Bachelor of Commerce in Human Resource Management: Module Guide

ECONOMICS
BACHELOR OF COMMERCE IN
HUMAN RESOURCE MANAGEMENT
ECONOMICS
MODULE GUIDE
Copyright © 2021
REGENT BUSINESS SCHOOL
All rights reserved; no part of this book may be reproduced in any form or by any means, including
photocopying machines, without the written permission of the publisher.
BACHELOR OF COMMERCE IN HUMAN RESOURCE MANAGEMENT

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Table of Contents
INTRODUCTION TO ECONOMICS .................................................................5
CHAPTER 1:
Introduction to Economics ..............................................................................11
CHAPTER 2:
A Closer Look at the Production Possibility Frontier ......................................20
CHAPTER 3:
The Circular Flow of Income and Spending ...................................................27
CHAPTER 4:
Demand and Supply Analysis ........................................................................34
CHAPTER 5:
Demand and Supply in Action ........................................................................45
CHAPTER 6:
Consumer Theory and Individual Demand .....................................................57
CHAPTER 7:
Elasticity .........................................................................................................62
CHAPTER 8:
The Theory of Production and Costs ..............................................................74
CHAPTER 9:
Perfect Competition ........................................................................................88
CHAPTER 10:
Imperfect Competition ..................................................................................101
BIBLIOGRAPHY ..........................................................................................115
BACHELOR OF COMMERCE IN HUMAN RESOURCE MANAGEMENT 2

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List of Tables and Figures
Figure 1.1: Summary of the Fundamental Economic Challenge .................... 16

Figure 1.2: The Production Possibility Frontier Illustrating Different
Combinations of the Production of Two Goods ............................................... 18
Figure 2.1: Improved Technique in the Production of Capital Goods
and the Production Possibility Frontier ............................................................ 22
Figure 2.2: Improved Technique in the Production of Consumer
Goods and the Production Possibility Frontier ............................................... 22
Figure 2.3: Increase in the Quantity or Productivity of the Available
Resources and the Production Possibility Frontier ......................................... 23
Figure 3.1: The Circular Flow of Production, Income and Spending ............. 29
Figure 4.1: The Market Demand Curve ......................................................... 37
Figure 4.2: Shifts of the Demand Curve ........................................................ 38
Figure 4.3: The Market Supply Curve ............................................................ 40
Figure 4.4: Shifts of the Supply Curve ........................................................... 41
Figure 4.5: Market Equilibrium ...................................................................... 42
Figure 5.1: Changes in Demand ................................................................... 47
Figure 5.2: Changes in Supply ...................................................................... 48
Figure 5.3: Government Intervention ............................................................. 52
Figure 5.4: The Welfare Cost of Minimum Price Fixing ................................. 54
Figure 5.5: The Welfare Cost of Maximum Price Fixing ................................ 55
Figure 7.1: Price Elasticity of Demand .......................................................... 66
Figure 7.2: Total Revenue and the Elastic and Inelastic Demand Curve ...... 67
Figure 8.1: Economic profit and accounting profit ......................................... 77
Figure 8.2: The Total Product Curve ............................................................. 80
Figure 8.3: The Total, Average and Marginal Product of Labour ................... 81
Figure 8.4: The Three Total Cost Curves ...................................................... 83
Figure 8.5: Marginal and Average Cost Curves ............................................ 84
Figure 8.6: The Long-Run Average Cost Curve ............................................ 86
Figure 9.1: Market Structures ........................................................................ 89
Figure 9.2: The Demand Curve for the Product of the Firm Under
Perfect Competition ....................................................................................... 94
Figure 9.3: Total Short-Run Costs of the Firm ............................................... 95

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Figure 9.4: Total Revenue, Total Cost and Total Economic Profit ................. 96
Figure 9.5: Marginal Revenue and Marginal Cost of a Firm Operating
in a Perfectly Competitive Market .................................................................. 96
Figure 9.6: Different Possible Short-Run Equilibrium Positions of the
Firm Under Perfect Competition .................................................................... 98
Figure 10.1: Marginal, Average and Total Revenue Under Monopoly ........... 105
Figure 10.2: The Equilibrium of the Firm Under Monopoly ............................ 106
Figure 10.3: Comparison Between Monopoly and a Perfectly
Competitive Industry ...................................................................................... 106
Figure 10.4: The Equilibrium of the Firm Under Monopolistic Competition .... 108
Figure 10.5: A Theory of Oligopolistic Behaviour:
The Kinked Demand Curve ............................................................................ 110
List of Tables and Figures
Table 1-1: Microeconomics Versus Macroeconomics: Some Examples ....... 13

Table 1-2: Production possibilities for the Wild Coast community .................. 17

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INTRODUCTION TO ECONOMICS
1. Introduction
Welcome to the Bachelor of Commerce in Human Resource Management. As part of

your studies, you are required to study and successfully complete a module on
Economics.
2. Module Overview
The module aims to introduce you to the core elements of microeconomic theory and
the conceptual frameworks underpinning it. The module will begin with a discussion of
Economics as a science and its basic principles and concepts. This will be followed by
an analysis of the key economic participants. We will study the market equilibrium, i.e.,
the supply and demand model and the impact of government intervention in the market
outcomes. The focus shifts to consumer theory and the theory of the firm to understand
the background to the supply and demand model. Finally, we examine the different
market structures and study their welfare implications.
3. Aim of the Module
This module aims to:
• Gain understanding of the introductory level core microeconomic models and

theories.
• Build knowledge of the microeconomic foundations of how markets function and
how government policies may shape market outcomes.
• Analyse microeconomic models by developing analytical skills.
• Develop the ability to analyse and discuss the welfare implications of government
interventions.

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4. Essential (Prescribed) Reading
Your essential (prescribed) reading comprises the following:
4.1. Prescribed Reading
Mohr, P. & Fourie, L. (2020). Economics for South African Students - 6th
Edition. Van Schaik Publishers
4.2. Recommended Reading
Parkin, M., Antrobus, G., Bruce-Brand, J., Fourie, A., Kohler, M., Mahonye.,
Mlilo, M., Neethling, L., Rhodes, B., Saayman, A., Schoer, V., Scholtz, D.,
Thompson, K., and Smit, C. (2019). Economics: Global and Southern African
Perspectives - 3rd Edition. Pearson Publishers
5. How to use the Module
This module should be studied using the relevant sections of the prescribed and
recommended textbooks. You must read about the topic that you intend to study in the
appropriate section before you start reading the textbooks in detail. Ensure that you
make your own notes as you work through both the textbooks and this module. You
will find a list of objectives and outcomes at the beginning of each section. These
outline the main points that you need to understand when you have completed the
section/s. The purpose of this guide is to help you study. It is important for you to work
through all the tasks and self-assessment exercises as they provide guidelines for
examination purposes.
Guidelines for the solutions to the self-assessment questions have been provided as
well. The relevant chapters and sections from the prescribed textbook have been
indicated.

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6. Navigational Icons
Think Point
When you see this icon, you should think about and reflect on the
issues/challenges/themes presented.
Tasks
When you see this icon, you will know that you are required to perform some
kind of task to gauge how well you remember or understand what you have
read or how good you are at applying what you have learnt.
Definitions
This icon will alert you to a specific definition related to the topic under
discussion
Case Studies
Case studies are often used to illustrate a concept within the setting of a
real-life scenario. Answer the questions that follow to ensure that you have
a proper understanding of what has been discussed.

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7. Specific Outcomes and Chapter Alignment
SPECIFIC PROGRAMME OUTCOMES CHAPTER

ALIGNMENT
SO 1: Apply the principles of economics in the analysis of the 1-10

behaviour of individual consumers and businesses in the
economy.
SO 2: Utilise analytical techniques to hypothetical as well as to 1, 2, 4,5

real world situations and to analyse and evaluate
economic decisions.
SO 3: Demonstrate an understanding of how free markets work 5

and allocate resources efficiently.
SO 4: Assist individual consumers to make economic decisions 6, 7, 8

to maximise utility and aid individual firms to make
decisions in terms of maximising profits.
SO 5: Identify the characteristics of the different market 9,10

structures and analyse the behaviour of firms in terms of
price and output decisions.
SO 6: Evaluate the outcome in each market structure with 9,10

respect to economic efficiency.
SO 7: Identify cases in which private markets fail to allocate 10

resources efficiently.

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8. Specific Outcomes and Assessment Criteria
SPECIFIC PROGRAMME OUTCOMES ASSESSMENT CRITERIA
The student should demonstrate the ability to:
SO 1: Apply the principles of • Explain the subject of economics from

economics in the analysis of the a theoretical viewpoint and apply the
behaviour of individual basic economic problem to the first
consumers and businesses in basic economic model.
the economy.
• Apply the two main factors affecting
economic growth to the PPF.
SO 2: Utilise analytical techniques to
hypothetical as well as to real • Determine the main sectors and
world situations and to analyse markets in an economy and explained
and evaluate economic the flow of income in the circular flow
decisions. model
SO 3: Demonstrate an understanding • Analyse how buyers and sellers
of how free markets work and interact with each other to determine
allocate resources efficiently. the prices of goods and services in

markets.
SO 4: Assist individual consumers to
• Apply the basic theory of demand and
make economic decisions to
supply to the demand and supply
maximise utility and aid
model.
individual firms to make
decisions in terms of maximising • Gauge the measure of satisfaction that
profits. an individual gets from purchasing a
good or service.
SO 5: Identify the characteristics of the
• Explain and differentiated the varying
different market structures and
measures of elasticity and how it
analyse the behaviour of firms in
influences the behaviour of buyers and
terms of price and output
sellers for a specific good in a market.
decisions.

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SPECIFIC PROGRAMME OUTCOMES ASSESSMENT CRITERIA
The student should demonstrate the ability to:
SO 6: Evaluate the outcome in each • Examine the relationship that exists

market structure with respect to between inputs and outputs used in
economic efficiency. production and the resulting outputs
and costs for firms characterised into
the main theoretical market structures.
SO 7: Identify cases in which private • Describe and explain how firms would
markets fail to allocate be classified in the different market
resources efficiently. structures according to economic
theory and competently explained the
different aspects of perfect competition.
• Differentiate amongst the various

market structures that exist under
imperfect competition and fully
explained their equilibrium positions
according to their various
characteristics as per economic
thought.

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CHAPTER 1:
Introduction to Economics
Chapter Outcomes
Upon completion of this chapter, you should be able to:
• Define economics
• Distinguish between microeconomics and macroeconomics
• Understand the fundamental economic challenges of “scarcity” and “choice”
• Apply the fundamental economic challenges of scarcity and choice to the
production possibility frontier
1.1. Introduction
Economics is essentially about the choices that people have to make on a daily basis.
Mohr (2020, p. 2) explains the origin of the word Economics: The word economics is
derived from the Greek words oikos, meaning house and némein, meaning manage.
Economics is thus considered the science of household management and as such is
indeed concerned with the ordinary business of life.
In this chapter a number of examples are used to indicate what economics is all about,
followed by a discussion on the difference between microeconomics and
macroeconomics. Important concepts of scarcity, choice and opportunity cost are
then introduced. These concepts are explained with the aid of a production
possibilities curve. This chapter is based on part of Chapter 1 of Mohr (2020).
1.2. Wants and Needs
Mohr (2020, p. 2) describes economics as a social science that studies human

behaviour as a relationship between ends and scarce means which have alternative
uses. Consequently, economics examines the problems that arise when individuals
and firms have consumption desires that are constrained by access to resources. This

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problem is often referred to as having infinite wants but finite resources. All economic
questions arise because we want more than we can get. Our inability to satisfy all our
wants is called scarcity.
Wants are our desires for goods and services, and are unlimited. Needs are
necessities and essential for our survival. Examples include food, water and shelter.
The economic concept of demand differs from wants, desires or needs. For there to
be demand for a good or service, those who want to purchase it must have the
necessary means to do so. In other words, they must have the purchasing power
(Mohr, 2020, p.4).
According to Parkin (2019), economics is a social science that studies the choices that
individuals, businesses, governments, and entire societies make as they cope with
scarcity and the incentives that influence and reconcile those choices.
1.3. Microeconomics and Macroeconomics
As indicated by Mohr (2020, p. 11), economics can be divided into two parts:
1. Microeconomics: This is the branch of economics that focuses on the

individual participants in the economy: producers, workers, employers and
consumers. Microeconomic policies focus on specific markets.
2. Macroeconomics: This is the study of the effects on the national economy

and the global economy of the choices that individuals, businesses and
governments make. It focuses on aspects such as inflation, the
maintenance of full employment, economic growth, the distribution of
income, government spending, and the nation’s money supply.
The following table from Mohr (2020, p. 12) provides some examples of the topics
studied under the branches of Microeconomics and Macroeconomics:

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Table 1-1: MICROECONOMICS VERSUS MACROECONOMICS: SOME

EXAMPLES
In microeconomics we study: In macroeconomics we study:
• The price of a single product • The consumer price index

• Changes in the price of a product • Inflation (i.e., the increase in the
• The production of maize general level of prices in the
• The decisions of individual country)
consumers • The total output of all goods and
• The decisions of individual firms or services in the economy
businesses • The combined outcome of the
• The market for individual goods decisions of all consumers in the
• The demand for a product country
• An individual’s decision whether • The combined decisions of all
or not to work firms in South Africa
• A firm’s decision whether or not to • The market for all goods and
expand its production of its services in the economy
products • The total demand for all goods and
• A firm’s decision to export its services in the economy
product • The total supply of labour in the
• A firm’s decision to import a economy
product from abroad • Changes in the total supply of
goods and services in the
economy
• The total exports of goods and
services to other countries
• The total imports of goods and
services from other countries
1.4. The Scope of Economics
Mohr (2020, p. 34) highlights the three important questions that summarise the scope
of economics, namely:
1. What goods and services will be produced and in what quantities? These
are output questions.
2. How will each of the goods and services be produced? How much of the
scarce resources will be used in the production of each good? These are
input questions.
3. For whom will the various goods and services be produced? Who will
receive the goods and services? How much of them will they receive? And
where will the production occur? These are distribution questions.

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1.5. The Problem of Scarcity
Now that we have distinguished between wants, needs and demand, attention should
now be on the economic problem of scarcity. People’s unlimited wants cannot be met
with the limited resources available. Therefore, choices need to be made (Mohr, 2020,
p. 5).
1.6. Factors of Production
These resources are used to produce goods and services and are referred to as
factors of production. Since the factors of production, (resources), used in the
production of goods and services are limited, it follows then that the goods and
services which can be produced from them are also limited (Mohr, 2020, p. 4).
Factors of production are grouped as follows:
• Natural resources (land)
• Labour
• Capital
• Entrepreneurship
Natural resources and labour are also known as primary factors of production, whilst
capital and entrepreneurship are called secondary factors (Mohr, 2020 p. 51).
As these factors of production are scarce, we are forced to make difficult choices. The
use of scarce resources to produce a certain good or service, means that those
resources are not available to produce other goods or services.
Stated differently, a decision to produce more of one good means that less of another
good can be produced. As resources are scarce, their use is never cost free. There
are always costs involved (Mohr, 2020 p. 51).

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1.7. The Fundamental Economic Challenge
The fundamental economic challenge encompasses the issue of having scarce

resources and how best to produce and distribute the scarce resources.
1.7.1. Choices, trade-offs and opportunity costs
The economic way of thinking places scarcity and its implication of choice, at centre
stage. Due to the fact that we face scarcity, we must make choices. When we make a
choice, we select from the available alternatives. Every choice can be considered a
trade-off – giving up one thing in order to get something else.
In making choices, we have to make decisions about the best possible choices in terms
of allocating resources efficiently and effectively. This includes incurring opportunity
costs. Thus, for every decision we take, we incur opportunity costs (Mohr, 2020, p. 5).
The highest-valued alternative that we give up to get something is the opportunity cost
of the activity chosen. The concept of opportunity costs refers to the best option
forgone. It is simply, giving up something to gain something else, for example, as a
business manager you are constantly faced with the problem of choosing among
alternative methods of production, pricing of products, and maximising profits and
minimising losses. Other decisions may relate to aspects of budgeting, human
resources, and a range of other firm activities. Understanding economics and
employing economic tools can help one solve many business problems. The economic
principles of scarcity, choice and opportunity cost are captured in the production
possibilities curve (Mohr, 2020, p. 5).

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Figure 1.1: Summary of the Fundamental Economic Challenge

Source: (Ruzivo Digital Learning, 2020)
1.7.2. The production possibility frontier
The production possibility curve shows the maximum amount of production that can
be produced by an economy with a given number of resources. If we want to increase
ourproduction of one good, we must decrease our production of something else – we
face trade-offs. The production possibilities frontier (PPF), is the boundary between
those combinations of goods and services that can be produced and those that cannot,
i.e., it is the limit to what we can produce.
To illustrate the PPF, we focus on two goods and hold the quantities of all other goods
constant. In other words, we look at a model economy in which everything remains the
same, (ceteris paribus), except the two goods we are considering. The following
example is used by Mohr (2020, p. 5) to illustrate the PPF: Consider an isolated rural
community along the Wild Coast whose main foods are potatoes and fish. The people
have found that by devoting all their available time and other resources to fishing, they
can produce five baskets of fish per working day. On the other hand, if they spend all
their production time gardening, they can produce 100 kilograms (kg) of potatoes per
working day. It is possible for them to produce either five baskets of fish or 100 kg of
potatoes, but in each case the entire production of the other good must be sacrificed.
The only way that the inhabitants can enjoy a diet which includes both fish and
potatoes is by using some of their resources for fish production, and some for

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production of potatoes. Therefore, resources must be shifted from one production

possibility to produce the other. By experimentation, they find that it is possible for
them to produce any of the combinations shown in Table 1-1. These combinations
represent the maximum amounts that can be produced with all the available
resources. If the people decide to produce combination E, they will be able to produce
four baskets of fish and 40 kg of potatoes per day. But in producing this combination
they have had to decide not to produce more fish or more potatoes. In producing four
baskets of fish, they have had to forgo the additional 60 kg of potatoes that they could
have produced if they had used all their resources to grow potatoes. Likewise, in
producing 40 kg of potatoes they have decided to forgo the extra (5th) basket of fish
that they might have produced.
The opportunity cost of producing the 40 kg of potatoes is the basket of fish; and the
opportunity cost of producing the 4 baskets of fish is the 60 kg of potatoes that have
to be forgone. The community therefore has to choose between more potatoes and
less fish, or more fish and less potatoes. Given the available resources, it is impossible
to produce more of one good without decreasing the production of the other good
(Mohr, 2020).
Table 1-2 Production possibilities for the Wild Coast Community
Possibility Fish (baskets per day) Potatoes (kg per day)

A 0 100
B 1 95
C 2 85
D 3 70
E 4 40
F 5 0
Source: (Mohr, 2020)
The different alternatives can be illustrated graphically in a production possibilities

curve as in Figure 1.2. The curve shows the possible levels of output in an economy
with limited resources and fixed production techniques. The production possibilities
curve indicates the combinations of any two goods or services that are attainable when
the community’s resources are fully and efficiently employed.

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As we move along the production possibilities curve from point A to point B through to
point F, the production of fish increases while the production of potatoes decreases.
To produce the first basket of fish, the community has to sacrifice 5 kg of potatoes
(from 100 to 95). To produce the second basket of fish, the sacrifice is an additional
10 kg of potatoes (the difference between 95 and 85). To produce the third basket of
fish, an additional 15 kg of potatoes have to be forgone, (the difference between 85
and 70). The opportunity cost of each additional basket of fish therefore increases as
we move along the production possibilities curve. This is why the curve bulges
outwards from the origin.
Figure 1.2 The Production Possibility Frontier Illustrating Different Combinations of

the Production of Two Goods
Source: (Mohr, 2020, p. 6)
All points to the right of the curve, such as G are unattainable. G is unattainable due
to scarcity (a lack of resources to achieve that level of production). Points within the
frontier are attainable but inefficient. All points along the frontier, (from A to F), are
attainable and efficient.
The need to choose among the available combinations along the curve illustrates the
concept of choice. The negative slope of the curve illustrates the concept of
opportunity cost. This means that the only way to obtain more of one good is to
sacrifice the other good. Therefore, opportunity therefore involves a trade-off between
the two goods (Mohr, 2020).

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Task
The government constantly makes choices regarding the allocation of funds to the
various sectors. Think of any two sectors that the government allocates funds to.
Illustrate the choices and costs faced using a production possibilities curve.
1.8. Conclusion
This chapter introduced the topic of economics, indicating what it is all about. Using
examples, there was a discussion on the difference between microeconomics and
macroeconomics. Important concepts of scarcity, choice and opportunity cost were
then introduced, which were explained with the aid of a production possibilities
curve.
The next chapter then explores the different scenarios that can be illustrated using the
production possibilities curve.
Self-Assessment Questions
1. Briefly discuss the four basic factors of production.

2. Distinguish between microeconomics and macroeconomics.
3. Use a production possibilities curve to distinguish between maximum
attainable combinations, attainable but inefficient combinations and
unattainable combinations of the production of two goods.
4. Highlight the three central economic questions that have to be answered in
each society?
Self-Assessment Questions – Guidelines
1. Chapter 3, Section 3.3 provides a detailed explanation on the factors of

production.
2. Chapter 1, Section 1.6.
4. Chapter 2 – Introductory section.

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CHAPTER 2:
A Closer Look at the Production Possibility Frontier
Chapter Outcomes
• Understand what happens to the production possibility frontier in the event of:
a) an increase in the availability of resources
b) an improved technique in the production of a good
2.1. Introduction
From Chapter 1, we have seen that resources are limited and that choices must be
made. The problems of scarcity, choice and opportunity cost were illustrated by using
a production possibilities frontier.
In any economic system, the first challenge is to produce one of the maximum
attainable combinations of goods and services illustrated in Figure 1.2 in Chapter 1.
In other words, the scarce resources should be used fully and as efficiently as
possible. This occurs when it is impossible to produce more of the one good without
sacrificing some production of the other good.
However, the quantity of available resources may increase and/or production

techniques may improve over time. If this happens, it can be illustrated by a production
possibilities curve that shifts outwards. Such an outward movement illustrates
economic growth.
Mohr (2020, p. 461) defines economic growth as “the annual rate of increase in total
production or income in the economy”.
To explain this, we use a production possibilities curve that illustrates the production
of consumer goods and capital goods, the two broad types of goods produced in the
economy.

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Consumer goods are goods that are used or consumed by individuals or households
(i.e., consumers) to satisfy wants. Some examples provided by Mohr (2020, p. 7)
include food, wine, clothing, shoes, furniture, household appliances and motorcars.
Capital goods are goods that are not consumed in this way by households but are
used in the production of other goods. Examples include all types of machinery, plant
and equipment used in manufacturing and construction, school buildings, university
residences, roads, dams and bridges (Mohr, 2020, p. 7).
Task
How important is investment in the production of capital goods as opposed to

investment in production of consumer goods only?
The potential production of consumer goods and capital goods can be increased in a
number of possible ways, and these are discussed in this chapter. This chapter is also
based on a section of Chapter 1 of Mohr (2020).
2.2.1. Improved technique in the production of capital goods
According to Mohr (2020, p. 9), more capital goods may be produced with the existing
factors of production if an improved technique for producing capital goods is
developed. The new production possibilities curve is thus indicated in Figure 2.1 by
AC. Except at point A, it is now possible to produce more capital goods and more
consumer goods than before. For example, at point Y more of both types of good are
produced than at point X.

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Figure 2.1: Improved Technique in the Production of Capital Goods and the
Production Possibility Frontier
2.2.2. Improved technique in the production of consumer goods
Similarly, if a new technique for producing consumer goods is developed, while the
available resources and the technique for producing capital goods remain the same,
the maximum potential output of consumer goods will increase. This is illustrated in
Figure 2.2. The maximum potential output of consumer goods increases from A to D,
while the maximum potential output of capital goods remains unchanged (at B). Except
at point B, it is now possible to produce more consumer goods and capital goods than
before, as illustrated, for example, by the movement from point X to point Y (Mohr,
2020, p. 9).
Figure 2.2: Improved Technique in the Production of Consumer Goods and the
Production Possibility Frontier

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2.2.3. Increase in the quantity or productivity of the available resources
The figure below illustrates what would occur should an economy experience an
increase in the quantity or productivity of resources. This would make it possible to
produce more consumer goods and capital goods. The production possibilities curve
now shifts outwards from AB to EF (Mohr, 2020. p. 9).
Figure 2.3: Increase in the Quantity or Productivity of the Available Resources and
the Production Possibility Frontier
2.3. A Further Look at Economic Growth
Economic growth is an increase in output – an expansion of production possibilities.

This expansion of production possibilities leads to an increase in the standard of living.
Two key factors influence economic growth:
2.3.1. Technological change: This refers to the development of new goods and of
better ways of producing goods and services. Improvements in technology have
a high impact on economic growth. As the scientific community makes more
discoveries, managers find ways to apply these innovations as more
sophisticated production techniques. The application of better technology
means the same amount of labour will be more productive, and economic
growth will advance at a lower cost (Woodruff, 2019).
2.3.2. Capital accumulation: This refers to the growth of capital resources, which
includes human capital. Improvements and increased investment in physical
capital – such as roadways, machinery and factories – will reduce the cost and

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increase the efficiency of economic output. Factories and equipment that are
modern and well-maintained are more productive than physical labour. Higher
productivity leads to increased output. Labour becomes more productive as the
ratio of capital expenditures per worker increases. An improvement in labour
productivity increases the growth rate of the economy.
The skills, education and training of the labour force have a direct effect on the
growth of an economy. A skilled, well-trained workforce is more productive and
will produce a high-quality output that adds efficiency to an economy. A
shortage of skilled labour can be a deterrent to economic growth. An under-
utilised, illiterate and unskilled workforce will become a drag on an economy
and may possibly lead to higher unemployment (Woodruff, 2019).
Case Study
South Africa’s economy grew by 1.1% in the first quarter of the year
Stats SA has published the latest gross domestic product (GDP) data covering the first
quarter of the year, showing that the economy grew by 1.1% in the first three months
of 2021.
The growth follows a revised 1.4% rise in real GDP in the fourth quarter of 2020. On an
annualised basis, the economy grew 4.6% quarter-on-quarter.
Questions:
1. Discuss some scenarios in which the government of a country make use of a PPF.
2. Indicate how government can make use of a PPF to illustrate economic growth as
described above?
2.4 Conclusion
This chapter discussed the various ways in which the potential production of consumer
goods and capital goods can be increased, and how the PPF can be used to illustrate
these scenarios.

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The next chapter looks at the major role players in the economy and how they interact
with each other.
1. Give an example of an economic problem involving opportunity cost

that the South African government is currently facing.
2. Mention and illustrate two possible reasons for a rightward

shift of the production possibilities curve.
3. Discuss two key factors that influence economic growth.
4. Labour and entrepreneurship are both human resources. Explain

the difference between these two factors of production.

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Solutions to all questions are available in Chapter 1, Section 1.4
1. Any relevant example may be applicable such as: making a choice

between allocating funds to the health sector or for
electricity/infrastructure.
2. Improved technique in the production of goods and increase in the
quantity of resources
3. Two key factors: technological change and capital accumulation
4. Labour: Labour refers to the effort expended by an individual to bring a
product or service to the market.
Entrepreneurship: An entrepreneur is an individual who creates a new
business, bearing most of the risks and enjoying most of the rewards. The
process of setting up a business is known as entrepreneurship. The
entrepreneur is commonly seen as an innovator, a source of new ideas,
goods, services, and business/or procedures.

ECONOMICS
CHAPTER 3:
The Circular Flow of Income and Spending
Chapter Outcomes
• Understand the major role players in the economy

• Describe the flow of income in the circular flow model
3.1. Introduction
This chapter focuses on total production, income and spending in the mixed
economy. A Simple Circular Flow Model of Income and Spending is first discussed. It
considers the interaction of the three main sectors in the economy. The sources of
production, called the factors of production are then considered. Finally, the focus
shifts to the interdependence of the main sectors in the economy. This is illustrated
by the circular flow diagram. This chapter is based on Chapter 3 of Mohr (2020).
3.2. A Simple Circular Flow Model of Income and Spending
The various circular flows illustrated and explained in this section are essential guides
towards understanding how the different sectors and markets are interrelated. The
circular flow of income shows the flow of inputs, outputs and payments between
households and firms within an economy. This model captures the essential essence
of macroeconomic activity. The economy is seen as nothing more than:
➢ A flow of goods;
➢ Production resources; and
➢ Financial payments

ECONOMICS
Definition
A stock has no time dimension and can only be measured at a specific moment.
When a shopkeeper takes stock, she counts all the goods in the shop at that
particular time. A flow has a time dimension and can only be measured over a
period (Mohr, 2020, p. 53).
Figure 3.1 illustrates the various links between government, on the one hand, and
households and firms, on the other.
Mohr (2020, p. 58) provides a brief explanation on the three macroeconomic sectors
included in this model:
• Household Sector: This includes everyone, all people, seeking to satisfy

unlimited wants and needs. This sector is responsible for consumption
expenditures. It also owns all productive resources.
• Firms: This includes the institutions, (especially proprietorships,

partnerships and corporations), that undertake the task of combining
resources to produce goods and services. This sector does the production.
It also buys capital goods with investment expenditures.
• Government sector: Regulation is the prime function of the government

sector, especially passing laws, collecting taxes and establishing
frameworks within which the economy operates.

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Figure 3.1 The Circular Flow of Production, Income and Spending

The two macroeconomic markets in this version of the circular flow are:
• Goods market: This is the combination of all markets in the economy that
exchange final goods and services. It is the mechanism that exchanges
gross domestic product.
• Factor market: This is the combination of all markets that exchange the
services of the economy's resources, or factors of production-including,
labour, capital, land, and entrepreneurship. (Mohr, 2020, p. 58).
Definition
A market is not only a physical place; a market exists wherever buyers and sellers
interact, for example, the Johannesburg Stock Exchange and online shopping.
Source: Shaikh (n.d.)

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3.3. Factors of Production
Mohr (2020, p. 54) provides a brief description on each of the factors of production
that has been summarised below:
Natural resources (land)
Natural resources (also referred to as land) consist of all the gifts of nature. They
include mineral deposits, water, arable land, vegetation, natural forests, marine
resources, other animal life, the atmosphere and even sunshine. One of the key
properties of natural resources is that they are fixed in supply. This means that the
availability of natural resources cannot be increased if we want more of them.
However, it is often possible to exploit more of the available resources. Unfortunately,
a lot of natural resources cannot be replaced once they have been used. These types
of resources are called non-renewable or exhaustible assets (Mohr, 2020, p. 54).
Labour
Human effort is essential in producing goods and services. Mohr (2020, p. 54)
highlights that labour can be defined as the “exercise of human, mental and
physical effort in the production of goods and services”. Labour includes all
human effort that is exerted with the aim to earn a reward in the form of income.
The quantity of labour depends on the size of the population and the proportion of the
population that is able and willing to work. The latter, in turn, depends on factors such
as the age and gender distribution of the population. The proportion of children,
women and elderly people all affect the available quantity of labour, which is called the
labour force (Mohr, 2020, p. 56).
The quality of labour is more important than the quantity of labour. Mohr (2020, p. 56)
describes the quality of labour as the human capital, which refers to the skill,
knowledge and health of the workers. Some key determinants of human capital are
education, training and experience.
Capital
Mohr (2020, p. 56) indicates that capital comprises all manufactured resources,
such as machines, tools and buildings, which are used in the production of
other goods and services. Capital goods are produced to produce other goods.

ECONOMICS
Capital as a factor of production refers to all tangible things that are used to produce
other things.
Mohr (2020, p. 56) indicates that in order to produce capital goods, current (i.e.,
present) consumption has to be sacrificed in favour of future consumption. The more
capital goods that are produced in a particular period, the fewer the number of
consumer goods that will be produced in that period, but the greater the production
capacity will be in future. However, if all current resources are used for producing
consumer goods, the future means of production will be fewer (Mohr, 2020, p. 56).
Like all other goods, capital goods do not have an unlimited life. Machinery, plant,
equipment, buildings, dams, bridges and roads are all subject to wear and tear.
Equipment can also become outdated or obsolete because of technological progress.
For example, huge mainframe computers installed a decade or two ago have been
replaced by much smaller, cheaper and more efficient personal computers. Provision
therefore has to be made for the replacement of existing capital goods. This is called
the provision for depreciation (or depreciation allowance) (Mohr, 2020, p. 56).
Entrepreneurship
The above three factors of production i.e., availability of natural resources, labour and
capital are not sufficient to ensure economic success. These factors of production
have to be combined and organised by people who see opportunities and are willing
to take risks by producing goods in the expectation that they will be sold. These people
are called entrepreneurs (Mohr, 2020, p. 56).
The entrepreneur is the driving force behind production. Entrepreneurs are the
initiators and innovators. They are the people who take the initiative and who introduce
new products and new techniques on a commercial basis. They are also the risk-
bearers. They take chances because they anticipate that they will make profits. But
they may also suffer losses and perhaps bankruptcy.
Entrepreneurship is an important economic force. In countries where entrepreneurship

is lacking, the government is sometimes forced to act as entrepreneur in an attempt
to stimulate economic development (Mohr, 2020, p. 56).

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3.4. Explanation of the Circular Flow Model
Firstly, let us consider households who are buyers, and firms who are producers and
sellers of goods and services in the goods and services market: Firms are buyers of
factors of production and households become sellers of factors of production in the
factor market. The income flow of factors of production is denoted by the outer line,
(clockwise direction of the arrow), whereas the inner line, (anticlockwise direction of
the arrow), represents the flow of spending on goods and services in the economy
(Mohr, 2020, p. 58).
The next participant that we introduce into the model is the government. The
government is responsible for providing public goods and services, such as roads,
bridges, and so on. for use by households and firms.
In order for government to provide these public goods and services, it receives tax
revenue from households and firms. Hence, we have flow of income in the form of tax
paid by firms and consumers and tax received by the government. In addition,
government provides subsidies to firms and households – flow of income (Mohr, 2020,
p. 60).
Next, we introduce the financial sector, which mainly comprises of financial

institutions, where consumers and firms deposit funds and earn interest on savings.
In addition, firms and consumers take loans to invest in capital goods and assets, and
have to pay interest on loans. Finally, we introduce the foreign sector. In the foreign
sector, importing countries pay using foreign exchange for imported goods and
services, and exporting countries earn foreign currency for exporting goods and
services (Mohr, 2020, p. 63).
This simple circular flow model of income, output and spending represents the
workings of a simple economy, and illustrates the importance of economic
interdependence. Importantly, it highlights the mutual dependence between the
microeconomy and the macroeconomy.

ECONOMICS
Task
Research an illustration of the circular flow model that includes the financial sector
and the foreign sector to analyse the interaction between these sectors and the
rest of the economy.
3.5 Conclusion
This chapter focused on total production, income and spending in the mixed
economy. A Simple Circular Flow Model of Income and Spending was first discussed to
observe the interaction of the three main sectors in the economy. We then looked at
the sources of production, called the factors of production. The chapter then shifted
its focus to the interdependence of the main sectors in the economy, illustrated by
the circular flow diagram.
1. Use diagrams to illustrate how goods and services, and

income and spending flow between households and firms.
2. Discuss the three basic flows in the economy and explain how
they are related.
3. Explain the terms “leakages” and “injections” as applicable to the

circular flow model of income and spending.
4. Distinguish between the “goods market” and the “factor market”.
1. Chapter 3, Figures 3.3 and 3.4

2. Chapter 3, Section 3.2 and Figure 3.1
3. Chapter 3, Section 3.7
4. Chapter 3, Box 3-4

ECONOMICS
CHAPTER 4:
Demand and Supply Analysis
Chapter Outcomes
• Understand how competitive markets operate

• Draw and read simple demand and supply graphs
• Understand why the market demand curve is a downward sloping curve
• Distinguish between a change in quantity demanded and a change in
demand
• Understand why the market supply curve is upward sloping
• Distinguish between a change in quantity supplied and a change in supply
• Determine market equilibrium
• Illustrate and explain market equilibrium, excess demand and excess supply
• Illustrate and identify the causes and effects on market equilibrium following
a change in any factor influencing demand and supply
• Understand how price controls operate when government intervenes
4.1. Introduction: The Importance of Demand and Supply Analysis
This chapter focuses on the goods market, by analysing individual markets for goods
and services. The households are the driving force behind the demand for consumer
goods and services, whereas the firms are the driving force behind the supply of
goods and services.
Demand and supply analysis forms an important part of Economics as it lays the
foundation for many economic analyses.
This chapter starts with a brief overview of demand. Households’ demand for goods
and services are then examined. This is followed by an explanation of the important
distinction between a movement along a curve and a shift of a curve. A similar
analysis of firms’ supply of goods and services is also discussed. Lastly, market

ECONOMICS
demand and market supply are combined to obtain the equilibrium price and
quantity of a product.
This chapter is based on Chapter 4 of Mohr (2020).
4.2. Demand
Demand flows from decisions about which wants to satisfy, given the available means.
If an individual demands something (in the economic sense), it means that he intends
to buy it and that he has the means, (i.e., the purchasing power), to do so. In other
words, demand refers to the quantities of a good or service that the potential buyers
are willing and able to buy at a given point in time.
Demand should not be confused with the concept of wants. Mohr (2020) describes
wants as the unlimited desires or wishes that people have for goods and services.
Only some of our wants can be satisfied as there are simply not enough means to
satisfy them all. Demand is only effective if the consumer is able and willing to pay for
the good or service concerned (Mohr, 2020).
Demand should also not be confused with needs or claims. When workers in a
particular firm or industry “demand” or claim a certain increase in their wages, those
“demands” are requests, (often supported by the threat of action), for certain wants or
needs to be satisfied (Mohr, 2020).
4.2.1. Individual demand
Mohr (2020) indicates that there are several determinants of individual demand, for
goods and services. They include:
• The price of the product – The lower the price of a good or service, the
larger the quantity the consumer will be willing and able to buy, ceteris
paribus (Mohr, 2020, p. 75).
• The prices of related products – A consumer’s choice about how much
of a good or service to purchase will also depend on the prices of related
products. Here we distinguish between complements and substitutes.
Complements are goods that are used jointly, forexample, tea and milk,
bread and butter or coffee and sugar. Substitutes are goods which can

ECONOMICS
be used instead of the good in question, for example, tomatoes can be

replaced by beans, (in a stew), or avocados or other ingredients, (in a
salad). Therefore, the prices of related goods also affect the consumer’s
decision about how much of a good or service to purchase (Mohr, 2020, p.
75).
• The income of the consumer – An individual’s buying plans will also be
affected by his/her income. The higher the consumer’s income, the more
goods and services he/she can afford, (and plan) to buy (Mohr, 2020, p.
75).
• The taste (or preference) of the consumer – A consumer’s decision will

also be influenced by their taste. The more the consumer enjoys for
example, tomatoes or dishes which require tomatoes as an ingredient, the
more tomatoes he/she will plan to buy. On the other hand, if a consumer
does not enjoy them, the lesser tomatoes he/she will plan to buy.
Therefore, taste can have a positive or a negative impact on the quantity
demanded (Mohr, 2020, p. 75).
• The size of the household – The larger the size of the household, the
more goods and services that household tends to demand and vice versa.
In other words, as households grow in size, they tend to purchase more
goods and services. Likewise, smaller households tend to purchase less
(Mohr, 2020, p. 75).
4.2.2. Market demand
Figure 4.1 illustrates the market demand curve. The market demand curve shows the
relationship between the quantities of goods and services that buyers are willing to
buy at different price levels, holding everything else, (the factors mentioned above),
constant. The market demand curve is based on the important law of demand. This
law states that any increase in the price level of a particular product will cause a decline
in the quantity demanded of that product, all other things remaining equal (ceteris
paribus) and vice versa. Any change in the price level causes a movement along the
given demand curve (Mohr, 2020, p. 75).

ECONOMICS
Definition
Ceteris paribus – the Latin term for “all things being equal”
In economics, it acts as a shorthand indication of the effect one economic

variable has on another, provided all other variables remain the same.
Source: (Liberto, 2021)
Figure 4.1: The Market Demand Curve

The negative slope of the demand curve indicates that a negative or inverse
relationship exists between price and quantity demanded (i.e., the law of demand).
4.2.3. Movements along the demand curve and shifts of the demand curve
As mentioned above, movements along the demand curve are related to changes in
the price of the good or service. When the price of a product changes, the quantity
demanded will also change, ceteris paribus, (all other factors remaining constant).
This can be seen in Figure 4.1. At a price of R50/kg, the quantity demanded is 2 kg.
With a drop in the price to R30/kg, the quantity demanded is now 4 kg – there is an
increase in quantity demanded with a drop in price. The opposite is also true. Assume

ECONOMICS
that the initial price is R20/kg. The quantity demanded is 5 kg. With an increase in
price to R40/kg, the quantity demanded is now 3 kg (Mohr, 2020, p. 78).
Figure 4.2 illustrates shifts in the demand curve. This occurs when factors influencing
the nature of demand change. Therefore, if a factor which determines the demand for
a product changes, (other than the price of the product), the demand curve for the
product will shift either to the left or to the right (Mohr, 2020, p. 79).
Figure 4.2: Shifts of the Demand Curve

The figure above illustrates the demand for a good, for example, Xbox games. The
original demand curve is DX. If the demand for Xbox games increases, due to for
instance, an increase in consumer’s income, the demand curve will shift outward to
the right, to D’X. The opposite is also true. If consumers’ income decreases, the
demand curve for Xbox games will shift from D’X to DX.
4.3. Supply
Supply can be defined as “the quantities of a good or service that producers plan
to sell at each possible price during a certain period” (Mohr, 2020, p. 81). Supply
refers to planned quantities – these are the quantities that producers or sellers plan
to sell at each price. As noted earlier, consumers must be able to execute their plans.

ECONOMICS
Similarly, producers must be willing and able to supply the quantities concerned given
their costs of production such as labour.
4.3.1. Individual supply
According to Mohr (2020, p. 82), there are several determinants of individual supply,
for goods and services. They include:
• The price of the product – The higher the price, the greater the quantity supplied
to the market. Prices convey information to market participants. High prices
indicate that demand in the market is good and therefore there is profit to be made
(Mohr, 2020, p. 82).
• The prices of alternative products – The decision to produce is not only

dependent on the price of the product in question – it is also dependent on the
prices of alternative products. A producer will have to decide which products to
produce with the given resources. Resources may be used to produce more than
one product and as a result, decisions have to be made as to how much of a
product to produce given the alternatives (Mohr, 2020, p. 82).
• Expected future prices – Production decisions are not made over a period or
periods of time and as a result plans have to be made with the future in mind.
Plans to produce are therefore made with the future in mind, i.e., producers make
decisions not only on the current market price but also on the prices they expect
to receive in the future (Mohr, 2020, p. 82).
• The state of technology – Technology plays an important role in the production

process as it impacts directly on the cost of production. Should there be
technological developments which allow producers to produce at lower cost, then
the quantity supplied will increase at each and every price level (Mohr, 2020, p.
82).
4.3.2. Market supply
The market supply curve shows the relationship between the price of the product and
the quantities supplied, (by all the firms), during a particular period. Figure 4.3
illustrates the market supply curve. The market supply curve slopes upwards from left

ECONOMICS
to right. In other words, there is a direct or positive relationship between price and
quantity supplied (Mohr, 2020, p. 81).
The market supply curve is based on the important law of supply. This law states that
any increase in the price level of a particular product will cause an increase in the
quantity supplied ofthat product, all other things remaining equal, (ceteris paribus) and
vice versa. Any change in the price level causes a movement along the given supply
curve (Mohr, 2020, p. 84).
Figure 4.3: The Market Supply Curve

The positive slope of the supply curve indicates that a positive relationship exists
between price and quantity supplied (i.e., the law of supply).
4.3.3. Movements along the supply curve and shifts of the supply curve
Any change in the price level will cause a movement along the given supply curve.
In Figure 4.3 above, a rise in the price level of motorcars, for example, causes a
movement from point a to point b along the supply curve, and vice versa. This change
in the price level, (an increase), causes the quantity supplied for motorcars to
increase.
Suppose advanced transport technologies and innovations are introduced in the

production of motorcars, all other things remaining constant. Figure 4.4 illustrates the
implications of this phenomenon. An increase in technology will lead to increased
production, and hence shifts the supply curve to the right. Alternatively, increases

ECONOMICS
in wages, which forms part of a firms costs of production, will cause the supply curve
to shift to the left at each price level (Mohr, 2020, p. 85).
Figure 4.4: Shifts of the Supply Curve

4.4. Market Equilibrium
Market equilibrium occurs where the quantity of a good/service demanded is equal

to the quantity supplied of that good/service. Equilibrium between households,
(demanders), and firms, (suppliers), will occur at equilibrium price (Mohr, 2020, p.
85).
At the equilibrium price, the plans of households and the plans of firms will be one
and the same, in that households will plan to purchase X amount of a good/service
and firms will plan to sell the same amount of the good/service. The result of this
matching of plans is that the market will come to a state of rest, this state occurs as
the two opposing forces, (demand and supply), are in a state of balance. As such,
therewill be no tendency for the conditions to change. However, should the underlying
forces change, the balance in the market will be upset and the market will adjust
accordingly (Mohr, 2020, p. 86).
To understand how the market arrives at a state of equilibrium, we need to

understand disequilibrium. Disequilibrium occurs when the price charged is at a

ECONOMICS
level other than the equilibrium price level, i.e., any price other than the equilibrium
price will bring about disequilibrium in the market (Mohr, 2020, p. 87).
Figure 4.5: Market Equilibrium
As can be seen in Figure 4.5, should a price above or below R5/kg be charged for
tomatoes, then demand and supply will not be equal, (disequilibrium). At a price above
R5/kg, the quantity supplied will be greater than the quantity demanded, there will
therefore be excess supply at prices above R5/kg.
This occurs as the higher price encourages producers to increase supply in the hope
of making greater profits. However, at prices greater than R5/kg consumers plan to
purchase less of the good than they would have at R5/kg. The result is that there will
be more of the good on the market than consumers are willing and able to purchase,
i.e., excess supply. Similarly, should the price fall below R5/kg, then the quantity
demanded will exceed the quantity supplied. This occurs because cheaper prices
result in more of the good being demanded, ceteris paribus, (the law of demand).
Whereas consumers are demanding more, producers are now producing less than
they wouldhave if the good was R5/kg, (low prices signal low demand and less profits),
there is now an excess demand in the market.
When the market is in disequilibrium, it goes through a process which leads it back to
equilibrium. In the case of excess demand there are too few goods on the market.
Firms have therefore sold their total production but households have not obtained the

ECONOMICS
quantity of the good that they demanded at the particular price. As households wish
to obtain more of the good, (at the going price), they offer more money for the product
(i.e., prices higher than the market price), in an effort to outbid other households. The
result is that the price of the product rises (Mohr, 2020, p. 86).
As the price starts to rise, firms realise that they can obtain a higher price for their
product and therefore increase their production of the good. However, as the price
rises, demand starts to slow down, (law of demand), and with it the rising price,
production will slow with demand and the process ends when equilibrium is obtained.
In the case of excess supply, there is not enough demand for the amount of goods on
the market. Firms are therefore unable to sell their products and as such are left with
a surplus of unsold goods (market surplus). These unsold stocks are also known as
inventories, and as the level of inventories rise, firms cut their production of the product
in an attempt to sell of the rising levels of stock and to compete with the other firms for
the limited demand.
By reducing their level of production, firms lower their cost and as a result, can charge
lower prices in order to compete. Graphically, this can be shown as a movement down
the supply curve towards the point of equilibrium. At the same time, demand will
increase as the price decreases and producers and consumers will move toward the
point where quantity demanded and quantity supplied are equal to each other.
Market equilibrium therefore occurs at the intersection of the demand and supply
curves (point E). This point is characteristic of both buyers and sellers agreeing upon
both, the quantity of goods that will be exchanged on the market and the price at which
these goods will be exchanged. At equilibrium, there is no tendency for change –
demand = supply (Mohr, 2020, p. 85).
4.5 Conclusion
This chapter started with a brief overview of demand. The households’ demand for
goods and services was examined which was followed by a discussion on the
distinction between a movement along a curve and a shift of a curve. The chapter
then focused on a similar analysis of firms’ supply of goods and services. Market
demand and market supply were combined to obtain the equilibrium price and
quantity of a product.

ECONOMICS
1. Distinguish between demand, wants and needs. What are the two basic
requirements for demand to exist?
2. Use diagrams to distinguish clearly between a change in demand and a

change in the quantity demanded.
3. Explain why it is important to differentiate between a change in demand
and a change in the quantity demanded.
4. Explain, with the aid of a graph, how a negative research finding about the
impact of chocolates on people’s health will affect the demand for
chocolates.
5. Explain what is meant by “the supply of a good”.
6. List and discuss three determinants of supply.

7. Explain what is meant by (a) equilibrium, (b) excess demand and (c)
excess supply in the market for bananas and explain how excess demand
and excess supply are eliminated by market forces.
8. List and discuss the determinants of individual demand for goods and
services.

2. Chapter 4, Section 4.2: Movements along the demand curve and shifts of the
curve. Figures 4.3, 4.4 and 4.6.
4. Demand will decrease. Demand curve will therefore shift to the left.

ECONOMICS
CHAPTER 5:
Demand and Supply in Action
Chapter Outcomes
• Graphically illustrate how the changes in either demand or supply or

simultaneous changes in demand and supply will affect the equilibrium price
and equilibrium quantity in the market
• Graphically illustrate the interaction between related markets
• Show what happen if the government intervenes in the price mechanism by
setting maximum and minimum prices
5.1. Introduction
As discussed in Chapter 4, demand and supply are among the most useful analytical
devices available to the economist. In Chapter 4, demand and supply were introduced
and we observed how they combine to determine the equilibrium price and quantity
exchanged in a goods market. In this chapter we will see how demand and supply can
be used to analyse certain situations in the economy. The focus of this chapter is on
predicting what will happen if something changes.
The chapter begins by examining how equilibrium prices and quantities react to
changes in demand. This is followed by a discussion of changes in supply. We then
look at simultaneous changes in demand and supply, followed by an analysis of the
interaction between related markets. The next section deals with government
intervention in markets, for example in the form of price fixing.
In Chapter 4, a number of factors that can cause a change in market demand as well
as the factors that can cause a change in market supply were mentioned. A change in
any determinant of demand or supply except the price of the product will result in a
change in demand or supply. This would be illustrated by a shift of the demand curve

ECONOMICS
or the supply curve. The impact of changes in demand or supply on the equilibrium
price and quantity of the product concerned are now examined.
5.2. Changes in Demand
As discussed earlier, should there be a change in any of the determinants of demand,

(except for the price), then the demand curve will shift.
To shift the demand curve to the right, Mohr (2020) explains that there would
need to be a change in any of the determinants to this effect:
• Increase in the price of a substitute, or
• Decrease in the price of a complementary product, or
• Increase in the consumers income, or
• Positive change in preferences towards the product, or
• Expectations of a price increase of the product.
If there is a change in any of the determinants to this effect, then it will be termed as
an increase in demand. This can be seen in panel (a) of Figure 5-1. Note that the
change in demand has not affected the supply curve. The change in demand from DD
to D1D1, (right shift), results in excess demand at the current market price of P 0. This
can be seen by extending the line P0E through to the demand curve D1D1. Therefore,
at a price of P0, demand for the product is greater than the amount of product being
sold, and as such consumers bid up the price. As the price rises, firms increase their
quantity supplied of the good (Mohr, 2020, p. 94).

ECONOMICS
Figure 5.1: Changes in Demand
At the same time, demand slows and eventually equilibrium is reached at point E1.
The characteristics of point E1 are: a higher price (P1), and a larger quantity supplied
(Q1). The move to equilibrium is therefore characterised by a movement along the
supply curve from E to E1 and a movement along the new demand curve (D1D1) from
where the extended P0E would intersect D1D1 to the point E1 (Mohr, 2020, p. 94).
Similarly, there is the case of a decrease in demand. This occurs when there is a
change in any ofthe determinants of demand, except the price of the product, namely:
• The price of a substitute falls.
• The price of a complementary product increases.
• A fall in consumer’s income.
• A reduced preference for the product.
• The price of the product is expected to fall.
In the above case, the demand curve will shift to the left. Like in the case of an increase
in demand, in the event of a decrease in demand, there is a shift of the demand curve
from DD to D2D2 in panel (b), with the supply curve remaining unchanged. At the
market price of P0 there is now an excess supply of goods on the market.
This can be seen by looking at the difference in the quantity demanded at the point
where P0E intersects D2D2, (the new demand curve), and the quantity supplied at price

ECONOMICS
P0 (this being Q0). This excess supply leads to a fall in the price of the product, as
producers have to compete to sell off their rising inventories. As producers cut back on
production and the price falls, demand for the product rises, (law of demand), and
equilibrium is reached at E2. This equilibrium of E2 is characterised by a lower price P2
and a lower quantity sold Q2. The move to equilibrium is therefore characterised by a
movement along the supply curve from E to E2 and a movement along the new
demand curve, (D2D2), from where P0E intersects D2D2 to the point E2 (Mohr, 2020).
5.3. Changes in Supply
We now turn our focus to changes in supply and their impact on the equilibrium
position of the market. An increase in supply results in a shift of the supply curve to
the right and is the result of changes in any of the determinants of supply, all
determinants other than price, namely:
• The fall in the price of an alternative product or should there be an increase

in the price of a joint product
• A reduction in the price of any of the factors of production, (i.e., a decrease
in the cost of production).
• An improvement in the factors of production, (the result of technological
progress) (Mohr, 2020, p. 95).
Figure 5.2: Changes in Supply

In Figure 5.2 above, an increase in supply can be seen in panel (a). As in our examples

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of changes in demand, changes in supply do not change the position of the demand
curve. The increase in supply from SS to S1S1 results in there being an excess supply
of the product at the market price of P0. This can be seen by extending the line P 0E
through to the new supply curve S1S1. As can be seen, the quantity demanded at P0
is Q0, (corresponding to point E), whilst the quantity supplied would be greater, (the
quantity corresponding to the point at which extended P 0E intersects S1S1) (Mohr,
2020).
The result of the excess supply is that the price of the product will fall as firms compete
for market share. The falling price will result in a rise in the quantity demanded and
the quantity supplied will slow. Market equilibrium will be reached at point E 1, -
characterised by a lower price P1 and a higher output Q1.
The move to equilibrium therefore becomes a movement along the demand curve from
E to E1 and a movement along the new supply curve (S1S1), from where the extended
line P0E would intersect S1S1 to the point E1 (Mohr, 2020).
A decrease in supply is shown as a shift of the supply curve to the left. This is illustrated
in panel in Figure 5-2, and is depicted as a shift from SS to S2S2. The shift in the supply
curve results from a change in any of the determinants of supply, other than price that
is, namely:
• An increase in the price of an alternative product or a fall in the price of a

joint product
• An increase in the price of any of the factors of production (i.e., an increase

in the cost of production)
• A decline in the productivity of the factors of production (this increases the
cost of production) (Mohr, 2020, p. 95).
The decrease in supply results in an excess demand at the original market price P0.
This can be seen by referring to panel (b). If we look at the broken line P0E, what can
be seen is that where it intersects the new supply curve S2S2, the quantity which
would be sold at that price is less than the quantity demanded or Q0, (the quantity
corresponding to point E).
This excess demand drives up the price of the product as consumers bid up the price

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in an attempt to obtain the scarce product. The increasing price reduces the demand
for the product and encourages producers to increase production. Equilibrium is
reached at point E2, where less of the product is sold, (Q2), and the price of the product
has increased to P2. The move to equilibrium is therefore characterised by a
movement along the demand curve from E to E2 and a movement along the new
supply curve (S2S2) from where P0E intersects S2S2 to E2 (Mohr, 2020, p. 95).
Case Study
Rolex shortages could ease this year as demand falls faster than supply
Quarterly financial updates from the publicly traded The Watches of Switzerland Group
(WOSG) are a treasure trove of insight and information on market conditions, and last
week’s investor call suggested there could be relief in sight for customers yearning for
the hottest watches from the likes of Rolex, Audemars Piguet and Patek Philippe.
This data comes on top of reports from secondary market players including Chrono24
and Chronext, which have reported that prices have dropped by up to 24% for watches
like the Rolex’s Rolex GMT Master II Batman, which could be another sign that the
market is expecting shortages to ease.
The Batman has seen some ups and downs over the last twelve months and is off its
highest price on Chrono24 by 24% at £12,900, although this is still well above its retail
price.
During his investor call, Brian Duffy, CEO of WOSG, made a simple, but potentially
important observation when he suggested that the Covid crisis has reduced demand
this year faster than supply has dropped with watchmaking factories closed.
“Supply is always our biggest constraining factor,” Mr Duffy says. “But we are seeing a
bigger impact on demand than on supply.”
He believes production will be down by around 25% across the luxury watch industry
this year.
Even with a slight rebalancing between supply and demand, the hardest to find unicorn
watches are certain to remain in short supply.

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Mr Duffy says there has been no change to the group’s waiting lists for these watches.
“We will not add anybody to waiting lists if we think they will have to wait more than
three years. Waiting lists have not reduced this year,” he reveals.
(Source: https://www.watchpro.com/rolex-shortages-could-ease-this-year-as-demand-
falls-faster-than-supply/)
Questions:
1. Discuss some of the factors that could be resulting in decrease in demand.

2. Discuss some of the factors that could be resulting in decrease in supply.
5.4. Simultaneous Changes in Demand and Supply
When dealing with changes in demand or supply, it is possible to predict what will
happen to equilibrium prices and equilibrium quantities in the market. However, should
both demand and supply change simultaneously, then the specific outcome cannot
be predicted (Mohr, 2020, p. 96).
For example, should there be an increase in demand, (due to a positive change in

preferences toward the product), accompanied by a decrease in supply, (due to an
increase in the price of the factors of production), then the thing that is certain is that
the price of the product will rise. This is due to the fact that both of the changes result
in an increase of the equilibrium price in the market. What the equilibrium quantity will
be however is uncertain. This is due to the fact that as far as equilibrium quantity is
concerned, the two forces work in opposition to each other. An increase in demand
works to raise the equilibrium quantity, ceteris paribus, whilst a decrease in supply
lowers the equilibrium quantity, ceteris paribus (Mohr, 2020, p. 96).
The outcome in the market therefore depends on the relative magnitudes of the
changes.

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Task
With the aid of diagrams, illustrate the various scenarios in which there are changes
in demand or supply. Use these diagrams to examine changes in equilibrium prices
and quantities.
5.5. Price Controls and Government Intervention
The free-market system allows prices and output to be determined by the forces of
demand and supply without any interference from the government. However, in reality,
this is not always the case. In certain circumstances where free markets do not yield
suitable outcomes, the government may need to take action to influence prices and
production levels in relevant markets. The government can intervene by setting for
example, maximum prices, (price ceilings), and setting minimum prices, (price
floors) (Mohr, 2020, p. 98).
A price ceiling is a maximum price set by the government, which is below the market
equilibrium price. A price floor is a minimum price set by the government, which is
above the market equilibrium price (Mohr, 2020, p. 99).
Figure 5.3: Government Intervention


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Let us take a closer look at each. Panel (a) of Figure 5.3 illustrates the effects of a
price ceiling on the market for food. Consider a small food importing country such as
Egypt. Suppose a civil war breaks out and disrupts the importation of food into this
country. The equilibrium price Pe will be too expensive and unaffordable for the
population to buy food. In this instance, the government decides to intervene to make
food more affordable, and thus lowers the price level to below the equilibrium price,
(price ceiling). The price ceiling is PC. At PC the quantity supplied for food is greater
than the quantity demanded. The difference between the quantity demanded and
quantity supplied (QD-QS) is equal to excess demand or market shortage. In other
words, a price ceiling leads to excess demand for food. Furthermore, this situation of
market shortage promotes black market activity (Mohr, 2020, p. 99).
Panel (b) illustrates the market for unskilled labour, for example, domestic workers.
Suppose a minimum wage law, (price floor) is set at PF, above the equilibrium or
market price of labour, Pe.
Note that wages, the price of labour, is determined in the same way as the price of
any other product in any other market. At PF the quantity demanded of labour is less
than the quantity of labour supplied. As labour forms a large part of a firm’s cost of
production, a higher price level contributes to higher costs of production at PF (Mohr,
2020, p. 102).
Higher production costs erode firms’ profits. Hence firms begin to lay off workers. This
causes a decrease in the quantity of labour demanded and an increase in the quantity
of labour supplied. The result is labour surplus or unemployment. There are not
enough jobs available for the number of workers to occupy (Mohr, 2020, p. 103).
5.6. The Welfare Costs of Price Fixing
Mohr (2020, p. 88) defines consumer surplus as “the difference between what
consumers pay and the value that they receive, indicated by the maximum amount
they are willing to pay”. Similarly, producers may be willing to supply units of the
product at less than the market price. The total gain to producers is called the producer
surplus (Mohr, 2020, p. 88). The concepts of consumer surplus and producer surplus
are used to demonstrate the welfare costs of price fixing.

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5.6.1. Minimum price fixing
Price controls are invariably implemented in the sincere belief that they are in the
best interests of society. In many cases it is motivated by an honest concern for
the well-being of poor consumers or low-income citizens (Mohr, 2020, p. 104).
Price controls, however, create problems of their own. The end result, illustrated
in Figure 5.4 is that the total welfare loss to society is represented by both
triangles B and C, this is referred to as the deadweight loss. The area made up
of triangles B and C has been lost to society and this comes about due to the
fact that less is being produced in society, and society itself is made up of both
producers and consumers (Mohr, 2020, p. 104).
Figure 5.4: The Welfare Cost of Minimum Price Fixing

Source: (Mohr, 2020, p. 104)
5.6.2. Maximum price fixing
The concepts of consumer surplus and producer surplus, can also be applied to
illustrate the welfare loss associated with maximum price fixing. This is illustrated in
Figure 5.5 below (Mohr, 2020, p. 102).

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Figure 5.5: The Welfare Cost of Maximum Price Fixing

Without price fixing, the equilibrium price is P1 and the equilibrium quantity Q1.
Government then fixes a maximum price Pm below the equilibrium price. The quantity
exchanged falls to Qm.
Rectangle B is transferred from the producer surplus to the consumer surplus. Triangle
A, which used to be part of the consumer surplus, and triangle C, which used to be part
of the producer surplus, both disappear. The total deadweight loss to society is equal
to A plus C.
5.7 Conclusion
In this chapter, how the tools of demand and supply can be used to analyse real world
situations were analysed by focusing on the direction of change. The impact of a
given change in demand or supply on the equilibrium price and quantity (i.e., the
magnitude of the change) will depend on the shape of the supply and demand curves.
1. “At market equilibrium both the consumer surplus and the

producer surplus are zero.” Do you agree with this statement?
Explain, using a diagram.
2. Use diagrams to illustrate what will happen to the equilibrium price

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and quantity of a product in each of the following cases, (clearly

indicate instances where the impact cannot be predicted):
a) a simultaneous increase in demand and supply.
b) a simultaneous decrease in demand and supply.
c) an increase in demand along with a decrease in supply.
d) a decrease in demand along with an increase in supply.

3. Explain, with the aid of a diagram, what happens in the market
for (say) electricity if the government fixes a maximum price
below the equilibrium price.
4. Use a diagram to explain how a so called black market can develop
when the government intervenes in the price mechanism by fixing
prices.

2. Chapter 5, Table 5.1

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CHAPTER 6:
Consumer Theory and Individual Demand
Chapter Outcomes
• Understand the theory of consumer choice according to the marginal utility

approach
• Understand the law of diminishing marginal returns
• Determine consumer equilibrium according to the marginal utility approach
6.1. Introduction
This chapter discusses the demand side of microeconomics. This refers to the
behaviour of consumers. The willingness of consumers to purchase goods and
services is the fundamental source of revenue and profits for any business.
Understanding the foundation of the conduct of consumers is important for business

managers when making decisions with respect to setting prices, advertising and
marketing programmes and production decisions.
In understanding how consumers behave, we will look at the marginal utility approach.
This approach looks at concepts such as utility, marginal utility and weighted marginal
utility. It is based on the law of diminishing marginal utility, which explains how a
rational consumer is likely to behave. All consumers strive to maximise their
satisfaction, (utility), but are constrained by a number of factors such as income, price,
interest rates, and so on

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6.2. The Marginal Utility Approach to Consumer Behaviour
In microeconomic theory, the concept of utility is referred to as the satisfaction or

desire that one receives from consuming a particular good or service. Utility is not
measurable, and is a subjective concept; therefore, we refer to units of utility.
Total utility
Total utility refers to the entire satisfaction that a consumer receives from consuming
a good or service (Mohr, 2020, p. 132).
Marginal utility
Marginal utility refers to the satisfaction received from consuming an additional

(marginal) unit of a particular good. More generally, marginal utility refers to the
change in total utility resulting from consuming an additional unit of a good or service.
The law of diminishing marginal utility states that each consecutive unit of a good
or service consumed yields less marginal utility. In other words, the marginal utility of
a good declines as more of that good is consumed (Mohr, 2020, p. 135). For example,
suppose you consume the first slice of a pizza. The satisfaction, (utility), that you
receive from consuming the first slice of pizza is quite large.
Then, you consume a second slice of pizza, a third and a fourth slice. Was the
satisfaction that you obtained from the fourth slice of pizza as good as the satisfaction
obtained from the first slice? If you rate your satisfaction in terms of units of satisfaction
(utility), would you rate the satisfaction that you obtained from the first slice of pizza
higher than the satisfaction that you obtained from the fourth slice? In other words, as
you tend to consume successive slices of pizza, your marginal utility of every
additional slice of pizza will decline (Mohr, 2020).
6.3. Consumer Equilibrium
Marginal utility theory assumes a rational consumer will always aim to obtain the
highest attainable level of satisfaction, (total utility). Many consumers have insufficient
incomes to purchase a variety of goods and services. Using the concept of consumer
equilibrium helps us to understand how consumers might choose a combination of

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goods or services, given the prices of those goods and services and the income levels
of consumers. Confronted with a variety of goods and services, consumers will choose
a combination of goods and services constrained by income levels and prices.
Consumers want to maximise their total utility for a combination of goods and services,
given their income levels and the prices of goods and services. Consumers experience
consumer equilibrium when they obtain maximum total utility, given their income
levels and prices of goods and services. In order to demonstrate consumer
equilibrium, we introduce another concept – weighted marginal utility. To determine
consumer equilibrium, we must find the combinations of goods for which the weighted
marginal utilities must be equal and for which the combinations of goods and service
are affordable, given income levels (Mohr, 2020, p. 136).
The consumer equilibrium condition can be expressed as:
𝑀𝑈𝑎 𝑀𝑈𝑏 𝑀𝑈𝑐 𝑀𝑈𝑧

= = =
𝑃𝑎 𝑃𝑏 𝑃𝑐 𝑃𝑧
Where: MUa, MUb MUc … denote the marginal utilities of goods a, b and c and Pa, Pb,
Pc… represent the prices of the respective goods.
Two conditions are required for consumer equilibrium to hold, namely:
a). Combinations of goods must be affordable.
b). The weighted marginal utilities of the various goods must be equal (Mohr,
2020, p. 137).

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Task
Complete the following table. Use the table to identify the combination of Goods A
and B that would maximise utility.
Price of Good A = R1 Price of Good B = R2
Units Total Marginal Marginal Total Marginal Marginal

Utility Utility Utility per Utility Utility Utility per
(Good A) (Good A) Rand (Good (Good B) Rand
(Good A) B) (Good B)
1 10 24
2 18 44
3 25 62
4 31 78
5 36 90
6 40 96
6.4. Conclusion
This chapter examined the decisions of an individual consumer by using the utility
approach to consumer theory, which is based on the notion of cardinal utility. The key
concept in the utility approach is marginal utility. Marginal concepts play an important
role in economic analysis. It is important to understand what “marginal” means and
how a marginal value relates to an average value and a total value.
The next chapter focuses on the responsiveness of the quantity demanded and the
quantity supplied to changes in price and other determinants of the quantity demanded
and the quantity supplied. To do so, the chapter contains an analysis of the price
elasticity of demand, the income elasticity of demand and the cross elasticity of
demand.

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1. Define the terms total utility and marginal utility.

2. Explain what the law of “equalising the weighted marginal utilities” means.
3. Suppose the marginal utility and total utility of Nthatho Moloi’s weekly
consumption of apples are both positive. He subsequently consumes
fewer apples per week. What will happen to his marginal and total utility
of apples? Explain your answer.

3. As consumption increases, total utility increases and marginal utility
decreases. This principle may be applied to the consumption of apples.

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CHAPTER 7:
Elasticity
Chapter Outcomes
• Define the concept of elasticity

• Understand the link between price elasticity and total revenue from sales
• Explain the determinants of price elasticity of demand
• Define and explain the concept of income elasticity of demand and cross
price elasticity of demand
7.1. Introduction
This chapter focuses on the responsiveness of the quantity demanded to changes in

price and other determinants of the quantity demanded. In the previous chapters, we
analysed how the equilibrium price and quantity in the market will respond to changes
in demand and supply. However, it is important to study what the absolute or relative
sizes of the changes in price and quantity would be. By how much, for example, will
the equilibrium price increase if supply decreases? And by how much will the
equilibrium quantity change? Furthermore, what will happen to the total revenue of the
suppliers, which is equal to the average price per unit multiplied by the quantity sold?
Will it decrease or will it increase? Will suppliers benefit from higher prices or from
lower prices, bearing in mind that the quantity demanded will probably react to a price
change? What determines the responsiveness of the quantity demanded to changes
in price? By how much does the quantity demanded respond to changes in income or
changes in the prices of substitutes or complements? These are the questions that
are examined in this chapter.
This chapter begins with a general definition of elasticity. This is followed by an

analysis of the price elasticity of demand, which constitutes the main part of the

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chapter. In the subsequent sections we examine the income elasticity of demand and
the cross elasticity of demand.
7.2. A General Definition of Elasticity
Elasticity is a measure of responsiveness or sensitivity. When two variables are

related, one often wants to know how sensitive or responsive the dependent
variable is to changes in the independent variable (Mohr, 2020). For example, it is
common knowledge that the size of the maize crop is dependent on rainfall. But how
sensitive or responsive is the size of the maize crop, to a one per cent change in
rainfall?
Elasticity can be defined as: “the percentage change in a dependent variable to the
percentage change in the independent variable” (Mohr, 2020, p. 114). This is
obtained by dividing the percentage change in the dependent variable by the
percentage change in the independent variable:
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑑𝑒𝑝𝑒𝑛𝑑𝑒𝑛𝑡 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒

𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 =
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑑𝑒𝑝𝑒𝑛𝑑𝑒𝑛𝑡 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒
7.3. Price Elasticity of Demand
Price elasticity of demand is the percentage change in the quantity demanded if the
price of the product changes by one percent, ceteris paribus (Mohr, 2020, p. 114).
%Δ𝑄𝑑
In other words, price elasticity of demand, 𝜀𝑃 = %Δ𝑃
Suppose we increase airline fares by 20 per cent, (increase in price). According to the
law of demand, the quantity demanded for flying will fall. This is how we would expect
consumers to behave. Now suppose ticket sales drop by 10 per cent, (quantity
demanded). The price elasticity of demand for ticket sales given the rise in prices will
equal -0.5. It was determined as follows:

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%Δ𝑄𝑑
𝜀𝑝 =
%Δ𝑃
−10
𝜀𝑝 =
20
𝜀𝑝 = −0.5
What does this -0.5 imply? The price elasticity of demand is negative because price
and quantity demanded move in opposite directions, (law of demand). We say that the
demand is inelastic because Ep is less than 1. This implies that passengers are not
very responsive to changes in airfares.
7.3.1. Categories of price elasticity of demand
The categories of price elasticity of demand are as follows:

• Perfectly inelastic demand
• Inelastic demand
• Unit elastic demand or unitary elasticity of demand
• Elastic demand
• Perfectly elastic demand
In the case of perfectly inelastic demand (ep = 0), consumers will plan to purchase
a fixed amount of the product regardless of the price which is charged. This can be
shown graphically by drawing the demand curve as a vertical line, as illustrated in
Figure 7.1 (a). In this case, producers can raise their revenue by increasing the price
charged for the product. As the quantity demanded does not change, raising price
results in an increase in total revenue. Remember Total Revenue (TR) = PQ (Mohr,
2020, p. 122).
In the case of inelastic demand (0 < ep < 1), the percentage change in quantity
demanded is smaller than the percentage change in price (remember, in the opposite
direction), as illustrated in Figure 7.1 (b). The demand curve which illustrates this case
is that of a steeply sloped demand curve. The steep slope of the demand curve serves
to illustrate the fact that the percentage change in quantity is smaller than that of the
price change. As a result of the fact that the quantity demanded changes
proportionately less than the change in price, producers have an incentive to raise

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their prices in order to increase their revenue. Likewise, there is no reason why
producers would decrease the price of their product as the revenue received from the
increase in quantity demanded will not offset the revenue lost due to the decrease in
price (Mohr, 2015, p. 110).
In the case of unitary elasticity (ep = 1), the demand curve used to illustrate the
properties ofunitary elasticity is a rectangular hyperbola, as illustrated in Figure 7.1(c).
This graph illustrates that the percentage change in quantity demanded is equal to
percentage change in the price of the product. In this case, as the proportional (i.e.,
percentage) changes in quantity demanded and price are the same, producers would
not gain anything by increasing or decreasing the price of the product (Mohr, 2015, p.
110).
In the case of elastic demand (1 < ep < ∞), the percentage change in quantity
demanded is greater than the percentage change in price (remember, in the opposite
direction), as illustrated in Figure 7.1 (d). The demand curve which illustrates this case
is that of a relatively flat demand curve. The flat slope of the demand curve serves to
illustrate the fact that the percentage change in quantity is greater than that of the price
change. As a result of the fact that the quantity demanded changes proportionately
more than the change in price, producers have an incentive to decrease their prices
in order to increase their revenue. Likewise, there is no reason why producers would
increase the price of their product as the revenue lost from the decrease in quantity
demanded will not offset the revenue gained due to the increase in price (Mohr, 2015,
p. 110).
In the case of perfectly elastic demand (ep = ∞), consumers will plan to purchase a
fixed amount of the product at a certain price. This can be shown graphically by
drawing the demand curve as a horizontal line, as illustrated in Figure 7.1 (e). When
demand is perfectly elastic, buyers will only buy at one price and no other. If producers
attempt to increase prices, quantity demanded will fall to zero and total revenue will
drop to zero as well (Mohr, 2015, p. 110).

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The five cases of price elasticity of demand are illustrated below:
Figure 7.1: Price Elasticity of Demand


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Task
Identify practical examples for each of the five categories of price elasticity of
demand.
7.3.2. Price elasticity of demand and total revenue
The price elasticity of demand can be used to determine by how much the total
expenditure byconsumers on a product, (which is also the total revenue of the firms
producing that product), changes when the price of the product changes. This is
probably the most important reason why economists, businesspeople and policy
makers are so interested in information concerning the price elasticity of demand
(Mohr, 2020, p. 122).
The total revenue (TR), accruing to the suppliers of a good or service, (or the total
expenditure by the consumers), is equal to the price (P) of the good or service
multiplied by the quantity (Q) ,sold. We know that there is an inverse relationship
between the quantity demanded (Q), and the price of a product, (P). Any change in
price leads to a change in the quantity demanded in the opposite direction to the
change in price. The effect of a price change on total revenue will thus depend on the
relative sizes of the price change and the change in the quantity demanded (Mohr,
2020).
Figure 7.2: Total Revenue and the Elastic and Inelastic Demand Curve
Source: (Mohr and Fourie, 2013)
In Figure 7.2 (a) above, total revenue is equal to the area of the rectangle, PXQ which

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is illustrated by the entire shaded area, R20x15 units = R300. Let us suppose the price
level falls. What happens to total revenue? A fall in the price level increases the
quantity demanded. Total revenue is equal to R15x30 units = R450. Therefore, total
revenue has increased from R300 to R450. Now, consider Figure 7.2 (b). If we do the
same exercise, we will find that total revenue will fall. Initially, total revenue is equal to
R20x15 units = R300, (note that the scales of the graphs are different).
Suppose the price level falls total revenue will now be equal to R15x18 units = R270.
Total revenue has declined from R300 to R270. Why has this happened? In both cases
the price level dropped by the same amount. This is due to price elasticity of demand.
Consider the first case above; the demand curve in this instance is price elastic. This
is generally implied by a relatively flat demand curve.
When demand is price elastic, the elasticity coefficient is greater than 1(Ed > 1).
Initially, total revenue was R300 (point Z). A fall in the price level increased total
revenue to R450 (point A). Total revenue increased because consumer response to
the lower price was relatively large. That is, the percentage change in the quantity
demanded was greater relative to the percentage change in the price level – see Figure
7.2 (a). Thus, we can say that a fall in the price level increases total revenue if demand
is elastic (Mohr, 2020).
In the second case, the demand curve is price inelastic, given by a relatively steep
demand curve. With inelastic demand, the coefficient is less than 1, (E d<1). Here, we
find that a price cut reduces total revenue. Total revenue fell because consumers
responded minimally to the fall in the price level. The percentage change in the quantity
demanded was smaller relative to the percentage change in the price level – see Figure
7.2 (b). Thus, a fall in the price level reduces total revenue if demand is inelastic.
This section shows that price cuts will not always yield the same results in total
revenue. This is so, due to whether demand is relatively elastic, relatively inelastic,
(which we have considered), unitary elastic, perfectly elastic or perfectly inelastic. Your
textbook takes a closerlook at the other categories of elasticities and their relationships
with total revenue. Price elasticity analysis helps businesses to predict how consumers
will respond to changing prices,and hence what will happen to total revenue (Mohr and
Fourie, 2013).

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7.4. Other Demand Elasticities
Quantity demanded does not only depend on price. The quantity demanded of a
product is also responsive to a change in income and to a change in the prices of
related products.
7.4.1. Income elasticity of demand
This elasticity measures consumer responsiveness (change in quantity demanded) to

a change in income. Income elasticity of demand is equal to the percentage change
in the quantity demanded divided by the percentage change in consumer’s income
(Mohr, 2020, p. 121) i.e.
%Δ𝑄𝑑
Income elasticity of demand = 𝜀𝑦 = %ΔY
Income elasticity of demand may be positive or negative. We say that the income
elasticity of demand is positive when an increase in consumers’ income results in
an increase in the quantity demanded of a particular product, and vice versa
(Mohr, 2020, p. 121).
Products that display positive income elasticities of demand are called normal
goods. Products with positive income elasticities of demand can be classified into
luxury goods and essential goods (Mohr, 2020, p. 121).
When the positive income elasticity is greater than one (Ey >1), the good is a luxury
good. When the positive income elasticity is less than one (Ey <1), the good is an
essential good.

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Products with negative income elasticities of demand means that an increase in

consumers’ income results in a decrease in the quantity demanded of a particular
product, and vice versa. They are called inferior goods.
Source: (Rittenberg and Tregarthen, 2017)
7.4.2. Cross Price Elasticity of Demand
This elasticity of demand measures consumer responsiveness (change in quantity

demanded) to changes in the prices of related goods. Cross elasticity of demand is
equal to the percentage change in the quantity demanded of one good, (good A),
divided by the percentage change in price of another related good, (good B), i.e.
%Δ𝑄𝑑𝐴
Cross elasticity of demand = 𝜀𝐶 = %Δ𝑃𝐵
Cross elasticity of demand may be positive or negative. When two goods are
substitutes, (e.g., mutton and beef), the cross elasticity of demand is positive. In other
words, an increase in the price of mutton, will lead to an increase in the quantity
demanded of beef. The two variables move in the same direction; hence EC is
positive.
When two goods are complements (for example, motor cars and motor car engines)
the cross elasticity of demand is negative. In this instance, an increase in the price of

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motor cars will lead to a decrease in the quantity demanded of motor cars, and a fall
in the quantity demanded of motor car engines. The two variables, namely, the price
of motor cars and the quantity demanded of motor car engines, move in opposite
directions, hence the EC is negative (Mohr, 2020, p. 124).
Source: (Rittenberg and Tregarthen,2017)
7.5. Conclusion
This chapter focused on the responsiveness of the quantity demanded to changes in

price and other determinants of the quantity demanded. The chapter started with a
general definition of elasticity. This was followed by an analysis of the price elasticity
of demand, the income elasticity of demand and the cross elasticity of demand.
The next chapter looks at the behaviour of firms. The theory behind the supply curve
will be examined, paying careful attention to different types of revenues earned and
costs incurred in the short-run and in the long-run.

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1. Define elasticity. Explain why economists are interested in measures

of elasticity.
2. Discuss why it is important to suppliers of products to have information

about the price elasticity of the demand for their products.
3. Use income elasticity of demand to distinguish between:
i. normal and inferior goods.
ii. essential and luxury goods.
4. Define the price elasticity of the demand for potatoes and discuss its
determinants.
5. Suppose the price elasticity of the demand for overseas holidays is

1,8.
i. Explain what this means.
ii. Give possible reasons why the elasticity coefficient in this

particular case is greater than one.
iii. Explain what will happen to the total revenue of the suppliers of
overseas holidays if the price of such holidays: (i) increases, (ii)
decreases.

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2. Chapter 6, Section 6.2: Subsection: Price elasticity of demand and total

revenue (or total expenditure)
3. Chapter 6, Section 6.3: Subsection: Income elasticity of demand
4. Potatoes may be considered a necessity. The price elasticity of demand for

potatoes is likely to be inelastic. This may be taken into consideration and
applied to the determinants of the price elasticity of demand as discussed in
Section 6.2: Subsection: Determinants of the price elasticity of demand.
5. Elastic demand. Apply relevant determinants of price elasticity of demand to

justify the elastic nature of demand for overseas holidays. If price increases,
total revenue would decrease. If price decreases, total revenue would
increase.

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CHAPTER 8:
The Theory of Production and Costs
Chapter Outcomes
• Understand the different types of firms and the goals of the firm
• Distinguish between short run and long run
• Distinguish between economic costs and profit, and accounting costs and
profit
• Distinguish between fixed and variable inputs
• Explain the short-run production function
• Understand the law of diminishing marginal returns and relate it to
production and costs
• Explain the relationship between the total product curve, average product
curve and marginal product curve
• Explain the relationship between the average total cost curve, average
variable cost curve, average fixed cost curve and the marginal cost curve
• Understand the concept of economies of scale
8.1. Introduction
This chapter looks at the theory behind the supply curve, and examines firms’
decisions about how many units of a good or a service to supply at each price. This
theory is usually called the theory of the firm. One of the key goals of microeconomic
theory is to explain and predict how firms behave and respond to changes in market
forces and economic policies.
In this chapter we examine the behaviour of firms. It is assumed that all firms aim to
maximise profit. This chapter begins with a discussion of revenue, cost and profit.
This is followed by a more detailed discussion of production and cost. Total, average
and marginal product and total, average and marginal cost are also introduced in

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this chapter. This chapter also highlights the difference between the short run and the
long run.
In microeconomics we examine the decisions of participants in the economy such as

households or firms. In this chapter we analyse the decisions of individual firms.
8.2. A Background to Supply
Supply also rests on a theoretical foundation, called production and cost theory, or
simply supply theory. This study unit deals with the fundamental income, cost and
production concepts required to analyse the decisions of firms about the quantities to
supply at various prices. Firms want to maximise profits. To earn higher profits,
producers must make the right supply decisions in terms of production and costs
(Mohr, 2020, p. 156).
8.2.1. Types of firms
Mohr (2020, p. 156) highlights that the most common types of firms in South Africa are
individuals, proprietorships, partnerships, cooperatives, trusts and public corporations.
We also have the informal businesses like street hawkers, vendors and illegal trading.
Not all firms function the same way. Smaller businesses tend to have only one product
or service whilst larger businesses sell a variety of products.
8.2.2. Goal of the firm
The main goal of every firm is to maximize profits. If a firm is not profitable it will not
be able to operate in the long run (Mohr, 2020, p. 156).
8.2.3. The short-run and long-run period of a firm
According to Mohr (2020, p. 157), it is important that we distinguish between the

short-run and the long-run. The short-run is referred to as the period in which at least
one fixed factor input cannot be changed. The long- run period refers to a time frame

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long enough so that all factor inputs may be changed, (no fixed costs). A firm’s
decisions tend to differ depending on the short-run and long-run time period.
8.3. The Concept of Revenue
• Total revenue, (TR), is defined as the “total value of sales and is equal to
price, (P), multiplied by quantity, (Q)” (Mohr, 2020, p. 156), i.e.,
𝑇𝑅 = 𝑃 𝑥 𝑄 (𝑜𝑟 𝑠𝑖𝑚𝑝𝑙𝑦 𝑃𝑄)
• Average revenue is equal to total revenue, (TR), divided by the quantity,

i.e.
𝑇𝑅 𝑃𝑄
𝐴𝑅 = = =𝑃
𝑄 𝑄
• Marginal revenue, (MR), is the additional revenue earned by selling an

additional unit of the product, i.e.
Δ𝑇𝑅 Δ𝑃𝑄
𝑀𝑅 = (𝑜𝑟 )
Δ𝑄 Δ𝑄
8.4. The Concept of Costs
Mohr (2020, p. 157) highlights that to the economist, the cost of using something in a
particular way is the benefit foregone by not using it in the best alternative way. This
is called opportunity cost. Accountants and businesspeople consider only the actual
expenses incurred to produce a product. However, the economist measures the cost
of production as the best alternative sacrificed, (or foregone), by choosing to produce
a particular product. The opportunity cost principle is used to determine the value of
all the resources used in production by the economist.
The difference between accounting costs and economic costs can be explained by
distinguishing between explicit costs and implicit costs. Accountants consider
explicit costs only. Explicit costs are the monetary payments for the factors of

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production and other inputs bought or hired by the firm. These costs are also referred
to as opportunity costs, since the payments for the inputs reflect opportunities that are
sacrificed (Mohr, 2020, p. 157).
For example, if a firm pays R2 million for a certain machine, it means that it has
decided not to do something else with the money (like purchasing a different machine,
purchasing a building or depositing the money with a financial institution).
Economists, however, use a broader concept of opportunity cost and consider implicit
costs as well as explicit costs. Implicit costs are those opportunity costs which are not
reflected in monetary payments. They include the costs of self-owned or self-employed
resources. For example, the owner of a one-person business must consider what
he/she would have earned if he/she had not been running the firm (i.e., the opportunity
cost of the owner's time must be included in the cost of production). The true economic
cost of using the resources in a particular way is the value of the best alternative uses,
(or opportunities), sacrificed (Mohr, 2020).
Figure 8.1: Economic profit and accounting profit


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8.5. The Concept of Profit
Profit is the difference between revenue and cost i.e.:
Profit = Revenue – Cost
In other words, a firm's profit is the difference between the revenue it earns by selling
its product and the cost of producing it. The economist's definition of profit is, however,
not the same as the accountant's definition of profit. As economists, we distinguish
between total, (or accounting) profit, normal profit and economic profit:
• Total (or accounting) profit: the difference between total revenue from the
sale of the firm's product(s) and total explicit costs;
• Normal profit: the best return that the firm's self-owned, self-employed
resources could earn elsewhere;
• Economic profit is the difference between total revenue from the sale of
the firm's product(s) and total explicit and implicit costs, (i.e., the total
economic, or opportunity, costs of all resources) (Mohr, 2020).
Therefore, it can be stated that:
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 = 𝑡𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑒𝑥𝑝𝑙𝑖𝑐𝑖𝑡 𝑐𝑜𝑠𝑡𝑠

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

𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑝𝑟𝑜𝑓𝑖𝑡 = 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 − 𝑛𝑜𝑟𝑚𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡
8.6. The Production Function
Mohr (2020, p. 162) describes production as the physical transformation of inputs into
output. Some goods and services i.e., the inputs, are combined to produce other
goods and services i.e., the output. The inputs typically consist of factors of production
and intermediate inputs. The production function is essentially the illustration of the
relationship between the quantity of inputs and the maximum output that can be
obtained from these inputs.

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8.6.1. Short-run production function
The production function shows the maximum amount that the firm can produce using
existing technology, a fixed input and a variable input. In the short-run, we may have
fixed inputs such as capital and land. For simplicity’s sake, we use labour as the
variable input, for example, we look at the production function for a maize farmer,
(below in figure 8.2). The graph illustrates how many tons of maize can be produced
with a given amount of land and machinery, (fixed inputs – land and capital), and
varying quantities of workers, (variable input – labour). When we employ one worker,
that worker produces 16 tons (Mohr, 2020, p. 162).
Refer to Table 8.1 below for the schedule of the maize farmer’s simple production
function.
Table 8.1: Production schedule of a maize farmer with one variable input
Units of Land Units of Labour Total Product (TP) in
tons
20 0 0
20 1 16
20 2 44
20 3 78
20 4 113
20 5 145
20 6 171
20 7 190
20 8 200
20 9 200
20 10 187
Source: (Mohr; 2020, p. 162)

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8.6.2. Total product
Eight workers produce a total product of 200 tons. The firm’s output depends on the
quantities of variable input employed. The total product curve is shown in the graph
below.
Figure 8.2: The Total Product Curve

8.6.3. Average product and marginal product
The average product, (AP), of the variable input is merely the average number of
units of output produced per unit of the variable input. It is attained by dividing total
output, (TP), by the quantity of the variable input, (N).
The marginal product (MP), of the variable input is the number of additional units
of output produced by adding one more unit, (the marginal unit), of the variable input.
As shown in Figure 8.2 above, together the first and second worker produces a total
product of 44 tons. However, to determine the marginal product of the second worker
we are interested in how many tons he produced on his own. That is, 44 - 16 tons
(change in total output) = 28 tons. The second worker’s marginal product is equal to
28 tons. In this particular example, the change in the quantity of the labour input is
always equal to one, because we add one extra worker every time. Thus, 28 tons/1
worker = 28 tons.
What will the marginal product of labour be for the third worker? 78 - 44 tons = 34
tons. As we move further along the total product, (TP), curve we can calculate the
marginal product of labour at different points along the TP curve. Lastly, we find that

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the marginal product of the eighth worker is equal to 10 tons, (although not shown in
the diagram, 200 - 190 tons = 20 tons.) In our example the marginal product increases,
and then decreases, as we employ more workers. As we hire more workers, total
output increases but the marginal product of the variable input eventually declines.
This brings us to the law of diminishing returns (Mohr, 2020, p. 163).
The law of diminishing returns states that as more of a variable input is combined with
one or more fixed inputs in a production process, points will eventually be reached
where first the marginal product, then the average product and finally the total product
start to decline.
The slope of the total product curve is equal to the marginal product of labour.
Why does the marginal product of labour decline? This implies that the land may
become overcrowded for all ten workers to do their jobs due to for example, limited
land space or insufficient machines. Thus, in the short run the availability of land space
or the number of machines, (capital), are fixed inputs, which are the cause of
diminishing marginal product (Mohr, 2020, p. 163).
Figure 8.3 illustrates that as the quantity of labour is increased, total product increases
from zero at an increasing rate, then starts increasing at a decreasing rate until a
maximum point is reached, after which TP declines. This S-shape of the total product
curve reflects the law of diminishing returns, or the law of diminishing marginal returns.
Figure 8.3: The Total, Average and Marginal Product of Labour


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8.7. Costs of Production in the Short-Run
So far, we have considered the output of firms given existing technology, fixed inputs,
and varying quantities of a variable input. Next, we expand the theory of the firm by
introducing the cost aspects of production. A firm cannot maximise output and profits
without examining its cost structure (Mohr, 2020, p. 165).
8.7.1. Total costs (TC)
Profit outcomes are determined by the difference between total revenue and total
cost. Here we introduce a number of cost concepts. The total cost curve is equal to
all costs involved in producing a particular product. Total costs include both total fixed
costs and total variable costs (Mohr, 2020, p. 165).
8.7.2. Total Fixed Costs (TFC)
Total fixed costs are costs that remain fixed even though output may change. For
instance, if no production takes place for a month, the firm will still incur its fixed
costs, for example, rent expense (Mohr, 2020, p. 165).
8.7.3. Total Variable Cost (TVC)
TVC are those costs that change as output changes, for example, direct labour and
electricity (Mohr, 2020, p. 165).
The diagram below illustrates the three total cost curves showing the relationship
between these three cost schedules.

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Figure 8.4: The Three Total Cost Curves

Source: (Bishops Economics Department, 2015)
The total fixed cost function or curve, (TFC), is a horizontal line with an intercept of
R9000 irrespective of total product.
The total variable cost function or curve, (TVC), has a reversed S-shape. It starts at
the origin and increases at a decreasing rate up to a point. Thereafter TVC increases
at an increasing rate.
The total cost function or curve, (TC), has the same shape as the variable cost
function, but does not start at the origin. It starts above the origin at the point on the
vertical axis which represents the total fixed cost. Total cost equals total fixed cost plus
total variable cost (Mohr, 2020, p. 165).
8.7.4. Average cost and marginal cost
To analyse a firm’s output decisions, we also have to examine average cost and
marginal cost. Since there are three measures of total cost, there are also three
measures of average cost, namely:
• Average fixed cost AFC (i.e., total fixed cost TFC divided by total product
TP)

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• Average variable cost AVC (i.e., total variable cost TVC divided by total
product TP)
• Average cost AC (i.e., total cost TC divided by total product TP)
Marginal cost, (MC), is the increase in total cost when one additional unit of output
is produced. By definition, marginal cost only consists of variable cost. The MC curve,
illustrated in Figure 8.5 is the opposite of the marginal product curve.
As an additional worker contributes less to total output (diminishing MP), it costs more
to produce an additional unit of output (rising MC). This is caused by the law of
diminishing returns, which implies rising costs (Mohr, 2020, p. 167).
Figure 8.5: Marginal and Average Cost Curves

8.8. The Relationship Between Production and Costs in the Short-

Run
A firm’s cost structure depends on the productivity of its inputs, (given the prices of
the inputs). In other words, the shape of the unit cost curves is determined by the
shape of the unit product curves. The most important relation between production
curves and cost curves is the influence of the law of diminishing marginal product,
(rising marginal costs). We combine marginal product and average product curves and
relate it to marginal cost and average variable cost curves to show the relationship
between the product curves and cost curves of the variable input labour (Mohr, 2020,
p. 168).

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Task
Draw curves for Average Product, Marginal Product, Average Cost and Marginal
Cost on the same set of axes and compare the shapes of the curves.
8.9. Costs of Production in the Long-Run
8.9.1. The long-run average cost curve (LRAC)
In the long-run there are no fixed inputs – all the inputs, (including all the factors of
production), are variable. In the long-run there are thus no fixed costs – all the costs
are variable (Mohr, 2020, p. 169).
• Returns to Scale
The term “returns to scale” refers to the long-run relationship between inputs and
output. Three possible situations can be distinguished:
• Constant returns to scale – This is when a given percentage increase in

inputs will give rise to the same percentage increase in output, (for
example, a doubling of the inputs leads to a doubling in output).
• Increasing returns to scale – This is where a given percentage increase

in inputs will lead to a larger percentage increase in output, (for example, a
doubling of the inputs leads to a trebling of output).
• Decreasing returns to scale – This is where a given percentage increase

in inputs will give rise to a smaller percentage increase in output, (for
example, a 100% increase in the inputs leads to a 50% increase in output)
(Mohr, 2020).
In the long-run all inputs are variable and economies or diseconomies of scale may
be experienced. Long-run average cost, (LRAC), curves can therefore take various
shapes. The three basic possibilities are illustrated in Figure 8.5 below. If economies
of scale are experienced, the firm’s LRAC curve will fall as output, (i.e., the scale of

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production) increases. On the other hand, if diseconomies of scale predominate,

LRAC will rise as output increases (Mohr, 2020, p. 170).
The third possibility is that neither economies nor diseconomies of scale are
experienced. In this case, the LRAC curve is horizontal, indicating constant costs.
Figure 8.6: The Long-Run Average Cost Curve

8.10. Conclusion
In this chapter we examined production and cost in both the short run and the long
run. We examined the behaviour of firms starting with an explanation of revenue, cost
and profit. This was followed by a more detailed discussion of production and cost.
This chapter also discussed total, average and marginal product and total, average
and marginal cost, and we distinguish between the short run and the long run.

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1. Define normal profit mean. Explain the difference between normal profit
and economic profit.
2. Highlight how the short-run is defined in production theory. Explain how

it differs from the long-run.
3. Use a diagram to illustrate and explain the relationships between average

fixed cost, average variable cost, average (total) cost and marginal cost.
4. Use a two-part diagram to illustrate the relationship between a firm’s cost

structure, (in the short run), and the product, (or productivity), of its
variable input.
Self-Assessment Questions: Guidelines
2. Chapter 9, Section 9.1: Subsection: The short-run and the long-run in

production and cost theory
3. Chapter 9, Figure 9.4/9.5 and accompanying discussion
4. Chapter 9, Figure 9.6 and accompanying discussion

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CHAPTER 9:
Perfect Competition
Chapter Outcomes
Upon completion of this chapter, you be able to:
• Illustrate how the structure of markets influences pricing and output

decisions
• Show how competitive firms behave in the short-run and why they cannot
sustain economic profits in the long-run
• Discuss the profit maximising rule of the competitive firm
• Understand what is meant by zero profits
9.1. Introduction
The equilibrium positions of firms are derived in Chapters 9 and 10. This allows us to
determine whether or not it is profitable for a firm to produce and, if so, what quantities
of the product the firm should supply at different prices of the product. In order to do
so, demand conditions have to be considered as well. In other words, both supply and
demand have to be taken into consideration.
It is assumed that firms aim to maximise profit (the difference between revenue and
cost). Total revenue (TR) from the production and sale of a product is calculated by
multiplying the quantity sold (Q) by the price (P) of the product. However, the price of
the product (and therefore also revenue) depends on the structure of the market. In
chapters 9 and 10, four standard forms of market structure are introduced: perfect
competition, monopoly, monopolistic competition and oligopoly. In this chapter we
define the four types, discuss the equilibrium conditions for any firm and then focus on
the position of a firm that operates under conditions of perfect competition. The other
three types of market structure are examined in Chapter 10.
The behaviour of a firm depends on the features of the market in which it sells its
product(s) and on its production costs. The major organisational features of a market
are called the structure of the market (or market structure). These features include the

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number and relative sizes of sellers and buyers, the degree of product differentiation,
the availability of information and the barriers to entry and exit.
9.2. A Benchmark
As highlighted by Mohr (2020, p. 180), perfect competition is the benchmark against

which all other market structures or types of competition are measured. The structure
of the market in which a firm sells its products is very important when managers have
to make decisions concerning prices and output. When referring to market structure,
we refer to the number and relative size of firms in a particular industry, highlight the
different market conditions underlying these markets, and the possible profit
outcomes. Figure 9.1 below shows the different market structures along a continuum
from left to right. We start with perfect competition and move toward imperfect
competition.
Figure 9.1: Market Structures

9.2.1. The equilibrium conditions (for any firm)
Firms operating in any market structure want to maximise profit. As previously

mentioned, economic profit is the difference between revenue and cost. This includes
normal profit. In order to examine the behaviour of firms, it is therefore important to
examine and combine their revenue and cost structures. Once these are known, two
decisions have to be taken by the firm:

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• The firm must first decide whether or not it is worth producing at all. Under
certain conditions it would not be in the firm’s interest to produce (but rather
to shut down its operations)
• If it is worth producing, the firm must determine the level of production (i.e.
the quantity) at which profit is maximised (or losses minimised).
These decisions have to be taken in any firm. This leads us to the two rules for profit
maximisation which apply to all firms, irrespective of the market conditions under which
they operate (Mohr, 2020, p. 181).
9.2.2. The shut-down rule
The first rule is that a firm should produce only if total revenue is equal to, or greater
than, total variable cost (which includes normal profit). This is often called the shut-
down (or close-down) rule, but it can also be called the start-up rule because it does
not just indicate when a firm should stop producing a product – it also indicates when
a firm should start (or restart) production. The shut-down rule can also be stated in
terms of unit costs – a firm should produce only if average revenue (i.e. price) is equal
to, or greater than, average variable cost (Mohr, 2020, p. 182).
In the long run all costs are variable. Production should therefore take place in the long
run only if total revenue is sufficient to cover all costs of production. However, in the
short run, certain costs are fixed. The question then arises whether production should
occur only if total revenue is sufficient to cover total costs (i.e., total fixed costs and
total variable costs)? The answer is no (Mohr, 2020, p. 182).
Once a firm is established, fixed costs cannot be avoided. Fixed costs are incurred
even if output is zero (i.e., if the firm does not produce at all). If the firm can earn a
total revenue greater than its total variable costs (or an average revenue greater than
its average variable costs), then the difference can help cover some of the unavoidable
fixed costs of the firm. It is advised that the firm maintains production in the short run,
even though it is operating at an economic loss. If total revenue is just sufficient to
cover total variable costs (ie if average revenue is equal to average variable costs) it
is irrelevant whether or not the firm continues production – its loss will be the same in
both cases (i.e. equal to its fixed costs). In such conditions firms tend to continue
production in order to retain their employees and clients.

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If total revenue is not sufficient to cover total variable costs (i.e., if average revenue is
lower than average variable cost), the firm will not produce, because to do so will result
in a loss greater than its fixed costs. In other words, the firm’s losses will be minimised
by not producing at all (Mohr, 2020).
9.2.3. The profit-maximising rule
The second rule is that firms should produce that quantity of the product such that
profits are maximised, or losses minimised. Since the same rule applies for profit
maximisation and loss minimisation, we usually refer to profit maximisation only, and
we do not always mention that the aim is also to minimise losses (Mohr, 2020, p. 182).
Profit maximisation can be explained in terms of total revenue (TR) and total cost (TC)
or in terms of marginal revenue (MR) and marginal cost (MC). Since profit is the
difference between revenue and cost it is obvious that profits are maximised where
the positive difference between total revenue and total cost is the greatest. However,
it is usually more useful to express the profit-maximisation condition in terms of
revenue and cost per unit of production. The rule is that profit is maximised where
marginal revenue (MR) is equal to marginal cost (MC) (Mohr, 2020, p. 182).
To understand why profits are maximised where MR = MC, it is imperative to consider

what happens if MR is not equal to MC. If marginal revenue MR (i.e. the addition to
revenue as a result of the production of an extra unit of the product) is greater than
marginal cost MC (i.e. the cost of producing that extra unit), the firm is still making a
profit on the last (extra) unit produced. The firm can therefore add to its total profit by
expanding its production until no extra profit is made on the last unit produced, that is,
until the revenue earned from the last unit (MR) is equal to the cost of producing the
last unit (MC). At that quantity the firm’s profit is maximised (Mohr, 2020, p. 182).
If the firm continues producing beyond that point, the cost of producing each additional
unit of output (MC) will be greater than the revenue gained from selling it (MR). In other
words, the firm will make a loss on the production of each additional unit of output and
its profit will therefore decrease. Profits are maximised when marginal revenue MR is
just equal to marginal cost MC (Mohr, 2020, p. 182).
The different possibilities may be summarised as follows:

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• When MR is greater than MC (ie MR > MC), output should be expanded.

• When MR is equal to MC (ie MR = MC), profits are maximised.
• When MR is lower than MC (ie MR < MC), output should be reduced (Mohr,
2020).
9.3. Defining Perfect Competition
Perfect competition occurs when none of the individual market participants, (i.e.,
buyers or sellers), can influence the price of the product. The price is determined by
the interaction of demand and supply and all the participants have to accept the prices
(Mohr, 2020).
9.3.1. Conditions necessary for perfect competition to exist
Perfect competition exists if the following conditions are met:
• There must be a large number of buyers and sellers of the product. Each
firm only supplies a small quantity of the total market supply.
• There must be no collusion between sellers.
• All the goods in the market must be identical.
• Buyers and sellers must be completely free to enter or leave the market.
• All the buyers and sellers must have perfect knowledge of market
conditions.
• There must be no government intervention influencing buyers or sellers.
• All the factors of production must be perfectly mobile.
• In these markets, no individual firm has any market power - all firms are
price-takers.
Definition
Barriers to entry is an economics and business term describing factors that can
prevent or impede newcomers into a market or industry sector, and so limit competition.
These can include high start-up costs, regulatory hurdles, or other obstacles that

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prevent new competitors from easily entering a business sector. Barriers to entry benefit
existing firms because they protect their market share and ability to generate revenues
and profits.
Common barriers to entry include special tax benefits to existing firms, patent
protections, strong brand identity, customer loyalty, and high customer switching costs.
Other barriers include the need for new companies to obtain licenses or regulatory
clearance before operation (CFI Education Inc, 2021)
Task
Can you think of any company in the real-world that could be classified as a perfectly
competitive firm? Motivate your answer.
9.3.2. Perfectly elastic demand curve
It is vital to distinguish the market or industry demand curve from the firm’s demand
curve. The market or industry’s demand curve is the same demand curve we
studied in Chapter 3 – it is a downward sloping curve. Generally, it includes all
individual firms’ demand curves. On the other hand, the individual firm’s demand curve
under perfect competition is horizontal at the market-determined price, (perfectly
elastic demand curve). At the market-determined price, each competitive firm must
charge that price, and has to make supply decisions within that constraint.
Panel (a) of Figure 9.2 demonstrates the market for shoes, which consists of many
shoe buyers and shoe producers. The market price is determined where market
demand intersects market supply.

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Panel (b) displays the demand curve for one shoe producer of firm. The prevailing
market price P1, determined in panel (a), is accepted by the individual firm in panel
(b). This means that each individual firm has to charge the same price for a pair of
shoes. If any one of the shoe firms decides to charge a price higher than the market
price P1 buyers would choose to buy from other firms because shoes have a large
number of perfect substitutes.
(a) (b)
Figure 9.2: The Demand Curve for the Product of the Firm Under Perfect Competition
Marginal revenue (MR), refers to the extra unit of output sold that adds to the firm’s
total revenue. The firm charges the same price for every unit of output sold. Therefore,
the revenue that it receives from selling every unit of output will be the same.
Consequently, MR must be equal to price under perfect competition. It follows then,
that MR curve must be equal to the demand curve. Furthermore, the firm’s average
revenue, (AR), curve is also equal to the demand curve because revenue per unit of
output is equal to price (Mohr, 2020).

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9.4. The Short-Run Equilibrium of the Firm Under Perfect

Competition
Since the firm under perfect competition does not have to make any pricing decisions,
(price- taker) – it can only choose the output at which it will maximise its profits, i.e.,
where MR = MC or where the positive difference between TR and TC is at its
maximum.
9.4.1. Equilibrium in terms of total revenue and total cost
The total cost curve is shaped like a reversed S, as illustrated in Figure 9.3. In the
short-run, the total cost curve does not start at the origin, since part of the firm's cost
is fixed.
Figure 9.3: Total Short-Run Costs of the Firm

Source: (Rekhi, n.d.)
In Figure 9.4 we combine the total revenue (TR) curve with the total cost (TC) curve
illustrated in above. Economic profit is the difference between TR and TC.
Graphically, it is measured by the vertical distance between the TR curve and the TC
curve. At levels of output below XA in Figure 9.4, TC is greater than TR and the firm,
therefore, incurs economic losses (indicated by the shaded area). At XA, the firm's total
economic profit is zero (since TR = TC). Between XA and XB, the firm makes an
economic profit at each level of output, (indicated by the shaded area), since TR > TC
(Trisha, n.d.).

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Figure 9.4: Total Revenue, Total Cost and Total Economic Profit
Source: Trisha; n.d.
At XB, total economic profit is zero once more and at higher levels of output the firm
again incurs economic losses. The firm's profit will be maximised where the positive
vertical distance between TR and TC is the greatest (i.e., somewhere between XA and
XB).
9.4.2. Equilibrium in terms of marginal revenue and marginal cost
Any firm maximises its profits where marginal revenue, (MR), is equal to marginal cost,
(MC), i.e., MR = MC. In Figure 9.2 we showed that the firm's marginal revenue, (MR),
is equal to the market price, (P), of the product. The profit maximising rule in the case
of a perfectly competitive firm can, therefore, also be stated as P = MC, (since MR
=P). This rule is further clarified in Figure 9.5 below (Mohr, 2020).
Figure 9.5: Marginal Revenue and Marginal Cost of a Firm Operating in a Perfectly
Competitive Market
Source: (Mohr; 2020)

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Marginal revenue (MR), is equal to the price, (P), of the product. Marginal cost (MC),
increases as more units of the product are produced. Profit is maximised where MR
(or P) = MC, i.e., at an output level of 4 units. At lower levels of production, profit can
be increased by expanding production. If more than 4 units of the product are
produced, profits start falling.
The firm's profit position can be illustrated clearly by adding average cost, (AC), to the
diagram, showing average revenue, (AR), marginal revenue, (MR), and marginal cost,
(MC). In the previous section, it was ascertained that the firm's profit per unit of output,
(or average profit), is equal to the difference between average revenue, (AR), and
average cost, (AC).
As long as AR is greater than AC, the firm is earning an economic profit. When AR is
equal to AC, the firm only earns a normal profit. The normal profit is the opportunity
cost of self- employed resources, (such as the owner's time and capital), and that
normal profit is included in the firm's cost (Mohr, 2020, p. 186).
9.5. Possible Profit Outcomes for Perfectly Competitive Firms in the

Short-Run
The same set of unit cost curves will be used throughout, but there are three different
market prices, and, therefore, three different AR and MR curves.
Figure 9.6 (a) illustrates the situation where a perfectly competitive firm earns a
positive economic profit.
The market price is P1 which is equal to the firm's AR and MR. Profit is maximised
where MR (= P1) is equal to MC. This occurs at a quantity of Q1.
At Q1, the firm's average revenue AR (=P1) is greater than its average total cost AC
(C1). The firm thus makes an economic profit per unit of production of P1 - C1.
The firm's total profit is given by the shaded area C1P1E1M which is equal to the profit
per unit of output (P1 - C1) multiplied by the quantity produced (Q1). Alternatively, the
area representing total profit can be obtained by subtracting the firm's total cost from
its total revenue. The firm's total revenue is equal to the price of the product P 1

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multiplied by the quantity produced (and sold) Q1. This is equal to the area OP1E1Q1.
Similarly, the firm's total cost is obtained by multiplying its average cost C 1 by the
quantity produced Q1. This is equal to the area OC1MQ1. The difference between these
two areas is the shaded area C1P1E1M, which represents the firm's total economic
profit (Mohr, 2020, p. 187).
Figure 9.6: Different Possible Short-Run Equilibrium Positions of the Firm Under
Perfect Competition
In Figure 9.6 (b), the market price is P2. It is equal to MC at the point where MC
intersects AC. The corresponding level of output is Q 2. At that level of output AR is
equal to AC and the firm does not earn an economic profit. It does, however, earn a
normal profit since all its costs, including the opportunity cost of self-owned, self-
employed resources are fully covered. Point P2 is called the break-even point.
In Figure 9.6 (c) the market price, (firm's AR and MR), is equal to P3. MR or price is
equal to MC at a quantity of Q3. At Q3, the firm's average revenue AR is lower than its

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average cost AC. It, therefore, makes an economic loss per unit of output, equal to
the difference between C3 and P3. If the price P, (=AR,) lies above the minimum AVC,
(not shown in diagram), the firm will continue production in the short-run. If it lies below
the minimum AVC, the firm will close down (Mohr, 2020).
9.6. The Equilibrium of the Industry in the Long-Run
Perfectly competitive firms can make an economic profit in the short-run. However,
this economic profit cannot be maintained in the long-run, due to the assumption that
underlies this type of market structure, namely free entry and exit.
When competitive firms experience economic profits in the short-run, (depicted in

Figure 9.6 a), it acts as an incentive for other firms to enter the industry and share in
the economic profit. This will continue until the economic profit is eroded and only
normal profits are being made, (as in Figure 9.6 b). It is at this point that the perfectly
competitive market reaches a point of equilibrium in the long-run, in other words, only
then will there be no inducement for new firms to enter the industry or for existing firms
to leave the industry (Mohr, 2020, p. 190).
9.7. Conclusion
This chapter focused on the derivation of the equilibrium positions of firms. This
chapter introduced perfect competition and discussed the short-run and long-run
equilibrium positions of a perfectly competitive firm.
The next chapter examines monopoly, monopolistic competition and oligopoly.

The last two are usually collectively referred to as imperfect competition. This is
followed by comparisons between perfect competition and the other three market
structures.

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1. List five requirements for perfect competition to exist.
2. Explain, with the aid of a diagram, the equilibrium of the firm in the
short-run. Show the economic profit, (or loss,) and clearly indicate
what equilibrium means in this context.
3. Use diagrams to illustrate the fact that perfectly competitive firms are
price takers. Explain how prices are determined in perfectly
competitive markets.
4. Indicate the importance of studying perfect competition if it does not

exist, or exists only very rarely, in the real world.
2. Chapter 10, Section 10.5: Equilibrium in the short run. Include Figure 10-4 to
discuss economic profit/loss scenarios
3. Chapter 10, Section 10.4 and Figure 10-2
4. Chapter 10, Section 10.3: Subsection: Relevance

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CHAPTER 10:
Imperfect Competition
Chapter Outcomes
• Compare the different market structures that operate under imperfect

competition
• Explain the equilibrium position of each market under imperfect competition
i.e. monopoly, monopolistic competition, and oligopoly
• Compare perfect competition with other market structures
10.1. Introduction
In Chapter 9 the behaviour of a firm in a perfectly competitive market was examined.

As highlighted by Mohr (2020, p. 197), perfect competition is a theoretical construct
which serves as a standard or norm against which we can compare other types of
market. In the real world there are many different types of market. Nearly every market
or industry is unique, and no simple classification system can accurately reflect this
enormous variety.
This chapter examines monopoly, monopolistic competition and oligopoly. The

last two are usually collectively referred to as imperfect competition. This is followed
by comparisons between perfect competition and the other three market structures.
The theory of the behaviour of firms (i.e., the theory of the supply side of the goods
market) is called the theory of the firm. The neoclassical version of this theory is
based on the assumption that all firms seek to maximise their profits (Mohr, 2020, p.
197).
In this chapter, the behaviour of profit-maximising firms under conditions of monopoly

and imperfect competition are examined. Under monopoly there is only one supplier
and entry to the industry is completely blocked (i.e. there is no competition), while

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imperfect competition refers to a situation in which at least one of the conditions for
perfect competition is not satisfied. The two broad categories of imperfect competition
are oligopoly and monopolistic competition.
In Chapter 9 we observed that the demand curve facing the perfectly competitive firm
is horizontal (at the level of the market price). Under monopoly and imperfect
competition, however, the demand curve for the product of an individual firm slopes
downward, like a normal market demand curve. This is one of the distinguishing
features of monopoly and imperfect competition. Another important feature of
imperfect competition (but not of monopoly) is that an individual firm can be affected
by the actions of competitors.
10.2. Different Types of Market Structures in the Real World
Perfect competition is a theoretical construct, which serves as a standard, or norm

against which we can compare other types of markets. In the real world, there are
many different types of markets.
Economists distinguish between four broad sets of markets (or different types of
competition), namely: perfect competition, monopoly, monopolistic competition and
oligopoly. In this section, we examine the last three types, which are usually
collectively referred to as imperfect competition (Mohr, 2020, p. 198).
The theory of the behaviour of firms, (i.e., the theory of the supply side of the goods
market), is called the theory of the firm. This theory is usually based on the
assumption that all firms seek to maximise their profits (Mohr, 2020, p. 197).
In this section, we examine the behaviour of firms under conditions of imperfect

competition. Imperfect competition refers to a situation in which at least one of the
conditions of perfect competition is not satisfied.
The three broad categories of imperfect competition are:

• Monopoly
• Monopolistic competition
• Oligopoly

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The behaviour of a firm depends on the features of the market in which it sells its
product(s) and on its production costs. The major organisational features of a market
are called the structure of the market (or market structure). These features include
the number and relative sizes of sellers and buyers, the degree of product
differentiation, the availability of information and the barriers to entry and exit (Mohr,
2020, p. 197).
See Table 10-1 in Mohr (2020, p. 180), for a Summary of the Key Features of the Market
Structures
10.3. Monopoly
A monopoly is a market structure in which there is only one producer/seller for a

product. In other words, the single business is the industry. Entry into such a market
is restricted due to high costs or other impediments, which may be economic, social
or political. For instance, a government can create a monopoly over an industry that it
wants to control, such as electricity.
Another reason for the barriers against entry into a monopolistic industry is that often,
one entity has the exclusive rights to a natural resource for example, in Saudi Arabia
the government has sole control over the oil industry. A monopoly may also form when
a company has a copyright or patent that prevents others from entering the market.
The diamond industry is a good example of an existing monopoly where De Beers
controls a massive amount of the market share in the world for diamonds and
establishes monopolistic controls as a result.
There are very few actual monopolies in existence today. It is far more likely to have
a few of firms acting as an oligopoly or in monopolistic competition (Mohr, 2020, p.
198).
10.3.1. Characteristics
The four key characteristics of monopoly are:

• A single firm selling all output in a market;
• A unique product;
• Restrictions on entry into and exit out of the industry; AND

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• Specialised information about production techniques unavailable to other

potential producers (Mohr, 2020, p. 198).
These four characteristics mean that a monopoly has extensive market control.
Monopoly controls the selling side of the market. If anyone seeks to acquire the
production sold by the monopoly, then they must buy from the monopoly. This means
that the demand curve facing the monopoly is the market demand curve. They are one
and the same.
The characteristics of monopoly are in direct contrast to those of perfect competition.

A perfectly competitive industry has a large number of relatively small firms, each
producing identical products. Firms can freely move into and out of the industry and
share the same information about prices and production techniques (Mohr, 2020, p.
198).
A monopolised industry, however, tends to fall far short of each perfectly competitive
characteristic. There is one firm, not a lot of small firms. There is only one firm in the
market because there are no close substitutes, let alone identical products produced
by other firms (Mohr, 2020).
A monopoly often owes its monopoly status to the fact that other potential producers
are prevented from entering the market. There is no freedom of entry here; neither is
there perfect information. A monopoly firm often has specialised information, such as
patents or copyrights that are not available to other potential producers.
10.3.2. The equilibrium (or profit-maximising) position of a monopoly
In principle, the profit maximising decision of a monopoly is exactly the same as that
of any other firm. Like any other firm, a monopoly should produce where marginal
revenue (MR) is equal to marginal cost (MC) - (the profit maximising rule), provided
that average revenue (AR) is greater than minimum average variable cost (AVC) - (the
shut-down rule) (Mohr, 2020, p. 200).
10.3.2.1. Total, average and marginal revenue under a monopoly
Since the monopoly is the only supplier of the product of the industry, the demand
curve for the product of a monopolistic firm is the market demand curve for the product

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of the industry. Since the market demand curve slopes downward, the monopoly can
only sell an additional quantity of output if it lowers the price of its product.
Figure 10.1: Marginal, Average and Total Revenue Under Monopoly

Source: (Mohr, 2020, p. 201)
The marginal revenue curve MR is also downward-sloping and lies halfway between
the AR curve and the price axis. The corresponding total revenue curve TR is shown
in (b). When MR is positive, TR increases; when MR is zero, TR remains unchanged;
and when MR is negative, TR falls. These relationships apply to all forms of imperfect
competition (Mohr, 2020, p. 201).
10.3.2.2. The equilibrium of the firm under a monopoly
The profit-maximising monopolist will also follow the profit-maximising rule as the
competitive firm, MR=MC. The demand curve of the monopolist, which has a
downward slope, indicates that the monopolist can increase its quantity of output
when it lowers the price of the product.
The marginal revenue (MR) curve of the monopolist also has a downward slope
because the additional revenue earned from producing an extra quantity of output
becomes smaller since the price falls for each successive quantity of output sold.
The MR curve of the monopolist falls below the demand curve. The firm’s average
revenue curve (AR) is equal to the price of the product because the revenue that is
earned per unit of output (AR=TR=PQ)/Q) will equal the price, which falls as the
quantity of output increases. Hence the demand curve is also the AR curve; therefore,

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the AR curve is downward-sloping. It is important to understand that the MR curve is

always below the AR curve when the demand curve slopes downward. Figure
10.2 illustrates the equilibrium position of the firm for a monopoly (Mohr, 2020).
Figure 10.2: The Equilibrium of the Firm Under Monopoly

Source: (Mohr, 2020, p. 202)
The figure shows the average revenue AR, marginal revenue MR, average cost AC
and marginal cost MC of a monopoly. The monopolist's profit is maximised by
producing a quantity Q1 at a price P1. The economic profit per unit is the difference
between M1 and K1, (or between P1 and C1). The firm's total economic profit is the
shaded area C1P1M1K1.
10.3.2.3. Monopoly verses perfect competition
Figure 10.3: Comparison Between Monopoly and a Perfectly Competitive Industry

Source: (Mohr, 2020, p. 216)

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AR is the demand curve for the product of the industry and MR is the monopoly's
marginal revenue curve. Marginal cost MC is also the supply curve S for the perfectly
competitive industry. Under perfect competition, long-run equilibrium Ec is established
by the interaction of demand AR and supply S at a price Pc and a quantity Qc.
Equilibrium for the monopolist is Em at a price Pm and a quantity Qm (Mohr, 2020).
Task
Having studied perfect competition and monopolies, do you think monopolies are
always “bad” for the various sectors of the economy?
10.4. Monopolistic Competition
Between the extremes of monopoly and perfect competition, there is a range of actual
market organisations. Some industries consist of a few large firms and a large number
of small ones. Other industries consist of a few large firms only. In some industries,
there are many firms producing a variety of similar products. In other industries, a few
large firms produce virtually identical products.
The first type of market in the spectrum between the extremes of perfect competition
and monopoly is monopolistic competition. The conditions for monopolistic
competition can be summarised as follows:
• Each firm produces a distinctive, differentiated product.

• Each firm, therefore, faces a downward-sloping demand curve for its
particular product.
• There is a large number of firms in the industry; and
• There are no barriers to entry (or exit)
Source: (Mohr, 2020, p. 208).

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10.4.1. The equilibrium of the firm under monopolistic competition
Figure 10.4 illustrates the short-run equilibrium and the long-run equilibrium of a
monopolistically competitive firm.
Figure 10.4: The Equilibrium of the Firm Under Monopolistic Competition

Source: (Mohr, 2020, p. 209)
Short-run and long-run equilibrium positions of a monopolistically competitive firm are

illustrated in (a) and (b), respectively. In both cases, D is the demand curve for the
product of the firm (or average revenue AR), MR is marginal revenue, MC is marginal
cost and AC is average cost.
The firm is in equilibrium where MR = MC. In the short-run conditions illustrated in

(a), the firm is in equilibrium at output Q1 and price P1. The firm's total profit is illustrated
by the shaded rectangle.
In the long-run, however, the firm only makes a normal profit at an output of Q e and
a price of Pe. At that price-output combination, AR is tangent to AC, MR = MC and AR
= AC (Mohr, 2020, p. 208).
10.4.2. Monopolistic competition versus perfect competition
A market structure is efficient if marginal cost MC is equal to price P and if production

occurs where average cost AC is at its minimum. These two types of efficiency are
called allocative efficiency and productive efficiency. The long-run equilibrium of a
monopolistically competitive firm occurs when only normal profits are made. In this

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respect, there is no difference between monopolistic competition and perfect

competition.
However, in long-run equilibrium, the monopolistically competitive firm produces

where price is higher than marginal cost and where average cost is not at a minimum.
Therefore, monopolistic competition is neither allocatively nor productively efficient.
Although the monopolistically competitive firms do not make economic profits in the
long-run, (as monopolists do), monopolistic competition is also characterised by an
inefficient use of resources. Consumers pay a higher price and less output is produced
than under perfect competition (Mohr, 2020, p. 209).
10.5. Oligopoly
Under oligopoly, a few large firms dominate the market. A duopoly exists when there
are only two firms in the industry. The product may be homogeneous (e.g., steel,
cement, petrol) but it is mostly heterogeneous (e.g., motorcars, cigarettes, household
appliances, electronic equipment, household detergents). When the product is
homogeneous, the market is described as a pure oligopoly, and when the product
is heterogeneous (or differentiated) the market is called a differentiated oligopoly
(Mohr, 2020, p. 210).
Oligopoly is the most common market form in modern economies. The main feature
of oligopoly is the high degree of interdependence between the firms. Each
oligopolist, therefore, always has to consider how its rivals will react to any action that
it takes. The other important feature of oligopoly is uncertainty. To reduce this
uncertainty, oligopolistic firms often collude (enter into agreements) about prices and
output (Mohr, 2020, p. 210).
Like a monopolist and a monopolistic competitor, the oligopolist faces a downward-

sloping demand curve. However, the slope of the curve is uncertain, since this
depends on how its competitors will react to price changes - they may decide to follow
or not to follow any price change.
Since oligopoly is dominated by a small number of powerful firms, the entry of new
firms is more difficult than under perfect competition or monopolistic competition.
However, in contrast to monopoly, entry is possible.

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Competition is often intense, although it tends to be non-price competition, rather than

price competition. The more intensely oligopolists compete, the closer they are likely
to come to perfectly competitive output (Mohr, 2020, p. 210).
10.5.1 Theory of oligopolistic behaviour: the kinked demand curve
Different oligopoly models are not discussed in this module, but to give you some idea
of what oligopoly models are, one of the classic oligopolistic theories (the kinked
demand curve) is outlined.
The kinked demand curve, as illustrated in Figure 9.5, does not explain how price and
output are determined under oligopoly, but it does illustrate the importance of
interdependence and uncertainty in oligopolistic markets. It is one of the possible
explanations for the observed degree of relative price stability under oligopoly.
Figure 10.5: A Theory of Oligopolistic Behaviour: The Kinked Demand Curve

Source: (Mohr and Associates, 2015)
The kink in the demand curve is at the market price P1 with the amount which the firm
produces at Q1; this is the point of profit maximisation. The significance of P 1 is that
oligopolists will be wary of moving away from it individually because they cannot be
certain of the reactions of their rivals. The curve is relatively elastic above P1 and
inelastic below it.

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Hence, if firms raise prices and their rivals do not follow, they will lose market share; if
they cut prices, their rivals will follow to protect their own position, which means that
all firms will end up with lower prices and profits on unchanged market shares.
Consequently, prices will be inflexible at P1 (Mohr and Associates, 2015, p. 195).
10.6. Conclusion
In this chapter we examined monopoly, monopolistic competition and oligopoly.

This was followed by comparisons between perfect competition and the other three
market structures. The behaviour of profit-maximising firms under conditions of
monopoly and imperfect competition were examined.
See Table 11-2 in Mohr (2020, p. 224) for a Summary of the Demand Curves and Equilibrium
Positions of the Different Market Structures
1. Highlight the main differences between a monopoly and an oligopoly.
2. Explain the shape of the demand curve facing an imperfectly competitive

firm.
3. Use a diagram to illustrate and explain the relationship between average

revenue and marginal revenue when the firm faces a downward-sloping
demand curve.
4. List the four main conditions for monopolistic competition to exist.

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1. Chapter 11, Table 11-2: Differentiate between the characteristics of

monopoly and oligopoly.
2. Downward sloping demand curve.
3. Chapter 11, Figure 11-1 and accompanying discussion
Case Study
'Monopolies strangling economy' – The South African President, 2019
Having only four major banks in SA is hampering the country's economic growth.
This is according to the South African President who yesterday bemoaned

monopolies in various sectors such as banking. Addressing a conference looking at
25 years of democracy at the University of Johannesburg, the president said very
little has been done to end white people's monopoly over important sectors of the
economy.
"The economy of our country is not open enough and it so happens that it is only
open to certain insiders who are white.
"The IMF long ago, with the World Bank, analysed our economy and said that one
of the key problems with our economy in South Africa is the dominance of
monopolies.
"That they have a stranglehold on the economy of our country and that was what
was designed in the past and it was so designed that it ensured that there were a
few insiders and it so happened that the insiders were white controllers of the
economy and that has continued right until today."

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The President said one such sector was banking. As it stands, there are four major
banks - Absa, FNB, Nedbank and Standard Bank - servicing the country's needs
from bonds, day-to-day banking and loans.
"You look at the banking sector, you've got only four banks that dominate the
economy of our country - the major ones that is - [servicing] the 57-million population
..."
He said that this was detrimental to the economy as it is meant to shut out new
players from participating in the sector.
People find it difficult, he said, to finance their businesses because of the limited
option. "With only four banks, your entry or your access to capital becomes very
constrained. If you want to go and start a company, you move from one bank to the
other and by the time you get to the third one they've all said no. Where else do you
go?
"We therefore need to open this economy and broaden the landscape so that black
players can also come in and have access to capital, they must have access to
market, they must have access to distribution channels, they must have access to
the shelves in the retail shops as well."
The President said his government would now pay a lot of attention to township
businesses as one way of ending the dominant rule of monopoly. He promised that
businesspeople in the townships would be assisted financially to get up and running.
(Adapted from: https://www.sowetanlive.co.za/news/south-africa/2019-07-24-

monopolies-strangling-economy-ramaphosa/)
Questions
1. Monopolies strangling economy”. Can you think of an economic theory that

supports this statement? What graph can be used to illustrate this economic
theory?
2. “Ramaphosa said his government would now pay a lot of attention to
township businesses as one way of ending the dominant rule of monopoly”.

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What would be some advantages of such a decision for the South African
economy?
3. The market structure of the banking sector, comprising of four major banks,
could also be classified as an oligopoly. What could be a possible shape of
the demand curve for the banks?

ECONOMICS
BIBLIOGRAPHY
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Bachelor of Commerce in Human Resource Management: Module Guide

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Bachelor of Commerce in Human Resource Management: Module Guide

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ECONOMICS

BACHELOR OF COMMERCE IN HUMAN RESOURCE MANAGEMENT

BACHELOR OF COMMERCE IN HUMAN RESOURCE MANAGEMENT 2

List of Tables and Figures

Figure 1.1: Summary of the Fundamental Economic Challenge .................... 16

BACHELOR OF COMMERCE IN HUMAN RESOURCE MANAGEMENT 3

List of Tables and Figures

Table 1-1: Microeconomics Versus Macroeconomics: Some Examples ....... 13

BACHELOR OF COMMERCE IN HUMAN RESOURCE MANAGEMENT 4

Welcome to the Bachelor of Commerce in Human Resource Management. As part of

3. Aim of the Module

This module aims to:

• Gain understanding of the introductory level core microeconomic models and

BACHELOR OF COMMERCE IN HUMAN RESOURCE MANAGEMENT 5

4. Essential (Prescribed) Reading

Your essential (prescribed) reading comprises the following:

4.1. Prescribed Reading

4.2. Recommended Reading

5. How to use the Module

BACHELOR OF COMMERCE IN HUMAN RESOURCE MANAGEMENT 6

BACHELOR OF COMMERCE IN HUMAN RESOURCE MANAGEMENT 7

7. Specific Outcomes and Chapter Alignment

SPECIFIC PROGRAMME OUTCOMES CHAPTER

SO 1: Apply the principles of economics in the analysis of the 1-10

SO 2: Utilise analytical techniques to hypothetical as well as to 1, 2, 4,5

SO 3: Demonstrate an understanding of how free markets work 5

SO 4: Assist individual consumers to make economic decisions 6, 7, 8

SO 5: Identify the characteristics of the different market 9,10

SO 6: Evaluate the outcome in each market structure with 9,10

SO 7: Identify cases in which private markets fail to allocate 10

BACHELOR OF COMMERCE IN HUMAN RESOURCE MANAGEMENT 8

8. Specific Outcomes and Assessment Criteria

SPECIFIC PROGRAMME OUTCOMES ASSESSMENT CRITERIA

The student should demonstrate the ability to:

SO 1: Apply the principles of • Explain the subject of economics from

SO 3: Demonstrate an understanding • Analyse how buyers and sellers

allocate resources efficiently. the prices of goods and services in

BACHELOR OF COMMERCE IN HUMAN RESOURCE MANAGEMENT 9

SPECIFIC PROGRAMME OUTCOMES ASSESSMENT CRITERIA

The student should demonstrate the ability to:

SO 6: Evaluate the outcome in each • Examine the relationship that exists

• Differentiate amongst the various

BACHELOR OF COMMERCE IN HUMAN RESOURCE MANAGEMENT 10

Upon completion of this chapter, you should be able to:

1.2. Wants and Needs

Mohr (2020, p. 2) describes economics as a social science that studies human

BACHELOR OF COMMERCE IN HUMAN RESOURCE MANAGEMENT 11

1.3. Microeconomics and Macroeconomics

1. Microeconomics: This is the branch of economics that focuses on the

2. Macroeconomics: This is the study of the effects on the national economy

BACHELOR OF COMMERCE IN HUMAN RESOURCE MANAGEMENT 12

Table 1-1: MICROECONOMICS VERSUS MACROECONOMICS: SOME

In microeconomics we study: In macroeconomics we study:

• The price of a single product • The consumer price index

1.4. The Scope of Economics

BACHELOR OF COMMERCE IN HUMAN RESOURCE MANAGEMENT 13

1.5. The Problem of Scarcity

1.6. Factors of Production

Factors of production are grouped as follows:

• Natural resources (land)

BACHELOR OF COMMERCE IN HUMAN RESOURCE MANAGEMENT 14

1.7. The Fundamental Economic Challenge

The fundamental economic challenge encompasses the issue of having scarce