Cycle
Real wage rate (2005 rand per hour)
Real interest rate (per cent per year)
(a) Loanable funds and interest rate (b) Labour and wage rate
In part (a), the supply of loanable funds SLF and initial the demand for labour decrease. The two demand curves
demand for loanable funds DLF0 determine the real interest shift leftward to DLF1 and LD1. In part (a), the real interest
rate at 6 per cent a year. In part (b), the initial demand for rate falls to 4 per cent a year. In part (b), the fall in the real
labour LD0 and supply of labour, LS0, determine the real interest rate decreases the supply of labour (the when-to-work
wage rate at R35 an hour and employment at 20 billion decision) and the supply of labour curve shifts leftward to
hours. A technological change temporarily decreases LS1. Employment decreases to 19.5 billion hours and the real
productivity and both the demand for loanable funds and wage rate falls to R34.50 an hour. A recession is under way.
other things remaining the same, the smaller is the rate changes; and (3) productivity shocks are as likely
supply of labour today. Many economists believe this to be caused by changes in aggregate demand as by
intertemporal substitution effect to be of negligible size. technological change.
RBC theorists believe that the effect is large and it is If aggregate demand fluctuations cause the
the key feature of the RBC mechanism. fluctuations in productivity, then the traditional
You saw in Fig. 29.11(a) that the decrease in the aggregate demand theories are needed to explain
demand for loanable funds lowers the real interest them. Fluctuations in productivity do not cause the
rate. This fall in the real interest rate lowers the return business cycle but are then rather caused by it.
to current work and decreases the supply of labour. Building on this theme, the critics point out that
In Fig. 29.11(b), the labour supply curve the so-called productivity fluctuations that growth
shifts leftward to LS1. The effect of the decrease in accounting measures are correlated with changes in
productivity on the demand for labour is larger than the growth rate of money and other indicators of
the effect of the fall in the real interest rate on the changes in aggregate demand.
supply of labour. That is, the demand curve shifts The defenders of RBC theory claim that the theory
farther leftward than does the supply curve. As a explains the macroeconomic facts about the business
result, the real wage rate falls to R34.50 an hour cycle and is consistent with the facts about economic
and employment decreases to 19.5 billion hours. growth. In effect, a single theory explains both growth
A recession has begun and is intensifying. and the business cycle. The growth accounting exercise
that explains slowly changing trends also explains the
What Happened to Money? The name real business more frequent business cycle swings. Its defenders
cycle theory is no accident. It reflects the central also claim that RBC theory is consistent with a wide
prediction of the theory. Real things, not nominal range of microeconomic evidence about labour supply
or monetary things, cause the business cycle. If the decisions, labour demand and investment demand
quantity of money changes, aggregate demand changes. decisions and information on the distribution of
But if there is no real change – with no change in the income between labour and capital.
use of resources and no change in potential GDP – the
change in the quantity of money changes only the price
level. In RBC theory, this outcome occurs because the REVIEW QUIZ
aggregate supply curve is the LAS curve, which pins 1 Explain the mainstream theory of the
real GDP down at potential GDP, so when aggregate business cycle.
demand changes, only the price level changes. 2 What are the four special forms of the
mainstream theory of the business cycle
Cycles and Growth The shock that drives the and how do they differ?
business cycle of RBC theory is the same as the force 3 According to RBC theory, what is the source
that generates economic growth: technological change. of the business cycle? What is the role of
On average, as technology advances, productivity fluctuations in the rate of technological change?
grows; but as you saw in Fig. 29.10, it grows at 4 According to RBC theory, how does a fall
an uneven pace. Economic growth arises from the in productivity growth influence investment
upward trend in productivity growth and, according demand, the market for loanable funds, the
to RBC theory; the mostly positive but occasionally real interest rate, the demand for labour, the
negative higher frequency shocks to productivity bring supply of labour, employment and the real
the business cycle. wage rate?
5 What are the main criticisms of RBC theory
Criticisms and Defences of RBC Theory The three and how do its supporters defend it?
main criticisms of RBC theory are that (1) the money
wage rate is sticky and to assume otherwise is at odds You can complete your study of economic
with a clear fact; (2) intertemporal substitution is fluctuations in Reading Between the Lines on
too weak a force to account for large fluctuations in pp. 668– 669, which looks at the shifting inflation–
labour supply and employment with small real wage unemployment trade-off and misery index in Namibia.
‘Namibia is the sixth most miserable country in the world because of its high unemployment and
inflation rates, according to an index published worldwide yesterday. Namibia is worse off than
countries like Iran, the Gaza Strip, Bosnia and Herzegovina and Haiti.
‘The 2012 Misery Index rated Zimbabwe as the world’s most miserable country. … The Misery
Index, invented by America economist Arthur Okun, works on the assumption that an increasing
unemployment rate and a relatively high inflation rate negatively impacts on economic growth.
‘Namibia’s score in the 2012 Misery Index is 56.5 per cent – the sum of its unemployment rate of 51.2
per cent and an inflation rate of 5.3 per cent as
stated in the CIA Factbook. Zimbabwe scored
100.6 per cent with its unemployment rate of 95 ESSENCE OF THE STORY
per cent and its inflation rate of 5.6 per cent. ◆ The Misery Index is the sum of the unemployment
rate and inflation rate of a country.
‘Other African countries are Liberia in second ◆ Africa, in particular, fared poorly on the Misery
place with 95 per cent …; Burkina Faso third Index 2011.
with 80.6 per cent …; Djibouti fifth with 66 per ◆ Namibia’s score is surprisingly high at 56.5 per cent.
cent …; and Lesotho with 52.2 per cent … .’ ◆ This is mainly attributed to the high unemployment
Source: © The Namibian. rate of 51.2 per cent in the country.
ECONOMIC ANALYSIS
◆ Namibia gained independence from South Africa
in 1990.
◆ Figure 1 illustrates the Misery Index for Namibia
since its independence.
◆ In 1991, the Misery Index for Namibia was 60 Misery index
23.6 per cent, which was the sum of an Inflation rate
Percentage and index number
◆ Since the year 2000, the main concern for the ◆ With a volatile inflation rate and an increasing
Namibian government has shifted from inflation unemployment rate, the policy options for the
to unemployment. Namibian government are not easy.
◆ From Fig. 1 it is evident that the unemployment ◆ In terms of the Phillips curve, there seems to
rate in Namibia has spiralled out of control to have been a real loss in employment in efforts to
reach 51.2 per cent during 2011. control inflation in the country.
Key Terms
Cost-push inflation, 656 Monetarist cycle theory, New Keynesian cycle Real business cycle
Demand-pull inflation, 654 664 theory, 664 theory, 664
Keynesian cycle theory, 664 New classical cycle Phillips curve, 660 Short-run Phillips curve, 660
Long-run Phillips curve, 661 theory, 664 Rational expectation, 659 Stagflation, 657
LAS SAS2
SAS1 inflation proceeds.
240
SAS0
5. Suppose that people expect deflation (a falling
200
price level), but aggregate demand remains
160 at AD0.
120
a. What happens to the short-run and long-run
aggregate supply curves? (Draw some new
80 AD2 curves if you need to.)
AD1 b. Describe the initial effects of an expected
AD0 deflation.
0 0.8 1.0 1.2 1.4 c. Describe what happens as it becomes
Real GDP (trillions of 2005 rand)
obvious to everyone that the expected
2. Some events occur and the economy experiences deflation is not going to occur.
a demand-pull inflation.
a. List the events that might cause a demand- Use the following info byte to work out Problems 6 to 8.
pull inflation.
b. Describe the initial effects of a demand-pull The Cost of Growth
inflation. Most economies can only wish for double-digit growth
c. Describe what happens as a demand-pull figures, such as China’s 11 per cent and more. But
inflation spiral proceeds. the inflation rate in China has more than doubled,
3. Some events occur and the economy experiences a problem most economies would not like to have.
a cost-push inflation.
The continued strong aggregate demand in China is Advisors have warned of possible social unrest as
supported by an investment boom and ever-increasing inflation is at 10 per cent and unemployment at
trade surplus. Production struggles to meet this demand 14 per cent.
and production bottlenecks are a growing problem. a. If Iran removes the subsidies and consumers
6. Is China experiencing demand-pull or cost-push do not know what the higher prices will be,
inflation? Explain. draw a graph to show the most likely path of
7. Draw a graph to illustrate the initial rise in the inflation and unemployment.
price level and the money wage rate response to a b. If Iran removes the subsidies and announces
one-time rise in the price level. the new prices so that consumers know what
8. Draw a graph to illustrate and explain how China they are, draw a graph to show the most
might experience an inflation spiral. likely path of inflation and unemployment.
13. Depression or Recession?
Use the following info byte to work out Problems 9 to 11. The US Great Depression of the 1930s saw huge
job losses and stagnation. The 2008 recession saw
Food and Energy Shocks only minimal job losses and no stagnation.
Producers bear the brunt of relative price shocks as a. Can the inflation and unemployment
global competition makes it difficult for them to pass trends during the Great Depression be
the higher costs on to consumers. Fortunately, higher explained by a movement along a short-run
input costs can be offset by higher labour productivity. Phillips curve?
Should the central bank intervene or allow a natural b. Can the inflation and unemployment trends
cycle where a growth slowdown follows on high infla- during 2008 be explained by a movement
tion? The major problem is that if consumers lose along a short-run Phillips curve?
hope of a price slowdown, then their inflation expec- 14. High Expectations
tations might just become reality. The central bank predicts a continued drop in the
9. a. Explain the two types of inflation described unemployment rate over the next two or three years.
in this info byte. Economists agree but warn that the unemployment
b. Explain why rising labour productivity can rate is still too high and will only reach acceptable
neutralise the effect on inflation of higher levels in five years time. Inflation should remain
input costs. fairly low if expectations can be managed.
10. Explain how slowing growth can reduce Is the central bank predicting that the economy
inflationary pressure. will move rightward or leftward along a short-run
11. Draw a graph to illustrate and explain how growing Phillips curve or that the short run Phillips curve
inflation expectations may become self-fulfilling. will shift up or down? Explain.
Inflation and Unemployment: The Phillips Curve Use the following information to work out Problems
Use the following information to work out Problems 24 and 25.
18 and 19.
Because the US Central Bank doubled the monetary
The Reserve Bank of New Zealand signed an base in 2008 and the government spent billions
agreement with the New Zealand government in of dollars bailing out troubled banks, insurance
which the Bank agreed to maintain inflation inside a companies and motor vehicle producers, some people
low target range. Failure to achieve the target would are concerned that a serious upturn in the inflation
result in the governor of the Bank losing his job. rate will occur, not immediately but in a few years’
18. Explain how this arrangement might have time. At the same time, massive changes in the global
influenced New Zealand’s short-run Phillips curve. economy might bring the need for structural change
19. Explain how this arrangement might have in the United States.
influenced New Zealand’s long-run Phillips curve. 24. Explain how the US Central Bank’s doubling of
the monetary base and government bailouts might
Use the following information to work out Problems influence the short-run and long-run unemployment–
20 and 21. inflation trade-offs. Will the influence come from
changes in the expected inflation rate, the natural
An economy has an unemployment rate of 4 per cent unemployment rate, or both?
and an inflation rate of 5 per cent a year at point A in 25. Explain how large-scale structural change might
the figure. influence the short-run and long-run unemployment–
inflation trade-offs. Will the influence come from
changes in the expected inflation rate, the natural
Inflation rate (per cent per year)
Boom and Bust aggregate supply. And you have learned about the
key sources of fluctuations in aggregate demand and
To cure a disease, doctors must first understand how aggregate supply.
the disease responds to different treatments. It helps to The AS–AD model explains the forces that
understand the mechanisms that operate to cause the determine real GDP and the price level in the
disease, but sometimes a workable cure can be found short run. The model also enables us to see the big
even before the full story of the causes has been told. picture or grand vision of the different schools of
Curing economic ills is similar to curing our macroeconomic thought concerning the sources
medical ills. We need to understand how the economy of aggregate fluctuations. The Keynesian aggregate
responds to the treatments we might prescribe for it. expenditure model provides an account of the factors
And sometimes, we want to try a cure even though we that determine aggregate demand and make it
do not fully understand the reasons for the problem fluctuate.
we are trying to control. An alternative real business cycle theory puts all
You have seen how the pace of capital the emphasis on fluctuations in long-run aggregate
accumulation and technological change determine supply. According to this theory, money changes
the long-term growth trend. You have learned how aggregate demand and the price level but leaves the
fluctuations around the long-term trend can be real economy untouched. The events of 2008 and
generated by changes in aggregate demand and 2009 will provide a powerful test of this theory.
John Maynard Keynes, born in England in 1883, Keynes’ book, The General Theory of
was one of the outstanding minds of the twentieth Employment, Interest and Money, written during
century. He represented Britain at the Versailles the Great Depression and published in 1936,
peace conference at the end of World War I, was revolutionised macroeconomics.
a master speculator on international financial
markets (an activity he conducted from bed every
morning and which made and lost him several ‘The ideas of economists and
fortunes), and played a prominent role in creating political philosophers, both when
the International Monetary Fund. they are right and when they are
He was a member of the Bloomsbury Group,
wrong, are more powerful than is
a circle of outstanding artists and writers that
commonly understood. Indeed the
included E.M. Forster, Bertrand Russell and
Virginia Woolf. world is ruled by little else.’
Keynes was a controversial and quick-witted
figure. A critic once complained that Keynes had JOHN MAYNARD KEYNES
changed his opinion on some matter, to which The General Theory of Employment,
Keynes retorted: ‘When I discover I am wrong, I Interest and Money
change my mind. What do you do?’
I
30
n 2012, the national government spent 33 cents of every rand that
South Africans earned. It raised 28 of those cents in taxes and
borrowed the other 5. The government had a deficit of 5 cents on
every rand earned and a total deficit of R198 billion. The 2012 deficit
was moderate compared to other countries, but national government
deficits are not new. Aside from the two years 2007 and 2008, the
government’s budget has been in deficit every year since 1964. Deficits
FISCAL bring debts and your share of the national government’s debt is around
R3 050.
POLICY Does it matter if the government does not balance its books? What
are the effects of an ongoing government deficit and accumulating
debt? Do they slow economic growth? Do they impose a burden on
future generations – on you and your children?
What are the effects of taxes and government spending on the
economy? Does a rand spent by the government on goods and services
have the same effect as a rand spent by someone else? Does it create
jobs, or does it destroy them?
These are the fiscal policy issues that you will study in this chapter.
In Reading Between the Lines at the end of the chapter, we look at fiscal
policy ideas to create jobs and boost real GDP in South Africa in the
national budget 2012.
Budget The National Budget FIGURE 30.1 The National Budget Timeline in
The national budget is an annual Fiscal 2012
statement of the expenditures and
1 April 2012 Fiscal 2012/2013 starts
receipts of the government of South
Africa together with the laws and
Early June 2012 Departments receive guidelines for and database
regulations that approve and support June – templates for the new budget year (2013/2014)
them. The national budget has two Government Departments, in cooperation with
purposes: National Treasury engage in planning processes for
the medium-term spending objectives to be included
www.quickto.mobi/
1. To finance national government in the Medium-Term Expenditure Framework (MTEF)
PEA-BUDGET
programmes and activities and September 2012
2. To achieve macroeconomic 25 October 2012 The Medium-Term Budget Policy Statement (MTBPS) is
objectives October 2012 – presented to Parliament. This contains preliminary
spending projections for the immediate next fiscal
year (2013) and the two following years. At the
The first purpose of the national budget was same time the Adjustments Estimate for the current
fiscal year (2012) is presented to Parliament
its only purpose before the Great Depression of the
Continuous process of adjusting the revenue and
1930s. The second purpose arose as a reaction to expenditure estimates for the present fiscal year
the Great Depression and the rise of the ideas of
economist John Maynard Keynes. The use of the February 2013 Continuous process of adjusting the revenue and
national budget to achieve macroeconomic objectives expenditure estimates for the present fiscal year
such as full employment, sustained economic growth Next National budget is presented to Parliament
The largest source of revenue is personal income When government according to economic
taxes, which in 2012 was expected to be R286 billion. classification is considered, the largest item
These taxes are paid by individuals on their incomes. (55.8 per cent of total expenditure) is current
The second largest source is value-added taxes. These payments. These are payments in the form
taxes are paid by consumers in South Africa. Third in of compensation of government employees,
size are corporate income taxes. These taxes are paid by purchases of goods and services by government
companies on their profits. Finally, the smallest source and interest and rent of land and buildings. In 2012,
of national receipts is what is called customs and excise this item was expected to be R560.6 billion. The
duties, and fuel levies. These taxes are on the sale of second largest component was payments in the
fuel, alcoholic beverages and a few other items. form of transfers and subsidies (39.3 per cent of
total expenditure). By far the largest expenditure
Expenditure Expenditures are classified into two types: item (15.7 per cent of total expenditure) in this
1. Functional classification: expenditure according category was transfers to households in the form
to the function of government for which it is of social grants.
intended, such as education, defence and safety,
housing, etc. State debt cost is also included as a Surplus or Deficit The government’s budget balance
separate item in this classification. is equal to revenues minus expenditures.
2. Economic classification: expenditure according
to its nature as either current payments (such Budget balance = Revenues – Expenditures
as salaries for government employees), transfers
and subsidies (such as grants to households If revenues exceed expenditures, the government
or subsidies to educational institutions) or, has a budget surplus. If expenditures exceed
lastly, as payments for capital assets (such as revenues, the government has a budget deficit. If
government purchases of buildings, machinery revenues equal expenditures, the government has
and equipment, etc.) a balanced budget. For fiscal 2012, with projected
expenditures of R997.7 billion and revenues of
TABLE 30.1 National Budget in Fiscal 2012 R799.3 billion, the government projected a budget
Item Projections
deficit of R198.4 billion.
(billions of rand) Big numbers like these are hard to visualise and
difficult to compare over time. To gain a better sense
Tax Revenues 799.3
of the magnitude of revenues, expenditures and the
Taxes on income and profit 475.7 deficit, we often express them as percentages of GDP.
Taxes on payroll and 11.1 Expressing them in this way lets us see how large
workforce government is relative to the size of the economy
Taxes on property 8.6 and also helps us to study changes in the scale of
government over time.
Domestic taxes on domestic 294.5 How typical was the national budget of 2012?
goods and services
Let us look at the recent history of the budget.
Taxes on international trade 36.4
and transactions
Expenditure 997.7
The Budget in Historical Perspective
Current payments 560.6 Figure 30.2 shows the government’s tax revenues,
expenditures and budget surplus or deficit since 1980.
Transfers and subsidies 393.7 Up to the end of 2006, there was a bigger deficit,
Payments for capital and 43.4 whereafter government ran a surplus for two years. The
financial assets South African government has, except for 2007 and
Deficit (after including 198.4 2008, consistently recorded deficits on the budget
non-tax revenue) since independence in 1961.
35
The figure records the government’s
expenditure, tax revenue and budget
Percentage of GDP
0
1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Year
Why did the budget deficit shrink from 1994? strong positive real economic growth and increasing
The answer lies in the changes in expenditure and collection efficiency on the administrative side.
tax revenue. But which components of government A long period of positive economic growth,
expenditure and tax revenues changed to swell and caused higher revenue potential, as most categories
then shrink the deficit? Let us look at tax revenue and of tax revenue tend to rise with increases in real
expenditure in a bit more detail. output. Overall efficiency in tax collection improved
substantially during this period. This was a result of a
Revenues Figure 30.3(a) shows the components of tax concerted effort to expand the capacity of the South
revenue as percentage of GDP from 1991 to 2012. This African Revenue Service, but also by simplifying the
period was characterised by significant increases in overall tax filing system, which in turn improved overall
tax revenue. This was mainly due to two factors: fairly compliance by taxpayers.
16
Taxes on income and profits goods and services remained the most
14 significant contributors to overall tax
12
revenue.
All sources of revenue kept rising
10 Domestic taxes on goods and services
as economic conditions improved
8 during the period 1994 to 2012.
0
1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Year
(a) Tax revenue
20
PART TEN Macroeconomic
Current payments Policy
% of GDP
18
16
9781775785026_gsp_eco_stb_ter_eng_za.indb 676 2014/03/14 7:14 AM
4
0
1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Year
(a) Tax revenue
The National Budget 677
20
Current payments In part (b), expenditure on goods
Expenditure as % of GDP
18
and services (reflected in ‘current
16 payments’) as a percentage of GDP
14
decreased from 2000 to 2012. In
contrast, transfers and subsidies kept
12
increasing as a percentage of GDP
10 as part of government’s conscious
commitment to poverty alleviation in
8
South Africa. A large portion of this
Transfers and subsidies
6
component was spent in the form of
4 social assistance (which included
Payments for capital assets
grants to the poor).
2
Source of data: National Treasury, Budget
0
1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Review 2012, Table 5.
Year
(b) Government expenditure
Expenditures Figure 30.3(b) shows the components a return. Highways, public schools and universities
of government expenditures as percentages of GDP and the stock of national defence capital all yield
from 2000 to 2012. Total expenditures remained a social rate of return that probably far exceeds the
fairly constant as a percentage of GDP over this interest rate the government pays on its debt.
period. The various components of total government
expenditures (according to the economic classification
of consolidated expenditure) changed significantly.
Provincial and Local Budgets
Current payments, which include amongst others The total government sector of South Africa includes
compensating government employees and purchases provincial and local governments, as well as the
of goods and services, have decreased over this national government. In 2012, when national
period. In contrast, the transfers and subsidies rose government expenditure accounted for 47.7% of
substantially. The rise was caused by expansion of overall spending, provincial and local spending
government’s social assistance programmes as part of amounted to 44% and 8.8% of overall expenditure.
its drive to alleviate poverty in South Africa. In 2012, Most of provincial and local expenditures were on
there were around 12.5 million people who received public schools and universities, local police and
some sort of social assistance (of which grants formed security services and roads.
the biggest portion) from government. It is the combination of national, provincial
Current payments also included interest and local government revenues, expenditures and
payments on government debt. These payments also budget deficits that influences the economy. But
shrank since 2000. To understand the role of debt provincial and local budgets are further designed to
interest, we need to see the connection between assist in the achievement of national policy goals for
government’s budget balance and debt. the economy.
Now that you know what the national budget is and what weakens the incentive to work and drives a wedge
the main components of revenues and expenditures are, it between the take-home wage of workers and the cost
is time to study the effects of fiscal policy. We will begin by of labour to firms. The result is a smaller quantity of
learning about the effects of taxes on employment, aggre- labour and a lower potential GDP.
gate supply and potential GDP. Then we will study the Figure 30.4 shows this outcome. In the labour
effects of budget deficits and see how fiscal policy brings market, the income tax has no effect on the demand
redistribution across generations. Finally, we will look for labour, which remains at LD. The reason is that
at fiscal stimulus and see how it might be used to speed the quantity of labour that firms plan to hire depends
recovery from recession and stabilise the business cycle. only on how productive labour is and what it costs –
its real wage rate.
But the supply of labour does change. With no
income tax, the real wage rate is R75 an hour and 4 billion
Supply-Side Effects of Fiscal Policy hours of labour a year are employed. An income tax
How do taxes on personal and corporate income weakens the incentive to work and decreases the supply
affect real GDP and employment? The answer to these of labour. The reason is that for each rand of before-tax
questions is controversial. Some economists, known earnings, workers must pay the government an amount
as supply-siders, believe these effects to be large and an determined by the income tax code. So workers look at
accumulating body of evidence suggests that they are the after-tax wage rate when they decide how much labour
correct. To see why these effects might be large, we to supply. An income tax shifts the supply curve leftward
will begin with a refresher on how full employment to LS + tax. The vertical distance between the LS curve
and potential GDP are determined in the absence of and the LS + tax curve measures the amount of income
taxes. Then we will introduce an income tax and see tax. With the smaller supply of labour, the before-tax wage
how it changes the economic outcome. rate rises to R88 an hour, but the after-tax wage rate falls to
R50 an hour. The gap created between the before-tax
and after-tax wage rates is called the tax wedge.
Full Employment and Potential GDP The new equilibrium quantity of labour
You learnt in Chapter 23 (pp. 504–506) how the full- employed is 3 billion hours a year – less than in the
employment quantity of labour and potential GDP no-tax case. Because the full-employment quantity
are determined. At full employment, the real wage of labour decreases, so does potential GDP. And a
rate adjusts to make the quantity of labour demanded decrease in potential GDP decreases aggregate supply.
equal the quantity of labour supplied. Potential GDP In this example, the tax rate is high – R38 tax
is the real GDP that the full-employment quantity of on a R88 wage rate is a tax rate of about 43 per
labour produces. cent. A lower tax rate would have a smaller effect on
Figure 30.4 illustrates a full-employment situation. employment and potential GDP.
In part (a), the demand for labour curve is LD and the An increase in the tax rate to above 43 per cent
supply of labour curve is LS. At a real wage rate of R75 would decrease the supply of labour by more than the
an hour and 4 billion hours of labour a year employed, decrease shown in Fig. 30.4. Equilibrium employment
the economy is at full employment. and potential GDP would also decrease still further. A
In Fig. 30.4(b), the production function is PF. tax cut would increase the supply of labour, increase
When 4 billion hours of labour are employed, real equilibrium employment and increase potential GDP.
GDP – which is also potential GDP – is R3.5 trillion.
Let us now see how an income tax changes
potential GDP.
Taxes on Expenditure and the Tax Wedge
The tax wedge that we have just considered is only a
part of the wedge that affects labour-supply decisions.
The Effects of the Income Tax Taxes on consumption expenditure add to the wedge.
The tax on labour income influences potential The reason is that a tax on consumption raises the
GDP and aggregate supply by changing the full- prices paid for consumption goods and services and is
employment quantity of labour. The income tax equivalent to a cut in the real wage rate.
350
Income
tax wedge
Taxes and the Incentive to Save and Invest
300
A tax on interest income weakens the incentive to save
200
and drives a wedge between the after-tax interest rate
After-tax earned by savers and the interest rate paid by firms.
100
wage rate Employment
LD These effects are analogous to those of a tax on labour
falls decreases
income. But they are more serious for two reasons.
First, a tax on labour income lowers the quantity
0 10 20 25 30 40 50 of labour employed and lowers potential GDP,
Labour (billions of hours per year) while a tax on capital income lowers the quantity
(a) Income tax and the labour market
of saving and investment and slows the growth rate of
real GDP.
Second, the true tax rate on interest income is
Real GDP (trillions of 2000-prices rand)
Effect of Income Tax on Saving and Investment When a tax is imposed, saving decreases and the
In Fig. 30.5, initially there are no taxes. Also, the supply of loanable funds curve shifts leftward to SLF
government has a balanced budget. The demand for + tax. The amount of tax payable is measured by the
loanable funds curve, which is also the investment vertical distance between the SLF curve and the SLF +
demand curve, is DLF. The supply of loanable funds tax curve. With this smaller supply of loanable funds,
curve, which is also the saving supply curve, is SLF. the interest rate rises to 4 per cent a year but the after-tax
The equilibrium interest rate is 3 per cent a year and interest rate falls to 1 per cent a year. A tax wedge is
the quantity of funds borrowed and lent is R200 driven between the interest rate and the after-tax interest
billion a year. rate and the equilibrium quantity of loanable funds
A tax on interest income has no effect on decreases. Saving and investment also decrease.
the demand for loanable funds. The quantity
of investment and borrowing that firms plan to
Tax Revenues and the Laffer Curve
undertake depends only on how productive capital
is and what it costs – its real interest rate. But a tax An interesting consequence of the effect of taxes on
on interest income weakens the incentive to save and employment and saving is that a higher tax rate does not
lend and decreases the supply of loanable funds. For always bring greater tax revenue. A higher tax rate brings
each dollar of before-tax interest, savers must pay the in more revenue per rand earned. But because a higher tax
government an amount determined by the tax code. rate decreases the number of rand earned, the two forces
So savers look at the after-tax real interest rate when operate in opposite directions on the tax revenue collected.
they decide how much to save. The relationship between the tax rate and the
amount of tax revenue collected is called the Laffer
curve. The curve is so named because Arthur B. Laffer,
FIGURE 30.5 The Effects of a Tax on Capital
a member of President Reagan’s Economic Policy
Advisory Board, drew such a curve on a table napkin and
Real interest rate (per cent per year)
7
Decrease in supply launched the idea that tax cuts could increase tax revenue.
of loanable funds SLF + tax
6
Figure 30.6 shows a Laffer curve. The tax rate is on
SLF the x-axis and total tax revenue is on the y-axis. For tax
5
rates below T*, an increase in the tax rate increases tax
Interest rate revenue; at T*, tax revenue is maximised; and a tax rate
rises Tax
4 wedge increase above T* decreases tax revenue.
Most people think that South Africa is on the
3 upward-sloping part of the Laffer curve; so is the United
After-tax States and the United Kingdom. But France might be
2 interest close to the maximum point or perhaps even beyond it.
rate falls
Investment DLF
1 and saving
decrease The Supply-Side Debate
0 140 160 180 200 220 240
Before 1980, few economists paid attention to the
Loanable funds (billions of 2005-prices rand per year) supply-side effects of taxes on employment and
potential GDP. Then, when Ronald Reagan took
The demand for loanable funds and investment demand curve
office as president, a group of supply-siders began
is DLF and the supply of loanable funds and saving supply
to argue the virtues of cutting taxes. Arthur Laffer
curve is SLF. With no income tax, the real interest rate is
was one of them. Laffer and his supporters were not
3 per cent a year and investment is R200 billion. An income
held in high esteem among mainstream economists,
tax shifts the supply curve leftward to SLF + tax. The interest
but they were influential for a period. They correctly
rate rises to 4 per cent a year, the after-tax interest rate falls to
argued that tax cuts would increase employment and
1 per cent a year and investment decreases to R180 billion.
increase output. But they incorrectly argued that tax
With less investment, the real GDP growth rate decreases.
cuts would increase tax revenues and decrease the
budget deficit. For this prediction to be correct, the
United States would have had to be on the ‘wrong’ We conclude this chapter by looking at fiscal
side of the Laffer curve. Given that US tax rates are policy as a tool for fighting a recession.
among the lowest in the industrial world, it is unlikely
that this condition was met. And when the Reagan
administration did cut taxes, the budget deficit
increased, a fact that reinforces this view.
Fiscal Stimulus
Supply-side economics became tarnished because The 2008–2009 recession brought Keynesian
of its association with Laffer and came to be called macroeconomic ideas (see p. 646) back into fashion and
‘voodoo economics’. But mainstream economists, put a spotlight on fiscal stimulus – the use of fiscal policy to
including Martin Feldstein, a Harvard professor who increase production and employment. But whether fiscal
was Reagan’s chief economic adviser, recognised the policy is truly stimulating and if so, how stimulating, are
power of tax cuts as incentives, but took the standard questions that generate much discussion and disagreement.
view that tax cuts without spending cuts would swell You are now going to explore these questions.
the budget deficit and bring serious further problems. Fiscal stimulus can be either automatic or
This view is now widely accepted by economists of all discretionary. A fiscal policy action that is triggered
political persuasions. by the state of the economy with no action by
government is called automatic fiscal policy. The
FIGURE 30.6 A Laffer Curve increase in total unemployment benefits triggered by
the massive rise in the unemployment rate through
2009 is an example of automatic fiscal policy.
Tax revenue
France?
United Kingdom A fiscal policy action initiated by an act of
Parliament is called discretionary fiscal policy. It
United States
requires a change in a spending programme or in a tax
law. These actions in SA are usually announced in and
funded by the national budget.
Whether automatic or discretionary, an increase in
government expenditures or a decrease in government
revenues can stimulate production and jobs. An increase
in expenditure on goods and services directly increases
aggregate expenditure. And an increase in transfer
payments (such as unemployment benefits) or a decrease
0 T* 100 in tax revenues increases disposable income, which enables
Tax rate
people to increase consumption expenditure. Lower taxes
A Laffer curve shows the relationship between the tax rate also strengthen the incentives to work and invest.
and tax revenues. For tax rates below T*, an increase in the We will begin by looking at automatic fiscal
tax rate increases tax revenue. At the tax rate T*, tax revenue policy and the interaction between the business cycle
is maximised. For tax rates above T*, an increase in the tax and the budget balance.
rate decreases tax revenue.
Tax rand paid depend on tax rates and incomes. But GDP is R3 trillion (line A), the government budget has
incomes vary with real GDP, so tax revenues depend a structural deficit. And if potential GDP is R5 trillion
on real GDP. When real GDP increases in a business (line C ), the government budget has a structural surplus.
cycle expansion, wages and profits rise, so tax revenues
from these incomes rise. When real GDP decreases in
FIGURE 30.7 Cyclical and Structural Surpluses
a recession, wages and profits fall, so tax revenues fall.
budget balance
Revenues
2005 rand)
and Deficits
4
Potential
Needs-Tested Spending The government creates
and balance
Revenues
of 2005ofrand)
GDP
4
programmes that pay benefits to qualified people and Potential
(trillions (trillions
and budget
businesses. The spending on these programmes results GDP
Cyclical
revenuesrevenues
in transfer payments that depend on the economic deficit
Cyclical
surplus
state of individual citizens and businesses. When the
2 Cyclical Cyclical
economy expands, unemployment falls, the number of
Expenditure,
deficit surplus
people experiencing economic hardship decreases, so 2
needs-tested spending decreases. When the economy is
Expenditure,
in a recession, unemployment is high and the number
of people experiencing economic hardship increases, so Outlays
A B C Revenues
expenditures decrease in a boom, the budget provides 4
automatic restraint to shrink an inflationary gap.
of 2005ofrand)
and balance
A B C Revenues
4
Cyclical and Structural Budget Balances To
(trillions (trillions
and budget
Structural
the business cycle, we distinguish between a structural deficit Structural
surplus
surplus or deficit, which is the budget balance that 2 Structural
Expenditure,
has a balanced budget. There is no structural surplus or In(b)part (a), potential GDP is R4 trillion. When real GDP is less
Structural deficit and structural surplus
deficit. But there might be a cyclical surplus or deficit. than potential GDP, the budget is in a cyclical deficit. When
If real GDP is less than potential GDP at R3 trillion, real GDP exceeds potential GDP, the budget is in a cyclical
expenditures exceed revenues and there is a cyclical surplus. The government has a balanced budget when real
deficit. If real GDP is greater than potential GDP at GDP equals potential GDP.
R5 trillion, expenditures are less than revenues and In part (b), if potential GDP is R3 trillion, there is a structural
there is a cyclical surplus. deficit and if potential GDP is R5 trillion, there is a structural surplus.
In Fig. 30.7(b), if potential GDP equals R4 trillion If potential GDP is R4 trillion, the budget is in structural balance.
(line B), the structural balance is zero. But if potential
Potential GDP is R4 trillion and real GDP is increase in government spending ends up making
below potential at R3 trillion so the economy has a only a small contribution to job creation. And because
recessionary gap of R1 trillion. government expenditure crowds out investment, it
To restore full employment, the government lowers future real GDP.
passes a fiscal stimulus package. An increase in So a fiscal stimulus package that is heavy on
government expenditure and a tax cut increase tax cuts and light on government spending works.
aggregate expenditure by ∆E. If this were the only But an increase in government expenditure alone
change in spending plans, the AD curve would shift is not an effective way to stimulate production and
rightward to become the curve labelled AD0 + ∆E in create jobs.
Fig. 30.8. But if fiscal stimulus sets off a multiplier The description of the effects of discretionary
process that increases consumption expenditure and fiscal stimulus and its graphical illustration in Fig. 30.8
does not crowd out much investment expenditure, make it look easy: Calculate the recessionary gap and
aggregate demand increases further and the AD curve the multipliers, change government expenditure and
shifts to AD1. taxes and eliminate the gap. In reality, things are not
With no change in the price level, the economy that easy.
would move from point A to point B on AD1. But the Getting the magnitude and the timing right is
increase in aggregate demand brings a rise in the price difficult and we will now examine this challenge.
level along the upward-sloping SAS curve and the
economy moves to point C. Magnitude of Stimulus Economists have diverging
At point C, the economy returns to full views about the size of the government spending and
employment and the recessionary gap is eliminated. tax multipliers because there is insufficient empirical
evidence on which to pin their size with accuracy.
This fact makes it impossible for Parliament to
Fiscal Stimulus and Aggregate Supply You determine the amount of stimulus needed to close
have seen earlier in this chapter that taxes influence a given output gap. Further, the actual output gap
aggregate supply. A tax on labour income (on wages) is not known and can only be estimated with error.
drives a wedge between the cost of labour and the For these two reasons, discretionary fiscal policy
take-home pay of workers and lowers employment is risky.
and output (p. 678). A tax on capital income (on
interest) drives a wedge between the cost of borrowing Time Lags Discretionary fiscal stimulus actions are
and the return to lending and lowers saving and also seriously hampered by three time lags:
investment (p. 679). With less saving and investment, ◆ Recognition lag
the real GDP growth rate slows. ◆ Law-making lag
These negative effects of taxes on real GDP and ◆ Impact lag
its growth rate and on employment mean that a
tax cut increases real GDP and its growth rate and Recognition Lag The recognition lag is the time it takes
increases employment. to figure out that fiscal policy actions are needed.
These supply-side effects of a tax cut occur This process involves assessing the current state of the
along with the demand-side effects and are probably economy and forecasting its future state.
much larger than the demand-side effects and make
the overall tax multiplier much larger than the Law-Making Lag The law-making lag is the time it
government expenditure multiplier. takes Parliament to pass the laws needed to change
An increase in government expenditure financed taxes or spending. This process takes time because
by borrowing increases the demand for loanable funds each member of Parliament has a different idea
and raises the real interest rate, which in turn lowers about what is the best tax or spending programme to
investment and private saving. This cut in investment change, so long debates and committee meetings are
is the main reason why the government expenditure needed to reconcile conflicting views. The economy
multiplier is so small and why a deficit-financed might benefit from fiscal stimulation today, but by the
Fiscal Policy
The South African government is looking at spending R3.2 trillion in the next three years on over 40
major infrastructure projects. In his Budget speech on Wednesday, Finance Minister Pravin Gordhan
outlined a range of measures to ensure that this money is effectively spent.
The measures are aimed at boosting planning and monitoring capacity in government departments
and municipalities to ensure that they carry out major projects and allocate the necessary spending on
them in an efficient way.
He said that departments and municipalities that did not spend, underspent or misspent their
allocated infrastructure funds would risk losing their allocations, while officials would also be held
liable in such cases.
The National Treasury would be monitoring the spending of grants to ensure there was value for
money and that departments and municipalities stuck to Expanded Public Works Programme
(EPWP) targets and implemented operational and maintenance programmes.
Measures outlined
The measures Gordhan outlined to improve the implementation of infrastructure projects include:
◆ Boosting planning and project-management capacity in state-owned entities, development
finance institutions and in the private sector.
◆ Assistance from the Infrastructure Development Improvement Programme to assist provincial
and national departments – largely in education and health projects and support for provincial
public works departments.
◆ The Cities Support Programme, which will improve spatial planning, public transport
and management of infrastructure utilities in cities – initially targeting the country’s eight
metropolitan areas.
◆ The launch this year of the Municipal Infrastructure Support Agency by Cooperative
Governance Minister Richard Baloyi to assist rural municipalities that lack planning capacity.
◆ Technical assistance to municipalities through the neighbourhood development programme,
which is aimed at helping townships to source business investment. Currently 220 projects are
being supported.
◆ The extension of the infrastructure skills development grant to a further 43 municipalities. The
grant this financial year supported 150 graduate interns in engineering and spatial planning.
◆ Improving procurement processes for major infrastructure projects to develop local suppliers and
improve delivery and value for money.
60 120
SAS
117
50 115
AD*
30 Cyclical
LD* 110
unemployment Recessionary gap
LD
AD
0 10 13.5 18 20 0 2 3 4 5
Employment (millions of workers) Real GDP (trillions of 2008 rand)
Figure 1 The labour market and cyclical unemployment Figure 2 Aggregate supply and aggregate
demand in 2012
Key Terms
Automatic fiscal policy, 681 Cyclical surplus or deficit, Fiscal stimulus, 681 National budget, 674
Balanced budget, 675 682 Government debt, 677 Structural surplus or deficit,
Budget deficit, 675 Discretionary fiscal policy, Government expenditure 682
Budget surplus, 675 681 multiplier, 683 Tax multiplier, 683
Current payments, 675 Fiscal policy, 674 Laffer curve, 680 Tax wedge, 678
A
31
t six regularly scheduled meetings a year, the South African
Reserve Bank decides whether the interest rate will increase, fall or
remain constant until the next decision date. Financial market traders,
journalists and analysts watch the economy for clues about what the
Reserve Bank will decide at its next meeting.
How does the Reserve Bank make its interest rate decision?
Can the Reserve Bank speed up economic growth
To explain their policy actions, inflation The numerical inflation target range set by the
targeters publish an inflation report that describes Reserve Bank is 3 to 6 per cent of CPI headline
the current state of the economy and its expected inflation. A range is targeted to allow the Reserve
evolution over the next two years. The report also Bank some discretion in the application of monetary
explains the central bank’s current policy and how policy. This numerical range becomes the ultimate
and why the central bank expects that its policy will goal in an inflation targeting framework, but the
achieve the inflation target. Reserve Bank also monitors bank credit extension
and money supply growth together with other
economic indicators, such as asset prices, international
What Does Inflation Targeting Achieve? developments and the output gap.
In general, the goals of inflation targeting are: (1) to The inflation target is communicated to the
state clearly and publicly the goals of monetary policy; public and the decisions taken by the Monetary
(2) to establish a framework of accountability; and Policy Committee are announced and explained
(3) to keep the inflation rate low and stable while after each meeting. A Monetary Policy Forum was
maintaining a high and stable level of employment. also established that meets twice a year to stimulate
There is wide agreement that inflation targeting discussions on monetary policy and economic
achieves its first two goals. And the inflation reports developments in South Africa. In addition a
of inflation targeters have raised the level of discussion Monetary Policy Review is published twice yearly
and understanding of the monetary policy process. to explain the decisions taken by the Reserve Bank
But monetary policy is about managing inflation and an analysis of economic developments – both
expectations. And it seems clear that an explicit in South Africa and abroad – that influences inflation
inflation target that is taken seriously and towards in the country.
which policy actions are aimed and explained is a
sensible way to manage expectations.
It is when the going gets tough that inflation Executing Monetary Policy
targeting has the greatest attraction. It is difficult to
imagine a serious inflation-targeting central bank How does the South African Reserve Bank execute its
permitting inflation to take off in the way that it monetary policy? This question has two parts:
did during the 1970s. And it is difficult to imagine ◆ What are the monetary policy instruments?
deflation and ongoing recession such as Japan has ◆ How does the Reserve Bank make its policy
endured for the past 10 years if monetary policy is decisions?
guided by an explicit inflation target.
The debate on inflation targeting will continue!
Monetary Policy Instruments
A monetary policy instrument is a variable that the
Inflation Targeting in South Africa Reserve Bank can control directly or at least very
South Africa embarked on an inflation targeting closely target.
monetary framework in February of the year 2000. Since the Reserve Bank is the sole issuer of the
The goal of inflation targeting in South Africa is: monetary base, it has monopoly power in the supply
(1) to make monetary policy clear in order to improve of reserves. Since it has monopoly power, the Bank
planning and decision making by both private and can either fix the price or it can fix the supply. In
public sector; (2) part of a coordinated approach the market for reserves, the Reserve Bank can thus
to reduce inflation in order to promote high and either set the price (interest rate) of reserves or set the
sustainable economic growth and employment monetary base. If the monetary base is controlled, the
creation; (3) to focus monetary policy and improve interest rate would adjust to ensure equilibrium in the
the accountability of the Reserve Bank; and (4) guide market for reserves and if the interest rate is set, the
inflation expectations and thus price and wage setting monetary base adjusts accordingly.
behaviour of economic agents. The Reserve Bank chose to set the interest rate
for reserves, i.e. the repo rate. The repo rate works
effectively as a policy instrument if banks have to due to a large payment to another bank, it is obliged
borrow from the Reserve Bank and this is achieved under law to offset or ‘square’ that account before
with the Bank’s refinancing system. the next morning. The bank will experience a typical
‘liquidity shortage’ (referred to as a ‘short’ reserves
position) and will have to borrow cash reserves from
The Repo Rate and the Refinancing System another source. If the Reserve Bank extends a loan to
The Reserve Bank’s main mechanism used for that bank it does so at a cost. The cost at which the banks
implementing monetary policy is the refinancing obtain liquidity from the Reserve Bank is referred to as
system. The refinancing system refers to the way in the repurchase rate, or simply the repo rate.
which a central bank extends credit to banks that are When banks are in need of cash reserves, they can
short of cash reserves. Through its refinancing system, also borrow from other banks in the interbank market.
the Reserve Bank provides liquidity to those banks But if all the banks simultaneously experience a shortage
which experience cash reserve shortages on a regular of liquidity, they can only eliminate the shortfall by
basis. The terms ‘liquidity’ and ‘cash reserves’ are often obtaining funding from the Reserve Bank at the repo rate.
used interchangeably and it is therefore useful to This facility is provided by almost all central banks in the
explain a few important concepts. world as part of their function as lender of last resort.
Two very important accounts held by most In South Africa the repo rate is an interest rate set by
commercial banks with the Reserve Bank are cash the Monetary Policy Committee (MPC) and which is
reserve accounts on the one hand and current accounts revised at every MPC meeting. It is therefore the main
(also known as settlement accounts) on the other. monetary policy instrument used by the Reserve Bank.
Although a bank is compelled to keep a prescribed Since March 1998, banks that are in need of
amount in its reserve account (see discussion below), liquidity can obtain funds from the Reserve Bank by
the deposits it holds in the current account at the engaging in a repurchase transaction with the Bank,
Reserve Bank are held at its own discretion. The latter at the repo rate. A repurchase transaction refers to a
balances are used to settle transactions between banks, transaction where a financial instrument is sold at an
with the Reserve Bank or the government. Examples agreed price, with the intention that the instrument
are tax payments by their clients to the government and will be bought back by the seller at a specified date.
cheque and internet payments by customers to other Thus, banks have to sell certain financial instruments,
parties. In addition, banks also keep notes and coin such as government bonds and Treasury bills,4 to the
on hand for those customers who want to withdraw Reserve Bank for a period of one week and obtain the
money from ATMs and so on. These physical cash cash in return. They pay interest on the cash received
balances are referred to as vault cash. It is important and the interest rate that prevails is the repo rate. When
to note that banks do not earn any interest on reserve the week is over, they have to buy back the instrument
balances, irrespective of whether they are utilised as from the Reserve Bank and provide the cash for it.
vault cash, required cash reserves or free reserves. In order for the repo rate to be an effective
The sum total of all the banks’ cash reserve and monetary policy instrument, there has to be a liquidity
current account balances at the Reserve Bank, as well shortage in the market. Thus, the Reserve Bank has to
as their vault cash balances is collectively called the ensure that banks have to borrow money from it at the
cash reserves of the banking system. The amount by repo rate. In order to achieve a liquidity shortage, the
which the total cash reserves of the banking system Reserve Bank uses two more instruments, namely:
exceed the total amount of required reserve balances ◆ Cash reserve requirements for banks
is referred to as ‘free’ or ‘excess’ reserves. These excess ◆ Open-market operations.
balances are regarded as ‘surplus liquidity’ but many
observers refer to the excess reserves simply as ‘liquidity’.3 Figure 31.2 illustrates how these forces work together
When a bank’s current account at the Reserve to influence banks’ interest rates that they charge the
Bank becomes negative on a specific day, perhaps public who wants to borrow funds from them.
3 Source: Surplus Liquidity: Implications for Central Banks by 4 A government bond is an obligation issued by government to finance the
Joe Ganley Lecture Series no.3 Centre for Central Banking Studies budget deficit. These bonds only expire over a number of years (5–20).
(http://www.pftac.org/filemanager/files/Macro2/5.pdf) A Treasury bill is a short-term debt instrument that expires in less than one
year, issued by government to finance its current expenditure.
FIGURE 31.2 The Monetary Policy or sells government securities (government bonds and
Implementation Framework Treasury bills) from or to a commercial bank or the
public. When the Reserve Bank buys securities from a
Cash reserve requirement The cash reserve requirement bank, it pays for them by increasing their cash reserve
Other open-market and open-market operations by deposits at the Reserve Bank. The bank now has more
operations
the Reserve Bank ensures that a reserves to lend out again, causing the money supply
shortage of liquidity exists in the to increase via the money multiplier (see Chapter 25).
Liquidity requirement
(shortage) in the money money market. The Reserve Bank When the Reserve Bank sells securities, banks have
market provides liquidity to banks at the to pay for them, which they do with the reserves held
repo rate, which influences the at the Reserve Bank. The decrease in their reserve
The Bank provides interest rates that banks charge. balances at the Reserve Bank now cause banks to
liquidity at the repo rate
experience a shortage of reserves and they have to
Source: South African Reserve
make up for this by borrowing from the Reserve Bank
Bank (2007) Fact Sheet 9: South
Banks adjust their interest at the repo rate. Therefore, open-market operations
rates according to African Reserve Bank’s System of
changes in the repo rate influence the reserves of banks. It is clear that the
Accommodation. Pretoria: SARB.
market for reserves is central in the execution of
monetary policy and is explained below.
The Cash Reserve Requirement
The Market for Reserves
The cash reserve requirement compels banks to keep
a certain percentage of their deposits in an account at In the market for reserves banks exercise a demand
the central bank. If a bank experiences an increase in for reserves, while the Reserve Bank supplies reserves.
its deposits, it is also required to keep more reserves. Banks hold reserves to meet the required reserve
Therefore, it is an essential tool for monetary policy, ratio and also to make payments to other banks, the
since it forces banks to obtain liquidity from the government and so on. But excess reserves are costly to
central bank whenever credit or the volume of money hold because they do not earn interest. The alternative
expands. In earlier years, the cash reserve requirement to holding reserves is to lend them to other banks in
was adjusted regularly to influence the credit creation the interbank market and earn the interbank rate. The
potential of banks. However, this is no longer regular interbank market is where banks with excess reserves
practice. The cash reserve requirement in South Africa is lend these to banks who experience a temporary
set at 2.5 per cent of deposits and banks can meet this shortage of reserves. If a bank cannot borrow from
requirement easily. It is regarded as an instrument other banks on the interbank market, it has to borrow
that helps to cause a so-called structural deficit (or from the Reserve Bank at the repo rate. Therefore,
shortage) in the money market. This means that the higher the repo rate, the greater the opportunity
it helps to ‘remove’ a certain amount of liquidity cost of holding excess reserves and the smaller is the
(reserves) from the money market on a permanent quantity of excess reserves demanded by banks.
or structural basis. In addition, it is always applied Figure 31.3 illustrates the demand for bank
(fixed) for a period of one month. That is why the reserves. The x-axis measures the quantity of reserves
cash reserve requirement ratio is not adjusted often by that banks hold on deposit at the Reserve Bank and
the central bank. In other words, it is not regarded as the y-axis measures the repo rate. The demand for
a short-term operational monetary policy instrument. reserves is the curve labelled RD.
The Reserve Bank provides just enough reserves to
ensure that the supply meets the demand at the target
Open-Market Operations rate set by the Bank. The Reserve Bank determines the
For the repo rate to influence banks’ interest rates supply of reserves, which is shown by the supply curve
effectively, the Reserve Bank has to create a liquidity RS. Since the Reserve Bank determines the supply of
shortage in the market. In addition to imposing reserves, the RS curve is vertical.5
the cash reserve requirement, the Reserve Bank also 5 This argument is consistent with the Classical view of money supply. Note that
conducts open-market operations, that is, it purchases there are alternative views, such as that of the Post Keynesians who advocate a
horizontal money supply curve, on which your lecturer might elaborate.
Equilibrium in the market for bank reserves decision. If inflation is above or is expected to move
determines the repo rate and it is where the quantity above the top of the inflation target band, the MPC
of reserves demanded by the banks equals the quantity considers raising the repo rate; and if inflation
of reserves supplied by the Reserve Bank. is below or is expected to move below the bottom
of the inflation target band, it considers lowering
the repo rate.
FIGURE 31.3 The Market for Reserves
Output Gap The Reserve Bank also monitors and
Repo rate (per cent per year)
RS
8.00 forecasts real GDP and potential GDP and the gap
7.50
between them, the output gap (see pp. 642–643).
If the output gap is positive, an inflationary gap, the
7.00
inflation rate will most likely accelerate, so a higher
6.50
interest rate might be required. If the output gap
6.00 Repo is negative, a recessionary gap, inflation might ease,
Equilibrium rate target
5.50 leaving room to lower the interest rate.
5.00 Once the Monetary Policy Committee has
4.50
decided on its policy action, it announces its new
interest rate policy – either a lower or a higher repo
4.00
rate, or no change at all. How is the change in policy
3.50 Supply of reserves
after open market then implemented to achieve the inflation target? We
3.00 operation RD next look at the transmission of monetary policy and
see how it achieves its goals.
0 25 50 75 100
Reserves on deposit at the SARB (billions of rand)
We are now going to trace the events that follow for banks changes and therefore banks adjust their
a change in the repo rate and see how those events lending rates. For example, if the Reserve Bank
lead to the ultimate policy goal. announces an increase in the repo rate, banks increase
We will begin with an overview of the their interest rates that they charge their customers for
transmission channels, which is followed by the loans accordingly. Since it is now more expensive to
transmission process. borrow money from banks, the demand for credit and
loans decrease.
What we see is that the increase in the interest rate
Transmission Channels makes money more expensive and less is borrowed
The Reserve Bank identifies three channels through from banks. Therefore, a change in the interest rate
which a change in the repo rate influences aggregate changes the quantity of money demanded. In general, a
demand and subsequently inflation in the economy: fall in the interest rate increases the quantity of money
◆ Bank credit channel demanded and an increase in the interest rate decreases
◆ Interest rate channel the quantity of money demanded (this represents a
◆ Exchange rate channel movement on the money demand curve).
Since households and businesses have less access
Figure 31.4 illustrates the various transmission to credit, it directly affects planned consumption
channels. From the diagram it is evident that a change and investment. With loans harder to get, consumers
in the repo rate influences planned expenditure in the and firms spend less. Therefore, the increase in the
economy through these channels. Let us see how a repo rate leads to a decrease in planned consumer
change in the repo rate works through each of these expenditure (C ) and planned investment expenditure
channels to influence expenditure and demand in the (I ). Similarly, a decline in the repo rate means that
economy, before we turn to the transmission process, consumers and firms have easier access to loans,
where we show how this works through the economy causing them to spend more. In this instance, planned
to reach the goal of inflation control. consumption and investment increase.
Because planned consumption and planned
Bank Credit Transmission Channel From the investment is affected, there is a change in total
above it is evident that as soon as the MPC announces expenditure (TE ), as well as aggregate demand (AD)
a new setting for the repo rate, the cost of funds in the economy.
Repo rate
Planned expenditure
Aggregate demand
Interest Rate Transmission Channel The monetary interest rates in the economy as well. These interest rate
policy decision taken by the MPC represents a change in effects occur quickly and relatively predictably. As is the
the repo rate. Since the repo rate changes, it affects other case with bank lending rates, an increase in the repo rate
expectations about future short-term interest rates, rate, many other factors also make the exchange
as well as current short-term interest rates. The alter- rate change.
native to borrowing or lending long term is to
borrow or lend using a sequence of short-term
securities. If the long-term interest rate exceeds the The Transmission Process
expected average of future short-term interest rates, We have seen that when the Reserve Bank changes
people will lend long term and borrow short term. the repo rate, it sets a number of effects into motion.
The long-term interest rate will fall. And if the long- These include bank lending rates that change, other
term interest rate is below the expected average of interest rates that change and the exchange rate
future short-term interest rates, people will borrow that adjusts. To understand how this leads to a
long term and lend short term. The long-term change in the inflation rate, we have to track the
interest rate will rise. changes from the initial change in the repo rate,
These market forces keep the long-term interest through the various markets. A quick summary of
rate close to the expected average of future short- the process, which will be discussed in more detail
term interest rates (plus a premium for the extra risk below, is as follows:
assoiated with long-term loans). The expected average When the Reserve Bank lowers the repo rate,
future short-term interest rate fluctuates less than the short-term interest rates and lending rates fall and
current short-term interest rate. the exchange rate weaken (the rand depreciates).
The quantity of money and the supply of loanable
The Exchange Rate Transmission Channel The funds increase. The long-term real interest rate falls.
exchange rate responds to changes in the interest The lower real interest rate increases consumption
rate in South Africa relative to the interest rates expenditure and investment. And the weaker exchange
in other countries – the South African interest rate rate makes South African exports cheaper and imports
differential. We explained this influence in Chapter 26 more costly. Thus, net exports increase. Easier bank
(see p. 579). loans reinforce the effect of lower interest rates on
When the Reserve Bank increases the repo rate, aggregate expenditure. Aggregate demand increases,
the South African interest rate differential increases which increases real GDP and the price level relative
and, other things remaining the same, the South to what they would have been. Real GDP growth and
African rand appreciates. And when the Reserve inflation speed up.
Bank lowers the repo rate, the interest rate differential When the Reserve Bank increases the repo rate,
decreases and, other things remaining the same, the as the sequence of events that we have just reviewed
rand depreciates. plays out, the effects are in the opposite directions.
If the rand appreciates, South African products Figure 31.6 provides a schematic summary of
become more expensive and foreign goods become these ripple effects for both a decrease and an increase
cheaper. This causes exports (X ) to decrease and in the repo rate.
imports (M ) to increase. Therefore an appreciation of These ripple effects stretch out over a period of
the rand causes planned expenditure to decrease. between one and two years. The interest rate and
The opposite is also true. A depreciation of the exchange rate effects are immediate. The effects on
rand makes South African products cheaper and money and bank loans follow in a few weeks and run
foreign products more expensive. This leads to an for a few months. Real long-term interest rates change
increase in exports (X ) and a decline in imports (M ), quickly and often in anticipation of the short-term
thereby increasing planned expenditure on South interest rate changes. Planned expenditure changes
African goods. and real GDP growth changes after about one year.
Many factors other than the South African The inflation rate changes between one year and two
interest rate differential influence the exchange rate. years after the change in the repo rate. But these time
When the Reserve Bank changes the repo rate, the lags are not entirely predictable and can be longer
exchange rate does not usually change in exactly the or shorter. Let us look closer at what happens in the
way it would with other things remaining the same. loanable funds market and with planned expenditure
So while monetary policy influences the exchange and aggregate demand.
FIGURE 31.6 The Ripple Effects of a Change in in the repo rate increases the quantity of bank loans
the Repo Rate demanded. Once there is a change in loans, there is
also a change in deposits. In Chapter 25 we looked
The Reserve Bank lowers The Reserve Bank raises at how banks create money through bank loans. You
the repo rate the repo rate have seen that an increase in loans leads to an increase
in deposits and this increases the money available for
Other short-term Other short-term lending via the money multiplier. This increase in
interest rates fall and interest rates rise and
the exchange rate falls the exchange rate rises
money available to lend signifies an increase in the
supply of banks loans. A fall in the repo rate increases
The quantity of The quantity of the demand for loans and this increases the supply
money and supply of money and supply of of bank loans. Similarly an increase in the repo rate
loanable funds increase loanable funds decrease
decreases the demand for loans and also the supply of
bank loans via the money multiplier.
The long-term The long-term
real interest real interest A fall in the repo rate that increases the supply of
rate falls rate rises bank loans increases the supply of loanable funds and
lowers the equilibrium real interest rate. A rise in the
Consumption Consumption
expenditure, investment, expenditure, investment,
repo rate that decreases the supply of bank loans also
and net exports increase and net exports decrease decreases the supply of loanable funds and raises the
equilibrium real interest rate.
Aggregate Aggregate These changes in the real interest rate, along
demand demand
increases decreases with the other factors just described, change planned
expenditure.
Real GDP growth Real GDP growth
and the inflation and the inflation
rate increase rate decrease Planned Expenditure
The ripple effects that follow a change in the repo rate
change three components of aggregate expenditure:
◆ Consumption expenditure
The Loanable Funds Market and Long-Term
◆ Investment
Real Interest Rate ◆ Net exports
Demand and supply in the market for loanable funds
determine the long-term real interest rate, which Consumption Expenditure Other things remaining
equals the long-term nominal interest rate minus the the same, the lower the real interest rate, the greater
expected inflation rate. The long-term real interest rate is the amount of consumption expenditure and the
influences expenditure decisions. smaller is the amount of saving.
In the long run, demand and supply in the
loanable funds market depend only on real forces – on Investment Other things remaining the same, the
saving and investment decisions. But in the short run, lower the real interest rate, the greater is the amount
when the price level is not fully flexible, the supply of investment.
of loanable funds is influenced by the supply of bank
loans. Changes in the repo rate change the supply Net Exports Other things remaining the same, the
of bank loans, which changes the supply of loanable lower the interest rate, the weaker is the exchange rate
funds and changes the interest rate in the loanable and the greater are exports and the smaller are imports.
funds market.
Above we explained why a change in the repo Therefore, a cut in the repo rate increases aggregate
rate changes the demand for credit, but we have not expenditure and a rise in the repo rate curtails
explained what happens to the supply of money. We aggregate expenditure. These changes in planned
have seen that an increase in the repo rate decreases aggregate expenditure also change aggregate demand,
the quantity of bank loans demanded and a decrease real GDP and the price level.
Banks
Banks lower
lower theirtheir lending
lending rates
rates andand
the the demand
demand for for
loansloans increase.
increase.
WithWith an increase
an increase in the
in the monetary
monetary
8.00
8.00 RS0RS0 RS1RS1 8.00
8.00 base,
base, banks
banks supply
supply more more loans
loans andand
Repo rate (per cent per year)
Repo rate (per cent per year)
7.00
7.00 TheTheMPCMPC lowers
lowers ... The
... The
Reserve
Reserve
BankBank 7.00
7.00
conducts
conductsan open
an open MSMS
1 1
the the repo
repo raterate
... ...
6.50
6.50 market
market
purchase
purchaseto to 6.50
6.50
increase
increase
the the
supply
supplyof of
6.00
6.00 reserves
reserves
so that
so that
justjust
enough
enough 6.00
6.00
reserves
reserves
arearesupplied
supplied
5.50
5.50 5.50
5.50
to reach
to reach
the the
reporepo
raterate
5.00
5.00 5.00
5.00
4.50
4.50 4.50
4.50
4.00
4.00 4.00
4.00
3.50
3.50 3.50
3.50
3.00
3.00 RD RD 3.00
3.00 MDMD
(a) (a)
TheThe
market
market
forfor
bank
bank
reserves
reserves (b) (b)
Money
Money
market
market
In part (a), the MPC lowers the repo rate from 5 per cent to In part (b), banks lower their lending rates and the supply of
4 per cent. The Reserve Bank buys securities in an open money increases from MS0 to MS1, via the money multiplier.
market operation and increases the supply of reserves from The short-term interest rate falls and theLAS quantity
LAS of money
Price level (GDP deflator, 2005 = 100)
Price level (GDP deflator, 2005 = 100)
Real interest rate (per cent per year)
Real interest rate (per cent per year)
8.00
8.00
RS0 to RS1 An An increase
increase
to reach the in the
in the
new supplyrate.
supply
repo demandedIncrease
Increase
in planned
in planned
increases. The short-term interest rate and the repo
7.50 of loanable
7.50 of loanable funds
funds lowers
lowers SLF0SLF0 expenditure
expenditure
increases
increases Multiplier
Multiplier
the the long-term
long-term raterate
andand rate change
aggregateby demand
aggregatealmost
demandsimilar amounts.
effect
effect
7.00
7.00 increases
increases investment
investment SLF1SLF1
6.50
6.50
6.00
6.00
5.50
5.50 SASSAS
PART
5.00
5.00 EIGHT Macroeconomic Trends 120120
4.50
4.50
DLFDLF
9781775785026_gsp_eco_stb_ter_eng_za.indb
4.00
4.00 702 2014/03/14 7:14 AM
115115
3.50 3.50
3.00 RD 3.00 MD
LAS
8.00
An increase in the supply Increase in planned
7.50 of loanable funds lowers SLF0 expenditure increases Multiplier
the long-term rate and aggregate demand effect
7.00 increases investment SLF1
6.50
6.00
5.50 SAS
5.00
120
4.50
DLF
4.00 115
3.50
AD1
3.00
AD0 AD0
(c) The market for loanable funds (d) Real GDP and the price level
In part (c), an increase in the supply of bank loans increases In part (d), the increase in investment increases aggregate
the supply of loanable funds and shifts the supply curve planned expenditure. The aggregate demand curve shifts to
from SLF0 to SLF1. The real interest rate falls and investment AD0 + ∆E and eventually it shifts rightward to AD1. Real GDP
increases. increases to potential GDP and the price level rises.
MS0 to MS1, the interest rate falls from 5 per cent to 4 curve is SAS and, initially, the aggregate demand curve
per cent a year and the quantity of money increases from is AD0. Real GDP is R1.25 trillion, which is less than
R3 billion to R3.1 billion. The interest rate in the money potential GDP, so there is a recessionary gap. The
market and the repo rate are close to each other, although Reserve Bank is reacting to this recessionary gap.
not always exactly the same. The increase in the supply of loans and the
decrease in the real interest rate increase aggregate
Loanable Funds Market Banks create money by planned expenditure. (Not shown in the figure, a
making loans. In the long run, an increase in the supply fall in the interest rate lowers the exchange rate,
of bank loans is matched by a rise in the price level and which increases net exports and aggregate planned
the quantity of real loans is unchanged. But in the short expenditure.) The increase in aggregate expenditure,
run, with a sticky price level, an increase in the supply of ∆E, increases aggregate demand and shifts the
bank loans increases the supply of (real) loanable funds. aggregate demand curve rightward to AD0 + ∆E. A
In Fig. 31.7(c), the supply of loanable funds curve multiplier process begins. The increase in expenditure
shifts rightward from SLF0 to SLF1. With the demand increases income, which induces an increase in
for loanable funds at DLF, the real interest rate falls from consumption expenditure. Aggregate demand
6 per cent to 5.5 per cent a year. (We are assuming a increases further and the aggregate demand curve
zero inflation rate so that the real interest rate equals the eventually shifts rightward to AD1.
nominal interest rate.) The long-term interest rate changes The new equilibrium is at full employment. Real
by a smaller amount than the change in the short-term GDP is equal to potential GDP. The price level rises
interest rate for the reason explained on p. 699. to 120 and then becomes stable at that level. So after
a one-time adjustment, there is price stability.
The Market for Real GDP Figure 31.7(d) shows In this example, the Reserve Bank changed the
aggregate demand and aggregate supply – the demand for repo rate by exactly the right amount to achieve
and supply of real GDP. Potential GDP is R1.3 trillion, full employment and keep the price level stable. In
where LAS is located. The short-run aggregate supply reality, the Reserve Bank will not easily achieve the
same precision because of the lags between policy securities and decreases the supply of reserves of the
action and the desired result. An approach that is banking system from RS0 to RS1.
too cautious, stimulating demand too little and
too late, might steer the economy into a recession. Money Market The increase in the cost of funds for
Alternatively, an approach that is too ambitious, banks causes banks to raise their lending rates and
stimulating demand too soon or too much, might the demand for loans decreases (as explained in the credit
push the economy into an inflation spiral. transmission channel). With less reserves, the banks make
less loans. Deposits shrink due to the decline in loans and
the supply of money decreases via the money multiplier.
The Reserve Bank Fights Inflation The short-term interest rate in the money market rises.
If the inflation rate is too high and real GDP is above In Fig. 31.8(b), the supply of money decreases
potential GDP, the Reserve Bank takes actions that are from MS0 to MS1, the interest rate rises from 5 per
designed to lower the inflation rate and restore price cent to 6 per cent a year and the quantity of money
stability. Figure 31.8 shows the effects of the Reserve decreases from R3 billion to R2.9 billion.
Bank’s actions starting in the market for reserves and
ending in the market for real GDP. Loanable Funds Market With a decrease in
reserves, banks must decrease the supply of loans.
Market for Bank Reserves In Fig. 31.8(a), which The supply of (real) loanable funds decreases and
shows the market for bank reserves, the MPC raises the supply of loanable funds curve shifts leftward in
the repo rate from 5 per cent to 6 per cent a year. Fig. 31.8(c) from SLF0 to SLF1. With the demand
To achieve the new target, the Reserve Bank sells for loanable funds at DLF, the real interest rate rises
8.00 8.00
Repo rate (per cent per year)
5.00 5.00
4.50 4.50
4.00 4.00
3.50 3.50
3.00 3.00 MD
RD
0 25 50 75 0 2.9 3.0
Reserves on deposit at the Reserve Bank (millions of rand) Real money (billions of 2005 rand)
In part (a), the MPC raises the repo rate from 5 per cent to In part (b), banks raise their lending rates and the supply of
6 per cent. The Reserve Bank sells securities in an open market money decreases from MS0 to MS1, via the money multiplier.
operation and supplies just enough reserves to decrease the The short-term interest rate
LAS rises and the quantity of money
Price level (GDP deflator, 2005 = 100)
SLF1
supply8.00
of reserves from RS0 to RS1 and reach the new repo rate. demanded decreases. The short-term interest rate and the
Real interest rate (per cent per year)
6.50 Decrease in
125 investment
6.00 decreases
aggregate
5.50 120 demand
PART EIGHT Macroeconomic Trends
5.00
4.50 DLF
9781775785026_gsp_eco_stb_ter_eng_za.indb 704 2014/03/14 7:14 AM
3.50 3.50
3.00 3.00 MD
RD
0 25 50 75 0 2.9 3.0
Reserves on deposit at the Reserve Bank (millions of rand) Real money (billions of 2005 rand)
LAS
6.50 Decrease in
125 investment
6.00 decreases
aggregate
5.50 120 demand
5.00
4.50 DLF
4.00 A decrease in the
supply of loanable funds AD 0
3.50
raises the long-term Multiplier
3.00 interest rate and effect
decreases investment
AD 1 AD 0
(c) The market for loanable funds (d) Real GDP and the price level
In part (c), a decrease in the supply of bank loans decreases In part (d), the decrease in investment decreases aggregate
the supply of loanable funds and the supply curve shifts planned expenditure. Aggregate demand decreases and
from SLF0 to SLF1. The real interest rate rises and investment the AD curve shifts leftward from AD0 to AD1. Real GDP
decreases. decreases to potential GDP and the price level falls.
from 6 per cent to 6.5 per cent a year. (Again, we are demand curve eventually shifts leftward to AD1. The
assuming a zero inflation rate so that the real interest economy returns to full employment. Real GDP
rate equals the nominal interest rate.) is equal to potential GDP. The price level falls to
120 and then becomes stable at that level. So after a
The Market for Real GDP Figure 31.8(d) shows one-time adjustment, there is price stability.
aggregate demand and aggregate supply in the market Again, in this example, the Reserve Bank
for real GDP. Potential GDP is R1.3 trillion where increased the repo rate by just enough to ensure that
LAS is located. The short-run aggregate supply curve the economy reaches full employment and that the
is SAS and initially the aggregate demand is AD0. price level is kept stable Again, if the Reserve Bank
Now, real GDP is R1.35 trillion, which is greater than was overcautious and delayed corrective action or did
potential GDP, so there is an inflationary gap. The not decrease demand sufficiently, the economy would
Reserve Bank is reacting to this inflationary gap. retain the inflationary gap and inflation would remain
The increase in the short-term interest rate, the above the levels desired to achieve price stability. And
decrease in the supply of bank loans and the increase if the Reserve Bank was overzealous, applying too
in the real interest rate decrease aggregate planned much corrective action too soon to decrease demand,
expenditure. (Not shown in the figures, a rise in the it could result in the economy entering a recession.
interest rate raises the exchange rate, which decreases
net exports and aggregate planned expenditure.)
The decrease in aggregate expenditure, ∆E, Loose Links and Long and Variable Lags
decreases aggregate demand and shifts the aggregate The ripple effects of monetary policy that we have just
demand curve to AD0–∆E. A multiplier process analysed with the precision of an economic model are,
begins. The decrease in expenditure decreases income, in reality, very hard to predict and anticipate.
which induces a decrease in consumption expenditure. To achieve its goal of price stability and stable
Aggregate demand decreases further and the aggregate economic conditions, the Reserve Bank needs a
combination of good judgement and good luck. Too large Loose links in the chain that runs from the repo
an interest rate cut in an underemployed economy can rate to the ultimate policy goals make unwanted
bring inflation, as it did during the early 1970s. And too policy outcomes inevitable. And time lags that are
large an interest rate increase in an inflationary economy both long and variable add to the Reserve Bank’s
can create unemployment, as it did in 1997 and 1998. challenges.
3
to the long-term bond rate, the Reserve Bank is trying to
–2
stimulate real GDP growth. When the repo rate rises 2 Repo rate minus
relative to the long-term bond rate, the Reserve Bank is bond rate
1
trying to restrain inflation and slow real GDP growth.
The blue line in the figure is the real GDP growth 0
rate one year later. You can see that when the MPC
–1
raises the repo rate, the real GDP growth rate slows
one to one and half years later. And when the Reserve –2
Bank lowers the repo rate, the real GDP growth rate 2002 03 04 05 06 07 08 09 10 11
Year
speeds up about one year later.
Not shown in the figure, other things remaining Interest Rates and Real GDP Growth
the same, the inflation rate increases and decreases in Source of data: South African Reserve Bank
You have seen how the Reserve Bank operates and the equilibrium real interest rate (which Taylor says is
the effects of its actions. We close this chapter by 2 per cent a year) plus amounts based on the inflation
looking at alternative ways in which the Reserve rate (INF ) and the output gap (GAP) according to the
Bank could operate. following formula (all the values are percentages):
The rule is based on the quantity theory of money translates to a stable velocity of circulation. Friedman
(see Chapter 25, pp. 563–564). McCallum’s idea is had examined data on money and nominal GDP and
that by making the monetary base grow at a rate equal argued that the velocity of circulation of money was
to a target inflation rate plus the long-term real GDP one of the most stable macroeconomic variables and
growth rate minus the medium-term growth rate that it could be exploited to deliver a stable price level
of the velocity of circulation of the monetary base, and small business cycle fluctuations.
inflation will be kept close to target and the economy Friedman’s idea remained just an idea until the
will be kept close to full employment. 1970s, when inflation increased to more than 10 per
The McCallum rule has some advantages over cent a year in the United States and to much higher
the Taylor rule. To target the interest rate using the rates in some other major countries.
Taylor rule, a central bank must estimate the long-run During the mid-1970s, in a bid to end the
equilibrium real interest rate and the output gap. inflation, the central banks of most major countries
In the Taylor rule, described above, the long-run adopted the k-per cent rule for the growth rate of the
equilibrium real interest rate is predetermined at, for quantity of money. The South African Reserve Bank,
example, 2 per cent a year. The interest rate is set at too, began to pay close attention to the growth rates
this level if the inflation rate and output gap are zero. of money aggregates, including M1, M2 and M3.
But if the long-run equilibrium real interest rate is not Inflation rates fell during the early 1980s in countries
2 per cent a year, the Taylor rule would set the interest that had adopted a k-per cent rule. But one by one,
rate either too high on average and bring persistent these countries abandoned the k-per cent rule.
recession, or too low on average and bring persistent Money targeting works when the demand for
and accelerating inflation. money is stable and predictable, that is when the
Similarly, if the central bank overestimated the velocity of circulation is stable. But in the world
output gap, it would set the interest rate too high of the 1980s and possibly in the world of today,
on average and bring persistent recession. And if the technological change in the banking system leads
central bank underestimated the output gap, it would to large and unpredictable fluctuations in the
set the interest rate too low on average and bring demand for money, which make the use of monetary
persistent inflation. targeting unreliable. With monetary targeting,
Because the McCallum rule does not react to aggregate demand fluctuates because the demand
either the real interest rate or the output gap, the for money fluctuates.
McCallum rule does not suffer from the problems of
the Taylor rule.
A disadvantage of the McCallum rule compared Exchange Rate Targeting Rule
to the Taylor rule is that it relies on the demand for The Reserve Bank could, if it wished to do so,
money and demand for the monetary base to be intervene in the foreign exchange market to target the
reasonably stable. This is not always the case and it is exchange rate. A fixed exchange rate is one possible
widely believed that shifts in the demand for money exchange rate target. The Reserve Bank could fix the
and the demand for monetary base would bring large value of the rand against a basket of other currencies.
fluctuations in the interest rate, which in turn would But with a fixed exchange rate, a country has no
bring large fluctuations in aggregate demand. control over its inflation rate. The reason is that for
internationally traded goods, purchasing power parity
(see Chapter 26 p. 583) moves domestic prices in line
Money Targeting Rule with foreign prices. If a computer flash drive costs
As long ago as 1948, Nobel Laureate Milton R120 in Cape Town and if the exchange rate is R10
Friedman proposed a targeting rule for the quantity of per $1, then the same computer flash drive will sell for
money. Friedman’s k-per cent rule makes the quantity $12 (ignoring local tax differences) in New York. If
of money grow at a rate of k per cent a year, where this purchasing power parity did not prevail, it would
k equals the growth rate of potential GDP. be possible to earn a profit by buying at the lower
Like the McCallum rule, Friedman’s k-per cent price and selling at the higher price. This trading
rule relies on a stable demand for money, which would compete away the profit and price difference.
Thus, prices of traded goods (and in the long rate, we would need to be able to identify changes in
run the prices of all goods and services) must increase the real exchange rate and offset them. This task is
at the same rate in South Africa as they do on the difficult to accomplish.
average in the other countries against which the value
of the rand is fixed.
The Reserve Bank could avoid a direct inflation Why Rules?
link by using a crawling peg exchange rate (see Chapter You might be wondering why all monetary policy
26, p. 586) as a means of achieving an inflation target. strategies involve rules. Why does the Reserve Bank
To do so, the Reserve Bank would make the exchange not just do what seems best every day, month and
rate change at a rate equal to the South African year, at its discretion? The answer lies in what you
inflation rate minus the target inflation rate. If other have just read. Monetary policy is about managing
countries have an average inflation rate of 3 per cent inflation expectations. In both financial markets
a year and South Africa wants an inflation rate of and labour markets, people must make long-term
4 per cent a year, the Reserve Bank would make the commitments. So these markets work best when plans
rand depreciate at a rate of 1 per cent a year against are based on correctly anticipated inflation outcomes.
the effective exchange rate of other currencies. A well-understood monetary policy rule helps to
Some developing countries that have an inflation create an environment in which inflation is easier to
problem use this monetary policy strategy to lower forecast and manage.
the inflation rate. The main reason for choosing this
method is that these countries do not have well- REVIEW QUIZ
functioning markets for bonds and overnight loans, so
1 What are the three alternative strategies for
they cannot use a policy approach that relies on these
conducting monetary policy (other than the
features of a banking system.
one currently used by the Reserve Bank)?
A major disadvantage of a crawling peg to target
2 What is the main objection to a money
the inflation rate is that the real exchange rate often
targeting rule?
changes in unpredictable ways. The real exchange rate
3 What is the main objection to an exchange
between South Africa and its trading partners reflects
rate targeting rule?
the relative price of the GDP basket of goods and
4 What is the main objection to a rule for
services in South Africa compared to the same basket
growth in the monetary base?
in other countries. South Africa’s GDP still contains
a larger proportion of commodities than the GDP
of its trading partners. So when the relative prices of To complete your study of monetary policy, take a look
these items change, South Africa’s real exchange rate at Reading Between the Lines on pages 710–711, which
changes. With a crawling peg targeting the inflation analyses the Reserve Bank’s interest rate decision in 2012.
‘Domestic inflation has continued its downward trend and is expected to remain within the target
range over the forecast period. However, despite some moderate employment creation over the past
year the economic growth outlook appears to be threatened by global developments and deteriorating
domestic business and consumer confidence.
‘The year-on-year inflation rate as measured by the consumer price index (CPI) for all urban areas was
5.5 per cent in June 2012, down from 5.7 per cent in May. … The inflation forecast of the Bank has
been revised downwards since the previous MPC meeting, apart from the final quarter of 2014 when
a slightly higher outcome is forecast. … The improved forecast is mainly due to lower-than-expected
recent inflation outcomes.
‘… The domestic economy appears to be slowing further, following the 27 per cent annualised
growth rate recorded in the first quarter of 2012. The Bank’s forecast of GDP growth for 2012 has
been revised down from 2.9 per cent to 2.7 per cent and to 3.8 per cent in 2013. The forecast for
2014 remains unchanged at 4.1 per cent.
‘… In the light of these developments the MPC views the prevailing conditions to be appropriate
for further monetary accommodation to the economy that will not undermine the inflation outlook.
The MPC has therefore decided to reduce the repurchase rate by 50 basis points to 5.0 per cent from
Friday 20 July 2012. While it is recognised
that such a move on its own will not overcome
ESSENCE OF THE STORY
the challenges facing the economy, it is felt
that it can help alleviate some of the pressures ◆ The Monetary Policy Committee assesses the
faced by some sectors. … The MPC will inflation and economic growth situation in the
continue to monitor both domestic and global country when making its policy decisions.
developments and will act appropriately in line ◆ Inflation in the country is within the target zone
with its mandate.’ and is still falling.
◆ Economic growth, however, slowed down in the
second quarter of 2012.
Source: Statement of the Monetary Policy Committee –
◆ The MPC therefore decided to cut the repo rate
2012-07-19 South African Reserve Bank Available online at:
in order to stimulate economic activity within
http://www.resbank.co.za/Publications/Statements/Pages/
South Africa.
MonetaryPolicyStatements.aspx © South African Reserve. Bank.
to the right.
◆ Banks decrease their lending rates and the
demand for loans from consumers and
Price level (GDP deflator)
businesses increase.
◆ Banks have excess reserves and therefore they SRAS
supply to meet the demand for more loans.
Since loans lead to deposits, the money
supply increases (MS curve shifts to the right 128
in Figure 2). 120
◆ The money market rate declines and so
does the real interest rate in the loanable AD 1
funds market. AD 0
shifts right in Figure 3). Figure 3 GDP and the price level
Key Terms
CPIX inflation rate, 692 k- per cent rule, 708 Quantity theory of money, Targeting rule, 707
Headline inflation, 692 McCallum rule, 707 708 Taylor rule, 707
Inflation rate targeting, 693 Monetary policy Real exchange rate, 709
Instrument rule, 707 instrument, 694 Repo rate, 692
2007
2000
2001
2002
2004
2005
2006
2008
2009
2010
provided in the text?
25. Suppose that the Bank of England decided to
Source: Data from http://databank.worldbank.org/ follow the Taylor rule. In 2005, the United
Kingdom had an inflation rate of 2.1 per cent a
19. Since 2008 South Africa has struggled to meet year and its output gap was –0.3 per cent. At what
its growth target of 5–6 per cent. What can the level would the Bank of England set the repo rate?
SARB do to promote growth and how will its 26. How would you adjust the Taylor rule equation
actions affect real GDP? to fit the South African economy and the SARB’s
20. What are the short-run and long-run effects of a stated objectives?
cut in the repurchase rate?
Monetary Policy Transmission 46. How does monetary policy affect house prices?
Use the data in the following graph to work out 47. What are the challenges in evaluating the impact
Problems 42 to 44. of monetary policy?
12.0
Central bank Use the data in the following graph to work out
intervention rate
10.0 Problems 48 and 49.
8.0 Inflation,
12.0
Central bank consumer
6.0 10.0 intervention prices
rate (%) (annual %)
4.0 8.0
Real interest
rate (%) 6.0
2.0
4.0
0.0 GDP growth
2.0
(annual %)
2003
2007
2000
2001
2002
2004
2005
2006
2008
2009
2010
0.0
–2.0
Source: Data from http://databank.worldbank.org/
–4.0
2003
2007
2000
2001
2002
2004
2005
2006
2008
2009
2010
42. What role does the long-term real interest rate
play in the monetary policy transmission process? Source: Data from http://databank.worldbank.org/
43. How does the repurchase rate influence the long-
term real interest rate? 48. Which monetary policy actions will lead to
44. What do you think happened to inflation an upturn in growth such as that experienced
expectations between 2003 and 2006? from 2003 to 2007? Explain when these actions
45. ‘The outlook for the domestic economy has took place.
deteriorated in recent months as global economic 49. What is the relationship and time difference
conditions worsen. Higher administered prices between inflation and growth? Use the period
will weigh on household disposable income, 2003 to 2007 to motivate your answer.
while the fragile global environment and slower
household consumption will discourage private Alternative Monetary Policy Strategies
sector investment. Supply disruptions in the 50. Given that alternative monetary policy strategies
mining sector and weak global manufacturing exist, why does the SARB follow an inflation
activity indicate that export performance will target?
remain poor for the foreseeable future.’ 51. Suppose that the Reserve Bank of New Zealand
Source: Nedbank Company Report, 11 September 2012 © Nedbank.
is following the Taylor rule. In 2009, it sets the
official cash rate (its equivalent of the federal
a. What happens to the exchange rate during a funds rate) at 4 per cent a year. If the inflation
downturn in the economy? How and why? rate in New Zealand was 2.0 per cent a year,
b. How can monetary policy influence the what was its output gap?
exchange rate?
Trade-Offs and Free Lunches and investment, the Reserve Bank gets both lower
inflation and faster real GDP growth. It enjoys a
A policy trade-off arises if, in taking an action to free lunch.
achieve one goal, some other goal must be forgone. The two chapters in this part have described
The Reserve Bank wants to avoid a rise in the inflation the institutional framework in which fiscal policy
rate and a rise in the unemployment rate. But if (Chapter 30) and monetary policy (Chapter 31)
the Reserve Bank raises the interest rate to curb are made, described the instruments of policy and
inflation, it might lower expenditure and increase analysed the effects of policy. This exploration of
unemployment. The Reserve Bank faces a short-run economic policy draws on almost everything that you
trade-off between inflation and unemployment. learned in previous chapters.
A policy free lunch arises if in taking actions to These policy chapters end off the discussion on
pursue one goal, some other (intended or unintended) macroeconomics and draw together all the strands in
goal is also achieved. The Reserve Bank wants to keep your study of the previous chapters.
inflation in check and, at the same time, to boost the Milton Friedman, whom you meet below,
economic growth rate. If lower inflation brings greater has profoundly influenced our understanding of
certainty about the future and stimulates saving macroeconomic policy, especially monetary policy.
Milton Friedman was born into a poor immigrant By reasoning from basic economic principles,
family in New York City in 1912. He was an Friedman (along with Edmund S. Phelps, the
undergraduate at Rutgers and a graduate student at 2006 Economics Nobel Laureate) predicted that
Columbia University during the Great Depression. persistent demand stimulation would not increase
From 1977 until his death in 2006, Professor output but would cause inflation.
Friedman was a Senior Fellow at the Hoover When output growth slowed and inflation
Institution at Stanford University. But his reputation broke out in the 1970s, Friedman seemed like a
was built between 1946 and 1983, when he was a prophet and for a time, his policy prescription,
leading member of the ‘Chicago School’, an approach known as monetarism, was embraced around
to economics developed at the University of Chicago the world.
and based on the views that free markets allocate
resources efficiently and that stable and low money
supply growth delivers macroeconomic stability. ‘Inflation is always and everywhere a monetary
Friedman has advanced our understanding phenomenon.’
of the forces that determine macroeconomic
performance and clarified the effects of the quantity
of money. For this work, he was awarded the 1977 MILTON FRIEDMAN
Nobel Prize for Economic Science. The Counter-Revolution in Monetary Theory