Study Guide 002 Ecs1501

© 2019 University of South Africa
All rights reserved
Printed and distributed by

University of South Africa
Muckleneuk, Pretoria
Compiled by the Department of Economics
ECS1501/2/2020-2022
70823251
Pdf: Florida Campus
Parts of some of the units are an adaption based on the following works:
Principles of Economics (https://open.lib.umn.edu/principleseconomics/) which is adapted from a

work produced and distributed under a Creative Commons license (CC BY-NC-SA) in 2011 by a
publisher who has requested that they and the original author not receive attribution. This work is
made available under the terms of a Creative Commons Attribution-NonCommercial-ShareAlike
license.
Principles of Economics (https://saylordotorg.github.io/text_principles-of-economics-v2.0/) by the
Saylaor Academy (2012) which is text adapted by Saylor Academy under a Creative Commons
Attribution-NonCommercial-ShareAlike 3.0 License without attribution as requested by the work's
original creator or licensor.
Contents
Page
Introduction ............................................................................................................................................... iv
9. Government intervention .................................................................................................................. 1
10. Price elasticity ................................................................................................................................ 26
11. Other elasticities ............................................................................................................................. 81
12. Theory of demand: Marginal utility analysis ............................................................................... 101
13. Theory of supply: Cost of production .......................................................................................... 124
14. Perfect and imperfect competition ............................................................................................... 168
15. Labour market .............................................................................................................................. 213
iii ECS1501/002
Introduction
In topic 6 in Study Guide 1 we have seen how prices are formed in a market. In topic 8 of Study Guide
1 we had a look at the adjustment process that takes place if market equilibrium is disturbed. In Study
Guide 2 (this guide) we continue our journey of discovery of the market. You will notice that we
continue with the numbering of the topics from Study Guide 1. That is, Study Guide 2 starts with topic
9. To summarise: Topics 1 to 8 is dealt with in this guide (Study Guide 1), and topics 9 to 15 form part
of Study Guide 2.
Study guide 1:
Topic
1 The study field of economics
2 The economist’s toolkit
3 Economic systems
4 Produtction possibilities curve
5 Circular flow
6 Demand, supply and prices
7 Consumer and producer surplus
8 Changes in demand and supply
Study guide 2:
Topic
9 Government intervention
10 Price elasticity
11 Other elasticities
Theory of demand: Marginal
12
utility analysis
Theory of supply: Cost of
13
production
Perfect and imperfect
14
competition
15 Labour market
iv ECS1501/002
Government
intervention 9
OVERVIEW
In the demand and supply model, we saw how the equilibrium price is determined by the forces of
demand and supply. While the equilibrium price ensures that the quantity demanded is equal to the
quantity supplied, this does not imply that there are no unhappy market participants. Sellers prefer a
higher price, while demanders prefer a lower price. These groups might put pressure on government to
use its powers to either increase or decrease the price.
Intervention in the functioning of the price mechanism, especially by the government, has a long
history. Governments have always tried to intervene in markets in order to change the outcome of the
market. The main reason for the intervention is that governments believe – sometimes because of
pressure from interest groups – that the outcome of a market is unfair or inefficient.
Governments might also believe that through government intervention, people can be protected from
this unfairness and the efficiency of markets improved.
TOPIC OUTCOME
After you have worked through this learning unit, you should be able to:
• explain and illustrate the impact of government intervention through price ceilings and price
floors on a market
9.1 Price ceiling and price floor

After you have worked through this section of the learning unit, you should be able to:
• distinguish between a price ceiling and price floor
One key way for a government to intervene in the market is through price controls. A price control is a
regulation that prevents a price from rising and/or falling beyond a certain level.
Price ceiling
When a price control measure establishes an upper limit, it is a price ceiling. For example, government
may believe that the market price of bread is too high, and to help poor households, it puts a price
ceiling on the price of bread. It is then illegal to charge a price higher than the ceiling price.
1 ECS1501/002
Price floor
When a price control measure establishes a lower limit, it is a price floor. An example of a price floor is
the minimum wage, which makes it illegal to pay a person less than the minimum wage.
ACTIVITY 1
1.1 Which one of the following is an example of a price ceiling?

a. During 2014, the lowest price charged for chicken was R34 per kg.
b. During 2014, the highest price charged for maize was R2 000 per ton.
c. The legally established minimum price for sugar in 2014 was R20 per kg.
d. The legally established maximum price for university fees in 2014 was R2 500 per subject.
1.2 Which one of the following is an example of a price floor?
a. During 2014, the lowest price charged for chicken was R34 per kg.
b. During 2014, the highest price charged for maize was R2 000 per ton.
c. The legally established minimum price for sugar is R20 per kg.
d. The legally established maximum price for university fees in 2014 was R2 500 per subject.
9.2 Impact of a price ceiling (maximum price)

After you have worked through this section of the learning unit, you should be able to
• illustrate and explain the impact of a price ceiling
2 ECS1501/002
A price ceiling occurs when the government puts a legal upper limit on the price that can be charged for
a good or service.
The purpose of a price ceiling is to make certain goods and services more affordable for households. In
recent years, price ceilings have been proposed for medication, medical and hospital fees, bank charges
and university fees.
While economists tend to disagree on many issues, one of the issues on which they seem to agree is the
consequences of rent controls. Rent control is a price ceiling which puts an upper limit on the rent that
a property owner can charge.
Many of us rent a room, an apartment or a house to live in. The rent we pay is a substantial part of
our income. Do you think the government should impose a limit on the maximum rent that an
owner can charge for the use of the room, apartment or house?
o Yes, this will really help the tenant
o No because this will be unfair to the owner
o No, because the market already determines the efficient price (rent) through supply and
demand
If you are a tenant, you may well have said "yes", but if you are a property owner, you would
probably have said "no".
If the market operates efficiently, one can argue there is no need for government intervention.
This is the argument we will develop in the rest of the section.
What do you think the impact of rent control on housing would be in South Africa?
Select all the possibilities that you think apply.
o It would be helpful for households because it would protect them from exploitation.
o It would limit the availability of housing, which would mean some people will be without
housing.
o It would decrease the quality of housing
o The owners of houses for rent will be worse off.
All the above effects are part of the consequences of rent controls, which we will analyse in the
following sections.
To analyse the impact of price ceilings, we use rent controls on apartments as an example. For the sake
of simplicity, we assume that all these apartments are exactly the same.
In the absence of government intervention, the price would adjust in this unregulated market so that the
quantity supplied would equal the quantity demanded. This occurs at the equilibrium point E, with an
equilibrium price of R3 000 per apartment and an equilibrium quantity demanded and supplied of 30
000 apartments.
3 ECS1501/002
Market for apartments
Suppose the government imposes a price ceiling that limits the rent to R2 000 per apartment, which is
lower than the equilibrium rent of R3 000. This is indicated by the grey horizontal line Pc in the
diagram below.
Study the following diagram and answer the following questions:
o What is the quantity demanded at a price of R2 000? ______

o What is the quantity supplied at a price of R2 000? ______
From the diagram, we can see that at a price of R2 000 the quantity demanded is 40 000 and the
quantity supplied is 20 000.
Apartments
4 ECS1501/002
With the quantity demanded at 40 000 and the quantity supplied at 20 000, an excess demand of 20 000
apartments exits on the market. And this excess demand will persist as long as a price ceiling of R2 000
is imposed on the market. Note that the when a price ceiling is imposed, it does not shift the demand
and supply curves. There are movements along the curves.
If one compares this position of an excess demand with the market equilibrium position at point E, the
following picture emerges:
At a price ceiling of R2 000 …
 the quantity of apartments supplied decreases from 30 000 to 20 000 apartments – a decline of
10 000 apartments supplied.
Apartments
 the quantity of apartments demanded increases from 30 000 to 40 000 – an increase of 10 000
apartments demanded.
Apartments
 an excess demand of 20 000 apartments are created.
At a price ceiling of R2 000, more people would like to rent an apartment but at that price, only 20 000
apartments are available and less people are therefore able to rent an apartment.
What about a price ceiling above the market equilibrium price? Let's assume that the government
imposes a price ceiling of R4 000, which is higher than the equilibrium price.
5 ECS1501/002
What do you think the impact would be?
o The owner would charge R4 000.
o The owner would charge R3 000.
A price ceiling is only binding if the price ceiling is lower than the equilibrium price.
 If the price ceiling is R4 000 it has no impact because suppliers are willing to supply the market
quantity at a price of R3 000, which is lower than the maximum price of R4 000 that they could
charge. Suppliers are allowed to ask any price that is below the price ceiling, and as the market
equilibrium price is below the price ceiling, renters and owners will settle on the market
equilibrium price.
Apartments
ACTIVITY 2
"Fees must fall"
Use the following diagram of the demand and supply of an economic course at universities to answer
the questions below:
Number of students
2.1 What it the market equilibrium fee per course?
2.2 What is the market equilibrium number of students enrolled for the course?
2.3 Are there any unhappy students at the market equilibrium? (An unhappy student is one who is
willing to take an economics course but cannot afford to do so at the equilibrium price.)
6 ECS1501/002
2.4 Are there any unhappy or unsatisfied suppliers in the market at the equilibrium position?
Owing to the pressure of students through the "Fees must fall" campaign, the government imposes a
price ceiling of R2 500 for a university subject.
Number of students
2.5 How many students would be willing and able to do the subject at R2 500?
2.6 How many students can be enrolled at R2 500?
2.7 With fees at R2 500, is there an excess demand, equilibrium or excess supply in the market?
2.8 Are there any frustrated students at R2 500? (A frustrated student is one who can pay the ruling
price, but cannot find a place.)
Consequences of a price ceiling

• consequences of a price ceiling
An efficient allocation between possible renters is one in which those who want an apartment badly
enough and are willing to pay a higher price will acquire the apartment (those who are willing to pay
R3 000), while those who do not need it that badly and are not willing to pay R3 000 will not acquire it.
This, however, does not happen in this market because there is a price ceiling which causes an excess
demand for apartments – 40 000 people are willing to rent an apartment at R2 000, but only 20 000
apartments are available.
Apartments
7 ECS1501/002
A price ceiling causes an excess demand, which means that a mechanism needs to be put in place to
solve the rationing problem in the market. In the market for apartments, there are 40 000 people
looking for apartments, but there are only 20 000 apartments. A decision needs to be made about who
acquires these apartments.
How do you think this rationing should be resolved?

Select all the possibilities you think apply.
o A first-come-first-served basis should be applied.
o A random lucky draw should be held.
o The supplier should decide who should be able to rent an apartment.
o The government should decide who should be able to rent an apartment.
o You should put your name on a waiting list.
All of these are possible, but leads to inefficiencies.
A consequence of rent control is that people acquire an apartment in this market through luck, bribery
or personal connections. It also creates an incentive for people to keep an apartment that no longer suits
their needs.
Take the case of Frederick, who has retired and bought a house in a seaside village, but still keeps his
lease on the rent-controlled apartment in the city which he uses when he visits the city. At R2 000, it is
affordable for him to keep the apartment. If the rent he has to pay is R3 000, he would probably
consider giving up the apartment and staying over with friends or family when he visits the city.
However, a family that desperately needs an apartment and is willing to pay R3 000 cannot acquire an
apartment. When there is a shortage of apartments, the cost of finding an apartment increases, and in
the process resources are wasted.
Since there is little incentive for suppliers to increase the quantity of apartments and to improve the
quality of the apartments, the shortage will persist and the quality of the apartments will deteriorate.
Instead of building new apartments, it might be more profitable to build offices and shopping centres.
Some apartment suppliers might also decide to convert their apartment buildings into office buildings.
This situation also leads to the creation of illegal markets (black markets) such as subletting. If you can
access a rent-controlled apartment at R2 000, you might be able to sublet it for, say, R4 000, and be
able to pocket R2 000. The owner of the apartment does not share in this R2 000.
We have discussed the effect of price ceilings on the specific case of rent controls for apartments. In
general, whether for soccer tickets, university fees or any good or service, a price ceiling has the
following impacts:
 A persistent shortage (excess demand) develops.
 There is an increase in the rationing costs. These are the costs associated with things such a
queuing and/or developing administration system to decide how the good or service is to be
distributed.
 An illegal or "black market" develops because of the persistent shortage, which makes illegal
trade profitable. Since there are people willing to pay more for the product but cannot acquire
it, an incentive is created for black marketeers to acquire the product at the lower price and sell
it at a higher price. The price that the black marketeers charge is usually higher than the
equilibrium price in an unregulated or free market.
 Opportunities for corruption and bribery are created.
8 ECS1501/002
Price ceilings also create winners and losers. Those people who are able to acquire the good or service
benefit, while those who cannot lose out. There are fewer consumers paying a lower price. Producers
lose out because they are willing to supply a higher quantity at a higher price, but because of the low
price, they supply a lower quantity.
ACTIVITY 3
3.1 The following demand and supply curves for an economics course illustrate the impact of a price
ceiling of R2 500 on the course fee.
Number of students
Which of the following statements are correct with regard to the above?
a. Owing to the excess demand that is created, a rationing mechanism needs to be put in place
to determine which students will be allowed to take the course.
b. In the absence of the price ceiling, the price will be the rationing method, and only those
students who are willing and able to pay R3 500 will be allowed to take the course.
c. Owing to the price ceiling, more students will be enrolled for the course.
3.2 A price ceiling requires an additional rationing mechanism because an excess demand is created
in the market. Which of the following are possible ways to deal with this excess demand?
a. The excess demand should be dealt with on a first-come-first-served basis.
b. A production quota system should be implemented whereby government would limit the
production of the product.
c. The supplier should decide who should be able to obtain the product.
d. Government should purchase the surplus production.
e. Government should decide who should be able to obtain the product.
3.3 The market price for a loaf of bread is R15. Government imposes a price ceiling of R12 per loaf
of bread. A consequence of this action is that a black market for bread could develop since people
who can obtain the bread at R12 can sell it to others who are willing to pay R15 for a loaf of
bread and pocket the difference.
a. The argument is correct.
b. The argument is incorrect because it applies to a price floor.
c. The argument is incorrect because nobody is willing to pay R15 for a loaf of bread.
9 ECS1501/002
9.3 Price floors (maximum price)
• illustrate and explain the impact of a price floor
A price floor means that the government puts a legal lower limit or minimum price that can be charged
for a good or service.
A price floor is the lowest legal price that can be paid in markets for goods and services, labour or
financial capital. Perhaps the best-known example of a price floor is the minimum wage, which is
based on the normative view that someone working full time should be able to afford a basic standard
of living. In 2015, the minimum wage for domestic workers in the main areas in South Africa was
R10,95 per hour. This important topic is dealt with in more detail in the section dealing with the labour
market.
Price floors are sometimes called "price supports", because they support a price by preventing it from
falling below a certain level. Around the world, many countries have passed laws to create agricultural
price supports. Markets for agricultural products are usually characterised by a stable demand, but a
fluctuating supply. Prices of agricultural goods, and thus incomes for farmers fluctuate, sometimes
widely. Hence even if, on average over time, farmers' incomes are adequate, in some years they might
be fairly low. The purpose of price supports is to prevent these swings and to stabilise the agricultural
sector.
We will use an example of the effects of a government policy that imposes a price floor (a minimum
price) above the equilibrium price for a product such as eggs.
Impact of a price floor (maximum price)
To illustrate and explain the impact of a price floor, we will use the diagram below of the market for
eggs. In the absence of government intervention, the price would adjust so that the quantity supplied
would equal the quantity demanded. This occurs at the equilibrium position E, with an equilibrium
price of R1,50 per egg and an equilibrium quantity of three million eggs.
Market for eggs (millions)
10 ECS1501/002
Who do you think will benefit if the price of eggs were fix at a price higher than the market price?
o Producers would benefit.
o Consumers would benefit.
Consumers would definitely not benefit because they would now pay a higher price for eggs, and
since the price is higher, they would consume less. Some producers would definitely benefit. This
is the argument we will develop in the rest of the section.
What do you think the impact would if the government were to decide to fix the price of eggs
above the market price?
o It would create an excess demand.
o It would create an excess supply.
As you will see shortly, it creates an excess supply.
Consider the case of a minimum price per egg of R2,00, which is higher than the equilibrium price.
This price is indicated in the diagram below as the horizontal line Pf.
Study the above diagram and answer the questions:

o What is the quantity demanded at a price floor of R2,00? _______
o What is the quantity supplied at a price floor of R2,00? ________
At a price floor of R2,00, the quantity demanded is two million and the quantity supplied four
million.
With the quantity demanded at two million and the quantity supplied at four million, an excess supply
of two million eggs exits on the market. And this excess supply will persist as long as a price floor of
R2,00 is imposed on the market. Note that the when a price floor is imposed, it does not shift the
demand and supply curves. There are movements along the curves.
If one compares this position of an excess supply with the market equilibrium position E, the following
picture emerges:
11 ECS1501/002
At a price floor of R2,00 …
 the quantity of eggs supplied increases from three million to four million eggs. – an increase of
one million eggs supplied.
 the quantity of eggs demanded decreases from three million to two million eggs – a decrease
of one million eggs demanded.
 an excess supply of two million eggs are created.
Indicate whether the following statements are true or false:

Since the quantity of eggs supplied increases by one million more people are consuming eggs.
o True
o False
At a price floor of R2.00 people are consuming more eggs compared ot the market equilibrium
positon E.
o True
o False
Both statements are false. While the quantity of eggs supplied did increase the quantity demanded
decreased and less eggs are consumed. At a price of R2,00, fewer eggs are consumed than at
R1,50, the equilibrium price.
Also note that it is only if the minimum price is higher than the equilibrium price that the price floor is
binding. If, for instance, the government sets the minimum price at R1,00 per egg, this would have no
impact since the market price that suppliers obtain would be R1,50. The farmer can charge any price
above the price floor; if the price floor is below equilibrium price, then the consumers and suppliers
will settle at the market price.
12 ECS1501/002
ACTIVITY 4
4.1 Milk producers were able to convince the government to impose a price floor on the price of
milk. The following diagram represents the market for milk before the price floor:
Litres of milk
a. What is the market equilibrium price of milk per litre?
b. What is the market equilibrium quantity of milk?
c. Are there any unhappy consumers of milk at the market price in the market?
d. Are there any unhappy or unsatisfied suppliers of milk at the equilibrium position?
4.2 Owing to the pressure from milk producers, the government imposes a price floor as indicated in
the following diagram:
Litres of milk
a. What is the price floor?
b. How many litres of milk are consumers willing and able to purchase at the price floor?
c. How many litres of milk are supplied at the floor price?
d. Is there an excess demand, equilibrium or excess supply in the market at the price floor?
Consequences of a price floor (maximum price)

• consequences of a price floor

13 ECS1501/002
A price floor creates an excess supply or surplus, and a decision must be made about what to do with
the excess supply or surplus.
Market for eggs
How do you think the rationing should be resolved?

Select all the possibilities that you think apply.
o Producers should store the excess supply of eggs at their own cost.
o Government should buy the excess supply and store the eggs at its own cost.
o The surplus eggs should be destroyed by the producers.
o The surplus eggs should be destroyed by government.
o A production quota system should be implemented whereby government would limit the
production of eggs.
o Government should purchase the surplus eggs and export it.
o Farmers should be paid not to produce eggs.
All the above is possible but it leads to inefficiencies.
Even a policy whereby the government buys the surplus eggs and exports them is not without costs to
society. The government would probably not be able to export the eggs at the price it paid for them, but
at a lower price, which would therefore involve a loss. It might also have serious consequences for the
producers of eggs in the country importing the eggs.
If producers were responsible for destroying the surplus, then the suppliers who are able to sell eggs at
the price floor would be better off, while those who cannot sell their eggs owing to low quantity
demanded would lose out.
Quotas would probably lead to lobbying, bribery and corruption.
Paying farmers not to produce would probably lead to more farmers claiming that they intend
producing eggs. Another possible result of binding price floors is that inefficient farmers are kept in
business and produce goods of which an excess supply already exists, while other goods have to be
imported.
Price floors usually have the following consequences on goods and services where the minimum price
is higher than the equilibrium price (or market clearing price):
 A persistent surplus (excess supply) develops.
 Consumers, including poor households, have to pay artificially high prices.
 Inefficient producers are protected and manage to survive.
 The disposal of the market surpluses usually entails further costs to tax payers and welfare
losses to society.
14 ECS1501/002
 To avoid these unintended consequences, government is forced to increase its intervention in
the market and thus impose even more costs on the system.
 Price floors also create winners and losers. Those producers that can sell at the higher price
benefit, while consumers lose since they have to pay a higher price. At this higher price, there
are fewer consumers of the good or service.
As you can see, government intervention through price ceilings and price floors can have extremely
negative consequences.
ACTIVITY 5
The following demand and supply curves for the market for milk illustrate the impact of a price floor of
R12,00:
Litres of milk
5.1 Which one of the following statements is correct with regard to the above?
a. Owing to the excess demand that is created, a rationing mechanism needs to be put in place
to determine who will be able to obtain milk.
b. Owing to the excess supply that is created, society must decide what is to be done with this
surplus.
c. The price floor is lower than the equilibrium price.
5.2 Indicate whether the following statements are true or false:
a. At a price floor of R12,00, more buyers can purchase milk compared to the equilibrium
position.
b. At a price floor of R12,00, a higher quantity of milk is supplied compared to the
equilibrium position.
c. If the price floor is lower than the equilibrium price, it will have no impact.
d. More people are excluded from buying milk at a price floor higher than at the equilibrium
position.
5.3 A price floor creates an excess supply, and society needs to decide how to deal with this excess
supply. Which of the following are possible ways to deal with this excess supply? Select all
answers that apply.
a. Buyers should be placed on a waiting list.
b. A production quota system should be implemented whereby government would limit the
production of product.
c. The supplier should decide who should be able to obtain the product.
15 ECS1501/002
d. Government should purchase the surplus production.
e. Government should decide who should be able to obtain the product.
f. The surplus should be destroyed by the producers.
5.4 Consider the following argument:
One way to deal with a surplus of milk that results from a price floor that is higher than the
equilibrium price is to give the surplus away for free.
a. The argument is correct since the milk has been produced and consumers will be better off.
b. The argument is incorrect since it will undermine the price floor since people who are
willing to purchase it at R12,00 will try to obtain it for free and people who can obtain it for
free can sell it for less than R12,00.
c. The argument is incorrect since there is no surplus when the price floor is higher than the
equilibrium price.
16 ECS1501/002
ANSWERS TO THE
ACTIVITIES
Activity 1
1.1 d.
A price ceiling occurs when the government puts a legal upper limit or maximum on the price
that can be charged for a good or service. In this case, the supplier may not charge a price higher
than R2 500 for a subject.
The highest price or lowest price that were paid for something does not imply it is a legally
binding price and is therefore neither a price ceiling nor a price floor. A legally binding minimum
price is a price floor.
1.2 c.
A price floor occurs when the government puts a legal lower limit or minimum on the price that
can be charged for a good or service. In this scenario, the government imposes a legal lower limit
of R20 per kg of sugar. This implies that supplier may not charge a price lower than R20 per kg.
Activity 2
2.1 What is the market equilibrium fee per course?

It is R3 500.
Number of students
17 ECS1501/002
2.2 What is the market equilibrium number of students enrolled for the course?
It is 15 000.
Number of students
2.3 Are there any unhappy students at the market equilibrium? (An unhappy student is one who is
willing take an economics course but cannot afford to do so at the equilibrium price.)
Yes. Unhappy students are those who would like to take the course but cannot pay the fee of R3
500. They are able to take the course at a lower fee. They are represented by the portion of the
demand curve lower than R3 500.
Number of students
2.4 Are there any unhappy or unsatisfied suppliers in the market at the equilibrium position?
Yes. Unhappy suppliers are those who are willing to offer the course but are not able to do it at a
fee of R3 500. They are willing and able to supply more at a higher price. They are represented
by the portion of the supply higher than R3 500.
18 ECS1501/002
Number of students
Owing to the pressure of students through the "Fees must fall" campaign, the government
imposes a price ceiling of R2 500 for a university subject.
Number of students
2.5 How many students would be willing and able to do the subject at R2 500?
18 000 students.
Number of students
19 ECS1501/002
2.6 How many students can be enrolled at R2 500?
12 000 students.
Number of students
2.7 With fees at R2 500, is there an excess demand, equilibrium or excess supply in the market?
Excess demand. There is an excess demand of 18 000 minus 12 000 students = 6 000 students. As
you can see in the diagram below.
Number of students
2.8 Are there any frustrated students at R2 500? (A frustrated student is one who can pay the ruling
price, but cannot find a place.)
Yes. All those students who are willing and able to pay R2 500 but cannot find a place. In this
scenario, there are 6 000 frustrated students (18 000 – 12 000 = 6 000).
Activity 3
3.1 a and b.
A consequence of a price ceiling is that it interferes with the rationing function of the price
mechanism and the result is an excess demand. In the absence of the price ceiling, the
equilibrium price will be reached and there will be no excess demand, and the 15 000 students
who are able and willing to pay R3 500 will be enrolled for the course.
20 ECS1501/002
When a price ceiling of R2 500 is imposed, 18 000 students will be able and willing to take the
course but there will only be place for 12 000 students. This then requires an additional rationing
mechanism to determine who these 12 000 students will be.
3.2 a, c and e.
The following are all possible measures to deal with the excess demand:
• The excess demand should be dealt with on a first-come-first-served basis.
• The supplier should decide who should be able to obtain the product.
• Government should decide who should be able to obtain the product.
The others are ways to deal with a surplus.
• A production quota system should be implemented whereby government would limit the
• Government should purchase the surplus production.
3.3 a.
It is indeed a consequence of a price ceiling that a black market might develop. In this scenario,
there is an excess demand for bread at R12. This means some people who are willing and able to
pay for bread cannot acquire it. Owing to the demand for bread, there are people willing and able
to pay R15 and more for a loaf of bread, and if the black marketeer can obtain it for R12, he or
she can sell it for R15 or the price people are prepared to pay for.
Activity 4
4.1
a. R8
b. 40 000
c. Yes, those that are only willing to pay less than R8.
d. Yes, those that are willing to supply at a price higher than R8.
4.2
a. The price floor is R12.
21 ECS1501/002
b. The quantity demanded is 20 000 litres of milk.
Market for milk

c. The quantity supplied is 60 000 litres.
Market for milk

d. There is an excess supply of 40 000 litres of milk.
Market for milk
22 ECS1501/002
Activity 5
5.1 b.
A consequence of a price floor is that it interferes with the rationing function of the price
mechanism, resulting in an excess supply. In the absence of the price floor, the equilibrium price
will be reached and there will be no excess demand or excess supply.
When a price floor of R12,00 is imposed, the quantity demanded is 20 000 litres of milk, while
the quantity supplied is 60 000 litres of milk. This gives us an excess supply of 40 000 litres of
milk. Society must now decide what should be done with this excess supply of milk.
5.2
a. False. At the equilibrium price of R8,00, the purchase of milk is 40 000 litres, while at a
price of R12,00, it is only 20 000. Less milk is bought at R12,00 compared to R8,00 –
which is the equilibrium price.
Market for milk

b. True. At the equilibrium price of R8,00, the quantity supplied is 40 000, while at a price of
R12,00 – the floor price – the quantity supplied is 60 000. A higher quantity of milk is
therefore supplied at R12,00 than at R8,00.
Market for milk

c. True. The floor price is only binding if it is higher than the equilibrium price.
23 ECS1501/002
d. True. A negative consequence of a price floor is that fewer people are willing and able to
purchase the product.
5.3 b, c and f.
The following are all possible measures to deal with the excess supply:
• A production quota system should be implemented whereby government would limit the
• Government should purchase the surplus production.
• The surplus should be destroyed by the producers.
The others are ways to deal with an excess demand:
• Buyers should be placed on a waiting list.
• The supplier should decide who should be able to get hold of the product.
• The government should decide who should be able to get hold of the product.
5.4 b. It will undermine the price floor since people who are willing to purchase it at R12,00 will try
to obtain it for free. It might also happen that people who obtain it for free can then sell it at a
lower price, thereby undermining the floor price.
24 ECS1501/002
CHECKLIST
Well Satis- Must

factory redo
Concepts and explanations
I am able to
define a price floor
define a price ceiling
give reasons why governments set price floors and price ceilings
identify the likley consequences of price celings
identify the likely consequences of price floors
list the actions that can be taken to deal with a shortage that results
from a price ceiling
list the actions that can be taken to deal with a surplus that results
from a price floor
Diagrams
I am able to
(i) show on a diagram
(ii) explain with or without the aid of a diagram
the impact of a price ceiling on a market
the impact of a price floor on a market
25 ECS1501/002
Price elasticity of
demand 10
OVERVIEW
We are still on our journey investigating how a society can deal with the economic problem of scarce
resources and unlimited needs and wants.
This scarcity problem forces us to make choices, and every choice we make has a cost – the
opportunity cost – which is the best alternative we give up by making this choice. We have seen that
because of this scarcity problem, every society needs to answer the following three fundamental
questions:
 What should be produced?
 How should it be produced?
 For whom should it be produced?
We have identified the market system as a possible way to deal with these questions, and indicated that
in a market system it is the price mechanism that helps society to deal with these fundamental
questions. To explain how the price mechanism operates, we have developed a model – the demand
and supply model.
In this model, we have shown how the price of a good or service is determined by the interaction
between the forces of demand and supply. We have explained demand with the aid of a demand curve
and supply with the aid of a supply curve, and indicated how the equilibrium price and quantity are
formed in the market.
Excess supply Excess demand
With this model, we have shown that prices have a signalling and rationing function in that they rise
and fall to indicate excess demand (shortage) and excess supply (surplus), and how through price
changes, this excess demand or excess supply is eliminated.
26 ECS1501/002
For instance, if households have a higher demand for goods and services, the demand for these goods
and services increases. An excess demand is thus created, which causes the price to rise and the
quantity demanded and supplied to adjust. A signal has thus been sent from the households to the
producers.
Increase in demand
However, if there is a decrease in the supply of a good or service, the supply from producers' decreases.
An excess demand is thus created, which causes the price to rise and the quantity demanded and
supplied to adjust. A signal has therefore been sent from producers to households.
Decrease in supply
In this topic called price elasticity, we will take a closer look at the demand for a good or service by
investigating the relationship between a change in price and the change in quantity demanded.
This will give us a better understanding of how households and firms are influenced by a change in the
price of a good or service.
Read through the following extract and reflect on the questions asked:
The price elasticity of demand is defined as “the percentage change in the quantity demanded
divided by the corresponding percentage change in its price” (Begg 2000). The application of this
theory to the retail fuel industry proposes that an increase in the fuel price leads to a reduction in
the demand for fuel. Considerable research has attempted to identify factors that influence fuel
demand, as well as to provide insights into the sensitivity of consumer demand to fuel prices
changes (Espey 1996). Fuel price has been identified as one of the key variables affecting the
demand for fuel (Graham & Glaister 2002). However, South African consumers have indicated a
relatively inelastic short-term demand for fuel because of a lack of alternative transport systems.
It could be expected, however, that higher levels of elasticity could be achieved through a
27 ECS1501/002
combination of a reduction in the use of vehicles, lift clubs, the use of public transport, better
driving techniques, more regular servicing of vehicles and a shift to more fuel-efficient vehicles
in the longer term (TDM Encyclopedia 2005a; 2005b). In this regard, Graham and Glaister
(2002) also highlight the impact of a better infrastructure and a functional public transport system
on fuel demand.
Graham and Glaister (2002) performed an extensive international survey on the response of
motorists to fuel price changes that indicated a fairly narrow range for short-term price elasticity
and a bigger range for long-term price elasticity. This research concluded that, in general,
international short-term price elasticity ranged between –0,10 and –0,3 and long-term price
elasticity between –0,6 and –0,8. The price elasticity of gasoline in the USA, for instance, was
estimated to be –0,15 in the short run and –0,6 in the long run (Bailly 1999). In South Africa, the
Bureau for Economic Research (2003) estimated that the short- and long-term price elasticity of
demand for petrol ranged between –0,21 and –0,51, respectively. All of these results indicate
short-term inelastic conditions that become more responsive over time.
In this regard, short-term inelasticity with respect to petrol in South Africa is illustrated by a 17%
increase in the petrol price in 2005, which only resulted in a 0,2% drop in sales …
Source: Sartorius, K., Eitzen, C & Hart, J. 2007. An examination of the variables influencing
the fuel retail industry. Retrieved from
https://actacommercii.co.za/index.php/acta/article/download/33/32
Questions for reflection
1. Are South African consumers sensitive or insensitive to a change in the price of fuel?
2. What do South African consumers do if the price of fuel increases?
3. Why is it not possible for South African consumers to adjust their use of fuel in the short run?
4. What happens to the revenue of fuel supplier if the price of fuel increases and what happens to
their revenue if the price of fuel decreases?
TOPIC OUTCOME
• explain and illustrate the concept price elasticity and the relationship between price elasticity
and total revenue
10.1 What do we do when prices increase?

How we react depends to a large degree on what kind of good or service it is and by how much the
price increases.
In the past, an increase in the price of bread in Iran has caused massive protests, an increase in public
transport fares in Brazil led to violent protests, and in South Africa a rise in the price of petrol usually
leads to strong verbal protests from motorists and taxi commuters.
Which one of the following would upset you the most?

o An increase in the price of petrol
o An increase in the price of ice cream
Most people will be more upset if the price of petrol rises than if the price of ice cream rises.
28 ECS1501/002
Think for a moment why people are more upset if the price of petrol rises than if the price of ice
cream rises. Is it because …
o it is the government's fault the price of petrol rises.
o it is extremely difficult for people to decrease the quantity of petrol they use.
o it is easier to decrease the quantity of ice cream bought than the quantity of petrol bought.
Yes, it is easier to eat less ice cream than to use less petrol. As the price of petrol increases, it is
very difficult to decrease the quantity of petrol we demand. That is probably why we get more
upset if the price of petrol rises than if the price of ice cream rises.
To get a better understanding of how households and firms react, and how they are influenced by price
changes, we need to unpack the concept of "price elasticity", which is what we will start doing in the
next section.
10.2 Description of price elasticity of demand

• describe the concept price elasticity of demand with the aid of a demand curve
Before we give a description of the concept of price elasticity, we need to recap what we have learned
about the law of demand, since the concept of price elasticity is closely related to the law of demand.
From the law of demand we know that if the price changes, the quantity demanded changes. According
to this law, an increase in price will decrease the quantity demanded, and a decrease in price will
increase the quantity demanded.
Study the following diagram and make sure you know what happens if the price changes.
o What happens to the quantity demanded if the price increases from P3 to P4?
o What happens to the quantity demanded if the price decreases from P4 to P2?
If the price increases from P3 to P4, the quantity demanded decreases, since an inverse relationship
exists between the price and the quantity demanded. The decrease is from Q3 to Q2.
If the price decreases from P4 to P2, the quantity demanded increases, since an inverse relationship
exists between the price and the quantity demanded. The increase is from Q2 to Q4.
29 ECS1501/002
From the law of demand, we know that if the price of a good or service increases, the quantity
demanded will decrease; and if the price decreases, the quantity demanded increases.
The question we are dealing with is:

By how much would the quantity demanded change if the price were to change? In other words, we
wish to measure the impact of a change in the price on the quantity demanded.
It is the concept of price elasticity of demand that gives us a measure of how sensitive or
responsive the quantity demanded is to a change in the price of a good or service.
Here we are moving from theoretical economics to empirical economics. When we dealt with the
theory of demand, supply and prices, we simply indicated the direction of change. We argued that if,
say, the supply of a good or service increases, the price decreases, which increases the quantity
demanded.
In empirical economics, we want to measure by how much the price decreases and by how much the
quantity demanded increases.
In the following diagram, we can see that an increase in supply will decrease the price from R4 to R2
and, in turn, will increase the quantity demanded from 500 to 600.
Price elasticity
We now have a basis to measure how sensitive or responsive the quantity demanded is to a change in
the price. In other words, we can measure the price elasticity of demand.
∆𝑃𝑃 → ∆𝑄𝑄𝑑𝑑
R4 to R2 →500 to 600
The topic of the next section is how to measure price elasticity on the basis of the data provided.
Before you continue to the section on the measurement of price elasticity, do the following activity to
make sure that you grasp the meaning of the concept of price elasticity.
30 ECS1501/002
ACTIVITY 1
1.1 Indicate whether the following statements relating to price elasticity of demand is true or false:
T F
a. The price elasticity of demand provides us with a measure of how sensitive or

responsive the price of a good or service is to a change in demand.
b. If you know what the price elasticity of petrol is, you will know how sensitive
or responsive the quantity demanded of petrol is to a change in the price of
petrol.
c. If you know what the price elasticity of petrol is, all you will be able to say is
that an increase in the price of petrol will reduce the quantity of petrol
demanded.
d. If you know what the price elasticity of petrol is, you will be able to predict what
happens to the price of petrol if the demand for petrol changes.
e. If the price elasticity of ice cream is greater than the price elasticity of petrol, it
means that households are more responsive or sensitive to a change in the price
of ice cream than to a change in the price of petrol.
f. People become more upset about an increase in the price of petrol compared to
an increase in the price of ice cream. This implies that they are more responsive
or sensitive to a change in the price of petrol than a change in the price of ice
cream.
g. If a business knows what the price elasticity of demand for its product is, it will
be able to predict what will happen to its sales if the price of the product changes.
h. If a supplier of fresh tomatoes knows what the price elasticity of fresh tomatoes
is, the supplier will be able to predict what will happen to his or her total revenue
from the sale of fresh tomatoes if the price of fresh tomatoes changes
31 ECS1501/002
1.2. Study the diagrams below. Which diagram represents what we are going to measure through
price elasticity?
a.
b.
10.3 Measurement of price elasticity of demand

• describe the measurement of price elasticity

• calculate the price elasticity coefficient using the midpoint method
32 ECS1501/002
Let's start with a question:
You are given the following information:
The price of a good or service increases by R5, while the quantity demanded decreases by 1 000.
Would you say that the price increase is:
o Big
o Small
o Need more information to make a judgment.
Would you say that the decrease in the quantity demanded is:
o Big
o Small
We need more information than only the absolute changes (i.e. R5 and 1 000). Unless we know
what the basis is on which these changes have taken place, we cannot say whether it is big or
small. We need to determine the relative changes in order to answer the question. In other words,
we need to know the percentage change in price and quantity before we can make a judgement.
Let's see what happens when we know what the percentage changes are. In each of the questions
below, select the best answer.
You are provided with the following information:
The price of a good increases by R5, which is a 100% increase in the price, while the quantity
demanded decreases by 1 000, which is a 1% decrease in quantity demanded.
Would you say that the price increase is:
o Big
o Small
Would you say that the decrease in the quantity demanded is:
o Big
o Small
There is no doubt that the increase in the price is big (100%), while the decrease in quantity
demanded is small (1%). We are now working with relative changes, and are thus in a position to
make a judgement.
Here, we can say that a big change in price leads to a small change in the quantity demanded, and
we can in effect calculate the price elasticity coefficient on the basis of this information.
Once we know these percentages changes, it is possible to measure price elasticity through the price
elasticity coefficient.
33 ECS1501/002
The price elasticity coefficient
The price elasticity coefficient gives us a measure of how sensitive or responsive the quantity
demanded of a good or service is to a change in the price of the good or service. It is our
measure of price elasticity.
If we know what the percentage change in price and the percentage change in quantity demanded are,
we can calculate the price elasticity coefficient by using the following formula:
% 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞 𝑑𝑑𝑑𝑑𝑚𝑚𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 =
% 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
Using symbols, this is written as follows:

%∆𝑄𝑄𝑑𝑑
𝑒𝑒𝑝𝑝 =
%∆𝑃𝑃
Using the data in our example, where the price increases by 100% and the quantity demanded decreases
by 1%, the price elasticity coefficient for the good is:
1%
𝑒𝑒𝑝𝑝 = = 0,01
100%
Should the answer not be –0,01? It should indeed. Since the quantity demanded decreases, it should be
reflected as –1%, and the answer should therefore be –0,01. Economists usually ignore the negative
sign, and report the elasticity coefficient as a positive value (in mathematics, this is called absolute
values). One of the reasons for this is that we know that the law of demand indicates a negative
relationship between the price and quantity demanded and, consequently, the value of the price
elasticity coefficient will always be negative. Nothing is lost by using the absolute values as long as we
remember that we are dealing with an inverse relationship.
Thus far it all seems to be straightforward. Obtain the percentage changes, and then calculate the price
elasticity using the formula. And it is indeed that simple, except that we need to deal with how the
percentage changes are to be calculated.
Calculate percentage change in price and percentage change in quantity demanded
You have the following information:
Price (P) Quantity demanded (Qd)

8 100
10 90
If the price increases from R8 to R10, what is the percentage increase in price?
What is the percentage decrease in quantity demanded if the price increases from R8 to R10?
What is the price elasticity coefficient, using the answers to the above questions?
The increase in price is R2, and the percentage increase in price is R2/R8 x 100 = 25%. The quantity
demanded decreases by 10 units (100 – 90), and the percentage decrease in the quantity demand is 10
units/100 units = 10%. In this case, the price elasticity coefficient is:
34 ECS1501/002
𝑒𝑒𝑝𝑝 =
%∆𝑃𝑃
10%
=
25%
= 0,4
If you do the same exercise, but assume that the price decreases from R10 to R8, will you obtain the
same price elasticity coefficient as in the previous example that used an increase in the price from R8
to R10?
Do the calculations to see what your answer would be.
If you did the calculations correctly, you will see that the percentage change in price is R2/R10 x 100 =
20%, and the percentage change in quantity demanded is 10 units/90 units x 100 = 11,1%. In this
example, the price elasticity coefficient is:
𝑒𝑒𝑝𝑝 =
%∆𝑃𝑃
11%
=
20%
= 0,55
The reason for this difference is that it depends on the starting point (the value we use as the basis for
our calculations). It the starting value for price is R8, a R2 increase in price implies a 25% increase in
the price. If the starting value for price is R10, a R2 decrease in price implies a 20% decrease in price.
The same happens for the change in quantity demanded.
What we are looking for is a measure that is independent of the starting point or direction of change. A
R2 increase in the price should give us the same answer as a R2 decrease in price.
To solve this problem, we make use of the midpoint method to calculate the price elasticity coefficient.
Arch elasticity: Midpoint method

When price elasticity is calculated using two points, it is known as arch elasticity. The midpoint
method involves using the average of the initial and ending values.
Let's use our previous example, where:
Price (P) Quantity demanded (Qd)

8 100
10 90
35 ECS1501/002
The calculation of price elasticity using the midpoint method involves the following:
Step 1: Calculate the midpoints for P and (Qd)

(8 + 10) (90 + 100)
Midpoint of 𝑃𝑃 = Midpoint of 𝑄𝑄 =
2 2
=9 = 95
Step 2: Calculate the percentage change in P and Qd if price increases from R8 to R10.
(10 − 8) (90 − 100)
%∆𝑃𝑃 = × 100 %∆𝑄𝑄𝑑𝑑 = × 100
9 95
2 10
= × 100 = × 100
9 95
= 22,2% = 10,5%
Step 3: Use the formula for price elasticity to calculate the price elasticity coefficient
𝑒𝑒𝑝𝑝 =
%∆𝑃𝑃
10,5%
=
22,2%
= 0,47
Assuming that the price decreases from R10 to R8 will give the same result as an increase from R8 to
R10, we have eliminated the "increase versus decrease" issue.
If we add all the above steps together, we end up with the following formula for calculating arch
elasticity:
(𝑄𝑄2 − 𝑄𝑄1 )
𝑄𝑄1 + 𝑄𝑄2
𝑒𝑒𝑝𝑝 = 2
(𝑃𝑃2 − 𝑃𝑃1 )
𝑃𝑃1 + 𝑃𝑃2
2
This looks rather intimidating, but it is nothing more than a combination of the various steps. The (Q2 –
Q1) is the difference between the end value and the initial value of the quantity demanded (90 – 100).
The [(Q1 + Q2 )/2] is the midpoint value for the quantity demanded [(100 + 90)/2]. The (P2 – P1) is the
difference between the end value and initial value for the price (R10 – R8).
The [(P1 + P2 )/2] is the midpoint value for the price [(R8 + R10)/2]. We have left out the multiplication
by 100 since it occurs above and below the line, which means that each cancels out the other.
The (Q2 – Q1 )/ [(Q1 + Q2 )/2] gives us the percentage change in quantity demanded
(10,5%) while (P2 – P1 )/[(P1 + P2 )/2] gives us the percentage change in price (22,2%).
36 ECS1501/002
We can even further simplify the formula by getting rid of the 2 since it occurs above and below the
line, and end up with the following formula for arch elasticity using the midpoint method:
𝑄𝑄2 − 𝑄𝑄1
𝑄𝑄 + 𝑄𝑄2
𝑃𝑃2 − 𝑃𝑃1
Using the data in our example, the arch elasticity can be calculated as follows:
(90 − 100)
(100 + 90)
𝑒𝑒𝑝𝑝 =
(10 − 8)
(8 + 10)
10
= 190
2
18
0,052
=
0,111
= 0,47
This price elasticity coefficient of 0,47 is the ratio between the percentage change in price and the
percentage change in quantity demanded, and tells us that a 1% increase in price will cause a 0,47%
decrease in quantity demanded, and that a 1% decrease in price will cause a 0,47% increase in quantity
demanded.
Do the following activity about the calculation of price elasticity of demand.
ACTIVITY 2
The following diagram shows what happens if the supply of say, restaurant meals, decreases because of
an increase in the cost of producing restaurant meals. The equilibrium price increases and the
equilibrium quantity declines. What you need to do is to calculate the price elasticity coefficient for
restaurant meals for the price increase range R100 to R110.
37 ECS1501/002
10.4 Types of price elasticity
• describe and differentiate between the different types of price elasticities
Now that we know how price elasticity is calculated by dividing the percentage change in quantity
demanded by the percentage change in price, we need to interpret different price elasticity coefficients.
If you look at the table below, which gives you the price elasticities of demand for various goods and
services, you will notice that the price elasticity ranges from 0,1 for salt to 4,68 for fresh tomatoes.
Different price elasticities
Goods and Price elasticity Goods and services Price elasticity

services coefficient coefficient
Salt 0,1 Tyres 0,9
Matches 0,1 Shoes 0,91
Electricity 0,13 Private education 0,1
(Households)
Coffee 0,25 Motor vehicles 0,14
Medical care 0,31 Beef 1,27
Tobacco products 0,45 Restaurant meals 2,27
Fuel (petrol) 0,6 Lamb and mutton 2,65
Beer 0,9 Fresh tomatoes 4,6
Source: Janse van Rensburg, J., Mconnel, C.R. & Brue, S.L. 2015. Economics. McGraw Hill:
London.
What is the meaning of the difference between a price elasticity of 0,1 for salt and 4,6 for fresh
tomatoes? Is this difference important?
An important difference is that a price elasticity of 0,1 for salt indicates that a 1% change in the price of
salt will cause a 0,1% change in the quantity demanded, while a price elasticity of 4,6 for fresh
tomatoes indicates that a 1% change in price will cause a 4,6% change in the quantity demanded.
Based on this, we can say that in the case of salt, a change in the price has a smaller effect on the
quantity demanded, and consumers are less responsive (sensitive) to a change in the price of salt
compared to a change in the price of fresh tomatoes.
Another difference is that in the case of salt, the price elasticity is less than 1, while for fresh tomatoes,
the price elasticity is greater than 1.
In fact, if you look at the table again, you will notice that goods and services can be classified as having
a price elasticity of less than 1 or more than 1.
38 ECS1501/002
Let's look at our formula for price elasticity:
𝑒𝑒𝑝𝑝 =
%∆𝑃𝑃
When the percentage change in price is greater than the percentage change in quantity demanded, the
price elasticity will be less than 1. If the percentage change in price is smaller than the percentage
change in quantity demanded, the price elasticity will be greater than 1.
As a general rule, we can state the following:
• If the percentage change in price is greater than the percentage change in quantity demanded,
then the price elasticity coefficient is less than 1. This applies to things such as salt, medical
services, fuel, beer and so forth. In these cases consumers are less responsive or sensitive to a
change in the price.
• If the percentage change in price is smaller than the percentage change in quantity demanded,
then the price elasticity coefficient is greater than 1. This applies to things such as private
education, restaurant meals and fresh tomatoes. In these cases consumers are more responsive
or sensitive to a change in price.
What we will identify and describe in the rest of this section are the different types of elasticity. These
are based on the varying impact of a change in price on the quantity demanded, as measured by the
price elasticity coefficient.
Do the following activity about the price elasticity coefficient.
ACTIVITY 3
3.1 You are given the following information:
Goods and services Price elasticity

coefficient
Private education 1,1
Electricity (Households) 0,13
Restaurant meals 2,27
Fuel (petrol) 0,6
a. Indicate for which goods and services is the % change in price greater than the % change in
quantity demanded and for which is the % change in price smaller than the % change in
quantity demanded.
b. Compare the price elasticity of electricity with restaurant meals and indicate whether
consumers are more responsive (sensitive) or less responsive (sensitive) to a change in the
price of electricity compared to a change in the price of restaurant meals.
39 ECS1501/002
3.2 If the % change P is greater than the % change in Qd, then the price elasticity coefficient is … .
a. smaller than 1
b. greater than 1
c. equal to 1
Relatively inelastic demand
The first type of elasticity we take a closer look at is known as a relatively inelastic demand.
In the case of a relatively inelastic demand, the percentage change in price is greater than the
percentage change in quantity demanded. And when the percentage change in price is greater than the
percentage change in quantity demanded, the price elasticity coefficient will have a value of less than 1.
In other words:
If ep < 1, we have a relatively inelastic demand.
In the price elasticity table, goods and services with a relatively inelastic demand are things such as
salt, medical care, tobacco products and petrol (fuel). They all have an elasticity coefficient of less than
1. What this means is that the quantity demanded is not highly sensitive to a change in the price.
Different price elasticities
Goods and services Price elasticity Goods and services Price elasticity
coefficient coefficient
Salt 0,1 Tyres 0,9
(Households)
Source: Source: Janse van Rensburg, J., Mconnel, C.R. & Brue, S.L. 2015. Economics.
McGraw Hill: London.
On the basis of this, we can argue that people are relatively unresponsive or insensitive to adjusting
their quantity demanded if the price changes. Note that unresponsive and insensitive in this sense
means that people find it difficult to change their quantity demanded of the good, and not that they do
not become upset if the price changes.
40 ECS1501/002
In the case of fuel (petrol), which has a price elasticity of 0,6 in the table, this implies that a 10% rise in
the price of fuel will reduce the quantity demanded by 6% – which is less than the percentage change in
price. This is referred to as a relatively inelastic demand.
Graphically, we can illustrate a relatively inelastic demand as follows:
Inelastic demand: % change in price > % change in quantity demanded and ep <= 1
Relatively inelastic demand
Examples are: salt, coffee, medical care and beer.

A 10,5% increase in price reduces the quantity demanded by 5,1%. The lower the price elasticity of
demand, the steeper the demand curve will be.
Relatively elastic demand

Where the percentage change in price is smaller than the percentage change in quantity demanded, we
have a relatively elastic demand. Whenever the percentage change in price is smaller than the
percentage change in quantity demanded, the price elasticity coefficient will have a value of more than
1.
In other words:
• If ep > 1, we have a relatively elastic demand.
In our table, goods and services with a relatively elastic demand are things such as private education,
motor vehicles, restaurant meals and fresh tomatoes. They all have an elasticity coefficient of more
than 1. What this means is that the quantity demanded is extremely sensitive to a change in the price.
On the basis of this, we can argue that people are relatively responsive or sensitive to adjusting their
quantity demanded if the price changes. In the case of private education, which has a price elasticity of
1,1, this implies that a 10% rise in the price of private education will decrease the quantity demanded
by 11% – the percentage change in price is less than the percentage change in quantity demanded. This
is then referred to as a relatively elastic demand.
41 ECS1501/002
Graphically, a relative elastic demand can be represented as follows:
Relatively elastic demand

Examples are: private education, beef and fresh tomatoes.
A 10,5% increase in price decreases the quantity demanded by 29%. The higher the price elasticity of
demand, the flatter the demand curve will be in the particular price range.
Unitary elasticity
Where the percentage change in price is equal to the percentage change in quantity demanded, the price
elasticity coefficient is equal to 1. In other words, a 1% increase in price leads to a 1% decrease in
quantity demanded, giving us a price elasticity coefficient of 1. This is called unitary elasticity.
In other words:
• If ep = 1, we have a unitary elastic demand.
If you examine the table, you can see that shoes are close to unitary elasticity. Most goods and services
in the table, however, either have an elasticity of less than 1 or more than 1.
Graphically, it can be represented as follows:
Unitary elasticity
A 10,5% increase in price decreases the quantity demanded by 10,5%.
42 ECS1501/002
Some extreme cases
Thus far we have identified three types of elasticity, namely relatively price inelastic (ep <1), unitary
elastic (ep= 1) and relatively elastic (ep >1). There are two other interesting theoretical types, namely
perfectly inelastic and perfectly elastic.
Perfectly inelastic demand

A perfectly inelastic demand curve occurs when a change in price does not have any impact on the
quantity demanded.
In terms of our formula, the percentage change in quantity demanded is equal to 0.
0
𝑒𝑒𝑝𝑝 =
%∆𝑃𝑃
Here the price elasticity coefficient is equal to zero since the percentage change in quantity demanded
is 0, and when you divide 0 by any value, the answer is still 0.
This kind of elasticity might occur when people are highly addicted to some kind of drug or need life-
saving medication.
Perfectly inelastic demand

A 10,5% increase in price does not have an impact on the quantity demanded.
Perfectly elastic demand

A perfectly elastic demand curve occurs when a small change in price has a major impact on the
quantity demanded. Here, a small percentage change in price causes a percentage change in the
quantity demanded that approaches infinity.
𝑒𝑒𝑝𝑝 = ∞
43 ECS1501/002
Graphically, it can be represented as follows:
Perfectly elastic demand

Do the following activity about the different types of elasticity.
ACTIVITY 4
4.1 If the % change in P is greater than the % change in Qd, then demand is …
a relatively inelastic.
b relatively elastic.
c unitary elastic.
4.2 A relatively elastic demand implies that …
a the % change in price is greater than the % change in Qd.
b the % change in price is smaller than the % change in Qd.
c the % change in price is equal to the % change in Qd.
4.3 A relative elastic demand implies that the price elasticity coefficient is …
a smaller than 1.
b greater than 1.
c equal to 1.
4.4 If a 12% change in P leads to a 6% change in Qd, the demand is ...
a relatively inelastic
b relatively elastic
c unitary elastic
4.5 If a 8% change in price leads to a 12% change in Qd, the demand is …
a relatively inelastic
b relatively elastic
c unitary elastic
4.6 Given the following information about the price elasticity of a good or service, select the
appropriate price elasticity characteristics for this product from the different categories.
44 ECS1501/002
An increase of 9% in the price of the product decreases the quantity demanded by 5%.
o Relatively inelastic
o Relatively elastic
o Unitary elastic
o Perfectly inelastic
o Perfectly elastic
o ep = 1
Categories o 0 < ep < 1
o 1 < ep < ∞
o ep = 0
o ep = ∞
o It has a relatively low price elasticity value.
o It has a relatively large price elasticity value.
o It has a unitary price elasticity value.
4.7 Given the following information about the price elasticity of a good or service, select the
appropriate price elasticity characteristics for this product from the different categories.
The product has a price elasticity of 1.7.
o Unitary elastic
o ep = 1
o 0 < ep < 1
o 1 < ep < ∞
Categories
o The % change in Qd is less than the % change in P.
o The % change in Qd is greater than the % change in P.
o The % change in Qd is equal to the % change in P.
o It can be argued that for this product people are not very
price sensitive.
o It can be argued that for this product people are price
sensitive.
4.8 Assume that due to an improvement in the weather, the maize crop increases. The equilibrium
price decreases from R1 000 per ton to R850 per ton while the equilibrium quantity increases
from 1 million tons to 1,1 million tons.
45 ECS1501/002
Select the appropriate price elasticity characteristics for maize.
o Unitary elastic
o Perfectly inelastic
o Perfectly elastic
o ep = 1
o 0 < ep < 1
o 1 < ep < ∞
o ep = 0
o ep = ∞
Categories
o The % change in Qd is equal to the % change in P.
o The % change in Qd is 0.
o The % change in Qd is infinite.
price sensitive.
sensitive.
4.9 You are given the following diagrams and must indicate whether the demand is relatively elastic,
relatively inelastic or unitary elastic.
a.
46 ECS1501/002
b.
c.
10.5 Elasticity along a linear demand curve

Study the following linear demand curve and decide whether it is relatively elastic, relatively
inelastic, unitary elastic, or all of them:
It all depends on which part of the demand curve (price ranges) we are referring to. By just looking
at it, we cannot tell whether it is relatively elastic, relatively inelastic or unitary elastic. In fact,
depending on which part of the linear demand curve you are looking at, it could be all three of
these – relatively inelastic, relatively elastic or unitary elastic.
47 ECS1501/002
Let's see why this is so.
Elasticity along a linear demand curve

If you calculate the midpoint elasticity when the price declines from R8 to R7, you will obtain an
elasticity of 5 (relatively elastic). In this high price range and low quantity range, the percentage change
in price is low (R8 to R7), while the percentage in quantity is high (10 to 20).
Calculating the midpoint elasticity for a change in price from R5 to R4 will give you a price elasticity
of 1 (unitary elasticity).
For a change in price from R2 to R1, you will obtain a price elasticity of 0,20 (relatively inelastic). In
this low price range and high quantity range, the percentage change in price is high (R2 to R1), while
the percentage in quantity is low (70 to 80).
Examine the data, not the graph, to decide whether demand is relatively inelastic, unitary elastic or
relatively elastic.
Take note of the following:
Price elasticity of demand gives us a measure of the response of the quantity demanded to a change in
the price. It is therefore closely related to (but not the same as) the slope of the demand curve. The
slope of the demand curve is calculated from absolute changes in quantity and price, while price
elasticity is calculated from relative changes.
As a rule of thumb, we can state that if we use the same scale on the axis, the flatter the curve that
passes through a given point, the greater the price elasticity of demand will be, and the steeper the
curve that passes through a given point, the smaller the price elasticity of demand will be.
10.6 Factors that have an impact on price elasticity

• describe the impact that factors such as availability of substitutes, proportion of income spend,
time period and nature of the product have on price elasticity
Looking again at our table of price elasticity for various goods and services, we are now able to classify
these according to relatively price inelastic and relatively price elastic. What we do not know yet is
what causes different goods and services to have different price elasticities.
48 ECS1501/002
Different price elasticity coefficients
Goods and Price elasticity Goods and services Price elasticity

services coefficient coefficient
Salt 0,1 Tyres 0,9
(Households)
Source: Source: Janse van Rensburg, J., Mconnel, C.R. & Brue, S.L. 2015. Economics.
McGraw Hill: London.
Why, for instance, is fuel relatively price inelastic, and restaurant meals relatively price elastic?
This might be due to the following factors:
 availability of substitutes
 proportion of income spend
 time period
 nature of the product
Availability of substitutes
Consider the following scenario:
Peter lives 25 kilometres from his work and owns a small car powered by petrol, which he uses to
travel to work. There is no public transport in the area in which he lives.
If the price of petrol increases by 10% on Wednesday, will Peter be able to decrease his quantity of
petrol by making use of a substitute?
Unfortunately for Peter, there is no substitute for petrol and he cannot make use of public transport
because there is none where he lives. He will therefore not be able to decrease his quantity of petrol
demanded by much. His demand for petrol is price inelastic, owing to the absence of substitutes. This
absence or non-availability of substitutes is therefore an important determinant of the price elasticity of
petrol for Peter.
However, bear in mind that the more substitutes there are, the more choices you have and the greater
the price elasticity of the good or service will be.
Take the example of a restaurant meal where there is a number of substitutes available, such as a home-
cooked meal, a take-away, and a pre-cooked meal from Shoprite or Woolworths. If the price of a
restaurant meal increases, you can always switch to one of the substitutes.
49 ECS1501/002
As you use more of a substitute, the quantity demanded of the other good decreases.
The more substitutes there are for a good or service, the more responsive or sensitive the quantity
demanded will be to a change in the price. The price elasticity of quantity demanded is therefore
higher and more elastic.
The fewer substitutes there are, the less responsive or sensitive the quantity demanded for a
change in price will be. The price elasticity of quantity demanded is therefore lower and demand
is more price inelastic.
Proportion of income spent

The last time I checked, a box of matches costs about 70 cents. If I buy four boxes of matches a month,
my total spending on matches will be R2,80. An increase in the price of matches to 77 cents, which is a
10% increase, would not make me change my behaviour.
Likewise, a 10% decline in the price of matches would also not make me buy more matches. So my
price elasticity for matches is relatively inelastic (it has a value of less than 1).
50 ECS1501/002
The reason for this is not that there are no substitutes available (I could, for example, buy a lighter), but
because the R2,80 is an insignificant proportion of my income. Whether I spend R2,80 or R3,08 per
month on matches is not a big deal for me.
However, if it is about buying something like a new fridge, which costs about R4 500 and is a large
proportion of my income, a 10% rise in the price of the fridge would make me reconsider buying it.
Whether I spend R4 500 or R4 950 is important to me, and it is to be expected that my price elasticity
for a fridge would be fairly elastic (has a value of more than 1).
In general, we can state the following:

The higher the proportion of income spent on a good and service, the more responsive or
sensitive the quantity demanded will be to a change in the price. The price elasticity of quantity
demanded is therefore higher and more elastic. The lower the proportion of income spent on a
good or service, the less responsive or sensitive the quantity demanded will be to a change in
price. The price elasticity of the quantity demanded is therefore lower and more inelastic.
But what about Peter's spending on petrol?
Since he does spend a significant proportion of his income on petrol, should his demand for petrol then
not be elastic?
In the case of Peter, there are two forces impacting on his elasticity – the unavailability of substitutes
and the proportion of income he spends on petrol.
The unavailability of substitutes makes it more inelastic, while the high proportion of his income that
he spends on petrol makes it more elastic. In his case, the unavailability of substitutes is the stronger
force.
51 ECS1501/002
A consequence of this relationship between the proportion of income spent on a good or service, and
the price elasticity of the good and service, is that different income groups have different price
elasticities for the same good and service. For instance, the price elasticity of bread might be more
elastic for a poor household than for a rich household, since poor households spend a larger proportion
of their income on bread compared to rich households.
One also finds that the price elasticity of cigarettes is different for teenagers and adults.
Consider the questions below and select the answers you think are most accurate.
What do you think?
Is the price elasticity of cigarettes higher or lower for teenagers than for adults?
o Higher
o Lower
Are teenagers more price sensitive than adults?

o Yes
o No
If the government increases the tax on cigarettes, will teenagers be more discouraged than adults to
smoke?
o Yes
o No
Teenagers are more price sensitive since their incomes are more limited than those of adults and,
consequently, their price elasticity is higher.
If teenagers have a higher price elasticity than adults, they will decrease their quantity demanded
more, and therefore smoke less if the government increases the tax on cigarettes.
Time period
In the short run, Peter has little choice about the amount of petrol he uses. He might cut down on some
of his travelling – fewer trips to the shops and over weekends. In the long run, however, he has more
choices. He could, for instance, replace his car with a more fuel-efficient car, join a lift club or move to
an area closer to his work.
 The longer the time period under consideration, the greater the price elasticity of a good or
service will be.
 This short-run versus long-run elasticity has an important impact on the way prices are set in a
market.
 Take, for example, the cost of an airline ticket from Johannesburg to Cape Town. If you
visit different airlines and you compare the cost of a ticket next week with one in three
months' time, you will probably find that purchasing an airline ticket three months in
advance is cheaper than purchasing it one week in advance.
 The reason is that you have more time to look for substitutes, and manage and change your
travel and accommodation arrangements.
52 ECS1501/002
Nature of the product
We can expect that goods that are necessary for our survival will tend to be relatively inelastic. These
are things such as water, food, shelter and medical services. Luxuries, however, such as vacations,
designer clothes and shoes, or champagne, will be relatively price elastic. Whether a good is regarded
as a luxury or necessity depends on the taste and preference of the individual, and there is no exact rule
to determine what goods can be classified as luxuries or necessities.
As a general rule, we can state that if a good is regarded as a necessity, it will be relatively inelastic,
whereas if it is regarded as a luxury good, it will tend to be elastic.
Do the following activities that deal with the factors that impact on price elasticity, and then move on
to explore the link between household spending and price elasticity.
ACTIVITY 5
5.1 Which of the following factor(s) will tend to cause the demand for a good or service to be price
elastic?
a. The more substitutes there are available for the good or service
b. The more necessary the good or service is
c. The lower the proportion of income spent on the good or service
d. The longer the time period is
5.2 Indicate whether the price elasticity of demand for Toyota sport utility vehicles (SUVs) will
increase, decrease or remain the same in the following situations:
a. Other motor manufacturers enter the market, resulting in a greater variety of SUVs.
53 ECS1501/002
b. The government bans the importation of SUVs.
c. Through advertising and marketing, Toyota is able convince the public that its SUV is the
safest.
5.3 Indicate whether the price elasticity of the demand for movie theatre tickets will increase,
decrease or remain the same because of the following:
a. Television broadcasts include more current movies.
b. The movies are released on DVD.
c. More people are able to download movies from the internet.
5.4 The following table indicates the demand for airline tickets between Johannesburg and Cape
Town for business travellers and holiday travellers.
Price (R) Business travellers Holiday travellers

(quantity demanded) (quantity demanded)
700 2 000 1 600
1 200 1 800 1400
1 700 1 600 1 200
3 000 1 400 1 000
3 500 1 200 800
4 000 1 000 600
Assume that the price increases from R3 000 to R3 500.

a. Using the midpoint method, calculate the price elasticity for business travellers and the
price elasticity for holiday makers.
b. Choose the correct option in brackets.
The price elasticity for business travellers is (more elastic, less elastic) compared to the
price elasticity for holiday travellers.
c. Which of the following might be the reason(s) for the difference between the price
elasticity for business travellers and the price elasticity for holiday travellers?
1. For business travellers travelling between Johannesburg and Cape Town, airline
tickets are more of a necessity than for holiday travellers.
2. Fewer substitutes are available for holiday travellers than for business travellers.
3. The travel costs for business travellers are paid by the business, while holiday
travellers pay for their travel costs out of their own pocket.
10.7 Household spending and price elasticity of demand

• explain in words and with the aid of a diagram the relationship between household spending
and price elasticity of demand
54 ECS1501/002
One of the reasons we study the demand for a good or service is to help us understand the determinants
of spending by households. How much households spend on a good or service and, in particular, what
happens to their spending if the price changes, are important issues that we need to investigate further.
From the law of demand, we know that if the price of a good or service decreases, people will demand
a higher quantity of it, and if the price increases, they will demand a lower quantity of it. But what
happens to their total spending if the price changes?
 Does an increase in the price of a good or service cause households to increase or decrease
their total spending on the good or service?
 Does a decrease in the price of a good or service cause households to increase or decrease their
total spending on the good or service?
What do you think would happen to the total spending of households on petrol in the following
examples?
The price of petrol increases. The price of petrol decreases.
o Households will spend more on petrol o Households will spend more on petrol
o Households will spend less on petrol o Households will spend less on petrol
What do you think will happen to the total spending by households on restaurant meals if the
following happens?
The price of restaurant meals increases. The price of restaurant meals decreases.
o Households will spend more on restaurant o Households will spend more on restaurant
meals meals
o Households will spend less on restaurant o Households will spend less on restaurant
meals meals
Intuitively, people believe that if the price of something increases, their total spending on that good
or service will increase as well. In the next sections, we will show that this is not necessarily the
case. Whether we spend more or less depends on the price elasticity of demand.
Total spending by households on a good or service is equal to the price (P) they paid for the good or
service times the quantity (Q) they bought. In symbols, this is written as:
Total spending = 𝑃𝑃 × 𝑄𝑄
What we want to know is what happens to total spending if the price changes. Remember that as the
price changes, so does the quantity demanded – both P and Q change. It is the price elasticity that will
tell us by how much the quantity demanded changes, and thus what happens to total spending.
We have identified two main types of price elasticity, namely inelastic and elastic. Now, let's see what
happens to total spending if we have a price inelastic demand.
Total spending and price inelastic demand

A price inelastic demand has a price elasticity of less than 1 and the percentage change in quantity
demanded is less than the percentage change in price. This indicates that the quantity demand is not
that sensitive or responsive to the price.
55 ECS1501/002
Increase in price
To see what the relationship is between a price inelastic demand and total spending, we will use the
example of Thabo's smoking habits.
You are given the following information about Thabo's smoking habits:
o Thabo smokes 10 packets of cigarettes in a week.

o The price of a packet of cigarettes is R30.
o His price elasticity is estimated at 0,5.
What do you expect will happen to his total spending on cigarettes per week if the price of a
packet of cigarettes increases by 10%?
o It will increase.
o It will decrease
o It will stay the same
To answer this question, we need to take his price elasticity coefficient for cigarettes into account.
Thabo’s weekly spending on cigarettes before the increase in price is P x Q = R30 x 10 = R300.
This information is entered in the first row of the following table:
Thabo's total spending
P Qd Total spending per

week (TS)
Weekly spending at R30 per packet R30 10 R300
Weekly spending at R33 per packet R33 9.5 R313,50
A 10% increase in the price of a packet of cigarettes increases the price to R33.
Given a price elasticity of 0,5, it means that for every 1% increase in price, the quantity demanded
decreases by 0,5%. A 10% increase in price therefore implies that the quantity demanded decreases by
10% x 0,5 = 5%.
His decrease in quantity demanded is therefore 5% x 10 packets = 0,5 packets. Thabo now smokes 10 –
0,5 = 9,5 packets of cigarettes per week, and his total weekly spending on cigarettes is R33 x 9,5 =
R313,50. This information is entered in the table above.
Looking at the information in the table, we can therefore conclude that as the price of cigarettes
increases by 10%, Thabo’s total spending on cigarettes will increase from R300 to R313,50.
What we can conclude from this is that if demand is relatively price inelastic, an increase in price will
cause an increase in total spending of the good or service. The reason for this is that the percentage
increase in price is greater than the percentage decrease in quantity demanded.
In spite of the fact that Thabo smokes fewer cigarettes, his total spending on cigarettes has increased.
56 ECS1501/002
We can represent the above as the following chain of events:
If ep < 1 : ↑P → ↑TS
If price elasticity is smaller than 1, an increase in price will lead to an increase in total spending.
Using diagrams to illustrate total spending and price inelastic demand

We will use the same example of Thabo's smoking habits to illustrate, with the aid of diagrams, what
happens to total spending if the price of a good or service with an inelastic demand changes.
 Thabo smokes 10 packets of cigarettes a week.
 The price of a packet of cigarettes is R30.
 His price elasticity is estimated at 0,5.
Thabo's total spending

week (TS)
Weekly spending at R30 per packet R30 10 R300
Weekly spending at R33 per packet R33 9.5 R313,50
Next, we show graphically what happens to Thabo's total spending if the price of cigarettes increases
by 10%. The calculations we use are the same as those in our previous example, and are summarised in
the above table:
Total spending
Given the price of R30 per packet, the quantity demanded by Thabo is 10 packets a week. His total
spending on cigarettes is therefore R30 x 10 = R300. This is indicated by the area 0-R30-E-10 in the
diagram. Assuming a decrease in the supply of cigarettes, the supply curve shifts upwards and the price
increases to R33. This is an increase of 10%. This increase in the price decreases his quantity
demanded to 9,5 packets. This is a decrease of 5%. His total spending on cigarettes is now R33 x 9,5 =
R313,50. This is indicated by the area 0-R33-E1-9,5. Comparing his total spending at R30 (area 0-R30-
E-10) with his total spending at R33 (area 0-R33-E1-9,5), it is clear that his total spending increases as
the price of cigarettes increases.
57 ECS1501/002
From this, we can conclude that if demand is inelastic, like in the case of cigarettes, an increase in the
price leads to an increase in total spending.
In the above explanation, we compared Thabo's total spending before and after the increase in price,
and then reached the conclusion that if demand is inelastic, an increase in price increases total
spending.
Decrease in price
What happens to Thabo's total spending if the price of cigarettes decreases by 10%?
Do the following activity by following the same steps as above to see whether a decrease in the price of
cigarettes increases or decreases his total spending.
ACTIVITY 6
Thabo smokes 10 packets of cigarettes a week and his price elasticity is estimated at 0,5. The price of a
packet of cigarettes is R30.
6.1 Complete the following table to determine whether his total spending increases or decreases if the
price of cigarettes decreases by 10%.

week
Weekly spending at R30
Weekly spending at R27
6.2 Choose the correct options in brackets.

Thabo's demand for cigarettes is (elastic, inelastic), and a decrease in the price of cigarettes
(decreases, increases) his total spending.
6.3 Is the following statement true or false?
What we can conclude from this activity is that in the case of a price inelastic demand, a
decrease in price will cause a decrease in total spending on the good or service. This happens
because the percentage decrease in price is greater than the percentage increase in the quantity
demanded.
6.4 Indicate which diagram represents his total weekly spending before the 10% decrease in price and
which diagram represents Thabo’s total weekly spending after the 10% decrease in price.
58 ECS1501/002
Diagram A Diagram B
6.5 Is the following statement true or false?

If the price of cigarettes decreases by 10%, Thabo smokes more, but his total spending on
cigarettes decreases.
Summary
Returning to our original questions:

 Does an increase in the price cause households to increase or decrease their total spending on
the good or service?
 Does a decrease in the price cause households to increase or decrease their total spending on
What we can say now is that if the price elasticity of a good or service is inelastic (less than 1), an
increase in price will increase total spending, while a decrease in price will decrease total spending.
If ep < 1: ↑P → ↑TS
If ep < 1: ↓P → ↓TS
Total spending and price elastic demand

We know now that if the demand for a product is price inelastic, an increase in the price will increase
total spending, while a decrease in price will decrease total spending.
Does this also apply to a price elastic demand?
If demand is price elastic, it has a price elasticity of more than 1. For price elastic demand, the
percentage change in price is smaller than the percentage change in quantity demanded, which indicates
that the quantity demanded is relatively sensitive or responsive to the price.
We will use the demand for restaurant meals, which has a price elasticity of 2,5, as an example to see
what happens to total spending if the price changes.
59 ECS1501/002
The price elasticity of restaurant meals is 2,5, and at a price of R100 a meal, households buy 1 000
meals per month.
What do you expect will happen to total spending on restaurant meals if the price of restaurant
meals increases by 10%?
o It will increase.
o It will decrease
Let's use our example top see what might happen.
At R100 a restaurant meal, the total spending by households is P x Q = R100 x 1 000 = R100 000. This
information is entered in the following table in the second row.
Total spending on restaurant meals

month (TS)
Monthly spending at R100 per meal R100 1,000 R100,000
Monthly spending at R110 per meal R110 750 R82,500
A 10% increase in the price of a restaurant meal increases the price to R110. Given a price elasticity of
2,5, it means that a 10% rise in the price will decrease the quantity demanded by 25% (10% x 2,5 =
25%). The quantity demanded therefore decreases by 25% x 1 000 = 250. At R110, the quantity
demanded is therefore 1000 – 250 = 750 restaurant meals.
 The total spending at R110 per meal is 750 x R110 = R82 500.
 Because the price of restaurant meals increased by 10%, their total spending declined from
R100 000 to R82 500.
 This information is entered in the second row of the table above.
What we can conclude from this is that in the case of a price elastic demand, an increase in price will
cause a decrease in total spending of the good or service. The reason for this is that the percentage
increase in price is smaller than the percentage decrease in quantity demanded.
The above can be represented as a chain of events as follows:
If ep > 1: ↑P → ↓TS
If price elasticity is greater than 1, then an increase in the price will result in a decrease in total
spending.
Using diagrams to illustrate total spending and price elastic demand

We will use the same example of the demand for restaurant meals to illustrate what happens with total
spending if the price of a good or service with an elastic demand changes. Remember, in this section
we are studying the effect of an increase in price.
meals per month.
60 ECS1501/002
What will happen to the total spending by households on restaurant meals if the price of a restaurant
meal increases by 10%?
The calculations we use are the same as those in our previous example and they are summarised in the
following table:
Total spending on restaurant meals

month (TS)
Monthly spending at R100 per meal R100 1,000 R100,000
Monthly spending at R110 per meal R110 750 R82,500
In the section below, we show graphically what happens to total spending if the price of restaurant
meals increases by 10%.
Total spending and elastic demand

Given a price of R100 per restaurant meal, the quantity demanded in a month is 1 000 meals. The total
spending on restaurant meals at R100 is R100 x 1 000 = R100 000. This is indicated by the area 0-
R100-E-1 000 in the diagram.
A decrease in the supply of restaurant meals shifts the supply curve upwards, and the price increases to
R110 (which is a 10% increase). This increase in the price of restaurant meals decreases the quantity
demanded to 750 meals (which is a 25% decrease). The total spending on restaurant meals is now R110
x 750 = R82 500. This is indicated by the area 0-R110-E1 - 750.
Comparing total spending at R100 (area 0-R100-E- 1 000) with total spending at R110 (area 0-R110-
E1 - 750), it is clear that total spending decreases as the price of restaurant meals increases. From this,
we can conclude that if demand is elastic, like in the case of restaurant meals, an increase in the price
leads to a decrease in total spending.
Decrease in price
We have established that if demand is elastic, such as the demand for restaurant meals, an increase in
the price will decrease total spending.
What happens if the price decreases?
Do the following activity to see what happens to total spending on restaurant meals if the price of
restaurant meals decreases.
61 ECS1501/002
ACTIVITY 7
meals per month.
7.1 Complete the following table to determine whether households will increase or decrease their
total spending on restaurant meals if the price of restaurant meals decreases by 10%:
P Qd Total spending per month

(TS)
Monthly spending at R100 per meal
Monthly spending at R90 per meal
7.2 Choose the correct option in brackets

The demand for restaurant meals is (elastic, inelastic) and a decrease in the price of restaurant
meals (decreases, increases) households' total spending on restaurant meals.
7.3 Is the following statement true or false:
What we can conclude from this activity is that in the case of a price elastic demand, a decrease
in price will cause an increase in total spending on the good or service. The reason for this is
that the percentage decrease in price is smaller than the percentage increase in quantity
demanded.
7.4 Indicate which diagram represents the total weekly spending on restaurant meals before the 10%
decrease in price and which diagram represents total weekly spending after the 10% decrease in
price of restaurant meals.
Diagram A Diagram B
Summary
Returning to our original questions:
the good or service if demand is elastic?
 Does a decrease in the price cause households to increase or decrease their total spending on
the good or service if demand is elastic?
62 ECS1501/002
What we can say now is that if the price elasticity of a good or service is elastic (greater than 1), an
increase in price will decrease total spending, while a decrease in price will increase total spending.
Comparing inelastic and elastic demand

Returning to our original question, we can now answer it:
 Does a decrease in the price cause households to increase or decrease their total spending on the
good or service?
The answer is that it depends on the price elasticity.
ACTIVITY 8
Choose the correct terms in brackets in the following table, which provides a summary of the impact of
a price change on total spending:
If the price If the price

increases decreases
Inelastic demand The % change in Total spending Total spending
price is (greater, (increases, (increases,
smaller) than the % decreases, stays the decreases, stays the
change in quantity same). same).
demanded.
Elastic demand The % change in Total spending Total spending
price is (greater, (increases, (increases,
smaller) than the % decreases, stays the decreases, stays the
change in quantity same). same).
demanded.
Now that we have established that if:

 demand is price inelastic;
 an increase in price will increase total spending by households, and
 a decrease in price will decrease total spending by households.
And if:
 demand is price elastic;
 an increase in price will decrease total spending by households, and
 a decrease in price will increase total spending by households.
We can now turn our attention to what happens to the total revenue of firms if the price of a good or
service changes.
63 ECS1501/002
10.8 Firms' total revenue and price elasticity
• explain with the aid of words and diagrams the relationship between a firms’ total revenue and
price elasticity
In this section, we take a closer look at what happens to the total revenue of firms if prices change.
While households are concerned about what happens to their total spending if prices change, firms are
concerned about what happens to their total revenue if prices change. Firms would typically want to
understand what will happen to their total revenue if the price of the good or service they supply
changes.
 Will a price increase cause their total revenue to increase or decrease?
 Will a price decrease cause their total revenue to increase or decrease?
To answer these questions, you need to understand the relationship between price elasticity and total
revenue.
What do you think will happen to the total revenue of cigarette suppliers if the price of cigarettes
increases?
o It will increase.
o It will decrease
What do you think will happen to the total revenue of cigarette suppliers if the price of cigarettes
decreases?
o It will increase.
o It will decrease
What do you think will happen to the total revenue of a restaurant if the price of a restaurant meal
increases?
o It will increase.
o It will decrease
What do you think will happen to the total revenue of a restaurant if the price of a restaurant meal
decreases?
o It will increase.
o It will decrease
You already know the answers: All you need to do is to make the link between total spending by
households and total revenue of firms.
64 ECS1501/002
Link between total spending and total revenue
The total revenue of firms and the total spending by households are directly related. As total spending
by households changes, the total revenue of firms will change. When households spend more, firms sell
more, and their total revenue thus increases.
However, if households decrease their total spending, firms will sell less and their total revenue will
decline.
As explained earlier, total spending by households is equal to the price they pay for a good or service
times the quantity bought of the good or service:
𝑇𝑇𝑇𝑇 = 𝑃𝑃 × 𝑄𝑄
The total revenue of firms is also equal to the price paid for the good or service times the quantity sold
to households:
𝑇𝑇𝑇𝑇 = 𝑃𝑃 × 𝑄𝑄
In other words:
𝑇𝑇𝑇𝑇 = 𝑃𝑃 × 𝑄𝑄 = 𝑇𝑇𝑇𝑇
Total spending and total revenue are two sides of the same coin.
 For example, if the total spending of households on restaurant meals is R100 000, then the
total revenue firms receive by supplying the restaurant meals is also R100 000.
If households increase their spending on restaurant meals by say, R10 000, then the total revenue of
firms supplying restaurant meals also increases by R10 000.
Total revenue and inelastic demand

In the section on household spending and price elasticity, we argued that if demand is price inelastic, an
increase in price will increase total spending by households, while a decrease in price will decrease
total spending by households. What does this imply for the total revenue of firms?
Do the following activity to see what happens to the total revenue of a firm if demand is inelastic and
the price increases.
Remember that the total revenue of firms is directly related to households total spending. If you are
unsure about what happens to total spending if demand is inelastic, quickly revise it.
65 ECS1501/002
ACTIVITY 9
Assume you are the financial manager of a firm that produces and sells cigarettes and your managing
director asks you what would happen to total sales and total revenue if the price of a packet of
cigarettes were to increase by 10%.
Based on the following information, what would your answer be?
The price elasticity of cigarettes is 0,5. At a price of R30, your company currently sells 10 000 packet
of cigarettes a week.
9.1 Complete the following table to indicate what would happen to your total sales and revenue if the
price of cigarettes were to increase by 10%:
P Qd (Sales) Total revenue per week
Weekly total revenue at R30
9.2 Complete the following by choosing the correct words in brackets and fill in the gaps:
a. A 10% increase in the price of a packet of cigarettes would (decrease, increase) total sales
by 500 packets of cigarettes and (increase, decrease) total revenue by R13 500.
b. You would tell the managing director that while an increase in price (decreases, increases)
the quantity demanded, the total revenue (increases, decreases) total revenue.
9.3 Which one of the following diagrams illustrate the impact of a 10% rise in the price of a packet
cigarettes on total revenue?
Diagram A Diagram B
66 ECS1501/002
In our activity, we established that if demand is inelastic, then an increase in price will lead to an
increase in total revenue. This is represented in the following diagram:
Inelastic demand and total revenue

An increase in the price of a packet of cigarettes from R30 to R33 decreases the quantity demanded
from 10 000 to 9 500. This has the impact that total revenue increases from R300 000 to R313 500.
So what happens to total revenue if the price decreases?
Do the following activity to see what happens to total revenue.
ACTIVITY 10
Your managing director tells you that she has heard of the law of demand, and that according to this
law, a decrease in price will increase the quantity demanded. She therefore proposes that the company
should decrease the price of cigarettes so that it can sell more, and by selling more, total revenue will
increase.
The price elasticity of cigarettes is 0,5. At a price of R30, you company currently sells 10 000 packet of
cigarettes per week. Your managing director proposes that the price of a packet of cigarettes should be
decreased by 10%.
What would your advice be based on the above information?
10.1 Complete the following table to indicate what would happen to your total sales and revenue if the
price of cigarettes were to decrease by 10%:
P Qd Total revenue per week
10.2 Complete the following by choosing the correct word in brackets and fill in the gaps:
a. You (agree, do not agree) with her.
b. A 10% decrease in the price of a packet of cigarettes would (decrease, increase) total sales
by 500 packets of cigarettes and (increase, decrease) total revenue by ______.
c. While a decrease in price does cause (an increase, a decrease) in quantity demanded, as
stated by the law of demand, it does not translate into (an increase, a decrease) in total
revenue because demand is (inelastic, elastic).
67 ECS1501/002
10.3 Which one of the following diagrams illustrate the impact of a 10% decrease in the price of a
packet cigarettes on total revenue?
Diagram A Diagram B
In conclusion, we can therefore state the following with regards to a price inelastic demand:
1. Since goods and services, such as salt and petrol and medical services, are price inelastic,
the quantity demanded by households is not that responsive to a change in price.
2. If the price of the good or service changes, the change in quantity demanded by households
is relatively small compared to the change in price.
3. The consequence of this for total spending by households is that in the event of a rise in the
price of the good or service, the total spending by households on the good or service
increases.
Since the total spending by households is the total revenue of firms, the total revenue of firms increases
as well.
However, if the price of a price inelastic good or service falls, total spending by households declines,
and the total revenue of firms therefore declines as well.
Total revenue and elastic demand

In the section on household spending and price elasticity, we argued that if demand is price elastic, an
increase in price will reduce total spending by households, while a decrease in price will increase total
spending by households.
Do the following activity to see what happens to the total revenue of a firm if demand is elastic and the
price increases. Remember that the total revenue of firms is directly related to the total spending by
households.
ACTIVITY 11
Assume you are a restaurant owner and the price elasticity of restaurant meals is 2,5.
What would happen to your total revenue if the price of a restaurant meal increases?
a. It increases.
b. It decreases.
c. It stays the same.
68 ECS1501/002
From our activity, we have established that if demand is elastic, then an increase in price will lead to a
decrease in total revenue. This is represented in the following diagram:
Elastic demand and total revenue

An increase in price from R100 to R110 per restaurant meal decreases the quantity demanded from 1
000 to 750. This has the impact that total revenue decreases from R100 000 to R82 500.
What will happen to total revenue if demand is elastic and the price decreases?
Using the example of restaurant meals with an elasticity of 2,5, we can graphically show what will
happen to total revenue is the price decreases by 10%.
Monthly revenue
P Qd Total revenue per

month
Monthly revenue at R100 per meal R100 1 000 R100 000
Monthly revenue at R90 per meal R90 1 250 R112 500
Elastic demand and total revenue

A decrease in price from R100 to R90 increases the quantity demanded from 1 000 to 1 250. This has
the impact that total revenue increases from R100 000 to R112 500. The total gain in revenue is R112
500 – R100 000 = R12 500.
69 ECS1501/002
Summary
In conclusion, we can therefore state the following:
 Since a good or service, such as a pair of shoes or a movie is price elastic, the quantity
demanded by households is highly responsive to a change in price.
 If the price of the good or service changes, the change in quantity demanded by households is
relatively large compared to the change in price. The consequence of this for total spending by
households, and the total revenue of firms, is that in the event of a rise in the price of the good
or service, the total spending by households on the good or service decreases.
 Since the total spending by households is the total revenue of firms, the total revenue of firms
declines as well.
 However, if the price of a price elastic good or service falls, total spending by households
increases, and the total revenue of firms therefore increases as well.
70 ECS1501/002
ANSWERS TO THE
ACTIVITIES
Activity 1
1.1
a. The statement is false.
It provides a measure of how sensitive or responsive the quantity demanded is to a change in
the price of a good or service. Note that the causality is from a change in the price to a change in
quantity demanded.
∆𝑃𝑃 → ∆𝑄𝑄𝑑𝑑
b. The statement is true.
You will indeed know what will happen to the quantity demanded of petrol if the price of petrol
changes.
c. The statement is false.
If you know the value of the price elasticity of petrol, you will be able to say by how much the
quantity demanded will change in relation to a given change in the price. You already know from
the law of demand that an increase in price reduces the quantity demanded.
d. The statement is false.
To predict what would happen to the price of petrol, you would need to know the demand and
supply functions of petrol. What you would be able to predict is by how much the quantity of
petrol would change if the price of petrol were to change.
e. The statement is true.
The greater the price elasticity, the bigger the impact will be of a change in the price on the
quantity demanded. If, for instance, the price of ice cream and petrol increases, households will
respond by reducing their quantity demanded of ice cream and petrol, but their decrease in the
quantity demanded of ice cream will be relatively larger.
f. The statement is false.
The phrase "sensitivity or responsiveness to" relates to how people adjust their quantity
demanded if the price changes and not how upset they are if the price changes. The reason why
people are upset if the price of petrol changes is because they find it difficult to reduce their
quantity of petrol demanded. In other words, it is because their quantity demanded is insensitive
or unresponsive that they are upset.
71 ECS1501/002
g. The statement is true.
Since price elasticity tells us what happens to the quantity demanded by households, the business
will be able to predict what will happen to the quantity sold (its sales).
h. The statement is true.
If you know the price elasticity of fresh tomatoes, you know what will happen to your sales (the
quantity demanded), and since your revenue depends on your sales, you will know what will
happen to your revenue. In other words, if you know that a decrease in price will increase the
quantity demanded by 100, and the price is R10 per packet, your sales as well as your revenue
will increase by R1 000.
∆𝑃𝑃 → ∆𝑄𝑄𝑑𝑑 → ∆Sales → ∆𝑇𝑇𝑇𝑇

1.2 Diagram B.
In diagram B we have an increase in price due to a decrease in supply. As the price increases an
upward movement along the demand curve takes place which leads to a decrease in the quantity
demanded. It is this impact of a change in price on quantity demanded that we will measure.
Diagram A represents the impact of a change in demand on the price and the quantity. This is not
what we will measure.
Activity 2
72 ECS1501/002
The data in the diagram is reproduced in the following table:
P Qd
R100 1 000
R110 750
In the above diagram, we see that as the price increases from R100 to R110, the quantity
demanded decreases from 1 000 to 750. We now have sufficient data to calculate the price
elasticity coefficient for restaurant meals for the price range R100 to R110. We do this by
applying the formula for price elasticity.
(𝑄𝑄2 − 𝑄𝑄1 )
𝑄𝑄1 + 𝑄𝑄2
(𝑃𝑃2 − 𝑃𝑃1 )
2
(1 000 − 750)
(750 + 1 000)
=
(110 − 100)
(100 + 110)
250
= 750
1
10
210
= 3
What this means is that for every 1% increase in the price, the quantity demanded will decrease by 3%,
and for every 1% decrease in price, the quantity demanded will increase by 3%.
Activity 3
3.1
a. Using the formula for price elasticity ep= (% ∆Qd)/(% ∆P), the % change in price is greater
that the percentage change in quantity demanded for electricity (0,13) and fuel (0,6) giving
it a value smaller than 1. For private education (1,1) and restaurant meals (2,27), the %
change in price is smaller than the % change in quantity demanded giving it a value greater
than 1.
b. If you compare the price elasticity of electricity of 0,13 with the price elasticity of
restaurant meals of 2,27, we can say that consumers are more sensitive to a change in the
price of restaurant meals than to a change in the price of electricity.
3.2
a. If the % change P is greater than the % change in Qd, the demand is relatively inelastic and
the price elasticity coefficient is smaller than 1.
Activity 4
4.1
a. If the % change in P is greater than the % change in Qd, then the demand is relatively
inelastic.
73 ECS1501/002
4.2
b. A relatively elastic demand implies that the % change in price is smaller than the % change
in Qd.
4.3
b. A relative elastic demand implies that the percentage change in price is smaller than the
percentage change in quantity demanded and the price elasticity coefficient is greater than
1.
4.4
a. Since the % change in P (12%) is greater than the % change in quantity demand (6%), the
demand is relatively inelastic.
4.5
b. Since the % change in P (8%) is smaller than the % change in quantity demand (12%), the
demand is relatively elastic.
4.6
Categories o 0 < ep < 1
In this case, the product is relatively inelastic since the % change in Qd is less than the % change
in P. The value of ep is therefore less than 1 and the product has a relatively low price elasticity
value, and it can be argued that people are not very price sensitive for this product.
4.7
o 1 < ep < ∞
Categories
sensitive.
In this case, ep >1 and it is therefore relatively price elastic meaning that the % change in Qd is
greater than the % change in P. It has a relatively large price elastic value and it can be argued
that for this product people are price sensitive.
74 ECS1501/002
4.8
o 0 < ep < 1
Categories
price sensitive.
Using the midpoint method, the price elasticity for maize is 0.59. This indicates that maize has a
price elasticity that is less than 1 since the % change in P is greater than the % change in Qd. It
therefore has a relatively low price elasticity value and it can be argued that in the case of maize
people are not price sensitive.
4.9
a. Relatively inelastic
b. Relatively elastic
c. Unitary elastic
Activity 5
5.1 a and d.
The more substitutes there are and the longer the time period, the more elastic the demand for the
good or service will be.
The more necessary and the lower the proportion of income spend on the good, the more inelastic
it will be.
5.2
a. Increase
b. Decrease
c. Decrease
75 ECS1501/002
With more manufactures, there are more substitutes, and the impact of this is that the price
elasticity of demand for Toyota SUVs becomes more elastic. In other words, the elasticity
coefficient increases.
If the government bans the importation of SUVs, then fewer substitutes are available and the
impact of this will be that the price elasticity of demand for Toyota SUVs becomes more
inelastic. In other words, the elasticity coefficient decreases.
If the public believe that Toyota SUVs are safer, there are fewer substitutes available in their
minds, and this will result in the price elasticity of demand for Toyota SUVs becoming more
inelastic. In other words, the elasticity coefficient decreases.
5.3 a, b and c.
All of these factors increase the number of substitutes available. The impact of this will be that
the price elasticity of movie theatre tickets becomes more elastic. In other words, the elasticity
coefficient increases.
5.4 a. Using the midpoint method, the price elasticity for business travellers is 1, and the price
elasticity for holiday makers 1,44.
b. The price elasticity for business travellers is less elastic compared to the price elasticity for
holiday travellers.
c. 1 and 2.
In the example, the price elasticity for business travellers is 1, while that for holiday makers is
1,44. This indicates that the demand for airline tickets by business travellers is unitary (it has a
value equal to 1), while the demand for airline tickets by holiday travellers is elastic (it has a
value of more than 1). It therefore follows that the price elasticity for business travellers is less
elastic compared to the price elasticity for holiday travellers.
The following are possible reasons for business travellers facing a less elastic demand for airline
tickets:
Business travel is more of a necessity than a luxury good. Business travellers usually have to be
at a meeting at a specific time and place.
Airline travel is the quickest way to travel between Johannesburg and Cape Town, and given the
fact that time is valuable for business travellers they tend not to regard the other modes of travel
between Johannesburg and Cape Town as viable options. There are therefore fewer substitutes
available for business travellers than for holiday makers.
For business travellers, the cost of airlines tickets is paid by the business and this will indeed tend
to decrease the elasticity of the demand for airline tickets.
Activity 6
6.1 Thabo's weekly spending before the increase in price is P x Q = R30 x 10 = R300. This
information is entered in the second row of the following table

week
Weekly spending at R30 R30 10 R300
Weekly spending at R27 R27 10,5 R283,50
76 ECS1501/002
A 10% decrease in the price of a packet of cigarettes reduces the price to R27.
A price elasticity of 0,5 means that a 10% decrease in the price will increase the quantity
demanded by 5%. (For every 1% decrease in price, the quantity demanded increases by 0,5%. A
10% decrease in price therefore implies that the quantity demanded increases by 10% x 0,5% =
5%.)
Thabo’s increase in quantity demanded is therefore 5% x 10 packets = 0,5 packets. He now
smokes 10 + 0,5 = 10,5 packets of cigarettes per week, and his total weekly spending on
cigarettes is R27 x 9,5 = R283,50. This information is entered in row 3 in the above table.
Looking at the information in the table, we can therefore conclude that if the price of cigarettes
decreases by 10%, Thabo’s total spending on cigarettes will decrease from R300 to R283,50. He
now spends R16,50 less on cigarettes.
While Thabo does in fact smoke more, his total expenditure on cigarettes declines from R300 to
R283,50.
6.2 Thabo's demand for cigarettes is inelastic, and a decrease in the price of cigarettes decreases his
total spending.
6.3 The statement is true.
6.4 Diagram A indicates his spending before the decrease in price, while diagram B indicates his
spending after the decrease in price.
6.5 The statement is true. Thabo now smokes 0,5 packets of cigarettes more (an increase of 5%). In
spite of the fact that he smokes more cigarettes, his total spending has declined because the %
decrease in price is greater than the % increase in quantity.
Activity 7
7.1 At R100 per restaurant meal, the total spending by households is P x Q = R100 x 1 000 = R100
000. This information is entered in the second row in the following table:

month (TS)
Monthly spending at R100 per meal R100 1 000 R100 000
Monthly spending at R90 per meal R90 1 250 R112 500
7.2 The demand for restaurant meals is elastic, and a decrease in the price of restaurant meals
increases households' total spending on restaurant meals.

What we can conclude from this activity is that in the case of a price elastic demand, a decrease
in price will cause an increase in total spending on the good or service. The reason for this is
that the percentage decrease in price is smaller than the percentage increase in quantity
demanded.
7.4 Diagram A represents the total spending before the decrease in price, while diagram B represents
the total spending after the decrease in price.
77 ECS1501/002
Activity 8
If the price increases If the price

decreases
Inelastic demand The % change in Total spending Total spending
price is greater, than increases. decreases.
the % change in
quantity demanded.
Elastic demand The % change in Total spending Total spending
price is smaller than decreases. increases.
the % change in
quantity demanded.
Activity 9
9.1
Weekly total revenue at R30 R30 10 000 R300 000
A 10% increase in the price of a packet of cigarettes increases the price to R33.
A price elasticity of 0,5 would mean a 10% rise in the price would reduce the quantity demanded
by 5%. (For every 1% increase in price, the quantity demanded decreases by 0,5%. A 10%
increase in price therefore implies that the quantity demanded decreases by 10% x 0,5% = 5%.)
The decrease in sales due to the decrease in quantity demanded is therefore 5% x 10 000 packets
= 500 packets. Customers are now smoking 10 000 – 500 = 9 500 packets of cigarettes per week
and your total revenue is R33 x 9500 = R313 500. This information is entered in row 3 in the
above table.
increases by 10%, your total revenue from cigarettes will increase from R300 000 to R313 500.
The total revenue therefore increases by R313 500 – R300 000 = R13 500.
9.2 You can now inform your managing director about the following:
A 10% increase in the price of a packet of cigarettes would decrease total sales by 500 packets of
cigarettes and increase total revenue by R13 500.
You would tell the managing director that while an increase in price decreases the quantity
demanded, the total revenue increases.
9.3 Diagram A.
Activity 10
10.1 The weekly total revenue before the decrease in price is P x Q = R30 x 10 000 = R300 000. This
information is entered in the second row of the following table:
78 ECS1501/002
A 10% decrease in the price of a packet of cigarettes reduces the price to R27.
Given a price elasticity of 0,5, it means that a 10% decrease in the price would increase the
quantity demanded by 5%. (For every 1% decrease in price, the quantity demanded increases by
0,5%. A 10% decrease in price therefore implies that the quantity demanded increases by 10% x
0,5% = 5%.)
The increase in sales due to the increase in quantity demanded is therefore 5% x 10 000 packets =
500 packets. Your customers are now smoking 10 000 + 500 = 10 500 packets of cigarettes per
week and your total revenue is R27 x 10 500 = R283 500. This information is entered in row 3 in
the above table.
decreases by 10%, your total revenue from cigarettes will decrease from R300 000 to R283 500.
The total revenue therefore decreases by R300 000 – R283 500 = R16 500.
10.2 You can now inform your managing director that you do not agree with her.
A 10% decrease in the price of a packet of cigarettes will increase total sales by 500 packets of
cigarettes and decrease total revenue by R16 500.
While a decrease in price does cause an increase in quantity demanded, as stated by the law of
demand, it does not translate into an increase in total revenue because demand is inelastic.
10.3 Diagram A.
Activity 11
Total revenue decreases.
Given a price elasticity of 2,5, it means that a 1% rise in the price will decrease the quantity demanded
by 2,5%. And since the % decrease in the quantity demanded is greater than the % increase in price
total revenue will decrease.
79 ECS1501/002
CHECKLIST
Well Satis- Must

factory redo
I am able to
define the price elasticity of demand
explain how price elasticity of demand is measured
explain the meaning of a specific elasticity coefficient (say ep = 1,5) –
in other words, to apply the general formula
distinguish between the five different categories of price elasticity of
demand
explain the most important determinants of price elasticity of demand
explain the relationship between households spending and price
elasticity of demand
explain the relationship between total revenue of a firm and price
elasticity of demand
Diagrams
I am able to
the concept price elasticity of demand
the different types of price elasticity of demand
the value of price elasticity of demand at different points on a linear
demand curve
the relationship between household spending and price elasticity of
demand
the relationship between the total revenue of a firm and price
leasticity of demand
Calculations
I am able to
calculate price elasticity of demand using the formula for arc
elasticity (midpoint method)
80 ECS1501/002
Other elasticities
11
OVERVIEW
The basic idea of elasticity — the relationship between a percentage change in one variable and the
percentage change in another variable — does not just apply to the responsiveness of quantity
demanded to changes in the price of a product. You will recall that quantity demanded (Qd) depends on
income, tastes and preferences, the prices of related goods and so on, as well as price. Elasticity can be
measured for any determinant of demand, not only the price.
Which of the following are non-price determinants of demand?
 Number of firms
 Income
 Taste
 Technology
 Price of complements
 Price of substitutes
 Fashion
The non-price determinants of demand are income, taste, the prices of related goods – complements
and substitutes and fashion. Factors such as the number of firms and technology are non-price
determinants of supply.
In the following section, we will deal with the relationship between income and the demand for goods
and services which is measured by income elasticity and the relationship between the price of related
goods and demand which is measured by cross elasticity.
TOPIC OUTCOME
After you have worked through the learning unit, you should be able to
• define the income elasticity of demand and explain what it means

• define the cross elasticity of demand and explain what it means
• define and illustrate price elasticity of supply
11.1 Income elasticity

• describe income elasticity and the measurement of income elasticity

• distinguish between the income elasticity of normal goods and inferior goods
• distinguish between the income elasticity of luxury goods and necessities
81 ECS1501/002
What we are interested in is how responsive the quantity demanded of a product is to a change in the
consumers' income – in other words, what is the income elasticity of demand.
In the case of a normal good, an increase in income increases the demand for it. Income elasticity tells
us something about the size of the increase.
The income elasticity of demand is the responsiveness of quantity demanded of a product to a
change in the consumers' income and is calculated as the percentage change in quantity demanded
divided by the percentage change in income.
% 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑜𝑜𝑜𝑜 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑒𝑒𝑦𝑦 =
% 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
Normal goods
What do you expect will happen of the demand for a normal good such as red meat if income
increases?
o It will increase.
o It will decrease.
o It will be unchanged.
In the case of a normal good such as red meat, an increase in income increases the demand for it.
Income elasticity tells us something about the size of the increase.
For most products, most of the time, the income elasticity of demand is positive – that is, a rise in
income will cause an increase in the quantity demanded. This pattern is common enough that these
goods are referred to as normal goods.
A higher level of income for a normal good causes the demand curve to shift to the right, which means
that the income elasticity of demand is positive.
How far the demand shifts depends on the income elasticity of demand.
A higher income elasticity means a larger shift of the demand curve for a given change in income.
The value of a positive income elasticity of demand is also an indication of whether a good is a
necessity or a luxury good.
 If the income elasticity is smaller than 1 (the percentage change in income is greater than the
percentage change in quantity demanded), the good is classified as a necessity or essential
good.
 If the income elasticity is greater than 1 (the percentage change in income is smaller than the
percentage change in quantity demanded, the good is classified as a luxury good.
82 ECS1501/002
Necessities Luxury goods
Betty, the owner of a travel agency, is concerned about the low economic growth forecasts given by
the Minister of Finance in his annual budget speech. Her concerns are _______.
o justified
o unjustified
It is justified since travel is a luxury good and as economic growth slows down, income slows down
and the demand for travel slows down.
Estimates of the income elasticity of demand are used to predict which industries will grow most
rapidly as the incomes of consumers grow or which industries will be most affected negatively when
the economy goes into a recession.
Luxury goods
When income rises, the demand for income elastic goods rises faster than income. As the income
elasticity of demand for luxury goods is greater than one, there is a strong correlation between the
increase in income and the increase in demand for the product. Producers of luxury goods can thus
expect a strong growth in the demand for their products should income increase.
The opposite also holds – if income decreases, producers of luxury goods will be most negatively
affected.
Necessities
In the case of necessities, an increase in income will have a positive influence on the demand for the
product, but not to the same extent as with luxury goods. Should incomes decrease, the demand for
necessities will not be affected that much.
For instance, if your income increases, you might consider buying those products that you normally do
not buy, eating out more often, going to the movies or spoiling yourself with a pedicure. When times
are tough, those will be the first goods that you will drop. However, if your income decreases, you will
not cut back on your spending on necessities that much – you still have to eat.
83 ECS1501/002
Necessities Luxury goods
Inferior goods
Bob, a student at the University of Yokufunda and a keen wine drinker, receives an increase in the
amount of pocket money he gets from his dad. Instead of buying wine packaged in boxes (box wine),
he now buys bottled wine with cork stoppers. From his behaviour, we know that Bob regards box
wines as a(n) _________ good.
o inferior
o luxury
o normal
Bob regards box wine as an inferior good since his demand for box wine decreased when his income
increased.
For a few goods, an increase in income means that one might purchase less of the good; for example,
individuals with a higher income might buy fewer fried chicken pieces, because they are buying more
steak instead, or those with a higher income might buy less wine and more craft beer. When the income
elasticity of demand is negative, the good is called an inferior good.
For an inferior good – that is, when the income elasticity of demand is negative – a higher level of
income would cause the demand curve for that good to shift to the left. Again, how much it shifts
depends on how large the (negative) income elasticity is.
ACTIVITY 1
1.1 A 10% increase in income causes a 20% increase in the quantity demanded for craft beer. It can
be concluded that _____.
a. the price elasticity is smaller than one
b. the income elasticity of demand is negative
c. craft beer is a necessity
d. craft beer is a luxury
84 ECS1501/002
1.2 An increase in income tends to cause a decrease in the demand for margarine. It can be concluded
that the _____.
a. price elasticity of demand is less than one
b. price elasticity of demand is more than one
c. income elasticity of demand is negative
d. income elasticity of demand is positive
1.3
a. Write down the formula for income elasticity.
b. Select the appropriate characteristics for an inferior good from the following categories:
Categories
Demand decreases when Income elasticity is positive. ey < 0
income increases.
Demand increases when Income elasticity is negative. 0 < ey < 1
income increases, but not as
rapidly as income.
Demand increases when ey > 1
income increases, but more
rapidly than income.
c. Select the appropriate characteristics for a luxury good from the following categories:
Categories
income increases.
rapidly as income.
d. Select the appropriate characteristics for a necessity from the following categories:
Categories
income increases.
rapidly as income.
85 ECS1501/002
11.2 Cross elasticity
• describe cross elasticity and the measurement of cross elasticity

• distinguish between the cross elasticity of complements and substitutes
A change in the price of one good can shift the demand for another good. If the two goods such as
bread and peanut butter are complements, then a drop in the price of one good will lead to an increase
in the demand for the other good.
However, if the two goods, such as plane tickets and train tickets, are substitutes, then a drop in the
price of one good will cause people to substitute that good and reduce consumption of the other good.
Cheaper plane tickets lead to fewer train tickets, and vice versa.
The cross-elasticity of demand puts some meat on the bones of these ideas. Specifically, the cross-
elasticity of demand is the responsiveness of quantity demanded of one good to a change in the
price of another good.
Cross elasticity of demand is calculated as the percentage change in the quantity of good A that is
demanded as a result of a percentage change in the price of good B.
% 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑄𝑄𝑑𝑑 𝑜𝑜𝑜𝑜 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝐴𝐴
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶-𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑒𝑒𝑐𝑐 =
% 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑃𝑃 𝑜𝑜𝑜𝑜 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝐵𝐵
Substitutes
Select the correct terms in brackets:

Bob, our wine-drinking student, has graduated and is now working at the Competition Commission.
An application for a merger between the Coca-Cola and Pepsi Cola companies lands on his desk.
From what he learnt in his first-year Economics module, Bob remembers that Coca-Cola and Pepsi
Cola cool drinks are (substitutes/complements) and have a (positive/negative) cross-elasticity.
Coca-Cola and Pepsi Cola cool drinks are substitutes and have a positive cross-elasticity.
Substitute goods have positive cross-elasticities of demand: If good A is a substitute for good B, like
coffee and tea, then a higher price for B will mean a larger quantity consumed of A.
If the goods are close substitutes, the cross-elasticity will be large, and if they are not close substitutes,
the cross-elasticity will be small. Thus, when the cross-elasticity of demand is positive, we are dealing
with substitutes, while the size is a measure of how closely substitutable the two goods are.
For instance, Coke and Pepsi, which are close substitutes for most people, will have a large cross-
elasticity. However, Coke and orange juice may not be close substitutes for most people, and will
therefore have a smaller cross-elasticity.
86 ECS1501/002
Complements

Coupled with the application for a merger between the Coca-Cola and Pepsi Cola companies, the
Coca-Cola company also applies for a merger with the True Blue Brandy company. Bob knows
Coca-Cola and brandy are complements and will therefore have a (positive/negative) cross-elasticity.
Coca-Cola and brandy are complements and will therefore have a negative cross-elasticity.
Complementary goods have negative cross-elasticities: If good A is a complement for good B, like
coffee and sugar, then a higher price for B will mean a lower quantity consumed of A. As with
substitutes, the size of the cross-elasticity of demand between two complements tells us how closely
they are associated. If the cross-elasticity is only slightly below zero, they are weak complements; and
if it is a large negative number, they are strong complements.
For example, cell phones and airtime are strong complements and therefore have a large negative value.
Note that the sign (plus or minus) is important as it tells us whether the two goods are complements or
substitutes and cannot be ignored as we did in the case of the price elasticity of demand.
Unrelated goods

To his surprise, Bob notices a third application from the Coca-Cola Company applying for a merger
with the Sticky Tyre Company. Bob is pretty sure that Coca-Cola and tyres are neither complements
nor substitutes, but cannot figure out what he should write in his report. Can you help him? They are
o complements.
o substitutes.
o independent goods.
Coca-Cola and tyres are independent goods and are not related.
The cross-elasticity of two independent or unrelated goods is equal to zero. A change in the price of
product A (coke) does not have any effect on the quantity demanded of product B (tyres).
ACTIVITY 2
2.1 Suppose the cross-elasticity of demand between two products, A and B, is negative. If the price
of product A increases as a result of a decrease in the number of firms supplying the product, the
quantity demanded will _____.
a. increase for both products A and B
b. fall for both products A and B
c. increase for product A and fall for product B
d. fall for product A and increase for product B
87 ECS1501/002
2.2 Suppose the cross-elasticity of demand between two products, A and B, is positive. If there is a
fall in the cost of producing good B, the quantity demanded will _____.
a. increase for both goods
b. decrease for both goods
c. increase for good A and decrease for good B
d. decrease for good A and increase for good B
2.3
a. Write down the formula for cross elasticity.
b. Select the appropriate characteristics for a complement good from the following categories:
Categories
The demand of one good Cross elasticity is negative. ec < 0
decreases when the price of
another increases.
The demand of one good Cross elasticity if positive. ec > 0
increases when the price of
another increases.
The demand of one good ec = 0
does not change when the
price of another increases.
c. Select the appropriate characteristics for a substitute good from the following categories:
Categories
another increases.
another increases.
88 ECS1501/002
d. Select the appropriate characteristics for an unrelated good from the following categories:
Categories
another increases.
another increases.
11.3 Price elasticity of supply

• describe price elasticity of supply and the measurement of price elasticity of supply
• differentiate between different price elasticity of supply using diagrams
• identify and describe the different factors that have an impact on the price elasticity of supply
When we looked at supply, we saw that there is a positive relationship between price and quantity
supplied. In other words, an increase in price will lead to an increase in the quantity supplied, while a
decrease in price will result in a decline in the quantity supplied.
Study the following supply curve and answer the questions:
o If the price increases from P3 to P4, the quantity supplied will (increase/decrease) from Q3 to Q4.
o If the price decreases from P4 to P2, the quantity supplied will (increase/decrease) from Q4 to Q2.
If the price increases from P3 to P4, the quantity supplied will increase from Q3 to Q4.
If the price decreases from P4 to P2, the quantity supplied will decrease from Q4 to Q2.
The question we wish to answer now is – By how much would the quantity supplied change if the price
were to change? In other words, we wish to measure the impact of a change in the price on the quantity
supplied.
89 ECS1501/002
The price elasticity of supply measures how sensitive or responsive the quantity supplied is to a change
in the price of a good or service and can be defined as the ratio between the percentage change in
quantity supplied of a product and the percentage change in its price, that is:
% 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑜𝑜𝑜𝑜 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 =
% 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
Select the answer you think is correct:

The price elasticity of supply is
o positive
o negative
The price elasticity of supply is positive, since an increase in price leads to an increase in quantity
supplied and a decrease in price leads to a decrease in quantity supplied.
Because price and quantity supplied change in the same direction, the value of the elasticity coefficient
is positive. As with the price elasticity of demand, the value of price elasticity of supply can range from
zero to infinity and can be graphically represented as follows:
Perfectly inelastic supply: es = 0
Inelastic supply: 0 < es < 1
90 ECS1501/002
Unit elastic supply: es = 1
Elastic supply: 1 < es < ∞
Perfectly elastic supply: es = ∞
91 ECS1501/002
Determinants of price elasticity of supply
Which one of the following factors do you think has the biggest influence on the price elasticity of
supply of a product?
o The demand for the product
o Time period
o Expected future price
It is time. The more time is available and the greater the number of opportunities to change, the
more elastic supply will be.
Time period
The passing of time is the main determinant of price elasticity of supply and most of the other
determinants of price elasticity of supply can be linked to time. In the short run, suppliers do not have
the time to respond quickly to price changes and the price elasticity of supply tends to be more
inelastic. However, in the long run, producers have time to change production techniques or increase
production capacity, so the price elasticity of supply becomes more elastic.
Expected prices
If producers see the change, say, in price, as a temporary occurrence, they will not change or increase
the production of the product in question and the price elasticity of supply will be inelastic. But, if they
expect prices to remain high, they will increase production and the price elasticity of supply will be
more elastic.
Labour-intensive versus capital-intensive production processes

It is easier to expand the production of machine-made goods than the production of goods that are
labour intensive. It takes time to recruit and train more workers if you wish to increase the production
of a product that is labour intensive. However, capital-intensive production processes that use a lot of
machines usually have excess capacity and can therefore quickly increase production should it be
required. The price elasticity of the supply of labour-intensive products is more inelastic than machine-
intensive products.
Agricultural products
Lastly, the price elasticity of supply of agricultural products, which tend to be perishable, is more
inelastic than goods that can be stored – stockpiled goods can be released quickly to the market.
92 ECS1501/002
ACTIVITY 3
Indicate what kind of price elasticity and the value of price elasticity that is represented by the
following diagrams:
Diagram A
Diagram B
Diagram C
93 ECS1501/002
Diagram D
Diagram E
94 ECS1501/002
ANSWERS TO THE
ACTIVITIES
Activity 1
1.1 d
An increase in income leads to an increase in the demand for craft beer. This is "normal
behaviour" and craft beer is thus classified as a normal product. The income elasticity of a normal
product is positive and this is also borne out (proven) by the statement – an increase in income (a
positive change) leads to an increase in quantity demanded (a positive change).
The income elasticity of craft beer can be calculated as follows:
% 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
𝑒𝑒𝑦𝑦 =
20
=
10
=2
The income elasticity of craft beer is larger than one, and is therefore classified as a luxury
product.
1.2 c
The relationship between the two variables income and demand is negative: an increase in
income (a positive change) leads to a decrease in demand (a negative change), and we know that
a positive divided by a negative gives us a negative answer.
1.3 a.
% 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑒𝑒𝑒𝑒
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑜𝑜𝑜𝑜 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑒𝑒𝑦𝑦 =
b. Inferior good
Categories
Demand decreases when Income elasticity is negative. ey < 0
income increases.
c. Luxury good
Categories
Demand increases when Income elasticity is positive. ey > 1
d. Necessity
Categories
Demand increases when Income elasticity is positive. 0 < ey < 1
rapidly as income.
95 ECS1501/002
Activity 2
2.1 b
The key to the question is given in the first sentence: "The cross-elasticity between two products
is negative." If the cross-elasticity is negative, we know that the two products must be
complements. An increase in the price of product A decreases the quantity demanded of A and
the demand for product B decreases.
The markets for motor vehicles and tyres can be used as an example:
The market for motor vehicles is represented in figure A. The equilibrium price is Pe and the
equilibrium quantity demand and supplied is Qe, as indicated by point E. The market for tyres is
represented in figure B. The equilibrium price is Pe and the equilibrium quantity demanded and
supplied is Qe, as indicated by point E.
A decrease in the number of motor vehicle producers shifts the supply curve for vehicles from S
to S1. The equilibrium price for motor vehicles increases from Pe to to P1 and the equilibrium
quantity demanded and supplied thus decreases from Qe to Q1.
Figure A – motor vehicles Figure B - tyres

The increase in the price of motor vehicles and the lower quantity demanded leads to a decrease
in the demand for tyres, because people buy fewer motor vehicles and therefore fewer tyres. In
the market for tyres, the demand curve for tyres shifts to the left from D to D1. This decrease in
the demand for tyres due to the increase in the price of motor vehicles causes a decrease in the
quantity of tyres demanded from Qe to Q1 and a decrease in the price from Pe to P1.
2.2 d
The key to the question is given in the first sentence: "The cross-elasticity between two products
is positive." If the cross-elasticity is positive, we know that the two products must be substitutes.
An increase in the price of product A decreases the quantity demanded of A and the demand for
product B increases.
The markets for butter and margarine can be used as an example:
The market for butter is represented in figure A. The equilibrium price is R9,00 and the
equilibrium quantity demanded and supplied is 250 kg, as indicated by point E. The market for
margarine is represented in figure B. The equilibrium price is R9,00 and the equilibrium quantity
demanded and supplied is 250 kg, as indicated by point E.
96 ECS1501/002
An increase in the production cost of butter shifts the supply curve for butter from S to S1. The
equilibrium price for butter increases from R9,00 per kg to R15,00 per kg, and the equilibrium
quantity demanded thus decreases from 250 kg to 150 kg.
Figure A – butter Figure B - margarine
The increase in the price of butter and the lower quantity demanded therefore leads to an increase
in the demand for margarine, because people buy margarine instead of butter. At each price of
margarine, more margarine is demanded when the price of butter increases from R9,00 per kg to
R15,00 per kg. In the market for margarine, the demand curve shifts to the right from D to D1.
This increase in the demand for margarine due to the increase in the price of butter, causes an
increase in the quantity of margarine demanded from 250 kg to 300 kg.
2.3 a.
% 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑄𝑄𝑄𝑄 𝑜𝑜𝑜𝑜 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝐴𝐴
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶-𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑒𝑒𝑐𝑐 =
% 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑃𝑃 𝑜𝑜𝑜𝑜 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝐵𝐵
b. Complement
Categories
another increases.
c. Substitute
Categories
The demand of one good Cross elasticity is positive. ec > 0
another increases.
97 ECS1501/002
d. Unrelated good
Categories
price of another increases
Activity 3
Perfectly inelastic
es = 0
Diagram A
Inelastic
0 < es < 1
Diagram B
Unit elastic
es = 1
Diagram C
98 ECS1501/002
Elastic
1 < es < ∞
Diagram D
Perfectly elastic
es = ∞
Diagram E
99 ECS1501/002
CHECKLIST
Well Satis- Must

factory redo
Concepts and relationships
I am able to
define income elasticity of demand
describe the measurement of income elasticity of demand
distinguish between luxury goods, necessities and inferior goods
distinguish a positive and a negative income elasticity of demand
define cross elasticity of demand
describe the measurement of cross elasticity of demand
distinguish between positive and negative cross elasticity of demand
values
define price elasticity of supply
distinguish between the different types of price elasticity of supply
describe the factors that impact on the price elasticity of supply
Diagrams
I am able to
compare the impact of income elasticity on the market for necessities
and luxury goods
the different types of price elasticity of supply
100 ECS1501/002
Theory of demand
12
OVERVIEW
When we dealt with the economic problem of scarcity, we indicated that an important question that
needs to be answered relates to the issue of what to produce. We also argued that we require our
economic system to be both technically and allocatively efficient. Allocative efficiency requires that we
produce the right combination of goods and services.
In the topic dealing with demand, supply and prices, we argued that consumers express their
preferences for goods and services through their demand for goods and services, and that the question
of what to produce is answered in a market system through the forces of demand and supply. We also
mentioned that a negative relationship exists between the price of a good or service and the quantity
demanded.
In this section, we will use the utility approach to explain why the demand curve is downward sloping.
In other words, we explain why consumers increase their quantity demanded when the price of a good
or service decreases, and why when the price increases consumers decrease their quantity demanded.
TOPIC OUTCOME
• explain the negative relationship between price and quantity demanded using the theory of
marginal utility
We start this section by taking a closer look at the meaning of the concept of utility.
12.1 Utility
• explain the concepts of utility and cardinal utility
Suppose after a long day of hard work you are hungry. You then consume fish and chips. You probably
enjoy the first portion and it satisfies your hunger. You then consume the second portion of fish and
chips. Did you enjoy the second portion as much as the first one? Can you tell how much each portion
satisfies you?
As consumers, we make decisions on what to buy every day. Economists are of the opinion that
consumers buy goods and services to satisfy their needs and wants and that they derive satisfaction
from the consumption of these goods and services. This satisfaction they receive is called utility.
101 ECS1501/002
Utility is therefore the satisfaction a consumer expects from the consumption of goods or services.
The decision of a consumer to demand a good or service is based on the expected satisfaction he or she
derives from consuming the good.
Consider the following questions.
1. If you eat three portions of fish and chips, does the third porting give you the same, more or
less satisfaction as the first one?
o Same
o More
o Less
2. Can you put a figure to how much satisfaction you derive from the third portion?
o Yes
o No
o Not sure
I think the third portion would definitely give me less satisfaction than the first. In numerical
terms, I could say that the first one gives me 100 feelings of satisfaction and the third only 20
feelings of satisfaction. This is, however, a very subjective measure. It only applies to me.
Economists have developed the concept of cardinal utility to deal with the measurement issue of utility.
And they measure this satisfaction or utility in utils. The assumption is that it is possible to place
numerical values on utility, an assumption that may seem questionable. You can buy a thermometer for
measuring temperature at the hardware store, but what store sells an "utilimometer" for measuring
utility? However, while measuring utility with numbers is a convenient assumption to clarify the
explanation, the key assumption is not that utility can be measured by an outside party, but only by the
individuals themselves. For example, you might indicate that you gain 20 utils from drinking coffee
and 15 utils from eating ice cream. Your friend, however, might indicate that he gains 35 utils from
drinking coffee and 50 utils from eating ice cream. Even though it is a subjective measure, it is
influenced by things such as income and prices.
The reason we buy goods and services is to satisfy our needs and wants. In other words, we buy goods
and services because it gives us satisfaction, and what we aim to do is to spend our income, given the
prices of goods and services, in such a way that we receive the maximum satisfaction possible. In terms
of utils, we want to obtain the highest possible number of utils.
Do the following activity about the meaning of the concept utility.
ACTIVITY 1
1.1 Utility is best defined as ________.

a. usefulness of a good or service
b. satisfaction from consuming the good or service
c. the price a consumer is willing to pay for a good or service
102 ECS1501/002
1.2 Indicate whether the following statement is true or false:
According to the cardinal utility approach, it is possible to measure utility objectively.
a. True
b. False
12.2 Total utility

• explain the concept total utility

• explain with the aid of a utility schedule and a diagram why total utility increases at a
decreasing rate
The analysis of consumer utility starts with the total utility derived from the consumption of different
quantities of a good or service. Total utility is the total amount of utility one gains from consuming
goods or services.
Study the example below for a better understanding of total utility.
Suppose that Marcel eats chocolate and records the amount of utility he receives from the
consumption of each unit of chocolate. The first column in the table shows the number of
chocolates consumed and the second column, the amount of total utility he obtained.
Total utility schedule
Number of chocolates
Total utility (utils)
consumed
0 0
1 8
2 14
3 19
4 23
5 26
6 28
7 29
8 29
9 25
103 ECS1501/002
Study the table and answer the following question.
What happens to Marcel’s total utility as he consumes the first seven units?
o It increases.
o It decreases.
o It stays the same.
As he consumes more chocolates, his total utility increases. This is indicated in column 2.
Before Marcel eats his first chocolate, he receives no utility. He cannot obtain any utility because he
has not consumed any chocolate.
His first chocolate gives him eight utils. If he eats four units of chocolate, he receives 23 utils. His
utility increases for the consumption of the first eight units of chocolates, until it starts to decline from
the nine units onwards. Marcel obtains the highest level of utility after consuming seven units of
chocolate.
Marcel's goal of consuming chocolate is to maximise his utility, that is, to consume the number of units
that will generate the highest level of utility. For Marcel, utility is maximised at seven units.
If you look at the increase in Marcel’s total utility does it increase at a(n) ________ rate?
o increasing
o decreasing
o constant
If you look at the change in total utility, you will see that it increases at a decreasing rate, namely
6, 5, 4 ,3.
104 ECS1501/002
Let's plot Marcel's total utility as a graph:
His total utility is measured on the vertical axis, while the quantity of chocolates is measured on the
horizontal axis.
Total utility schedule
Number of chocolates Total utility (utils)

consumed
0 0
1 8
2 14
3 19
4 23
5 26
6 28
7 29
8 29
9 25
Total utility
By combining the points we obtain the total utility curve.
An important thing to notice about the total utility curve is how it first increases at a decreasing rate,
then reaches a maximum and then starts to decline.
105 ECS1501/002
ACTIVITY 2
2.1 Study the following diagram of the total utility for units of beer consumed by William and
answer the questions:
Units of beer Total utility (utils)

0 0
1 12
2 22
3 30
4 37
5 42
6 45
7 46
8 46
9 42
a. Do you agree with the following statement?

To maximise his utility from drinking beer, William should drink nine units of beer – in other
words, as much beer as he possibly can.
1. Agree
2. Disagree
b. Is the following statement true or false?
William's total utility increases by the same amount of utils for every additional beer he drinks.
1. True
2. False
c. Choose the correct option in brackets:
As William consumes more units of beer, his total utility increases at a(n) (increasing,
decreasing) rate.
12.3 Marginal utility and the law of diminishing marginal utility

• explain the concept marginal utility

• explain and illustrate with the aid of an example and diagram the law of diminishing marginal
utility
• describe the relationship between marginal utility and total utility
106 ECS1501/002
Marginal utility is the amount of additional utility the person receives from the consumption of
additional units of a good or service. This is the extra satisfaction gained from the consumption of an
extra unit of a good or service.
It is calculated as follows:
𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
Marginal utility =
𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑡𝑡ℎ𝑒𝑒 𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑜𝑜𝑜𝑜 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
In symbols it can be written as:
𝑇𝑇𝑇𝑇2 − 𝑇𝑇𝑇𝑇1
𝑀𝑀𝑀𝑀 =
𝑄𝑄2 − 𝑄𝑄1
where
TU is the total utility
Q is the number of units consumed
The following table indicates the marginal utility for Marcel:

Total and marginal utility schedule
Number of
Marginal utility
chocolates Total utility (utils)
(utils)
consumed
0 0
1 8 8
2 14 6
3 19 5
4 23 4
5 26 3
6 28 2
7 29 1
8 29 0
9 25 -4
For the first unit, he obtains eight utils, for the second unit, six utils (14 utils – 8 utils), for the third
unit, four utils (23 – 19) and so on. Notice that for the ninth unit, his marginal utility is -4 since his total
utility decreases from 29 to 25.
107 ECS1501/002
What happens to Marcel’s marginal utility? It ________ as he consumes more chocolates.
o decreases
o increases
As you can see from column 3, as he eats more chocolates, his marginal utility declines:
8,6,5,3,2,1,0,-4.
This decline in marginal utility can now be summed up by the law of diminishing marginal utility,
which states that the marginal utility or extra satisfaction gained from consuming a good or
service declines as more of a good is consumed in a given period.
The additional unit consumed is less satisfying than the previous one. The law provides an
understanding of the demand curve and the law of demand. The reason the demand curve slopes
downward, as we will later explain in more detail, is the diminishing marginal utility. If each additional
unit of a good or service is less satisfying, then the consumer is only prepared to purchase an additional
unit at a lower price than the previous one.
Let's plot Marcel's marginal utility as a graph:
His marginal utility of chocolate is measured on the vertical axis, while the quantity of chocolates is
measured on the horizontal axis.
Number of
Marginal utility
(utils)
consumed
0 0 0
1 8 8
2 14 6
3 19 5
4 23 4
5 26 3
6 28 2
7 29 1
8 29 0
9 25 -4
108 ECS1501/002
Marginal utility
By combining the points, we obtain the marginal utility curve.
It decreases and eventually becomes negative. In the case of Marcel, this negative value might be
because he gets an upset stomach from eating too many chocolates.
This diagram also demonstrates the law of diminishing marginal utility, which indicates that the
marginal utility or extra satisfaction gained from consuming an additional good or service, declines as
an individual consumes more of the good or service in a given period.
12.4 Relationship between total utility and marginal utility

From the data in the table and the diagram below, we can establish the following relationship between
total utility and marginal utility:
Number of
Marginal utility
(utils)
consumed
0 0
1 8 8
2 14 6
3 19 5
4 23 4
5 26 3
6 28 2
7 29 1
8 29 0
9 25 -4
109 ECS1501/002
The relationship between total utility and marginal utility is as follows:
1. As total utility increases at a decreasing rate, then marginal utility decreases.
2. When total utility is at a maximum point, then marginal utility is zero.
3. When total utility starts to decline, then marginal utility becomes negative.
Do the following activity on marginal and total utility
110 ECS1501/002
ACTIVITY 3
3.1 The table below is based on William's consumption of units of beer. Complete the table by
calculating his marginal utility for units of beer.
Units of beer Total utility Marginal utility

(utils) (utils)
0 0 0
1 12 12
2 22
3 30 8
4 37
5 42 5
6 45
7 46 1
8 46 0
9 42
3.2 The following diagrams are based on William's consumption of beer:
Study these diagrams and answer the questions:

a. As the units of beer consumed by William increase, his total utility _______.
1. increases and marginal utility increases
2. decreases and marginal utility decreases
3. increases and marginal utility decreases
b. Indicate whether the following statement is true or false:
Since the marginal utility of the first beer is the highest, William should only consume one
beer in order to maximise his utility.
1. True
2. False
111 ECS1501/002
c. Choose the correct words in brackets.
The relationship between total utility and marginal utility indicates that when marginal
utility decreases, total utility (increases, decreases) at a(n) (increasing, decreasing) rate, and
when total utility is at a (maximum, minimum) point, marginal utility is zero and total
utility starts to decline if marginal utility is (negative, positive).
d. Choose the correct words in brackets.
The law of diminishing marginal utility states that the marginal utility or extra satisfaction
gained from consuming an additional good or service (declines, increases) as people
consume (more, less) of the good or service in a given period.
12.5 Consumer equilibrium

• describe the concept marginal utilities per rand

• describe the concept consumer equilibrium
• use an example explain how a consumer with an income constraint reaches consumer
equilibrium
The aim of a consumer is to spend his or her income, given the prices of goods and services, in such a
way that he or she attains the highest possible total utility. Once this happens, we can say that the
consumer is in equilibrium – that is, utility maximisation has occurred.
In making the decision on how utility maximisation is to be reached, the consumer needs to take the
following into account:
 the utility (satisfaction) he or she gains from consuming goods and services
 the prices of goods and services
 his or her income
The price of the goods or services and income are the constraints that the consumer faces, and it is
because of these constraints that the consumer must attempt to maximise utility.
Help Fiona maximise her satisfaction.
Fiona provides the following information on the marginal utility she obtains from eating
ice cream and a chocolate.
The marginal utility of a chocolate is 72.

The marginal utility of ice cream is 100.
If she is offered chocolate and ice cream for free (income and prices are not constraints)
and she must choose between the two, which one do you think she should choose?
o Chocolate
o Ice cream
In this case, she should choose the ice cream since it gives her more additional utility than
the chocolate.
112 ECS1501/002
However, for most of us to have a chocolate or ice cream, we must pay for it.
Let's see what happens to Fiona's choice if she has to pay for the ice cream and chocolate.
Fiona now faces an income constraint.
According to the following information on the marginal utility and price of ice cream and
chocolate, which one do you think she should choose?
The marginal utility of a chocolate is 72 and the price is R3.

The marginal utility of ice cream is 100 and the price of an ice cream is R5.
o Chocolate
o Ice cream
Before a decision can be made, we need know what the marginal utility per rand is that she
obtains from the chocolate and ice cream. In other words, what is the "bang for her buck"
(value for the money she spends).
The marginal utility per rand, also called the weighted marginal utility, is calculated as follows:
𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
Weighted marginal utility =
𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
In symbols it can be written as:
𝑀𝑀𝑀𝑀
𝑀𝑀𝑀𝑀𝑃𝑃 =
𝑃𝑃
In the case of Fiona, the weighted marginal utility of the chocolate and ice cream are as follows:
chocolate:
72
=
3
= 24 marginal utilities per rand
ice cream:
100
=
5
= 20 marginal utilities per rand
Based on the above information about the weighted marginal utilities help Fiona decide.
If she can only buy one of them, which one should she buy?
o Chocolate
o Ice cream
Since her marginal utility per rand is higher for chocolate (24) than for ice cream (20), she
should choose chocolate as it gives her more utilities per rand spend.
Fiona's weighted marginal utility for units of chocolate and ice cream is indicated in the following
table, given a price of R3 for a chocolate and R5 for an ice cream:
113 ECS1501/002
Weighted marginal utility
Chocolate (P = 3) Ice cream (P = 5)

Units MU MU/P MU MU/P
1 72 24 120 24
2 66 22 115 23
3 54 18 100 20
4 42 14 85 17
5 36 12 70 14
6 27 9 65 13
7 24 8 60 12
8 18 6 45 9
9 9 3 35 7
The first column shows the number of units. The second column indicates the marginal utility she
derives from eating units of chocolate. The third column provides her weighted marginal utility, given
a price of R3 for a chocolate. The fourth column indicates her marginal utility for units of ice cream
and in the fifth column her weighted marginal utility for an ice cream, given a price of R5 for an ice
cream.
Note how her marginal utility for chocolate and ice cream decreases as she consumes more units. This
is because of the law of diminishing marginal utility. Also note how her marginal utility per rand
(weighted marginal utility) for ice cream and chocolate decreases as she consumes more.
Help Fiona decide how to spend her income to reach maximum satisfaction.
Assuming that Fiona has R50, how should she spend her income in order to maximise her
satisfaction?
o 7 chocolates and no ice cream

o No chocolates and 4 ice creams
o 2 chocolates and 3 ice creams
Let's see how Fiona makes this decision:
o Her first purchase can be either a chocolate or an ice cream. Why? Because both
chocolate and ice cream have a weighted marginal utility of 24.
o Let's assume she buys the chocolate first. Her second purchase should then be an ice
cream since it has a higher weighted marginal utility (24) than a second chocolate
(22).
o Her third purchase should be a second ice cream since it has a higher weighted
marginal (23) utility than a second chocolate (22).
o Her fourth purchase should be a second chocolate (22) and a third ice cream (20).
She should then continue to purchase chocolate and ice cream based on the marginal
utilities per rand until her income is spend.
114 ECS1501/002
The process that Fiona follows can be written as the following rule:
The utility-maximising choice between goods occurs where the weighted marginal utility
(marginal utility per rand) is the same for both goods.
In symbols it is written as
𝑀𝑀𝑀𝑀𝑎𝑎 𝑀𝑀𝑀𝑀𝑏𝑏
=
𝑃𝑃𝑎𝑎 𝑃𝑃𝑏𝑏
In the case of Fiona who has R50 to spend, this occurs where the weighted marginal utility for ice
cream and chocolate is 12. She therefore maximises her utility by buying five units of chocolate and
seven units of ice cream as indicated in the following table.

Units MU MU/P MU MU/P
1 72 24 120 24
2 66 22 115 23
3 54 18 100 20
4 42 14 85 17
5 36 12 70 14
6 27 9 65 13
7 24 8 60 12
8 18 6 45 9
9 9 3 35 7
ACTIVITY 4
4.1 A consumer has R30 available and wants to purchase cups of tea and chocolates. The price of tea
is R5 and the price chocolate is R10. How many quantities can the consumer buy if she spends
her entire income on chocolates?
a. 3 units
b. 6 units
c. 20 units
115 ECS1501/002
4.2 The table below is based on Glenda's consumption of coffee and tea. Complete the missing
values of weighted marginal utilities.
Coffee (P = 3) Tea (P = 4)
Utils
MU MU÷P MU MU÷P
1 30 10 48
2 24 40 10
3 18 6 32 8
4 12 4 16
5 6 12 3
4.3 Given the price of goods and services, which of the following indicates consumer equilibrium?
a. The consumer spends his or her income in such a way that he or she attains the highest
possible total utility.
b. The consumer spends his or her income in such a way that the weighted marginal utility
(marginal utility per rand) is the same for the goods.
c. The consumer spends his or her income in such a way that the marginal utilities are the
same for the goods.
4.4 The table below indicates Glenda's consumption of coffee and tea. Use the table to answer the
following questions:
Utils
MU MU÷P MU MU÷P
1 30 10 48
2 24 40 10
3 18 6 32 8
4 12 4 16
5 6 12 3
a. If Glenda has already consumed two cups of coffee and three cups of tea and she must now
decide whether to buy another cup of tea or another cup of coffee, what advice would you
give her to ensure that she maximises her satisfaction?
1. Purchase another cup of tea.
2. Purchase another cup of coffee.
b. If Glenda has R28 to spend on tea and coffee, at which combination of coffee and tea
would she be in equilibrium if he spends her total income of R28?
1. 4 units of coffee and 4 units of tea
2. 1 unit of coffee and 2 units of tea
3. 2 units of coffee and 3 units of tea
116 ECS1501/002
12.6 Deriving the demand curve from consumer equilibrium
• illustrate and explain how the demand curve is derived from consumer equilibrium
A consumer's equilibrium position will change if the price of a good changes.

To illustrate the impact of a change in price, we will use our example of Fiona's spending on chocolate
and ice cream. We assume that the price of chocolate decreases to R2. The weighted marginal utility
for chocolate at a price of R2 is added in the following table:
Chocolate
(P = 2)
Units MU MU/P MU/P MU MU/P
1 72 24 36 120 24
2 66 22 33 115 23
3 54 18 27 100 20
4 42 14 21 85 17
5 36 12 18 70 14
6 27 9 13,5 65 13
7 24 8 12 60 12
8 18 6 9 45 9
9 9 3 4,5 35 7
Given that Fiona still has R50, how many units of chocolate and how may units of ice cream must she
buy in order to maximise her utility?
By following the same procedure as in the above example, she ends up buying seven units of chocolate
and seven units of ice cream and has R1 left.
From our examples, we can then conclude the following:
 At a price of R3 for a chocolate, we saw that Fiona maximises her utility by buying five units
of chocolate and seven units of ice cream.
 At a price of R2 for a chocolate, we saw that Fiona maximises her utility by buying seven
units of chocolate and seven units of ice cream.
This data can be used to plot Fiona’s demand curve for chocolate. At a price of R3, her quantity
demanded is five units and at a price of R2, her quantity demanded is seven units. Other points can also
be derived by changing the price. By combining the points, we obtain the demand curve which
indicates a negative relationship between price and quantity demanded.
117 ECS1501/002
ACTIVITY 5
The table below indicates Glenda's consumption of coffee and tea. Use the table to answer the
questions that follow:
Coffee Tea
Utils
MU MU÷P MU÷P MU MU÷P
(R3) (R6) (R4)
1 30 10 5 48 12
2 24 8 4 40 10
3 18 6 3 32 8
4 12 4 2 16 4
5 6 2 1 12 3
5.1 If the price of coffee increases from R3 to R6, what is the new equilibrium position for Glenda if
she spends her total income of R28?
a. 3 units of coffee and 5 units of tea
b. 4 units of coffee and 4 units of tea
c. 2 units of coffee and 4 units of tea
5.2 What is the quantity of coffee demanded by Glenda at a price of R3?
5.3 What is the quantity of coffee demanded by Glenda at a price of R6?
5.4 Would you agree or disagree with the following statement?
If the price of coffee increases, Glenda must purchase less coffee in order to stay in equilibrium.
This indicates that there is a negative relationship between the price of coffee and the quantity
demanded by Glenda, and her demand curve is downward sloping.
a. Agree
b. Disagree
118 ECS1501/002
ANSWERS TO THE
ACTIVITIES
Activity 1
1.1 b
Utility is not only influenced by the usefulness of a good or service, but is the satisfaction derived
from the consumption of a good or service. Utility is also not the price that a consumer will pay
for a good or service, but the satisfaction derived from the consumption of a good or service.
1.2 False
The utility approach is based on the assumption that consumers can assign values to the amount
of satisfaction derived from the consumption of a good or service. This assigning of satisfaction,
however, is subjective.
Activity 2
2.1
a. You should disagree.
To maximise his utility, William should drink eight beers, which gives him a total utility of 46. If
he drinks nine beers, his total utility is only 42.
b. False
It is indeed the case that if he drinks more beer, his total utility increases but it does not increase
by the same amount.
c. Decreasing
It increases at a decreasing rate. For unit two, the increase is ten, for unit three, the increase is
eight, for unit four, the increase is seven and so on.
Activity 3
3.1
How to calculate MU:
Second unit: 22 – 12 = 10
Fourth unit: 37 – 30 = 7
Sixth unit: 45 – 42 = 3
Ninth unit: 42 – 46 = -4
119 ECS1501/002
The completed table should look like this:
Units of beer Total utility Marginal utility

(utils) (utils)
0 0 0
1 12 12
2 22 10
3 30 8
4 37 7
5 42 5
6 45 3
7 46 1
8 46 0
9 42 -4
3.2
a. 3
As William consumes more beer, his marginal utility will decrease, while his total utility will
increase.
120 ECS1501/002
b. False
William wants to maximise his total utility, and he does so when he consumes seven beers.
c. The relationship between total utility and marginal utility indicates that when marginal
utility decreases, total utility increases at a decreasing rate, and when total utility is at a
maximum point, marginal utility is zero and total utility starts to decline if marginal utility
is negative.
d. The law of diminishing marginal utility states that the marginal utility or extra satisfaction
gained from consuming an additional good or service declines as people consume more of
the good or service in a given period.
Activity 4
4.1 3 units
Since the price of chocolate is R10 per unit, the quantity of chocolate that can be bought is three
units (R30 ÷ R10).
4.2 To calculate weighted marginal utilities, MU is divided by price. The completed table should
look like this:
Utils
MU MU÷P MU MU÷P
1 30 10 48 12
2 24 8 40 10
3 18 6 32 8
4 12 4 16 4
5 6 2 12 3
4.3 a and b
It is indeed the case that if the consumer has spent his or her income in such a way that the
highest possible total utility is reached, consumer equilibrium exists.
Consumer equilibrium is also the point where the weighted marginal product is the same for the
different goods.
121 ECS1501/002
4.4
a. Purchase another cup of coffee
By purchasing the third cup of coffee, she gains six utils per rand (weighted marginal utility),
whereas if she purchases a fourth cup of tea, she gains only four utils per rand.
b. a
The condition for consumer equilibrium is that weighted marginal utilities must be equal. Glenda
will be at equilibrium at four units of coffee and four units of tea. This is because the weighted
marginal utilities are the same for coffee and tea, and then she has spent her total available
income of R28.
Although the weighted marginal utilities are the same at two units of coffee and three units of tea
Glenda has not spent her total available income of R28.
Activity 5
5.1 c
When the price of coffee increases from R3 to R6, Glenda will be in equilibrium at two units of
coffee and four units of tea. This is because the weighted marginal utilities are the same for
coffee and tea, and Glenda spends her total available income of R28.
5.2 4 cups of coffee
5.3 2 cups of coffee
5.4 You should agree.
Her demand curve looks like this:
122 ECS1501/002
CHECKLIST
Well Satis- Must

factory redo
I am able to
describe the aim of consumer behaviour
define the concept utility
describe the concept cardinal utility
distinguish between total utility and marginal utility
explain the relationship between total utility and marginal utility
formulate the law of diminishing marginal utility
describe the concept weighted marginal utility
describe the concept consumer equilibrium
use an example to explain how a consumer with an income constraint

reaches consumer equilibrium
Diagrams
I am able to
marginal utility
total utility
how the demand curve is derived from consumer equilibrium
Calculations
I am able to calculate
marginal utiltiy
total utility
weighted marginal utility
123 ECS1501/002
Theory of supply:
Cost of production 13
OVERVIEW
We are still on our journey to see how a market system solves the economic problem of scarcity, which
arises because resources are limited and our wants and needs are unlimited. One of the fundamental
questions that we have identified is the question of how to produce goods and services. Firms that are
responsible for the production of goods and services shoulder this responsibility. The challenge that
economic systems face is how to ensure that firms not only produce goods and services efficiently, but
also produce the right combination of goods and services – in other words, how to ensure both
technical and allocative efficiency
Looking at our circular flow model, we can see that firms have a central position in that they employ
the factors of production, and through this employment, income is generated. Firms also then supply
goods and services through the goods market to households.
124 ECS1501/002
The goods market consists of the demand and supply of goods and services, and in studying the
behaviour of a market, we have seen how the forces of demand and supply determine the equilibrium
price and how changes in the price of a good or service ensure that market equilibrium is reached.
We have also identified that behind the supply is firms' willingness and ability to supply goods and
services, and that the cost of production is a major determinant of the supply of a good or service. In
this section, we take a closer look at the cost of production for a firm in a market system.
A firm’s total costs relate to the production of goods and services. A firm (or business) combines the
inputs of labour, capital, land and raw or finished component materials to produce outputs. If the firm is
successful, the outputs are more valuable than the inputs. This activity of production goes beyond
manufacturing (i.e. making things). It includes any process or service that creates value, including
transportation, distribution, wholesale and retail sales. Production involves a number of important
decisions that define the behaviour of firms. These decisions include, but are not limited to, the
following:
 What product or products should the firm produce?
 How should the products be produced (i.e. what production process should be used)?
 How much output should the firm produce?
 What price should the firm charge for its products?
 How much labour should the firm employ?
The answers to these questions depend on the production and cost conditions facing each firm, and this
will influence the firm’s cost of production. In the sections that follow we will take a closer look at the
cost of production.
TOPIC OUTCOME
• explain and illustrate the cost of production
13.1 Profit and profit maximisation

• distinguish between profit and profit maximisation
Firms play an important role in helping society to solve the economic problem of scarcity. They are
responsible for the production of goods and services that society needs in order to satisfy their needs
125 ECS1501/002
and wants. Nevertheless, we require more from them than only the production of goods and services –
we also require them to make efficient use of resources since our resources are scarce. It is through the
payment of profits that an incentive is provided to firms not only to produce those goods and services
society need and want, but also to do so in the most efficient way possible.
Profit is simply the difference between total revenue and total cost:
Profit = total revenue − total cost

Profit = 𝑻𝑻𝑻𝑻 − 𝑻𝑻𝑻𝑻
Total revenue is the income brought into the firm from selling its products. It is calculated by
multiplying the price of the product by the quantity of output sold:
Total revenue = price × quantity

𝑻𝑻𝑻𝑻 = 𝑷𝑷 × 𝑸𝑸
Which one of the following statements indicates that the profits of BY Construction have
increased?
o The total revenue of BY Construction rose more than its total costs.
o The total revenue of BY Construction rose less than its total costs.
o The total revenue of BY Construction rose by the same amount as its total costs.
o For the first time in 10 years, the total revenue of BY Construction is less than its total costs.
As long as total revenue rises more than total cost, profits will increase.
For firms to survive in a market economy, the bottom line for them is that they should make a profit.
Apart from making a profit, they might also have other objectives such as having the largest market
share, maximising their sales or revenue or maximising employment. We will assume that they wish
not only to make a profit, but also to maximise their profits.
Which one of the following firms do you think is maximising its profits?
o ABC Manufacturing decided to increase its production in order to employ more people,
knowing that it would decrease its total profits.
o Global Industries' profit mark-up over its cost is around 80%.
o BBC Bakeries decides to decrease its production, because it shows that by decreasing its
production by 5%, it will be able to increase its total profits by 10%.
It is when BBC Bakeries decreases its production. Is not about whether it makes 10% or 80%, but
whether the difference between total revenue and total cost is the greatest, and that is what BBC
Bakeries intends doing.
Profit maximisation of a firm occurs when the positive difference between total revenue (TR) and total
cost (TC) is the greatest. Note that this might not necessarily correspond to the point where total
revenue or total employment is at its highest.
126 ECS1501/002
Profit maximisation occurs where the positive difference between total revenue (TR) and total cost
(TC) is the greatest.
Now do the following activity to see if you have grasped the concept of profit maximisation:
ACTIVITY 1
1.1 Profit maximisation occurs _______.

a. whenever total revenue exceeds total cost
b. when a firm’s profit mark-up is more than 80%
c. when the positive difference between total revenue and total cost is at its greatest
1.2 You are given the following information about BC Construction. You are asked to advise the
company on a number of issues.
Number of houses Total cost Total revenue

500 R26 million R40 million
a. How many houses should BC Construction build to maximise its profits?

b. If BC Construction wishes to maximise employment opportunities, how many houses
should it build?
c. If BC Construction wishes to maximise revenue, how many houses should it build?
13.2 Explicit versus implicit costs

• distinguish between explicit and implicit costs
The total cost of production will have an important impact on a firm’s profit because profit is equal to
total revenue minus total cost. The concept of total cost might seem straightforward. If you ask an
127 ECS1501/002
accountant, he or she will tell you that it is all the payments that are actually made to produce the goods
or services, and includes things such as wages, rent, equipment costs and administration costs. This is
referred to as explicit costs.
Economists, however, have a more subtle if not complicated view of cost since we are interested in the
opportunity cost of things. What economists are interested in is not only the actually cost that the firm
incurs, but what the cost is to society of producing goods and services. Moreover, the reason we are
interested in opportunity cost is because our resources are scarce and we would like to see that they are
used in the best possible way to satisfy as many needs and wants as possible. Economists will therefore
include the opportunity cost of making use of all self-owned resources into account and not only actual
payments as accountants do. This is referred to as implicit costs.
Take the following as an example of the different ways an accountant and an economist would
calculate costs:
Thabo currently works for a corporate law firm. He is considering opening his own legal practice. To
run his own firm, he would need an office and a law clerk. He decides to use his own home as an
office. He is also able to find a law clerk whom he hires for R120 000 per year. He estimates his
administration costs to be R80 000.
An accountant would do the following cost calculation:
Salary for law clerk: R120 000
Administration costs: R80 000
Total cost: R200 000
Before an economist can do the cost calculation, he or she would need to know the cost of the self-
owned resources (implicit cost). This would require the following information:
How much would he have to pay to rent an office? This then is the opportunity cost of using his own
home as an office. Let's assume the rent would have been R60 000.
How much did he earn when he worked for the law firm? This is the opportunity cost for working for
himself. Let’s assume that he earned R450 000 per year. This reflects his opportunity cost of working
for himself.
128 ECS1501/002
Let's see how the economist would calculate cost:
The cost calculation of an economist would include both the explicit and the implicit cost.
Based on the above example, what would be the explicit cost for Thabo?
It is R200 000 and is calculated as follows:

Administration costs: R80 000
Total explicit cost: R200 000
What would be the implicit cost?
It is R510 000 and it is calculated as follows:
It consists of the opportunity cost of self-owned resources, which includes the opportunity cost of
using his own home, which is the rent of R60 000 he would have paid, as well as his salary of
R450 000.
Rent: R 60 000
Forgone salary: R450 000
Total implicit cost: R510 000
Based on the above example, what would be the total cost according to an economist?
It is R710 000.
An economist’s calculation is explicit cost + implicit cost = R200 000 + R510 000 = R710 000.
To summarise:
Based on the example of Thabo, this is how an accountant and an economist would calculate total cost:
An accountant uses only explicit costs An economist uses both explicit and
implicit costs
Salary for law clerk: R120 000 Salary for law clerk: R120 000
Administration costs: R80 000 Administration costs: R80 000
Total explicit cost: R200 000 Total explicit cost: R200 000
Rent: R60 000
Own salary: R450 000
Total cost: R710 000
Explicit cost is the actual payments that are made towards the production of goods and services, while
implicit cost is the opportunity cost of the use of self-owned resources in the production of goods and
services. Accounting cost only includes explicit costs, while economic costs include both explicit and
implicit costs.
129 ECS1501/002
13.3 Accounting profit, normal profit and economic profit
• distinguish between accounting profit, normal profit and economic profit
Total profit is equal to total revenue minus total cost. Since accountants and economists calculate costs
differently, their profit estimates will also differ.
Accounting profit is total revenue minus explicit costs, while economic profit is total revenue minus
explicit and implicit costs.
Based on the example of Thabo, this is how an accountant and an economist would calculate total cost:
An accountant uses only explicit cost An economist uses both explicit and implicit
costs
Administration costs: R 80 000 Salary for law clerk: R120 000
Administration costs: R 80 000
Rent: R 60 000
Own salary: R450 000
Total implicit cost R510 000
Total cost R710 000
Assume that Thabo's total revenue is R750 000.
o What is his accounting profit?

o What is his economic profit?
Accounting profit is total revenue minus explicit cost = R750 000 – R200 000 = R550 000.
For an economist the economic profit is total revenue minus explicit and implicit costs =
R750 000 – (R200 000 + R510 000) = R40 000.
When looking at profit, economists also distinguish between normal profit and economic profit.
Take a look at the profit position of Thabo, which is based on the above data:
Total revenue R 750 000
minus explicit cost R 200 000
minus implicit cost R 510 000
Profit R 40 000
This profit of R40 000 is known as economic profit because this amount indicates that total revenue
exceeds total cost (including the opportunity cost).
If the total revenue is equal to the total cost, then no economic profit is earned – only normal profits.
Remember that included in the total cost is the opportunity cost of self-owned resources.
If the total revenue is less than total cost, an economic loss is made.
130 ECS1501/002
In the case of Thabo, as a society, we are paying him more than is necessary to keep him in his current
position. According to his revenue and cost data, we are not only covering his explicit and implicit
costs – we are paying him an additional R40 000. By only paying him R710 000, he would still be
doing what he is doing since we have been compensating him for his opportunity cost.
To summarise:
 Accounting profit is the difference between total revenue and explicit cost.
 Economic profit is the excess between a firm's total revenue and the sum of its explicit and
implicit costs.
 Normal profit occurs when total revenue equals total cost (explicit and implicit).
 Economic loss occurs when total revenue is less than total cost (explicit and implicit).
Do the following activity to see if you understand the different cost and profit concepts:
ACTIVITY 2
2.1 Consider the following scenario:

You run your own business and your total revenue is R100 000. Your actual payments towards
your costs are R40 000. If you did not work for yourself, you could have earned R60 000
working for another firm.
If I tell you that the total cost of your business is R100 000, have I calculated your accounting
cost or your economic cost?
a. accounting cost
b. economic cost
Steven owns his own auto repair shop.
He uses his own premises as a workshop. If he had rented his premises to someone else, he would
have received R18 000 in rent.
He initially invested R50 000 in his business to buy tools and machines. If he had invested the
money, he could have earned 10% per year on the money, which is R5 000 per year.
If he did not work for himself, he could have earned a salary of R60 000.
His expenditure for the year consisted of the following:
Oil, petrol, sparkplugs, fan belts and other materials: R70 000
Salary for two junior mechanics: R35 000
Admin costs: R15 000
Assume that the total revenue of the auto shop is R230 000.
a. Identify and calculate his explicit costs.
b. Identify and calculate his implicit costs.
c. Calculate his total economic costs.
d. Calculate Steve’s accounting profit.
e. Calculate Steve’s economic profit.
f. If Steve’s revenue is R203 000, will he be making a normal profit only?
1. Yes
2. No
131 ECS1501/002
13.4 Law of diminishing returns
• describe the law of diminishing returns
The law of diminishing returns plays a central role in determining the cost of production for any kind of
business in the short run.
The law of diminishing returns states that in the short run, as more of a variable input is used,
while all the other inputs are fixed (kept the same), each additional unit of the variable input will
eventually produce less and less additional output. In economics, we say that the marginal product
(MP) of the variable input will decline.
To understand the above paragraph, work through the following example:
Our example is based on a small firm called the Blaker Maker, which manufactures garden ornaments
from steel. To produce these ornaments, the firm employs the factors of production. Since we are
dealing with the short run, we will assume that labour is the only variable input, while the other factors
such as machines and factory space are fixed.
The question we then ask is what happens to the output level for Blaker Maker if it increases the
amount of labour it uses to produce garden ornaments.
In the first column, we list the number of workers who will be employed; in the second column, we list
the total product (TP) or output that the workers produce; and in the third column, we list the marginal
product (MP) of each worker. The marginal product is the contribution that an additional worker
makes to total production.
Total product and marginal product for Blaker Maker
Variable input Total product Marginal

labour (TP) product (MP)
0 0 ---
1 500 500
2 1 500 1 000
3 3 000 1 500
4 4 000 1 000
5 4 500 500
6 4 750 250
7 4 750 0
8 4 500 -250
The first row tells us that if one worker is employed, the total product (output) of the firm is 500 units
and the contribution of the first worker to the total product – which is his marginal product – is 500
units.
132 ECS1501/002
The second row indicates that if the second worker is employed, the total product increases to 1 500
units.
What is the marginal product of the second worker?
o 500
o 1 000
o 1 500
It is 1 000. By employing the second worker, the total product increases by 1 000 units (1 500 – 5
00 = 1 000).
By how much does the total product increase if the third worker is employed?
o 500
o 1 000
o 1 500
It is 1 500. By employing the third worker, the total product increases by 1 500 units (3 000 – 1
500 = 1 500).
If you look at the marginal product of the first three workers, would you say that we are seeing
increasing returns or decreasing returns?
o Increasing returns
o Decreasing returns
Because there is an increase in each additional worker's contribution, we are looking at increasing
returns.
Why does the marginal product for the first three workers increase?
What we see here are the benefits of specialisation. The first worker has to do everything – fetch the
steel rods, cut them, bend them, weld them, paint them, put them in the store room, clean the place, and
so on. After the second worker is employed, we see the benefit of the division of labour. While the first
worker cuts the iron rods, the second worker might be busy bending them. This benefit of specialisation
increases once the third worker is employed.
Note that the higher marginal product of the third worker has nothing to do with the quality of the third
worker – we assume that they are equal in all respects. It is because of the division and specialisation
that the third worker is more productive.
What happens when the fourth worker is added?
Is there still an increase in the total product or does it decrease when the fourth worker is
employed?
o Total product increase
o Total product decrease
Total product increases from 3 000 to 4 000.
What is the marginal product of the fourth worker?

o 500
o 1 000
o 1 500
It is a 1 000 because after adding the fourth worker, total product increases from 3 000 to 4 000.
133 ECS1501/002
If you compare the marginal product of the fourth worker to that of the third worker, is it higher or
lower?
o Higher
o Lower
It is lower. For the third worker it is 1 500, while for the fourth worker it is 1 000.
Once the fourth worker is added, the total product increases by 1 000 and the marginal product of the
fourth worker is 1 000. This increase in total product, however, is lower compared to the increase when
a third worker, whose marginal product is 1 500, is added. What we see here is the start of diminishing
marginal returns. Total product increases at a diminishing rate.
This trend continues when the fifth and sixth worker are added. When the fifth worker is added, total
product increases from 4 000 to 4 500, and the marginal product of the fifth worker is 500. When the
sixth worker is added, total product rises from 4 500 to 4 750, and the marginal product of the sixth
worker is 250. It is clear that the marginal product declines as the variable input, in this case labour,
increases.
Why does this happen?
The marginal product falls because while the number of workers increases, other inputs such as the
machines and space remain fixed. The amount of other inputs available per worker declines and this
has an impact on productivity.
What one can also calculate from the data is the average product of labour, which gives one an
indication of the productivity of labour.
Total, marginal and average product
Variable input Total product Marginal product Average product

labour (TP) (MP) (AP)
0 0 --- ---
1 500 500 500
2 1 500 1000 750
3 3 000 1500 1 000
4 4 000 1000 1 000
5 4 500 500 900
6 4 750 250 792
7 4 750 0 679
8 4 500 -250 563
Average product (AP) is equal to the total product (TP) divided by the number of workers employed.
𝑻𝑻𝑻𝑻
𝑨𝑨𝑨𝑨 =
number of workers
134 ECS1501/002
For instance, for five workers, the average product is:
4 500
=
5
= 900
What one can also observe from the figures is that it first increases and then starts to decrease. This is
because of the law of diminishing returns.
Read the following paragraph again and decide whether you understand the meaning. If not work
through the example again.
The law of diminishing returns states that, as more of a variable input is used, while all the other inputs
are fixed (remain the same), each additional unit of the variable input will eventually produce less and
less additional output. In economics, we say that the marginal product (MP) of the variable input
declines.
If you are confident that you understand the law of diminishing returns do the following activity:
ACTIVITY 3
3.1 Indicate whether the following statements relating to the law of diminishing returns
is true or false:
T F
a. The law of diminishing returns only applies if the variable input is labour.
b. If all inputs change, the law of diminishing returns does not apply

You have a plot of land on which you are going to grow carrots. You have a spade, which is your
capital good, a certain amount of seeds and water, your intermediate inputs and yourself, the
entrepreneur.
Your variable input is the amount of fertiliser you are going to use.
Let’s assume that if you do not use any fertiliser, your harvest (total product) is 10 kg. By adding
the first kg of fertiliser, your harvest (total product) increases to 20 kg. By adding a the adding kg
of fertiliser, your total product increases to 32 kg. By adding a third kg of fertiliser, it increases to
40 kg, and by adding a fourth kg of fertiliser it increases to 46 kg.
135 ECS1501/002
a. Use this information to complete the following table by calculating the marginal product of
fertiliser:
Amount of Total product Marginal

fertiliser (kg) product
(kg)
0 10 ---
1 20
2 32
3 40
4 46
b. If a fifth kg of fertiliser is added, it will increase total product by (more than, less than)
6 kg.
c. Do you agree with the following statement?
By adding more and more fertiliser to a fixed plot of land, the harvest will continuously
increase.
1. Agree
2. Disagree
Total product and marginal product as graphs

• present total product and marginal product with the aid of diagrams
• describe the relationship between total product and marginal product
136 ECS1501/002
The following data about the production of Blaker Maker can be used to graphically illustrate the
production function and law of diminishing returns.
To construct the production function, the

total product or output is plotted on the
vertical axis, while the number of
labourers is plotted on the horizontal axis.
Production for Blaker Maker
Variable input Total product

labour (TP)
0 0
1 500
2 1 500
3 3 000
4 4 000
5 4 500
6 4 750
7 4 750
8 4 500
Joining the points gives us our production

function for Blaker Maker.
If you look closely at the above graph of the production function for Blaker Maker, you will see that
total production increases at an increasing rate until the third worker is employed. Thereafter total
production continues to increase, but at a decreasing rate until the seventh worker is employed. It then
starts to decline.
To demonstrate the law of diminishing returns, we will use the marginal product for Blaker Maker that
we calculated previously.
137 ECS1501/002
The marginal product is indicated on the vertical axis, while the number of workers (labour) is
indicated on the horizontal axis.
Marginal product for Blaker Maker
Variable Total Marginal

input product product
labour (TP) (MP)
0 0 ---
1 500 500
2 1 500 1000
3 3 000 1500
4 4 000 1000
5 4 500 500
6 4 750 250
7 4 750 0
8 4 500 -250
Joining the points gives us our marginal

product for Blaker Maker.
If you look more closely at the diagram, you will notice that the marginal product increases up to the
third worker, it then decreases until the seventh worker and then becomes negative.
By comparing the marginal product diagram with the production function diagram we can see the
relationship between marginal product and production function.
Marginal product for Blaker Maker Production function for Blaker Maker
If the marginal product increases, then the total product increases at an increasing rate, and when
marginal product decreases, total product increases at a decreasing rate. When marginal product is
negative, total production declines.
138 ECS1501/002
Do the following activity to see if you understand the graphical representation of the law of
diminishing returns:
ACTIVITY 4
4.1 The diagram below represents the production function for Best Barber. Study this diagram and
answer the question.
a. What is the marginal product of the second barber?

b. What is the marginal product of the fifth barber?
c. What is the maximum number of haircuts that Best Barber can reach?
d. How many barbers should Best Barber employ to reach its maximum output?
e. At what point does the marginal product start to diminish?
f. At what point does total product start to decrease?
4.2 According to the law of diminishing returns ____________.
a. the total product declines as more units of a variable factor are added to a fixed factor
b. the marginal product eventually increases as more units of a variable factor are added to a
fixed factor
c. the marginal product of a variable factor eventually declines as more units of it are added to
a fixed factor
d. as long as the marginal product is positive, total product will decrease
13.5 Cost of production

The cost of producing a firm’s output depends on how much labour and physical capital the firm uses.
A list of the costs involved in producing cars looks very different from the costs involved in producing
computer software or haircuts or fast-food meals. However, the cost structure of all firms can be broken
down into some common underlying patterns. When a firm looks at its total costs of production in the
short run, a useful starting point is to divide total costs into two categories: fixed costs that cannot be
changed in the short run and variable costs that can be changed.
139 ECS1501/002
Fixed and variable costs
• distinguish between fixed and variable costs
Fixed costs are expenditures that do not change regardless of the level of production, at least not
in the short run. Whether you produce a lot or a little, the fixed costs are the same. One example is the
rent on a factory or a retail space. Once you sign the lease, the rent is the same regardless of how much
you produce, at least until the lease runs out. Fixed costs can take many other forms: for example, the
cost of machinery or equipment to produce the product, research and development costs to develop new
products, or even an expense like advertising to popularise a brand name. The level of fixed costs
varies according to the specific line of business: for instance, manufacturing computer chips requires an
expensive factory, but a local moving and hauling business can survive with almost no fixed costs at all
if it rents trucks by the day when needed.
Variable costs, however, are incurred in the act of producing – the more you produce, the greater
the variable cost. The cost of labour is treated as a variable cost, since producing a greater quantity of a
good or service typically requires more workers or more work hours. Variable costs would also include
the cost of raw materials.
Consider the following cost items for a barbershop called Best Barber and identify the fixed costs
and the variable costs:
Fixed cost Variable cost

Wages for barbers o o
Rent for the premises o o
Cost of equipment o o
Electricity o o
Advertising o o
Variable cost varies with output, and in this example, it would probably be wages for barbers and
electricity.
Fixed cost does not vary with output, and in this example, it would probably be rent for the
premises and advertising.
Fixed and variable costs for Best Barber

To explain fixed and variable costs in more detail, we will make use of an example of a barbershop
called Best Barber.
It is estimated that the total fixed cost, which includes the space and equipment, is R320 per day. The
total variable cost is the cost of hiring barbers and is estimated at R160 per barber per day. This
information is provided in the following table:
140 ECS1501/002
Total cost for Best Barber
Total fixed Total variable

Quantity of Total cost
Labour costs cost
haircuts TC
TFC TVC
TP (rand)
(rand) (rand)
0 0 320 0 320
1 16 320 160 480
2 40 320 320 640
3 60 320 480 800
4 72 320 640 960
5 80 320 800 1 120
6 84 320 960 1 280
7 82 320 1 120 1 440
In the first column, the quantity of barbers employed is given, and in the second column, the quantity
of haircuts (total product) the business produces per day.
Study the first two columns of the total cost table for Best Barber and answer the following
questions:
By how much does the quantity of haircuts increase if the quantity of barbers increases from three
to four?
o 24
o 20
o 12
o 8
o 4
It increases by 12. The marginal product of the fourth worker is therefore 12.
If you look closely at columns 1 and 2, you will see that as more barbers are employed, the quantity of
haircuts increases.
As more barbers are employed (from 3 to 6), the quantity of haircuts increases, but it increases at a
________ rate.
o diminishing
o increasing
o constant
It increases at a diminishing rate (20, 12, 8 and 4) since the law of diminishing returns apply.
Column 3 indicates the total fixed cost for the different quantities of haircuts (output). Of importance
here about the total fixed cost is that it is the same, namely R320, for the different output levels.
141 ECS1501/002
The total fixed cost is the same for all levels of output because it involves _________.
o payments the firm must make in the short run regardless of its output level
o cost, which is under control of the management of the firm
The total fixed cost is in fact payments that do not vary with the level output, and one can say that
it is not under the control, at least in the short run, of the management of the firm.
The fourth column indicates the total variable cost. Since labour is the only variable cost, the total
variable costs for the different quantities of haircuts are calculated by multiplying the quantity of labour
(barbers) by the wage paid. For example, three barbers would cost 3 × R160 = R480, and the variable
cost associated with an output level of 60 haircuts is R480. This is entered in column 4.
If you look closely at column 4, you will notice that as the level of output (haircuts) increases, the total
variable cost rises as well. This is because total variable cost is linked to the level of output, and the
higher the level of output, the higher the total variable cost is.
What is the total variable cost associated with an output level of 60 haircuts?
What is the total variable cost associated with an output level of 80 haircuts?
For 60 haircuts it is R480, and for 80 haircuts R800.
Labour costs cost
haircuts TC
TFC TVC
TP (rand)
(rand) (rand)
0 0 320 0 320
1 16 320 160 480
2 40 320 320 640
3 60 320 480 800
4 72 320 640 960
5 80 320 800 1 120
6 84 320 960 1 280
7 82 320 1 120 1 440
The fifth column indicates the total cost for the different output levels. The total cost is calculated by
adding the fixed costs in the third column and the variable costs in the fourth column since:
Total cost = total fixed cost + total variable cost
TC = TFC + TVC
Therefore, for example, for an output level of 72 haircuts, the total cost would be R320 + R640 = R960.
142 ECS1501/002

Labour costs cost
haircuts TC
TFC TVC
TP (rand)
(rand) (rand)
0 0 320 0 320
1 16 320 160 480
2 40 320 320 640
3 60 320 480 800
4 72 320 640 960
5 80 320 800 1 120
6 84 320 960 1 280
7 82 320 1 120 1 440
If you look closely at column 5, you will notice that as the level of output (haircuts) increases, the total
cost rises as well. This is because the total variable cost increases as more is produced. Notice that the
total fixed cost does not change as the level of output increases.
o What is the total cost associated with an output level of 60 haircuts?
o What is the total cost associated with an output level of 80 haircuts?
For 60 haircuts, it is R800 and for 80 haircuts, it is R1 120.
Do the following activity to see if you understand the difference between total fixed and total variable
costs:
ACTIVITY 5
5.1 As the level of production decreases in the short run, fixed cost __________.
a. stays the same, while variable cost increases
b. decreases, while variable cost decreases
c. increases with less than variable cost
d. stays the same, while variable cost decreases
143 ECS1501/002
5.2 The table below provides the cost data for Blaker Maker, a firm that manufactures garden
ornaments. Fill in the missing values.
Quantity of Total fixed Total variable Total cost

ornaments Q costs cost TC
TFC TVC (rand)
(rand) (rand)
0
1 000 20 000 30 000 50 000
2 000 20 000 70 000
3 000 20 000 65 000
4 000 85 000 105 000
5 000 20 000 110 00
6 000 150 00 170 000
7 000 20 000 230 000
Fixed cost, variable cost and total cost curves

• present fixed cost, variable cost and total cost aid of diagrams
• describe the relationship between total product and marginal product
We can now use the data for the total fixed cost (TFC), total variable cost (TVC) and total cost (TC) of
Best Barber to graphically construct the total fixed cost curve, the total variable cost curve and the total
cost curve.
On the vertical axis, we measure the costs in rand and on the horizontal axis the level of output in terms
of the quantity of haircuts.
144 ECS1501/002
In the table below, first select the fixed cost data, then the variable cost data, and finally the total cost
data to see how the points are plotted on the graph.

Total Total
Quantity
fixed variable Total cost
of
Labour costs cost TC
haircuts
TFC TVC (rand)
TP
(rand) (rand)
0 0 320 0 320
1 16 320 160 480
2 40 320 320 640
3 60 320 480 800
Total fixed cost (TFC), total variable cost
4 72 320 640 960
(TVC) and total cost (TC)
5 80 320 800 1 120
6 84 320 960 1 280
7 82 320 1 120 1 440
Note the following about the cost curves:

The shape of the total cost curve is the same as the shape of the total variable cost curve. This is
because the total fixed cost curve does not vary as the level of output varies.
The vertical distance between the total cost curve and the total variable cost curve is equal to the fixed
costs. The total cost if the level of output at zero is R320, which is equal to the fixed cost.
The difference between total cost and total variable cost is the total fixed cost
Once production starts, total costs and variable costs rise. While variable costs may initially increase at
a decreasing rate at some point, they begin increasing at an increasing rate. This is caused by
diminishing marginal returns.
145 ECS1501/002
Do the following activity to see if you understand the different cost curves:
146 ECS1501/002
ACTIVITY 6
The diagram below indicates the fixed cost, variable cost and total cost curve for Blaker Maker:
These cost curves are based on the following data:

TFC TVC (rand)
(rand) (rand)
0 20 000 0 20 000
1 000 20 000 30 000 50 000
2 000 20 000 50 000 70 000
3 000 20 000 65 000 85 000
4 000 20 000 85 000 105 000
5 000 20 000 110 00 130 000
6 000 20 000 150 00 170 000
7 000 20 000 210 000 230 000
a. Identify the different curves:

Curve 1 ________
Curve 2 ________
Curve 3 ________
b. The vertical distance between the total cost curve and the variable cost curve is equal to
________.
c. The shape of the total cost curve is determined by the shape of the ________.
1. total fixed cost curve
2. total variable cost curve
147 ECS1501/002
d. Choose the correct terms in brackets.
According to the total variable cost curve, up to an output level of 3 000, total variable cost
increases for every 1 000 units by (lower amounts; higher amounts), while from 3 000 it increases
for every 1 000 units by (lower amounts; higher amounts).
Marginal cost
• describe marginal cost

• calculate marginal cost
Marginal cost is the additional cost of producing one more unit of output. It is therefore not the
cost per unit of all units being produced, but only the next one.
If data on total cost is available in increments of one unit of output, it is easy to calculate it, as the
following activity demonstrates.
The following data is provided:

The total cost to produce three units = R100.
The total cost to produce four units = R110.
The total cost to produce five units = R122.
o Calculate the marginal cost of producing the fourth unit.
o Calculate the marginal cost of producing the fifth unit.
The marginal cost of producing the fourth unit = the total cost of producing four units – the total
cost to produce three units = R110 – R100 = R10. The marginal cost of producing the fifth unit =
the total cost of producing five units – the total cost to produce four units = R122 – R120 = R12.
Let's take an example where we have production data for intervals of more than one unit change, as in
the case of Best Barber.
At an output level of 72 haircuts, the total cost is R960.
At an output level of 80 haircuts, the total cost is R1 120.
In this case, the marginal cost is calculated by taking the change in total cost and dividing it by
the change in total product.
𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒊𝒊𝒊𝒊 𝑻𝑻𝑻𝑻
𝑀𝑀𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 =
𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒊𝒊𝒊𝒊 𝑻𝑻𝑻𝑻
The change in total cost (TC):
= the total cost of 80 haircuts - the total cost of 72 haircuts
= 𝑅𝑅1 120 − 𝑅𝑅960
= 𝑅𝑅160
The change in quantity (TP):
= 80 ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 − 72 ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
= 8 ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
148 ECS1501/002
The marginal cost is therefore
𝑅𝑅160
=
8
= 20
Use the following data to calculate the marginal cost:
At an output level of 40, the total cost is R640.

At an output level of 60, the total cost is R800.
The marginal cost is therefore R _______.
The change in total cost is R800 – R640 = R160.
The change in haircuts = 60 – 40 = 20.
The marginal cost = R160 ÷ 20 = R8.
In the following table, the marginal cost of haircuts for Best Barber is added to the cost data:
The marginal cost of haircuts for Best Barber
Total Total
Quantity Total Marginal
Quantity fixed variable
of cost cost
of labour costs costs
haircuts (TC) (MC)
(TFC) (TVC)
(rand) (rand)
(rand) (rand)
0 0 320 0 320 ---
1 16 320 160 480 10,00
2 40 320 320 640 6,67
3 60 320 480 800 8,00
4 72 320 640 960 13,33
5 80 320 800 1 120 20,00
6 84 320 960 1 280 40,00
7 82 320 1 120 1 440 80,00
The data used to calculate marginal cost is highlighted, and the formula that is used is
∆ 𝑻𝑻𝑻𝑻
𝑴𝑴𝑴𝑴 =
∆ 𝑸𝑸
The important thing to notice about marginal cost is that it first decreases, reaches a minimum and then
increases. It is the increasing part of marginal cost that we are mainly interested in.
Do the following activity to see if you understand marginal cost:
149 ECS1501/002
ACTIVITY 7
Complete the following table for the marginal cost for Blaker Maker, a firm that manufactures garden
ornaments by filling in the correct amounts:
Total
Marginal
Quantity of Total fixed variable Total cost
cost
ornaments cost TFC cost TC
MC
TP (rand) TVC (rand)
(rand)
(rand)
0 20 000 0 20 000 ---
1 000 20 000 30 000 50 000 30
2 000 20 000 50 000 70 000 20
3 000 20 000 65 000 85 000
4 000 20 000 85 000 105 000 20
5 000 20 000 110 00 130 000
6 000 20 000 150 00 170 000 40
7 000 20 000 210 00 230 000
Marginal cost curve
• present marginal cost with the aid of a diagram
Based on the data for Best Barber, we can now draw the marginal cost curve.
150 ECS1501/002
The marginal cost is measured on the vertical axis, while the quantity of haircuts is measured on the
horizontal axis.
Marginal cost for Best Barber

Quantity Total Marginal
Quantity
of cost cost
of labour
haircuts (TC) (MC)
(rand) (rand)
0 0 320 ---
1 16 480 10,00
2 40 640 6,67
3 60 800 8,00
4 72 960 13,33 Marginal cost curve
5 80 1 120 20,00
6 84 1 280 40,00
Joining the points gives us the marginal cost curve.

To summarise:
As total product increases, marginal cost first decreases, reaches a minimum and then increases.
151 ECS1501/002
Now do the following activity to see if you understand the marginal cost curve:
ACTIVITY 8
The following diagram represents the marginal cost for Blaker Maker:
8.1 Until what unit of production does the marginal cost decrease?
8.2 At what output level is the marginal cost the lowest?
8.3 As Blaker Maker increases production from 5 000 to 6 000 to 7 000, marginal cost increases.
This increase in marginal cost is by ________.
a. lower amounts
b. higher amounts
c. the same amounts
13.6 Relationship between production and costs

• describe the relationship between production and costs
What determines the shape of the marginal cost curve? In order to answer this question, we need to go
back to the law of diminishing returns, which states that as more of a variable input is used, while all
the other inputs are fixed (remain the same), each additional unit of the variable input will eventually
produce less and less additional output. In economics, we say that the marginal product (MP) of the
variable input will decline.
In our example of Best Barber, the variable input is the number of barbers and the output is the quantity
of haircuts. The marginal product is the contribution each additional haircutter adds to total haircuts.
152 ECS1501/002
Total product and marginal product of barbers
Quantity of Quantity of Marginal
labour haircuts product
Q TP MP
0 0 ---
1 16 16
2 40 24
3 60 20
4 72 12
5 80 8
6 84 4
As the number of barbers increases from zero to one in the table, output increases from zero to 16 for a
marginal gain of 16; as the number rises from one to two barbers, output increases from 16 to 40, a
marginal gain of 24. From that point onwards, however, the marginal gain in output diminishes as each
additional barber is added. For example, as the number of barbers rises from two to three, the marginal
output gain is only 20; and as the number rises from three to four, the marginal gain is only 12.
To understand the reason behind this pattern, consider that a one-man barbershop is an extremely busy
operation. The single barber needs to do everything: greet clients entering the shop, answer the phone,
cut hair, sweep up and operate the cash register. A second barber reduces the level of disruption from
jumping back and forth between these tasks, and allows a greater division of labour and specialisation.
The result can be greater increasing marginal returns. However, as other barbers are added, the
advantage of each additional barber is less, since the specialisation of labour can only go so far. The
addition of a sixth, seventh or eighth barber simply to greet people at the door will have less impact
than the second barber did. This is the pattern of diminishing marginal returns. At some point, you may
even see negative returns as the additional barbers begin bumping elbows and getting in each other’s
way. In this case, the addition of still more barbers would actually cause output to decrease.
How does this then influence marginal cost?
In our example. we assumed that a barber is paid R160 per day, which is the variable cost. Every time a
barber is added, the variable cost increases by R160.
If the first barber is added, the marginal product of this barber is 16 haircuts. The marginal cost is the
𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
and since change in haircuts is equal to the marginal product, it can be written as
𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑝𝑝𝑟𝑟𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜
Therefore, the marginal cost for the first barber is

𝑅𝑅160
=
16
= 𝑅𝑅10
153 ECS1501/002
Answer the following questions:
o What is the marginal cost for the second barber?
o What is the marginal cost for the third barber?
For the second barber it is 160 ÷ 24 = R6,67 and for third barber R160 ÷ 20 = R8,00.
In the following table the marginal cost is added.

Marginal product and marginal cost for Best Barber
Quantity Quantity Total cost Marginal

Marginal
of labour of haircuts (TC) cost
product
(rand) (MC)
(MP)
(rand)
0 0 --- 320 ---
1 16 16 480 10,00
2 40 24 640 6,67
3 60 20 800 8,00
4 72 12 960 13,33
5 80 8 1 120 20,00
6 84 4 1 280 40,00
Look closely at the data for the marginal product and marginal cost.
What happens to marginal cost if marginal product increases from 16 to 24?

o It increases.
o It decreases.
It decreases. As the marginal product increases from 16 to 24, the marginal cost decreases from
R10 to R6,67.
What happens to marginal cost if marginal product decreases from 20 to 12?
o It increases.
o It decreases.
It increases. As the marginal product decreases from 20 to 12, the marginal cost increases from
R8,00 to R13,33.
What we can conclude from this is as marginal product increases, marginal cost decreases, and as
marginal product decreases, marginal cost rises. The law of diminishing returns is therefore the reason
why marginal cost rises.
Graphically, this can be depicted as follows:
154 ECS1501/002
The declining part of the marginal product curve indicates the law of diminishing returns, while the
rising part of the marginal cost curve indicates the impact of the law of diminishing returns on marginal
cost.
The diagram shows the marginal product of The diagram indicates the marginal cost curve
barbers (labour). At first, by adding a barber, for haircuts, and it is the inverse of the marginal
the marginal product rises, but then starts to fall product curve. As the marginal product rises,
and the law of diminishing returns sets in. the marginal cost declines, and as the marginal
product falls, the marginal cost increases.
155 ECS1501/002
Do the following activity to see if you understand the relationship between production and costs:
ACTIVITY 9
Complete the following paragraphs by selecting the correct options:

The following two diagrams represent the marginal product and the marginal cost for Blaker Maker:
Variable input Marginal Quantity of Marginal cost

labour product (MP) ornaments MC (rand)
Q
0 ---
0 ---
1 500
1 000 30
2 1000
2 000 20
3 1500
3 000 15
4 1000
4 000 20
5 500
5 000 25
6 250
6 000 40
7 0
7 000 60
9.1 By adding the first three workers, the marginal product (increases; declines). After adding the
fourth, fifth, sixth and seventh workers, marginal product (increases; decreases). The law of
diminishing returns is represented by the (rising; falling) part of the marginal product curve.
9.2 The marginal cost (falls; rises) for the first 3 000 units. After increasing production from 4 000 to
7 000, the marginal cost (falls; rises).
9.3 As marginal product rises, marginal cost (rises; falls), and as marginal product decreases,
marginal cost (rises; falls).
156 ECS1501/002
ANSWERS TO THE
ACTIVITIES
Activity 1
1.1 c. It occurs when the positive difference between total revenue and total cost is at its greatest.
1.2
a. 700
Column 4 indicates the profit, which is the difference between total revenue and total cost. Since
maximum profit is where the positive difference between total revenue and total cost is the
greatest, the firm should build 700 houses. By building more houses, the firm still makes a profit,
but it is not its point of maximum profits.
Number of houses Total cost Total revenue Profits

500 R26 million R40 million R14 million
b. 900
To maximise employment opportunities, BC Construction needs to build 900 houses as this will
require the most number of labourers. Note that this does not necessarily correspond to the firm's
profit maximisation position, which occurs at 700 houses.

157 ECS1501/002
c. 900
To maximise revenue, BC Construction should build 900 houses, since it is for this number of
houses that total revenue is the greatest. Note that this does not necessarily correspond to the
firm’s profit maximisation position, which occurs at 700 houses.

Activity 2
2.1 Economic cost

The actual payments, which are what the accountant calculates, are R40 000. This is the explicit
cost only. The economic cost is equal to the explicit cost plus the implicit cost. In includes both
the R40 000, which is the actual payments (explicit cost), and the R60 000 you could have earned
(the implicit cost), which is equal to R100 000.
2.2
a. His explicit costs are as follows:
Oil, petrol, sparkplugs, fan belts and other materials: R70 000
Salary for two junior mechanics: R35 000
Admin costs: R15 000
b. His implicit costs are:
Use of his own premises: R18 000
Return on investment: R5 000
Opportunity cost of working for himself: R60 000
c. His total economic cost = explicit costs + implicit costs = R120 000 + R83 000 = R203 000.
d. His accounting profit is:
Total revenue – explicit costs = R230 000 – R120 000 = R110 000.
e. His economic profit is:
Total revenue – economic costs = R230 000 – R203 000 = R27 000.
f. Yes. Normal profit occurs when total revenue equals total cost (explicit and implicit).
Included in his implicit cost is his opportunity cost.
158 ECS1501/002
Activity 3
3.1
a. False
The law of diminishing returns applies to any input. If you keep everything else constant and,
say, increase the number of machines, the marginal product of the machines will eventually
decrease.
b. True.
The law of diminishing returns only applies to the short run, and the short run is defined as the
period in which all the inputs are fixed except one.
3.2
a.
Amount of Total product Marginal

fertiliser (kg) product
(kg)
0 10 ___
1 20 10
2 32 12
3 40 8
4 46 6
b. It will be less than 6 kg because the law of diminishing returns is in operation.

c. You should disagree with the statement. As more and more fertiliser is added, the law of
diminishing returns will eventually cause the marginal product to become negative.
Activity 4
4.1
a. As the second barber is added, the total product (the quantity of haircuts) increases by
40 – 16 = 24 as can be seen from the following diagram:
159 ECS1501/002
b. As the fifth barber is added, the total product (the quantity of haircuts) increases by
80 – 72 = 8 as can be seen from the following diagram:
c. It is 84, as indicated by the following diagram:
d. It is six barbers.
160 ECS1501/002
e. It is after the third barber, as indicated in the following diagram:
f. Total product reaches its maximum when six barbers are employed and then starts to
decrease.
4.2 c
According to the law of diminishing returns, as more of a variable input is added to fixed inputs,
total product will increase, but at a diminishing rate. In other words, the marginal product
decreases.
Activity 5
5.1 d
It is true that fixed cost stays the same. Variable cost, however, varies as the level of output
varies. If the level of output decreases, variable cost decreases, while fixed cost stays the same.
161 ECS1501/002
5.2

TFC TVC (rand)
(rand) (rand)
0 20 000 0 20 000
1 000 20 000 30 000 50 000
2 000 20 000 50 000 70 000
3 000 20 000 65 000 85 000
4 000 20 000 85 000 105 000
5 000 20 000 110 00 130 000
6 000 20 000 150 00 170 000
7 000 20 000 210 00 230 000
Note that the fixed cost of R20 000 stays the same for all levels of output, including an output
level of zero. At an output level of zero, however, the variable cost is zero and the total cost is
therefore R20 000.
Total cost (TC) = fixed cost (FC) + variable cost (VC). At an output level of 3 000, total cost is
therefore R20 000 + R65 000 = R85 000.
Variable cost (VC) = total cost (TC) – fixed cost (FC). At an output level of 20 000, the variable
cost is therefore R70 000 – R20 000 = R50 000.
Activity 6
a. Curve 1 is the total fixed cost (TFC) curve.
Curve 2 is the total variable cost curve.
Curve 3 is the total cost curve.
162 ECS1501/002
b. It is equal to R20 000, which is the fixed cost.
c. It is determined by the shape of the total variable cost curve.

d. According to the total variable cost curve, up to an output level of 3 000, total variable cost
increases for every 1 000 units by lower amounts, while from 3 000, it increases for every
1 000 units by higher amounts.
Activity 7
Marginal cost is calculated by taking the change in total cost and dividing it by the change in total
product.
∆ 𝑇𝑇𝑇𝑇
𝑀𝑀𝑀𝑀 =
∆ 𝑇𝑇𝑇𝑇
For the 3 000th unit, it is
𝑅𝑅85 000 − 70 000
𝑀𝑀𝑀𝑀 =
3 000 − 2000
= 𝑅𝑅15
𝑅𝑅130 000 − 105 000
𝑀𝑀𝑀𝑀 =
5 000 − 4000
= 𝑅𝑅25
𝑅𝑅230 000 − 170 000
𝑀𝑀𝑀𝑀 =
7 000 − 6000
= 𝑅𝑅60
163 ECS1501/002
Total
Marginal
Quantity of Total fixed variable Total cost
cost
ornaments cost TFC cost TC
MC
TP (rand) TVC (rand)
(rand)
(rand)
0 20 000 0 20 000 ---
1 000 20 000 30 000 50 000 30
2 000 20 000 50 000 70 000 20
3 000 20 000 65 000 85 000 15
4 000 20 000 85 000 105 000 20
5 000 20 000 110 00 130 000 25
6 000 20 000 150 00 170 000 40
7 000 20 000 210 00 230 000 60
Activity 8
8.1 It is at 3 000 ornaments.

8.2 It is at 3 000 ornaments.
8.3 Marginal cost increases by higher amounts.
164 ECS1501/002
Activity 9
9.1 By adding the first three workers, the marginal product increases. After adding the fourth, fifth,
sixth and seventh worker, marginal product decreases. The law of diminishing returns is
represented by the falling part of the marginal product curve.
165 ECS1501/002
9.2 The marginal cost falls for the first 3 000 units. After increasing production from 4 000 to 7 000,
the marginal cost rises.
9.3 As marginal product rises, marginal cost falls, and as marginal product decreases, marginal cost
rises.
166 ECS1501/002
CHECKLIST
Well Satis- Must

factory redo
I am able to
identify the goal of the firm
define profit maximisation
distinguish between explicit and implicit costs
define economic costs of production
distinguish between accounting profit, economic profit and normal
profit
describe the law of diminishing returns
distinguish between total product, marginal product and average
product
distinguish between fixed, variable, total and marginal cost
describe the relationship between marginal product and marginal cost
Diagrams
I am able to
the relationship between total and marginal product
the law of diminishing returns
the relationship between total fixed, total varibale and total cost
marginal cost
the relationship between marginal product and marginal cost
Calculations
I am able to calculate
explicit and implicit cost
accounting and economic profit
total product, marginal product and average product
total cost, total variable cost and marginal cost
167 ECS1501/002
Perfect and imperfect
competition 14
OVERVIEW
We have now arrived at a point where it is possible to lay the foundation for how, in a perfectly
competitive market system, the economic problem of what to produce, how to produce and for whom
to produce is solved.
We start the section with an explanation of the requirements of perfect competition. We then take a
closer look at how a firm will behave in this perfect competitive world.
TOPIC OUTCOME
• explain and illustrate the output decision of a firm under perfect competition
• explain and illustrate the profit position of a firm under perfect competition
14.1 Requirements of perfect competition

• identify the requirements of perfect competition
The following are the requirements which must exist in a market for it to be considered perfectly
competitive:
 There must be a large number of buyers (consumers) in the market.
 There must be a large number of sellers (suppliers) in the market.
 There should be no collusion between sellers.
 All goods sold in the market must be homogeneous.
 Buyers and sellers must have complete freedom of entry and exit into and out of the market.
 All buyers and sellers must have perfect knowledge of market conditions.
 There must be no government intervention.
 All factors of production must be perfectly mobile.
While it will be difficult to find a market that meets all of the above requirements, most markets have
elements of a perfectly competitive market.
168 ECS1501/002
Select all the elements of perfect competition you think the South African telecommunications
market (Cell C, Vodacom, Telkom, MTN etc.) has?
o Large number of buyers
o Large number of sellers
o No collusion between sellers
o Homogeneous goods
o Complete freedom to enter and exit
o Perfect knowledge of market conditions
o No government intervention
o Perfectly mobile factors of production
From the following discussion, you will see that there are many buyers, a fairly homogenous
product and no collusion.
It is estimated that there are 59 million cell phones in use in South Africa, which means that there
are definitely a huge number of buyers in the market. The reason for the requirement of having
many buyers is to ensure that a buyer or a group of buyers cannot manipulate the market price. For
perfect competition to exist, buyers must be price takers.
Collusion occurs when rival firms cooperate to their advantage. This usually involves price fixing
between rival firms. There is currently no evidence of this having occurred in the
telecommunications market. A requirement for a perfect market is then also that there must be
many suppliers to ensure that a supplier or group of suppliers cannot manipulate the market price
through their actions. In a perfect competitive market, sellers have small market shares and are
also price takers.
While the quality of service may differ between the operators, they provide a fairly homogeneous
good to the market. What happens here is that suppliers try to differentiate their product through
advertising and offering contracts that are different from those of their competitors. This gives
them some control over the price they can charge. In perfect competition, there is no product
differentiation in that the product is perfectly homogeneous. The product of one supplier cannot be
distinguished for another supplier in that the product has the same characteristics and quality.
Which elements of perfect competition do you think the following market for tomatoes has?
169 ECS1501/002
o Large number of buyers
o Large number of sellers
o No collusion between sellers
o Homogeneous goods
o Complete freedom to enter and exit
o Perfect knowledge of market conditions
o No government intervention
o Perfectly mobile factors of production
What one finds in this market is that there are probably many buyers and many sellers and that the
product that is sold is homogeneous.
Complete freedom of entry and exit requires that it must be possible for firms and buyers to
easily enter and exit a market. There are no barriers to entry in the form of legal, financial,
technological, physical or other restrictions that inhibit the free movement of buyers, sellers and
producers. This means that new firms can enter the market to compete with existing firms.
Perfect knowledge of market conditions requires that buyers are aware of the price charged by
sellers and that sellers are aware of the price charge by other sellers. This ensures that a seller
cannot charge a buyer a higher price than the other sellers, and sellers will not sell at a price lower
than other sellers. This requirement of perfect knowledge also extends to issues such as use of
technology, different production techniques and availability and the cost of factors of productions.
Under perfect competition, all firms have access to the same information.
Perfect mobility of the factors of production implies that land, labour and capital can be moved
according to changing market conditions. This ensures that the factors of production are allocated
in the most efficient manner.
Perfect completion also requires that there is no government intervention in the market. It is left
to the forces of demand and supply to sort out the economic problem of what to produce, how to
produce and for whom to produce.
Given the requirements of perfect competition, which of the following markets do you think
satisfies all the requirements?
o The stock exchange
o The market for electricity
o The foreign exchange market
o The maize market
o None of the above.
None of the above would be the safest choice here because in the real world, there is no market
that can fulfil all the requirements of perfect competition.
While some markets are closer to perfect competition than others, there is no market in the real world
that satisfies all the requirements. For instance, while the stock exchange market and the foreign
exchange market closely resembles perfection competition there are however restrictions on entering
and information might be costly to acquire and can be complex to understand.
In South Africa, the market for electricity is dominated by only one supplier and therefore violates the
principle of many sellers. To enter the maize market as a supplier might also be difficult.
170 ECS1501/002
At this stage, you are probably asking why one needs to study perfect competition if it is only a
theoretical ideal. We can still learn a lot about how a firm operates and what motivates an
entrepreneur’s decisions. Once we understand the basic principles underlying the theory of the firm
under perfect competition, we can start to explore how a firm operates in a more complex environment.
ACTIVITY 1
Indicate whether the following statements relating to perfect competition is true or false:
T F
1.1 Under perfect competition, buyers are price takers, while suppliers are price
makers.
1.2 Under perfect competition, a producer is a price taker since it cannot influence
the market price and has to take the market price as given.
1.3 Perfect competition can only exist if the goods sold in the market by different
sellers are identical or homogeneous.
1.4 Perfect competition is characterised by a large degree of government

intervention.
1.5 Perfect competition represents a standard or norm against which the functioning
of all other markets can be compared.
14.2 The demand curve of the perfectly competitive firm
• derive the demand curve for a perfectly competitive firm
Let's assume that the market for fried chicken pieces is a perfectly competitive market. There are many
buyers and sellers in this market, the suppliers produce a homogeneous good, there is no collusion
between the sellers and buyers, and firms are free to enter and exit the market as they wish. In addition,
we also assume there is perfect knowledge about market conditions, there is no government
intervention in the market, and the factors of production in the market are perfectly mobile.
In this market, suppliers of fried chicken pieces are price takers. A price taker is a firm that has no
control over the price at which it is able to sell its product. But how do firms know which price they are
supposed to "take" or charge?
In a perfectly competitive market, the price of a product is determined by the forces of market demand
and market supply; and the price is set at such a level that the quantity demanded is equal to the
quantity supplied. In terms of the demand and supply curves, this occurs where the market demand and
the market supply curves intersect. Do you remember how the market equilibrium price is determined?
If not, refer back to the unit on market equilibrium.
171 ECS1501/002
Market for fried chicken pieces
Let's take a closer look at what it means for an individual firm to be a price taker.
As an example, we will use Funky Chicken, which is a supplier of fried chicken pieces in the market
for fried chicken pieces.
The market for fried chicken, which is represented in diagram A, consists of the market demand and
market supply of fried chicken pieces. Given this market demand and market supply, the equilibrium
price is established at R4 and the equilibrium quantity at 100 000 fried chicken pieces.
Diagram A Diagram B
In diagram B, the position of the individual supplier of fried chicken pieces, Funky Chicken, is
represented. Since Funky Chicken is a price taker, it has to take the price of R4 as given and sell its
fried chicken pieces at R4. By extending the market price of R4 to diagram B as a horizontal line, the
demand curve facing the individual firms is derived. This demand curve is perfectly elastic and
indicates that Funky Chicken can sell any quantity at a price of R4. Remember that Funky Chicken has
a small market share since there are many sellers in the market.
Why can it not sell chicken pieces for R5? It is selling the same product as other suppliers, and since
buyers know that they can obtain a piece of fried chicken for R4, nobody would be prepared to buy it
for R5. Why not sell a piece of fried chicken for R3? Because Funky Chicken knows that it can sell all
its fried chicken pieces for R4, and because it wishes to maximise its profits, it would be irrational for
the business to sell it for R3 if it can obtain R4 for a piece of fried chicken.
Change in the market and the individual demand curve

• demonstrate how a change in the market influences the demand curve for a firm
172 ECS1501/002
We have now learnt that the perfectly competitive firm is a price taker. So what implications would a
change in the market have for the individual firm?
Assume that the income of households increase. How do you think the market for fried
chicken would react to this increase in income?
The market demand for fried chicken pieces would increase and the equilibrium price
would rise.
The market supply of fried chicken pieces would decrease and the equilibrium price would
rise.
It would increase the demand for fried chicken pieces and the equilibrium price would rise.
If the equilibrium price for fried chicken pieces in the market increases from R4 to R6, at
what price would Funky Chicken sell its fried chicken?
o R4
o R6
It would sell at the market equilibrium price, which is R6, because Funky Chicken is a
price taker.
Graphically, the impact of an increase in the market demand on the individual demand by Funky
Chicken can be represented as follows:
In the market for fried chicken pieces, the market demand curve shifts to the right and the equilibrium
price increases from R4 to R6. The impact on the individual demand for Funky Chicken can now sell
any quantity at R6.
ACTIVITY 2
2.1 Indicate whether the following statements relating to the quantities of Spar Cold-drinks
is true or false:
T F
a. By changing its quantity supplied, Spar Cold-drinks can influence the market
equilibrium price of cold drinks.
b. Customers are able to purchase cold drinks at the market equilibrium price from
any supplier of cold drinks.
173 ECS1501/002
T F
c. If Spar Cold-drinks charges a higher price than the price determined by the
market, the quantity demanded for the firm’s cold drinks will fall to zero.
d. Spar Cold-drinks can only sell 50 cold drinks at the equilibrium price.
e. Selling cold drinks at a price lower than the market equilibrium price would not
be beneficial for Spar Cold-drinks since the business can sell any quantity at the
equilibrium price.
2.2 Use the diagram to complete the following paragraph by choosing the correct option in brackets:
An increase in the number of suppliers will cause a (rightward; leftward) shift of the (market
supply; market demand) curve. This will cause the market equilibrium price to (decrease;
increase) and the individual demand curve facing the firm will shift (upwards; downwards).
14.3 Total revenue, average revenue and marginal revenue of the perfectly
competitive firm
• distinguish between total revenue, average revenue and marginal revenue of the perfectly
competitive firm
Total revenue is the income brought into the firm from selling its products. It is calculated by
multiplying the price of the product by the quantity of output sold:
𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓 = 𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑 × 𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒
𝑻𝑻𝑻𝑻 = 𝑷𝑷 × 𝑸𝑸
If the price of a product is R100 and the firms sells 20 units, the total revenue of the firm is R100 x 20
= R2 000.
174 ECS1501/002
If the market price for a fried chicken piece is R4, what is the total revenue of Funky Chicken if it
sells ______?
o 1 piece of fried chicken
o 4 pieces of fried chicken
o 10 pieces of fried chicken
For one piece of fried chicken, it is R4 x R1 = R4, for four pieces it is R4 x 4 = R16 and for ten
pieces it is R4 x 10 = R40. As its sells more, its total revenue increases.
Average revenue is the revenue generated per unit sold and is calculated by dividing the total
revenue by the quantity sold.
𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓
𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓 =
𝒒𝒒𝒒𝒒𝒒𝒒𝒏𝒏𝒏𝒏𝒏𝒏𝒏𝒏𝒏𝒏
𝑻𝑻𝑻𝑻
𝑨𝑨𝑨𝑨 =
𝑸𝑸
If the total revenue of a firm is R5 000 and the quantity sold is 1 000, then the average revenue per unit
is R5 000 ÷ 1 000 = R5.
What is the average revenue of Funky Chicken if its total revenue is _____?
R12 and the number of units sold is 3
R20 and number of units sold is 5
If total revenue is R12 and the number of units sold is three, then the average revenue is R12 ÷ 3 =
R4; and if total revenue is R20 and the number of units sold five, it is R4. You will see later that
for a firm under perfect competition, its average revenue is equal to the price.
Marginal revenue (MR) is the increase in total revenue that results from the sale of one
additional unit of output. Marginal revenue is calculated by dividing the change in total revenue by
the change in quantity.
𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒊𝒊𝒊𝒊 𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓
𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓 =
𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒊𝒊𝒊𝒊 𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒
∆𝑻𝑻𝑻𝑻
𝑴𝑴𝑴𝑴 =
∆𝑸𝑸
If a firm sells one additional unit for R100, the marginal revenue of the firm is R100.
Given the following information for Funky Chicken, calculate the marginal revenue for the 4th and
5th unit.
The total revenue for three units is R12, and the total revenue for four units is R16.
By increasing its sales from four to five units, the total revenue for Funky chicken increases from
R16 to R20.
By selling the 4th unit, the marginal revenue is R4 and by selling the 5th unit, the marginal
revenue is R4. As you will shortly see, for a firm under perfect competition, the marginal revenue
is equal to the price.
175 ECS1501/002
The following table indicates the total revenue, average revenue and marginal revenue for Funky
Chicken:
Total revenue, average revenue and marginal revenue
Total Marginal Average

Price
Quantity revenue revenue revenue
P
Q TR MR AR
(rand)
(rand) (rand) (rand)
R4 - --- ---
1 R4 4 4 4
2 R4 8 4 4
3 R4 12 4 4
4 R4 16 4 4
5 R4 20 4 4
The market price for a fried chicken piece is R4 and this is indicated in column 2. Note that the market
price does not change as the quantity changes, since the firm under perfect competition is a price taker.
The total revenue is equal to the price (column 2) times the quantity (column 1) and is indicated in
column 3. The marginal revenue is the revenue from selling an additional unit and is provided in
column 4. Since the quantity is given for intervals of one, the marginal revenue for the fourth unit can
be calculated as follows: total revenue for four units minus total revenue for three units = R16 – R12 =
R4.
The interesting thing to note about the marginal revenue is that it is a constant R4 and equal to the price
of R4. In other words, the marginal revenue does not change as the firm produces more output and is
equal to the price. Think of it in this way: If the price at which a firm can sell its product is given, then
the marginal revenue (the additional revenue the firm obtains by selling an additional unit) is also equal
to the price that the firm can obtain for that additional unit. Funky Chicken is a price taker and is too
small to influence the market price by supplying more. So, every time Funky Chicken sells one more
fried chicken piece, its revenue increases by exactly the same amount as the market price of R4.
Average revenue, which is indicated in column 5, is calculated by dividing the total revenue (column 3)
by the quantity (column 1). It is also constant and equal to the market price of R4.
From the above table, we can see that price (P) = marginal revenue (MR) = average revenue (AR). The
demand curve facing the individual firm under perfect competition is therefore also the marginal
revenue curve and the average revenue curve.
176 ECS1501/002
Total revenue is indicated by the area under the individual demand curve (P x Q).
Now do the following activity to see if you understand the difference between total revenue, marginal
revenue and average revenue:
ACTIVITY 3
3.1 Study the following diagram of the market for cold drinks and individual demand facing Spar
Cold-drinks in the market for cold drinks and then answer the following questions:
a. Use the data in the diagram to complete the following table.
Quantity Price Total revenue Marginal Average

Q P TR revenue revenue
(rand) (rand) MR AR
(rand) (rand)
1
2
3
4
5
6
177 ECS1501/002
b. If the market equilibrium price increases to R12, then marginal revenue for each output
level will be ______.
c. If the market equilibrium price increases to R12, then average revenue for each output level
will be ____.
3.2 Do you agree or disagree with the following statement?
For Spar Cold-drinks, the price (P) = marginal revenue (MR) = average revenue (AR). The
demand curve facing Spar Cold-drinks under perfect competition is therefore also the marginal
revenue curve and the average revenue curve.
a. Agree
b. Disagree
14.4 Profit maximisation of the individual firm

• identify, describe and illustrate with the aid of diagrams the profit maximisation position of a
firm
The goal of all firms is to maximise their profit. Under perfect competition, a firm cannot determine the
price of the good or service it sells because it is a price taker. However, what it can decide on is the
quantity of the good or service it will provide; and if it wishes to maximise its profits, it should set its
quantity at such a level that it maximises its profit.
The profit maximisation position of the firm can be understood in terms of total revenue (TR) and total
costs (TC), but can also be determined using marginal revenue (MR) and marginal cost (MC).
We will make use of the marginal revenue (MR) and marginal cost (MC) approach to determine the
profit maximisation position of a firm under perfect competition.

The marginal cost of producing an additional fried chicken piece is R3,20.
The marginal revenue of this additional fried chicken piece is R4.
Should Funky Chicken produce this additional fried chicken piece?
o Yes, because it contributes to its profits.
o No, because it decreases its profit.
The additional cost is only R3,20, while the additional revenue is R4. By producing this additional
fried chicken piece, Funky Chicken adds 80 cents to its profits.
According to the marginal revenue marginal cost approach, a firm under perfect competition should
continue to increase its production as long as the marginal revenue exceeds the marginal cost. In other
words, as long as the revenue of an additional unit is greater than the additional cost to produce that
unit, profits are growing and it is worth producing the additional unit.

The marginal cost of producing an additional fried chicken piece is R6.
The market price of a fried chicken piece is R4.
Should Funky Chicken produce the additional unit?
178 ECS1501/002
o No, because the marginal cost is greater than the marginal revenue.
o Yes, because the marginal cost is less than the marginal revenue.
o I cannot say, because the marginal revenue is unknown.
The marginal cost is indeed greater than the marginal revenue since the marginal revenue is R4.
Remember that P = MR. In this case, producing the additional unit will cost more than what it can
be sold for and profits therefore decline. Funky Chicken should therefore not produce the
additional unit.
As a general rule, we can now state the following:

 If marginal revenue is greater than marginal cost (MR > MC), the firm should increase
production.
 If marginal revenue is equal to marginal cost (MR = MC), profit maximisation is reached.
 If marginal revenue is less than marginal cost (MR < MC), the firm should decrease
production.
In order to determine the profit maximisation position, we need to add the cost of production data.
The following table indicates the cost and revenue data for Funky Chicken:
Table: Cost and revenue data for Funky Chicken
Quantity Marginal
Total cost Total revenue Marginal cost
(units of fried revenue
TC TR MC
chicken MR
pieces) (rand)
0 62 0 --- ---
10 90 40 2,80 4,00
20 110 80 2,00 4,00
30 126 120 1,60 4,00
40 144 160 1,80 4,00
50 166 200 2,20 4,00
60 192 240 2,60 4,00
70 224 280 3,20 4,00
80 264 320 4,00 4,00
90 324 360 6,00 4,00
100 404 400 8,00 4,00
Column 1 indicates the quantity of fried chicken pieces. The total cost to produce these quantities is
provided in column 2, while the total revenue from selling these quantities is provided in column 3.
Column 4 indicates the marginal cost and column 5 the marginal revenue.
179 ECS1501/002
Study the above table and answer the following questions:
Which one of the following correctly describes what is happening to marginal cost as more is
produced?
o Marginal cost is constant.
o Marginal cost eventually increases at an increasing rate.
o Marginal cost eventually increases at a decreasing rate.
o Marginal cost decreases.
What we see is that marginal cost eventually increases at an increasing rate (1,6; 1,8; 2,2; 2,6; …).
This is due to the law of increasing costs.
Which one of the following correctly describes what is happening to marginal revenue as more is
produced?
o Marginal revenue is constant.
o Marginal revenue eventually increases at an increasing rate.
o Marginal revenue eventually increases at a decreasing rate.
o Marginal revenue decreases.
What we see is that marginal revenue is constant.
To determine at which output level Funky Chicken maximises its profits, we can use the rule that profit
maximisation occurs where marginal revenue equals marginal cost (MR = MC).
According to the data for Funky Chicken, this occurs at an output level of 80. This is also the point
where the difference between total revenue and total cost is the greatest, as indicated in the following
table:
Revenue and cost
Quantity Marginal cost Marginal

Total cost Total revenue Profit
(units of fried MC revenue
TC TR TR-TC
chicken) (rand) MR
Q (rand)
0 62 0 --- --- -62
10 90 40 2,80 4,00 -50
20 110 80 2,00 4,00 -30
30 126 120 1,60 4,00 -6
40 144 160 1,80 4,00 16
50 166 200 2,20 4,00 34
60 192 240 2,60 4,00 48
70 226 280 3,40 4,00 54
80 264 320 4,00 4,00 56
90 324 360 6,00 4,00 36
100 404 400 8,00 4,00 -4
180 ECS1501/002
We can now represent the profit maximisation position of Funky Chicken graphically. For this purpose,
we will only use the quantity, marginal revenue and marginal cost data as indicated in the table below.
Marginal cost and revenue for Funky Chicken The firm maximises profits at point E where
Quantity (units Marginal marginal revenue is equal to marginal cost. The
Marginal cost output level at this point is 80.
of fried revenue
MC
chicken) MR
(rand)
Q (rand)
10 2,80 4,00
20 2,00 4,00
30 1,60 4,00
40 1,80 4,00
50 2,20 4,00
60 2,60 4,00
70 3,40 4,00
80 4,00 4,00
90 6,00 4,00
100 8,00 4,00
Consider an output level of 60 in the following diagram:
What is the marginal revenue at this output level?

What is the marginal cost at this output level?
Should the firm increase or decrease its production?
At an output level of 60, the marginal revenue is R4,00 and the marginal cost is R2,60. Since
marginal revenue is greater that marginal cost, Funky Chicken should increase its production
because the additional units produced add to the firm's profits.
181 ECS1501/002
Consider an output level of 90 in the following diagram:
What is the marginal revenue at this output level?

What is the marginal cost at this output level?
Should the firm increase or decrease its production?
At an output level of 90, the marginal revenue is R4,00 and the marginal cost is R6,00. In this case,
the profits from Funky Chicken decrease since it costs R6,00 to produce the additional unit.
However, the revenue from it is only R4,00, and there is a loss of R2,00. By decreasing its
production, Funky Chicken can increase its profits.
Levels of output to the right of 80, where MR = MC, indicate that marginal revenue is less than
marginal cost, and it is in the interest of the firm to decrease its production in order to increase its
profits.
To summarise, we can conclude the following:

The firm maximises profits if it produces the quantity where the marginal revenue (MR) is equal to the
marginal cost (MC).
If MR = MC, then there is profit maximisation.
If MR > MC, then profits increase.
The reason for this is straightforward. For as long as the marginal revenue is greater than the marginal
cost, the marginal revenue contributes towards total profits. By producing and selling an additional
unit, the producer gains more than it costs to produce the additional unit, and its profits increase.
If MR < MC, then profits decrease.
182 ECS1501/002
When marginal revenue is less than marginal cost, total profits will decline. It is costing the firm more
to produce the additional unit than it obtains from selling the additional unit. It is therefore not in the
interest of the firm to produce the extra unit because this decreases its profits.
Now do the following activity to see if you understand the profit maximisation position of the
individual firm:
ACTIVITY 4
Each graph indicates the output which the ice cream factory is currently producing. Based on the
following graphs, what should the firm do to its output in each instance if it wishes to maximise its
profits?
4.1
a. Expand output
b. Leave output unchanged
c. Reduce output
4.2
a. Expand output
c. Reduce output
183 ECS1501/002
4.3
a. Expand output
c. Reduce output
14.5 Profit position of the firm

• distinguish between normal profit, economic profit and a loss
To determine whether a firm is making a normal profit, an economic profit or a loss we need to add the
average cost (AC) curve to the individual firm's marginal cost (MC) and marginal revenue (MR)
curves.
If you do not remember the characteristics of the average cost (AC) curve refer to the topic "Cost of
production".
Normal profit
Normal profit is the best return that the firm's self-owned, self-employed resources could earn
elsewhere. It can be regarded as the minimum payment required by the owner of the firm to stay in the
particular business. Normal profit includes the cost of the owner's time and capital. Thus, if an
economist talks about the cost of doing business, he or she would include the normal profits that must
be paid to the owners to keep them in the particular business.
Consider the diagram below where the average cost curve has been added to the marginal revenue and
marginal cost curves. Average cost consists of average fixed cost and average variable cost and the
average cost curve (AC) is U-shaped. The marginal cost curve (MC) is upward sloping and the
marginal and average revenue curves (AR = MR) are the same and horizontal.
184 ECS1501/002
Given a market price of P, profit is maximised where MR = MC = P. This occurs at a quantity of Q. At
Q, the firm's average revenue (AR) per unit of production is P, which is also equal to the average cost
per unit (AC). Since AR = AC, the firm only earns a normal profit, since all its costs, including the
opportunity cost of self-owned, self-employed resources, are fully covered. Point E is usually called the
break-even point which is the point where the firm is able to cover its costs and earns only a
normal profit.
As long as average revenue is equal to average cost, the firm is earning a normal profit.
If AR = AC, then a normal profit is earned.

Alternatively, you can find the firm's profit position 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, multiplied by the quantity
produced (and sold) Q. This is equal to the area 0-P-E-Q in the above diagram. The total cost of the
firm is equal to the average cost, which is equal to P, multiplied by the quantity Q, and is also
represented by the area 0-P-E-Q (the same as for total revenue). Therefore, total revenue equals total
cost and the producer is only making a normal profit.
Economic profit
Economic profit is equal to the total revenue that exceeds the total cost. Economic profit is the extra
profit the owner receives above the minimum payment required (the normal profit) by the owner of the
firm to stay in the particular business. Economic profit is sometimes called excess profit, abnormal
profit, super-normal profit or pure profit.
Given a market price of P, profit is maximised where MC = MR = P. This occurs at a quantity of Q. At

Q, the firm's average revenue (AR) per unit of production is P. The average cost per unit of
185 ECS1501/002
production is C. At an output level of Q, the firm is making an economic profit per unit of production
of P – C. The total profit is given by the area C-P-E-M, which is equal to the profit per unit of output P
– C multiplied by the quantity produced Q.
As long as average revenue is greater than average cost, the firm is earning an economic profit.
If AR > AC, then an economic profit is earned.

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 multiplied by the
quantity produced (and sold) Q. This is equal to the area 0-P-E-Q. The total cost of the firm is equal to
the average cost C, multiplied by the quantity Q, and is represented by the area 0-C-M-Q. The
difference between these two areas is the economic profit and is represented by the area C-P-E-M.
Economic loss
As long as the price is equal to or higher than average cost per unit, the firm makes a profit. But what
happens if, for some reason, the price falls below the average cost per unit or the average cost increases
and total revenue is less than total cost? In this case, the firm makes an economic loss.
Given a market price of P, MR = MC at point E. This occurs at a quantity of Q. At Q, the firm's

average revenue (AR) per unit of production is P, which is lower than the average cost per
unit C. Since AR < AC, the firm therefore makes an economic loss per unit of output, equal to the
difference between C and P. The total economic loss is indicated by the area P-C-M-E.
If AR < AC, then an economic loss occurs.

Alternatively, the area representing a total loss 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 multiplied by the
quantity produced (and sold) Q. This is equal to the area 0-P-E-Q. The total cost of the firm is equal to
the average cost C, multiplied by the quantity Q, and is represented by the area 0-C-M-Q. The
difference between these two areas is the economic loss indicated by the area P-C-M-E.
186 ECS1501/002
Now do the following activity to see if you understand the profit maximisation position of the
individual firm:
ACTIVITY 5
5.1 Indicate whether the following statements relating to average and marginal variables
is true or false:
T F
a. Whenever marginal revenue (MR) is greater than marginal cost (MC), the firm
is making a total profit.
b. If a firm's average revenue (AR) is greater than its average cost (AC), it is
earning a normal profit.
c. If a perfectly competitive firm is earning a normal profit only, it follows that

its average cost, marginal cost, average revenue and marginal revenue are all
equal at the equilibrium quantity and also equal to the market price.
d. If a perfectly competitive firm is making an economic loss, it implies that its

average cost (AC) is greater than the market price.
5.2 Study the following diagram and answer the questions:
a. At what point does the firm maximise profits?

b. What is the output level at the profit maximisation point?
c. What is the total revenue at the profit maximisation point?
d. What is the total cost at the profit maximisation point?
187 ECS1501/002
e. Is average cost greater, the same or smaller than average revenue at point B?
f. Is the firm making an economic profit, a normal profit or an economic loss?
5.3 Study the following diagram and answer the questions:
a. At what point does the firm maximise profits?

b. What is the output level at the profit maximisation point?
c. What is the total revenue at the profit maximisation point?
d. What is the total cost at the profit maximisation point?
e. Is average cost greater, the same or smaller than average revenue at point A?
f. Is the firm making an economic profit, a normal profit or an economic loss?
14.6 The shutdown point

• identify and describe the shutdown point with the aid of a diagram
When should a firm considering shutting down its production? The first warning lights for a firm to
consider shutting down its production is when the total revenue (TR) the firm receives for its product is
less than the total cost of production (TC).
However, making a loss is not a sufficient enough reason for a firm to shut down its production in the
short run. To understand why it might be in the interest of a firm to continue production even if it
makes a loss, we need to revisit the difference between fixed and variable costs.
Fixed costs and variable costs
Fixed costs (FC) Variable costs (VC)

 The costs that remain constant
 The costs that change with the level of
irrespective of the level of output that is
output. They represent the cost of the
produced. Even if the level of production
variable inputs. As more of a good or
of a firm is zero, it must still pay its fixed
service is produced, the variable costs
costs.
increase.
 As the firm increases production, the
 Include payments for raw materials,
fixed costs do not increase but remain the
power, labour services, water, etc.
same.
 Are also called direct costs, prime costs
 Examples of fixed costs are the cost
or avoidable costs.
associated with the maintenance of a
188 ECS1501/002
building, factory or equipment and the  These are the costs that the firm can
rent that must be paid even if it shuts avoid if it shuts down its operations.
down its operations.  In the long run, all inputs are variable, a
 Fixed costs are also known as sunk, firm can build another factory or sell the
unavoidable, overhead or indirect costs. one it has.
Fixed cost is only fixed in the short run. In the long run a firm can cancel the rental agreement for the
factory.
The following example of two firms that produce cold drinks in a perfectly competitive market
illustrates why it is in the interest of a firm to continue its production even if it makes a loss:
Given that the price of a cold drink is R5 and that each firm produces a 1 000 cold drinks, their total
revenue (TR) – that is, the price times the quantity (P x Q) – is R5 000. Both firms face the same fixed
cost of R2 000.
Their variable costs, however, differ. In the case of firm 1, the variable cost (VC) is R4 000, while for
firm 2, it is R5 500. The reason for the difference in the variable costs might be that firm 1 is more
efficient in using its resources than firm 2. The total cost of production (TC) for firm 1 to produce 1
000 cold drinks is therefore R2 000 (the fixed cost) + R4 000 (the variable cost) = R6 000; and for firm
2, it is R2 000 (fixed cost) + R5 500 (variable cost) = R7 500. In both cases, the total revenue is smaller
than the total cost, and both firms make a loss. The total loss for firm 1 is R5 000 – R6 000 = -R1 000,
while for firm 2, it is R5 000 – R7 500 = -R2 500.
The shutdown point
Firm 1 Firm 2
Total revenue (TR) R5 000 R5 000
Fixed cost (FC) R2 000 R2 000
Variable cost (VC) + R4 000 + R5 500
Total cost (TC) - R6 000 R6 000 - R7 500 R7 500
Total loss if it stays in
-R1 000 -R2 500
business
Total loss if it shuts
R2 000 R2 000
down
Should both firms shut down their production? Not necessarily. Let's see why.
Looking at firm 1, how much would it lose if it shuts down its production?
o R1 000
o R2 500
o R2 000
By shutting down its production, it would lose its revenue of R5 000, but it would also avoid the
variable cost of R4 000. However, it must still pay its fixed cost of R2 000. By shutting down its
operations, it would therefore lose R2 000. The choice for firm 1 is either to continue with its
production and lose R1 000 or shut down and lose R2 000. Which choice do you think the firm
should make?
189 ECS1501/002
Looking at firm 2, how much would it lose if it shut down its production?
o R1 000
o R2 500
o R2 000
By shutting down its production, it would lose its revenue of R5 000, but it would also avoid its
variable cost of R5 500. However, it must still pay its fixed cost of R2 000. The choice for firm 2
is therefore to continue its production and lose R2 500 or shut down its business and lose R2 000.
What choice do you think the firm should make?
In the case of firm 1, it should keep on producing since it would only lose R1 000 as opposed to
R2 000, while firm 2 should shut down its business because by doing so it would only lose R2 000. If it
decides to keep the business open, it would lose R2 500. In this case, we say that firms are minimising
their losses.
There is another way of explaining the shutdown rule, that is, by comparing the price of the product
(P), which is also the average revenue (AR), with the average variable cost of production (AVC).
Remember:
𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄
𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨 𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 =
𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸 𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑
In the above example, the average variable cost to produce 1 000 cold drinks for firm 1 is R4 000 ÷
1 000 = R4 per cold drink, while for firm 2 it is R5 500 ÷ 1 000 = R5,50.
As long as the price (and average revenue) is greater than the average variable cost, it is in the interest
of the firm to continue production. This is the case for firm 1 where the average revenue is R5 and the
average variable cost is R5.
P = AR > AVC keep on producing

If the price is lower than the average variable cost, the firm should shut down its business. This is the
case for firm 1, where the average revenue is R5 and the average variable cost is R5,50.
P = AR < AVC to shut down production

The following diagram provides a summary of the shutdown rule for the firm:
190 ECS1501/002
In terms of a diagram, it can be represented graphically as follows:
The shutdown point for the firm is where P = AR = AVC. At a point below the shutdown point, the
average revenue is smaller than the average variable cost and the firm should shut down its production.
Do the following activity to see if you understand the shutdown point:
ACTIVITY 6
Indicate whether the firm should continue production or shut down.
6.1 Its average revenue is R12, while its average variable cost is R15.
a. Continue
b. Shut down
6.2 Its average revenue is R10, its average cost is R12 and its average variable cost is R8.
a. Continue
b. Shut down
6.3 Its total revenue is less than its total variable cost.
a. Continue
b. Shut down
6.4 The price is greater than the average variable cost.
a. Continue
b. Shut down
191 ECS1501/002
6.5 Use the diagram to complete the following sentence:
The breakeven point is represented by point _____ and the shutdown point by point ______ .
14.7 The supply curve of the firm and market supply

• derive the supply curve for an individual firm under perfect completion
An individual firm under perfect competition is a price taker and changes in the market will influence
its behaviour through changes in the price of the goods or services. In reaction to a change in the
market price, the firm will change the quantity it produces.
Let's consider the case where an increase in the income of households leads to an increase in the market
demand for fried chicken pieces. This impact is shown in diagram A, where the market demand curve
shifts to the right, causing the equilibrium price to increase to R5. The impact on Funky Chicken is
indicated in diagram B. Since Funky Chicken is a price taker, its individual demand curve shifts
upwards to R5. At this new price of R5, the marginal revenue is greater than the marginal cost at an
output level of 80. It is therefore in the interest of Funky Chicken to increase its output until marginal
revenue is equal to marginal cost. This occurs at an output level of 100.
Diagram A: Market Diagram B: Individual firms

What we can conclude from this is that an increase in the price leads to an increase in the quantity
supplied. We have now provided an explanation for why the supply curve is upward sloping – in other
words, why it is that an increase in price leads to an increase in the quantity supplied, and vice versa.
192 ECS1501/002
One can also view this from another angle and argue that owing to the law of increasing marginal cost,
a firm will only be willing to supply a higher quantity if it can obtain a higher price.
We have also identified the shutdown point as point B – the point where the average revenue (AR) is
equal to the average variable cost (AVC). At a price lower than P2, the firm will not be willing to
supply goods and services. The part of the marginal cost curve that lies below point B is therefore not
part of the supply curve of the firm. For instance, a point such as A, where the price is P1 and the
average revenue (AR) is smaller than the average variable cost (AVC), is not part of the firm's supply
curve.
The part of the marginal cost curve that lies above the shutdown point, point B, however, is part of the
firm's supply curve. As the price rises from P2, the firm supplies a higher quantity. Note that even if it
makes a loss, that is, between points B and C, it is still in the firm’s interest to supply the good since it
is minimising its losses.
By adding all the different supply curves of firms together, one can obtain the market supply curve.
ACTIVITY 7
7.1 Study the graph below and answer the questions that follow:
a. Which point is not part of the firm's supply curve?

b. Which point is the shutdown point?
c. Does the firm make an economic loss at point C?
d. At which point on the supply curve does the firm make a normal profit?
e. At which point on the supply curve does the firm make an economic profit?
f. The supply curve runs from point ______ onwards.
193 ECS1501/002
14.8 Long-run equilibrium of the individual firm
• describe the long-run equilibrium position
We have learnt that, in the short run, firms will be restricted in some way by the presence of fixed
costs. However, in the long run, all factors of production and costs become variables, and firms are able
to enter and exit the market. If firms in the market are making economic profits, this will attract new
entrants into the market, whereas if firms are making economic losses, this will lead to firms exiting the
market.
What condition of perfect competition allows firms to enter and exit?
o Many buyers and sellers
o Homogeneous goods
o Complete freedom of entry and exit
This is due to complete freedom of entry and exit.
When existing firms are making an economic profit, it will attract new firms wishing to enter the
market. As more firms enter the market, the market supply increases and the equilibrium price
decreases. This process will continue until firms are only making a normal profit.
This can be illustrated by the following diagrams:
The market is represented in diagram A, while the individual firm is represented in diagram B.
At a market price of P1, the firm is making an economic profit as the average revenue is greater than the
average cost. This is indicated by point A. The economic profit attracts firms to enter the market, and
the market supply curve thus shifts to the right, and the market equilibrium price decreases to P2. As the
market equilibrium price decreases, the firm's economic profit declines, as indicated by point B. This
process of an increase in the number of new entrants, an increase in the market supply and a decrease in
market equilibrium price continues until point C is reached, where only normal profits are earned.
Thus, in the perfectly competitive market, long-run equilibrium will only be achieved once all firms are
earning normal profits.
Diagram A Diagram B
194 ECS1501/002
ACTIVITY 8
Indicate whether the following statement relating to a competitive market is true or false:
T F
8.1 If all the firms in a perfectly competitive industry earn economic profits, new
firms will be attracted to the market. The supply of the goods will increase,
thus lowering the price. Eventually, all the firms will be earning normal profit
only.
8.2 Complete the paragraph by selecting the correct options in the brackets.
If individual firms make an economic loss it will result in (new firms entering; existing firms
exiting). The market supply thus (increases; decreases) and the market supply curve shifts
(leftwards; rightwards) and the market price (increases; decreases). This change in the market
price causes the marginal revenue curve of the individual firm to (shift downwards; shift
upwards) causing the (economic profit; normal profit; economic loss) of the firm to decline. This
process continues until only (an economic profit; a normal profit; an economic loss) is made by
the firm.
Summary: Efficiency in perfectly competitive markets

When profit-maximising firms in perfectly competitive markets combine with utility-maximising
consumers, something remarkable happens: the resulting quantities of outputs of goods and services
demonstrate both technical and allocative efficiency.
Technical efficiency means producing without waste, so that the choice is on the production possibility
curve. In the long run, in a perfectly competitive market, because of the process of entry and exit, the
price in the market is equal to the minimum of the long-run average cost curve. In other words, goods
are being produced and sold at the lowest possible average cost. Those firms that are inefficient will not
be able to profitably produce goods at this price and will be forced to leave the market.
Allocative efficiency means that among the points on the production possibility frontier, the point that
is chosen is socially preferred – at least in a particular and specific sense. In a perfectly competitive
market, price will be equal to the marginal cost of production. Think about the price that is paid for a
good as a measure of the social benefit received for that good; after all, willingness to pay conveys
what the good is worth to a buyer. Then think about the marginal cost of producing the good as
195 ECS1501/002
representing not only the cost for the firm, but also more broadly as the social cost of producing that
good. When perfectly competitive firms follow the rule that profits are maximised by producing at the
quantity where price is equal to marginal cost, they are thus ensuring that the social benefits received
from producing a good are in line with the social costs of production.
To explore what is meant by allocative efficiency, it is useful to work through an example. Begin by
assuming that the market for wholesale flowers is perfectly competitive – hence P = MC. Now,
consider what it would mean if firms in that market were to produce a smaller quantity of flowers. At a
smaller quantity, marginal costs would not yet have increased as much, so that price would exceed
marginal cost; that is, P > MC. In that situation, the benefit to society as a whole of producing
additional goods, as measured by the willingness of consumers to pay for marginal units of a good,
would be higher than the cost of the inputs of labour and physical capital needed to produce the
marginal good. In other words, the gains to society as a whole from producing additional marginal units
would be greater than the costs.
Conversely, consider what it would mean if, compared to the level of output at the allocative efficient
choice when P = MC, firms were to produce a greater quantity of flowers. At a greater quantity, the
marginal costs of production would have increased so that P < MC. In that case, the marginal costs of
producing additional flowers would be greater than the benefit to society as measured by what people
would be willing to pay. For society as a whole, since the costs outstrip the benefits, it would make
sense to produce a smaller quantity of such goods.
When perfectly competitive firms maximise their profits by producing the quantity where P = MC, they
also ensure that the benefit to consumers of what they are buying, as measured by the price they are
willing to pay, is equal to the costs to society of producing the marginal units, as measured by the
marginal costs the firm must pay – and thus that allocative efficiency holds.
The statement that a perfectly competitive market in the long run will feature both technical and
allocative efficiency needs to be taken with a pinch of salt. Remember, economists use the concept of
"efficiency" in a particular and specific sense, not as a synonym for "desirable in every way". For one
thing, consumers' ability to pay reflects the income distribution in a particular society. Thus, a homeless
person may not have the ability to pay for housing because he or she has insufficient income. Although
the market could be efficient, it does not imply that it is equitable.
Perfect competition, in the long run, is a hypothetical benchmark. For market structures such as
monopoly, monopolistic competition and oligopoly, which are more frequently observed in the real
world than perfect competition, firms will not always produce at the minimum of average cost; nor will
they always set the price equal to marginal cost. Thus, these other competitive situations will not
produce productive and allocative efficiency.
196 ECS1501/002
Moreover, real-world markets include many issues that are assumed away in the model of perfect
competition, including pollution, the invention of new technology, poverty, which may result in some
people being unable to pay for basic necessities of life, government programmes like national defence
or education, discrimination in labour markets, and buyers and sellers who must deal with imperfect
and unclear information.
However, the theoretical efficiency of perfect competition does provide a useful benchmark for
comparing the issues that arise from these real-world problems.
14.9 Imperfect competition
OVERVIEW
The perfectly competitive market introduced in the previous section lies at one end of a spectrum of
market models. At the other end is the monopoly model. It assumes a market in which there is no
competition, a market in which only a single firm operates. Two models that fall between the extremes
of perfect competition and monopoly are monopolistic competition and oligopoly.
In this section we will take closer look at the characteristics of a monopoly, monopolistic competition
and oligopoly.
TOPIC OUTCOME
• identify the characteristics of a monopoly, monopolistic competition and oligopoly

• describe the sources of monopoly power
Monopoly
Monopoly is at the opposite end of the spectrum of market models from perfect competition.
A monopoly firm has no rivals. It is the only firm in its industry. There are no close substitutes for the
good or service a monopoly produces. Not only does a monopoly firm have the market to itself, but it
also need not worry about other firms entering. In the case of monopoly, entry by potential rivals is
prohibitively difficult.
A monopoly does not take the market price as given; it determines its own price. It selects from its
demand curve the price that corresponds to the quantity the firm has chosen to produce in order to earn
the maximum profit possible. The entry of new firms, which eliminates profit in the long run in a
competitive market, cannot occur in the monopoly model.
A firm that sets or picks price based on its output decision is called a price setter. A firm that acts as a
price setter possesses monopoly power.
As was the case when we discussed perfect competition in the previous section, the assumptions of the
monopoly model are rather strong. In assuming there is one firm in a market, we assume there are no
other firms producing goods or services that could be considered part of the same market as that of the
monopoly firm. In assuming blocked entry, we assume, for reasons we will discuss below, that no other
firm can enter that market. Such conditions are rare in the real world. As always with models, we make
the assumptions that define monopoly in order to simplify our analysis, not to describe the real world.
The result is a model that gives us important insights into the nature of the choices of firms and their
impact on the economy.
197 ECS1501/002
Sources of Monopoly Power
Why are some markets dominated by single firms? What are the sources of monopoly power?
Economists have identified a number of conditions that, individually or in combination, can lead to
domination of a market by a single firm and create barriers that prevent the entry of new firms.
Barriers to entry are characteristics of a particular market that block new firms from entering it. They
include economies of scale, special advantages of location, high sunk costs, a dominant position in the
ownership of some of the inputs required to produce the good, and government restrictions. These
barriers may be interrelated, making entry that much more formidable. Although these barriers might
allow one firm to gain and hold monopoly control over a market, there are often forces at work that can
erode this control.
Economies of Scale
Scale economies and diseconomies define the shape of a firm’s long-run average cost (LRAC) curve as
it increases its output. If long-run average cost declines as the level of production increases, a firm is
said to experience economies of scale.
A firm that confronts economies of scale over the entire range of outputs demanded in its industry is
a natural monopoly. Utilities that distribute electricity, water, and natural gas to some markets are
examples. In a natural monopoly, the LRAC of any one firm intersects the market demand curve where
long-run average costs are falling or are at a minimum. If this is the case, one firm in the industry will
expand to exploit the economies of scale available to it. Because this firm will have lower unit costs
than its rivals, it can drive them out of the market and gain monopoly control over the industry.
Location
Sometimes monopoly power is the result of location. For example, sellers in markets isolated by
distance from their nearest rivals have a degree of monopoly power. The local movie theater in a small
town has a monopoly in showing first-run movies. Doctors, dentists, and mechanics in isolated towns
may also be monopolists.
Sunk Costs
The greater the cost of establishing a new business in an industry, the more difficult it is to enter that
industry. That cost will, in turn, be greater if the outlays required to start a business are unlikely to be
recovered if the business should fail.
Suppose, for example, that entry into a particular industry requires extensive advertising to make
consumers aware of the new brand. Should the effort fail, there is no way to recover the expenditures
for such advertising. An expenditure that has already been made and that cannot be recovered is called
a sunk cost.
Restricted Ownership of Raw Materials and Inputs

In very few cases the source of monopoly power is the ownership of strategic inputs. If a particular firm
owns all of an input required for the production of a particular good or service, then it could emerge as
the only producer of that good or service.
Government Restrictions
Another important basis for monopoly power consists of special privileges granted to some business
firms by government agencies. State and local governments have commonly assigned exclusive
198 ECS1501/002
franchises—rights to conduct business in a specific market—to taxi and bus companies, to cable
television companies, and to providers of telephone services, electricity, natural gas, and water,
although the trend in recent years has been to encourage competition for many of these services.
Governments might also regulate entry into an industry or a profession through licensing and
certification requirements. Governments also provide patent protection to inventors of new products or
production methods in order to encourage innovation; these patents may afford their holders a degree of
monopoly power during the 17-year life of the patent.
Patents can take on extra importance when network effects are present. Network effects arise in
situations where products become more useful the larger the number of users of the product. For
example, one advantage of using the Windows computer operating system is that so many other people
use it. That has advantages in terms of sharing files and other information.
Monopolistic competition
The model of monopolistic competition assumes a large number of firms. It also assumes easy entry
and exit. This model differs from the model of perfect competition in one key respect: it assumes that
the goods and services produced by firms are differentiated. This differentiation may occur by virtue of
advertising, convenience of location, product quality, reputation of the seller, or other factors. Product
differentiation gives firms producing a particular product some degree of price-setting or monopoly
power. However, because of the availability of close substitutes, the price-setting power of
monopolistically competitive firms is quite limited. Monopolistic competition is a model characterized
by many firms producing similar but differentiated products in a market with easy entry and exit.
Restaurants are a monopolistically competitive sector; in most areas there are many firms, each is
different, and entry and exit are very easy. Each restaurant has many close substitutes—these may
include other restaurants, fast-food outlets, and the deli and frozen-food sections at local supermarkets.
Other industries that engage in monopolistic competition include retail stores, barber and beauty shops,
auto-repair shops, service stations, banks, and law and accounting firms.
Oligopoly
In an oligopoly, the fourth and final market structure that we will study, the market is dominated by a
few firms, each of which recognizes that its own actions will produce a response from its rivals and that
those responses will affect it.
The firms that dominate an oligopoly recognize that they are interdependent: What one firm does
affects each of the others. This interdependence stands in sharp contrast to the models of perfect
competition and monopolistic competition, where we assume that each firm is so small that it assumes
the rest of the market will, in effect, ignore what it does. A perfectly competitive firm responds to the
market, not to the actions of any other firm. A monopolistically competitive firm responds to its own
demand, not to the actions of specific rivals. These presumptions greatly simplify the analysis of
perfect competition and monopolistic competition. We do not have that luxury in oligopoly, where the
interdependence of firms is the defining characteristic of the market.
Some oligopoly industries make standardized products: steel, aluminum, wire, and industrial tools.
Others make differentiated products: cigarettes, automobiles, computers, ready-to-eat breakfast cereal,
and soft drinks.
199 ECS1501/002
ACTIVITY 9
Complete the following table by adding the appropriate characteristics:
Perfect Monopoly Monopolistic Oligopoly

competition competition
Freedom of
entry
Other
competitors
Characteristics
of product
Price setting
Interdependence
200 ECS1501/002
ANSWERS TO THE
ACTIVITIES
Activity 1
1.1 The statement is false.
Both buyers and sellers are price takers.
Producers are price takers and cannot influence the market price, and they have to take it as
given.
There must be no product differentiation, and the product should be identical or homogeneous.
Consumers should be indifferent between the products of different firms in a perfectly
competitive market – they should not prefer the product of one firm above another.
1.4 The statement is false.
There is no government intervention in perfect competition.
In reality, there are no such thing as a perfectly competitive market. However, the idea of a
competitive market serves as benchmark against what other markets can be compared.
Activity 2
2.1
Spar Cold-drinks is a price taker and is too small to influence the market equilibrium price of
cold drinks.
b. The statement is true.
Buyers of cold drinks know what the market price is and they can obtain the product from any of
the many suppliers in the market.
c. The statement is true.
If Spar Cold-drinks sells the product for more than the market equilibrium price, buyers will not
buy from the business and the quantity demanded will therefore fall to zero.
d. The statement is false.
Spar Cold-drinks can sell any quantity at the market price.
e. The statement is true.
Spar Cold-drinks can sell any quantity at the market equilibrium price and has no incentive to sell
it at a lower price.
2.6 An increase in the number suppliers will cause a rightward shift of the market supply curve.
This will cause the market equilibrium price to decrease and the individual demand curve facing
the firm will shift downwards.
201 ECS1501/002
Activity 3
3.1 a.
Quantity Price Total revenue Marginal Average

Q P TR revenue revenue
(rand) (rand) MR AR
(rand) (rand)
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10
6 10 60 10 10
b. R12. By selling an additional unit, their total revenue increases by R12.

c. R12. The price is R12, and their average revenue is also R12.
3.2 You should agree, because for Spar Cold-drinks the price (P) = marginal revenue (MR) = average
revenue (AR). The demand curve facing Spar Cold-drinks under perfect competition is therefore
also the marginal revenue curve and the average revenue curve.
202 ECS1501/002
Activity 4
4.1 Expand output. Since marginal revenue is greater than marginal cost, the firm can increase its
profits by producing more.
4.2 Leave output unchanged. Since marginal revenue is equal to marginal cost, the firm is
maximising profits. If it expands production, its profits will decrease.
4.3 Reduce output. Since marginal revenue is smaller than marginal cost, the firm should reduce its
output in order to increase its profits.
203 ECS1501/002
Activity 5
5.1
When marginal revenue is greater than marginal cost, the firm is making a profit on this
additional unit. It does not mean that the firm is making a total profit. For the firm to make a total
profit, its average revenue must be greater than its average cost.
b. The statement is false.
If a firm's average revenue (AR) is greater than its average cost (AC), it is earning an economic
profit.
c. The statement is true.
At point E, AC = MC = AR = MR = P.
d.. The statement is true.
At a point such as M, average cost (AC) is greater than the market price P.
5.2
a. At point B. Profit is maximised where marginal revenue (MR) is equal to marginal cost
(MC). This occurs at point B where MR = MC = R10.
b. It is 100. Profit is maximised at point B, and the output level at point B is 100.
c. It is R1 000. Total revenue is price times quantity = P x Q = R10 x 100 = R1 000.
204 ECS1501/002
d. It is R1 000. Total cost is average cost times quantity = AC x Q = R10 x 100 = R1 000.
e. It is the same. At point B, average cost (AC) = average revenue (AR) = R10.
f. It is making a normal profit because average revenue (AR) = average cost (AC) or total
revenue (TR) = total cost (TC). The firm will make an economic profit if average revenue
(AR) > average cost (AC) or total revenue (TR) > total cost (TC).
5.3
a. At Point A. Profit is maximised where marginal revenue (MR) is equal to marginal cost
(MC). This occurs at point A where MR = MC = R10.
b. It is 100. Profit is maximised at point A, and the output level at point A is 100.
c. It is R1 000. Total revenue is price times quantity = P x Q = R10 x 100 = R1 000.
d. It is R1 200. Total cost is average cost times quantity = AC x Q = R12 x 100 = R1 200.
205 ECS1501/002
e. It is greater. Average cost (AC) > average revenue (AR). At point B, average cost (AC) is
R12, while average revenue is R10.
f. It is making an economic loss since average revenue (AR) < average cost (AC) or total
revenue (TR) < total cost (TC). The firm will make an economic profit if average revenue
(AR) > average cost (AC) or total revenue (TR) > total cost (TC).
206 ECS1501/002
Activity 6
6.1 Shut down. Since its average revenue is smaller than its average variable cost, it should shut
down.
6.2 Continue. Since its average revenue is greater than its average variable cost, it should continue
with production. The firm has some revenue left to pay some of the fixed costs.
6.3 It should shut down. If total revenue (area 0-P1-A-Q) is less than total variable cost (area 0-P2-A-
Q), it implies that average revenue is less than average cost.
207 ECS1501/002
6.4 Continue. The price is equal to average revenue, and if average revenue is greater than average
variable cost, the firm should continue with production.
6.5 The breakeven point is represented by point A and the shutdown point by point B.
Activity 7
7.1
a. Point A is not part of the supply curve since average revenue (AR) is smaller than average
variable cost (AVC).
b. Point B is the shutdown point since at this point average revenue (AR) is equal to average
variable cost (AVC).
c. It does. At point C, average revenue (AR) is less than average cost (AC) and the firm makes an
economic loss.
d. At point D, average revenue (AR) is equal to average cost (AC) and the firm makes a normal
profit.
e. At point E, average revenue (AR) is greater than average cost (AC) and the firm makes an
economic profit.
208 ECS1501/002
f. The supply curve runs from point B onwards.
Activity 8
8.1 The statement is true. Economic profits attract new entrants and the market supply increases,
which decreases the price; and as the price decreases, economic profits decline.
8.2 If individual firms make an economic loss, it will result in existing firms exiting. The market
supply thus decreases and the market supply curve shifts leftwards and the market price
increases. This change in the market price causes the marginal revenue curve of the individual
firm to shift upwards causing the economic loss of the firm to decline. This process continues
until only a normal profit is made by the firm.
The above is illustrated in the following diagram:
209 ECS1501/002
Activity 9
Perfect Monopoly Monopolistic Oligopoly

competition competition
Freedom of Easy Barriers to Easy Difficult
entry entry
Other Many None Less than Few
competitors perfect
competition
Characteristics Homogenous Unique Differentiated Differentiated and
of product unique
Price setting Price taker Price setter Limited price Limited price setting
setting
Interdependence None None None Between firms
210 ECS1501/002
CHECKLIST
Well Satis- Must

factory redo
I am able to
describe perfect competition
list the conditions necessary for perfect competition to exist
define a price taker and price maker
define total revenue, average revenue and marginal revenue and
identify the relationship between them
define the equilibrium position of the firm under perfect competition
describe the marginal revue marginal cost approach and how it relates
to the production decision of the firm
define normal profit, economic profit and an economic loss
identify the break-even point
identify the shut-down point
explain why the supply curve for a firm is upward sloping
describe the long run equilibrium of an individual firm
identify the characteristics of a monopoly, monopolistic competition
and oligopoly
identify the essential difference between monopolistic competition
and monopoly
identify the essential difference between monopolistic competition
and perfect competition
identify the sources of monopoly power
Diagrams
I am able to
the demand curve for a perfectly competitive firm
how a change in the market influence the demand curve for a
perfectly competitive firm
the relationship between total revenue, average revenue and marginal
revenue
the break-even point and the shut-down point
the profit maximisation positon of a firm
211 ECS1501/002
Well Satis- Must
factory redo
distinguish between normal profit, economic profit and an economic
loss
the supply curve of the firm
the impact of new firms entering the market
Calculations
I am able to
calculate total, marginal, and average revenue under perfect
competition
calculate, with given prices and quantities, the profit and/or loss
position of the firm in the short run
212 ECS1501/002
Labour market
15
OVERVIEW
In our discussion of the economic problem, we have argued that the fundamental economic problem
that every society must deal with is the scarcity problem that arises since the needs and wants of society
are unlimited while its resources are limited. We have identified these limited resources as land, human
resources (which includes labour) and capital.
When we dealt with the circular flow model, we have identified the factor market as an important
market where the factors of production – of which labour is one – are bought and sold. In this learning
unit, we will take a closer look at this factor market by concentrating on the labour market.
In our discussion of demand and supply and prices, we have concentrated on the goods market and we
have explained how the equilibrium price and quantity of a good and service are determined by the
interaction of the forces of demand and supply. We have also dealt with the important issue of what
happens to the equilibrium price and quantity when the demand and supply change. And, importantly,
we have demonstrated how the economic problem of scarcity is addressed through price changes.
213 ECS1501/002
Interaction of demand and supply
Impact of an increase in demand

In this learning unit, we will use the principles of demand and supply to analyse the labour market. We
will start by looking at the demand for labour and then the supply of labour. This is followed by a
discussion of how the demand and supply of labour determines the wage – which is the price of labour.
We end the learning unit by considering the impact of a minimum wage on the labour market.
TOPIC OUTCOME
After you have worked through the learning unit, you should be able to:
• use demand and supply analysis to illustrate and explain how the wage is determined in the
labour market
• illustrate and explain the impact of a minimum wage on the labour market
15.1 The demand for labour

• explain why the demand for labour is a derived demand

• explain the concept marginal revenue product of labour
Firms are responsible for the production of goods and services. The challenge that an economic system
faces is how to ensure that firms not only produce goods and services with technical efficiency, but also
produce the right combination of goods and services to ensure allocative efficiency. Behind the supply
is firms' willingness and ability to supply goods and services and the cost of production is a major
214 ECS1501/002
determinant of the supply of a good or service. An important cost item for a firm is the cost of labour,
and an important decision for every firm is how much labour should be employed in order to supply the
market with a good or service.
Which of the following factors do you think will have an important impact on a firms' decision to
employ labour?
o The demand for the product it supplies to the market
o The price of labour (the wage rate)
o The productivity of labour
As you will shortly see, all these factors will have an important impact on the decision to employ
labour.
Demand for labour is a derived demand
What do you think will happen to the demand for labour to produce fried chicken pieces if the
demand for fried chicken pieces decreases?
o The demand for labour use in the production of fried chicken pieces will increase.
o The demand for labour used in the production of fried chicken pieces will decrease.
o The demand for labour used in the production of fried chicken pieces will be unchanged.
If the demand for fried chicken pieces decreases, the firm will produce fewer fried chicken pieces
and the demand for labour used in the production of fried chicken pieces will decrease as well.
This is true for any good or service produced by firms. If the demand for steel decreases, then the
demand for steelworkers decreases. If the demand for haircuts increases, then the demand for
barbers will increase.
Since the demand for labour depends on the demand for the good or service it helps to produce,
we refer to it as a derived demand – it is derived from the demand for the good or service. This
applies to other production factors such as land and capital as well. The demand for the factors of
production is derived from demand for the good or service produced by the factors of production.
Marginal revenue product of labour

Another important factor that influences the decision of a firm to employ labour is the productivity of
labour.
215 ECS1501/002
The following table is based on the example of the Blaker Maker that we used when we explained the
cost of production.
Total and marginal product
Variable input Total product Marginal product
labour (TP) (MP)
0 0 ---
1 500 500
2 1 500 1000
3 3 000 1500
4 4 000 1000
5 4 500 500
6 4 750 250
7 4 750 0
Study the above table and answer the following questions:

o What happens to total product as more labour are employed?
o What happens to marginal product as more labour are employed?
o What is the reason for the way marginal product behaves?
As you can see, total product increases as more units of labour are employed but the marginal
product of labour eventually decreases. The reason for this is the law of diminishing returns. If you
are not sure what this law is about, revise it before you continue.
A firm like Blaker Maker is interested in the contribution units of labour make to its total revenue and
profits. The firm needs this information to be able to decide whether it is profitable to employ an
additional unit of labour. This contribution to total revenue by an additional unit of labour is
called the marginal revenue product of labour.
To calculate the marginal revenue product of labour, we need the marginal product of labour and the
market price for the goods or services that are produced. By multiplying the marginal product of labour
(MP) with the price of the good or service (P), we obtain the marginal revenue product of labour
(MRP).
Marginal revenue product of labour = marginal product of labour multiplied by the market price
𝑴𝑴𝑴𝑴𝑴𝑴 = 𝑴𝑴𝑴𝑴 × 𝑷𝑷
If the price of a garden ornament is R5, we can calculate the marginal revenue product of labour by
multiplying the marginal product by R5. This is indicated in the following table for the first three units
of labour:
216 ECS1501/002
Marginal
Variable input Total product Marginal Price
revenue product
labour (TP) product (MP) (P)
(MRP)
0 0 --- R5 ---
1 500 500 R5 R2 500
2 1 500 1000 R5 R 5 000
3 3 000 1500 R5 R7 500
4 4 000 1000 R5
5 4 500 500 R5
6 4 750 250 R5
7 4 750 0 R5
Complete the above table by calculating the marginal revenue product for the rest of the labour
units.
As you can see from the following table, the marginal revenue product of labour declines as more
units of labour are employed.
Variable input Total product Marginal Price Marginal revenue product
labour (TP) product (MP) (P) (MRP)
0 0 --- R5 ---
1 500 500 R5 R2 500
2 1 500 1000 R5 R 5 000
3 3 000 1500 R5 R7 500
4 4 000 1000 R5 R5 000
5 4 500 500 R5 R 2 500
6 4 750 250 R5 R1 250
7 4 750 0 R5 0
217 ECS1501/002
ACTIVITY 1
1.1 Indicate whether the following statements relating to marginal revenue product is true or false:
T F
a. Marginal revenue represents the cost of employing an additional unit of labour.
b. The marginal revenue product (MRP) is obtained by the multiplying marginal
product (MP) by the market price of the product in question.
c. If the market price of the product stays the same, the marginal revenue product
increases as more units of labour are employed.
1.2 Complete the following table:
Total product Marginal Marginal

Price per pair
(pairs of product (pairs revenue
Units of labour of shoes
shoes) of shoes) product
(R)
(TP) (MPP) (MRP)
0 0 --- 70
1 12 12 70
2 22 10 70
3 31 9 70
4 36 5 70
5 40 4 70
6 42 2 70
1.3 Choose the correct term in brackets:

As more units of labour are employed, the total product (rises, falls), the marginal product (rises,
falls) and the marginal revenue product (rises, falls).
1.4 Assume the price of a pair of shoes increases to R80.
a. What happens to the total product of four units of labour?
b. What happens to the marginal product of the fourth unit of labour?
c. What happens to the marginal revenue product of the fourth unit of labour?
Marginal revenue product is the demand for labour

• graphically illustrate and explain the demand for labour

• explain why the demand for labour curve is downward sloping
• explain why a negative relationship exists between the wage rate and the quantity of labour
demanded
• explain how the marginal revenue product and the wage rate influence the employment
decisions by firms
218 ECS1501/002
The marginal revenue product represents the demand for labour. In the following diagram, the marginal
revenue product of labour curve for Blaker Maker is drawn using the data in the above table. On the
horizontal axis, the quantity of labour is plotted and on the vertical axis, the marginal revenue product
(MRP) of labour.

Note that we are only interested in the downward-sloping part of the marginal revenue product of
labour curve. As you will shortly see, this represents the demand for labour curve.
Marginal revenue product and demand for labour

To determine the quantity of labour the firm will employ, we need to know what the marginal cost of
labour is. In this case, the marginal cost of employing an additional unit of labour is the wage that is
paid to the additional unit of labour and the rule is that a profit maximisation firm will continue to
employ labour up to the point where the marginal revenue product of labour equals the marginal cost of
labour.
Marginal revenue product of labour = Marginal cost of labour = wage
MRP = MCL = w
The reasoning behind this rule is that as long as an additional worker contributes more to total revenue
than what it cost to employ this worker, it is worthwhile for the firm to employ the worker.
219 ECS1501/002
Study the above marginal revenue curve for labour and answer the following questions:
If the wage rate is R2 500 …
o will the firm employ worker number 3?

At a wage rate of R2 500, which is the marginal cost of labour, the firm will employ the third unit
of labour since the marginal revenue product of the third unit of labour exceeds the marginal cost
of employing the third unit of labour. The marginal revenue product of the third unit of labour is
R7 500 while its marginal cost is R2 500. This is also true for the fourth unit of labour. The
marginal revenue product for the fourth unit of labour is R5 000 while its marginal cost is R2 500.
This process continues until the fifth unit is employed where the marginal revenue product is equal
to the marginal cost of R2 500. The firm will not employ the sixth unit of labour since the marginal
revenue product, which is R1 000, is less than the marginal cost of R2 500. In this case, the
contribution labour makes to total revenue is less than the cost of labour which will lead to a
decrease in profits.
This employment decision is represented graphically by adding the marginal cost of labour curves
(MCL), which is the wage (w) that is paid, to our marginal revenue curve (MRP) for labour.
Demand for labour curve

From the diagram, we can see that at a wage of R7 500, three units of labour will be employed, at a
wage of R5 000, four units of labour, at a wage of R2 500, five units of labour, and at a wage of
R1 000, six units of labour. The marginal revenue curve of labour therefore represents the demand for
labour indicating that there is a negative relationship between the wage and the quantity of labour
demanded. An important consequence of this downward-sloping demand for labour curve, which is
determined by the law of diminishing returns, is that firms will only be willing to employ more workers
if the wage rate falls.
220 ECS1501/002
Market demand for labour
• graphically represent the market demand for labour
In the previous sections, we look at the demand for labour from the perspective of an individual
producer. What we are however interested in is the market demand for labour. Assuming that we are
operating in a perfectly competitive labour market and we know that there are many producers in this
market that produce the same product. To obtain the labour market demand schedule, we add all the
individual labour demand schedules. This labour market demand schedule has the same properties as
the individual labour demand schedules and it indicates that a negative relationship exists between the
wage rate and the quantity of labour demanded. This labour market demand is represented graphically
in the following diagram:
Market demand for labour
ACTIVITY 2
2.1 Indicate whether the following statements relating to the demand for labour is true or false:
T F
a. The marginal cost of labour is the cost associated with employing an additional
unit of labour and is equal to the price of the product.
b. The marginal revenue product (MRP) curve represents the demand curve for
labour.
c. A firm will continue to hire labour until MRP is equal to the wage rate.
d. If the MRP is greater than the wage rate, it will be profitable for a firm to employ
additional labour.
e. Between the wage and the units of labour employed, a positive relationship
exists.
221 ECS1501/002
2.2 Use the data in the following table to:
Marginal
Total product Price per pair of Marginal
product (pairs
Units of labour (pairs of shoes) shoes revenue product
of shoes)
(TP) (R) (MRP)
(MPP)
0 0 --- 70 ---
1 12 12 70 840
2 22 10 70 700
3 31 9 70 630
4 36 5 70 350
5 40 4 70 280
6 42 2 70 140
a. Draw the demand for labour curve.

b. Indicate how many units of labour will be employed at a wage rate of R280.
c. Indicate how many units of labour will be employed at a wage rate of R700.
d. What happens with the unit of labour employed if the wage increases?
15.2 Changes in the demand for labour

• illustrate and explain the impact of a change in the demand for a good or service on the
demand for labour
• illustrate and explain the impact of a change in productivity of labour on the demand for
labour
There are a number of factors other than the wage that will cause a change in the demand for labour.
These non-wage factors are things such as:
 the price of the product produced by labour
 the productivity of labour
 the cost of other inputs
 the number of firms
222 ECS1501/002
Consider the following scenario:
The following data represents the data for a manufacturer of shoes:
Units of labour Total product Marginal Price per pair Marginal

(pairs of shoes) product (pairs of shoes revenue
(TP) of shoes) (R) product
(MP) (MRP)
0 0 --- 70 ---
1 12 12 70 840
2 22 10 70 700
3 31 9 70 630
4 36 5 70 350
5 40 4 70 280
6 42 2 70 140
Demand for labour

If there is an increase in the demand for shoes in the shoe market, how will that influence the price
of shoes?
o It will increase the price of shoes.
o It will decrease the price of shoes.
o It will leave the price of shoes unchanged.
When we dealt with the topic of demand, supply and prices, we have seen that an increase in the
demand for a good or services increases the price of the good or services. We can therefore expect
that an increase in the demand for shoes will increase the price of shoes.
223 ECS1501/002
Assume that the price of shoes increases to R80. How will that influence the data in the above table
for our shoe manufacturer?
o It will increase the total product (TP).
o It will increase the marginal product (MP).
o It will increase the marginal revenue product (MRP).
The total product and the marginal product are unchanged since there was no change in the
productivity of the factors of production. However, the marginal revenue product is higher since
the price of shoes has increased to R80. This is indicated in the following table:
Units of labour Total product Marginal product Price per pair Marginal
(pairs of shoes) (pairs of shoes) of shoes revenue
(TP) (MPP) (R) product
(MRP)
0 0 --- 80 ---
1 12 12 80 960
2 22 10 80 800
3 31 9 80 720
4 36 5 80 400
5 40 4 80 320
6 42 2 80 160
In terms of our demand for labour curve at each wage, the demand for labour is higher and the demand
for labour curve shifts to the right.
An increase in the productivity of labour increases the total product, the marginal product and the
marginal revenue product. This is also indicated as a rightward shift of the demand for labour curve,
which implies that the demand for labour increased.
Shift in the demand for labour
224 ECS1501/002
ACTIVITY 3
The following data represents the data for a manufacturer of shoes:
Marginal
Total product Marginal product Price per pair
revenue
Units of labour (pairs of shoes) (pairs of shoes) of shoes
product
(TP) (MP) (R)
(MRP)
0 0 --- 70 ---
1 12 12 70 840
2 22 10 70 700
3 31 9 70 630
4 36 5 70 350
5 40 4 70 280
6 42 2 70 140
Assume that the productivity of labour increases as follows:
Marginal
revenue
product
(TP) (MP) (R)
(MRP)
0 0 --- 70 ---
1 15 15 70
2 28 13 70
3 40 12 70
4 48 8 70
5 55 7 70
6 60 5 70
3.1 Complete the table.
3.2 Will the demand curve for labour shift to the left or the right?
15.3 Supply of labour

• explain the difference between the income and substitution effect of a change in wages
• explain why a positive relationship exists between wages and the quantity of labour supplied
• derive the market supply for labour
225 ECS1501/002
It is now time to consider the supply of labour, and in this section you will see it is quite different from
the supply of a product. The supply of a product originates from the firm while the supply of labour is a
function of the decision made by households. Let's see what the factors are that influence the decision
by households to supply labour.
Which of the following factors do you think a household will take into account when deciding
whether to supply labour to the market or not?
o The wage that will be earned
o The goods and services that can be purchased with the wage earned
o The leisure time that must be sacrificed
o The number of hours that a person must work
All of them are important as we will shortly explain.
Individual supply of labour

In the real world, few of us can choose how many hours we would like to work. Usually an offer is
made which might allow you negotiate for the wage, but not necessarily for the hours. We will,
however, assume in the following analysis that you can determine the number of hours you wish to
work. In the following section, we will take a closer look at what the factors are that influence a
rational individual's choice on how many hours to work.
Take the case of Kevin. Kevin needs to decide how many hours to allocate to work and how many
hours to allocate to leisure. Since he is a rational individual, he will compare the marginal utility of an
additional hour of leisure with the marginal utility he gets from working an additional hour.
Assume Kevin can earn a R100 per hour. What is his marginal utility he gets from working an
additional hour? And what is the opportunity cost of working this additional hour? The marginal utility
he gets from working an additional hour is the satisfaction he derives from goods and services he can
purchase with a R100. What he gives up to earn this R100 is the loss of an additional hour of leisure.
This is his opportunity cost to work an additional hour.
If Kevin estimates that a R100 worth of goods and services adds more to his total utility than an
additional hour of leisure, what advice would you give him?
o He should work an additional hour.
o He should rather take the additional leisure time.
Since Kevin is a rational individual, he is interested in maximising his total utility. If an additional
hour of work adds more to his total utility than an additional hour of leisure, the rational choice for
him is to work an additional hour. If, however, an additional hour of leisure adds more to his total
utility than an additional hour of work, he should take the leisure hour and work fewer hours.
From this behaviour, we can derive the rule that for an individual, the optimal labour supply choice is
to allocate his or her hours between work and leisure in such a way that the marginal utility of an hour
of leisure is equal to the marginal utility derived from the goods he or she can purchase with the hourly
wage. What we observe here is the same behaviour we saw when consumers must decide how to spend
their limited income. In this case, it is time that is limited.
226 ECS1501/002
How will Kevin change his behaviour if the wage rate increases from R100 per hour to R200 per
hour?
o He will work longer hours since his incentive to work has increased. He can now afford to buy
more goods and services.
o Since he gets more income for working the same amount of hours, he will not increase his
hours of work. In this case, he prefers leisure to working and earning an income.
Both might apply to him depending on his circumstances.
We have two effects operating in different directions – the substitution effect and the income effect.
The substitution effect is where he prefers to work longer hours to obtain a higher income, which
allows him to purchase more goods and services. In this scenario, the opportunity cost of leisure, that is
the wage he gives up, has increased and he therefore allocates more time to work and less to leisure.
The income effect, on the other hand, implies that since he gets paid more per hour than before, his
total income has increased (for the same amount of hours) and he might decide to work fewer hours
since he prefers to have more leisure.
Assuming that for Kevin the substitution effect is stronger than the income effect, which of the
following applies to him?
o He will work more hours and his labour supply increases.
o He will work fewer hours and his labour supply decreases.
Since the substitution effect is greater than the income effect, he will work more hours and
sacrifice leisure time.
Between the wage rate and his labour supply (in terms of hours) a positive relationship exists. In other
words, as the wage rate increases, his labour supply increases and as the wage rate declines, his labour
supply decreases. His supply of labour curve therefore looks as follows:
227 ECS1501/002
ACTIVITY 4
Indicate whether the following statements is true or false:
T F
4.1 A rise in the wage increases the opportunity cost of leisure.
4.2 A higher wages will cause people to work more hours via the substitution effect.
4.3 A higher wages will cause people to work more hours via the income effect.
4.4 A wage increase raises the quantity of labour supplied through the substitution
effect, but it reduces the quantity supplied through the income effect.
Market supply of labour

The market supply curve is the summation of the individual supply curves and has the same properties
as the individual supply curve. Assuming that the substitution effect is greater than the income effect,
the market supply curve is upward sloping indicating that a positive relationship exists between the
wage rate and the labour supply.
Market supply of labour
15.4 Change in supply of labour

• explain what the factors are that might influence the supply of labour
A change in any factor other than the wage will cause a shift of the supply curve for labour. These are
things such as changes in preferences and social norms, changes in population, changes in wealth and
changes in working conditions.
If, for instance, there is an increase in the number of workers for an occupation due to an increase of
new entrants into the labour market, the supply of labour for this occupation will increase. In terms of
the market supply curve of labour, this is indicated by a rightward shift of the market supply curve
from S1 to S2 as indicated in the following diagram:
228 ECS1501/002
A change in social norms and preferences can also have a major impact on the supply of labour, such as
a change in the role women play in the economy since the 1960s.
ACTIVITY 5
Which of the following factors will cause an increase in the supply of labour?
1. A decrease in the wage
2. An increase in the wage
3. A decrease in the number of new entrants into the market
4. A higher participation in the labour market by women
15.5 Equilibrium in the labour market

• explain and illustrate labour market equilibrium, excess demand for labour and excess supply
of labour
Equilibrium in the labour market occurs where the quantity of labour demanded equals the quantity
supplied.
The following diagram represents the labour market for a manufacturer of shoes:
229 ECS1501/002
o At which point is the quantity of labour demanded equal to the quantity of labour supplied?
o What is the equilibrium quantity of labour units?
o What is the equilibrium wage rate
Equilibrium occurs a point E where the quantity of labour demanded is equal to the quantity
supplied. The equilibrium quantity of labour is 2 000 and the equilibrium wage rate is R100.
Let's see what happens in the labour market if the wage is higher or lower than the equilibrium wage
rate.
Excess supply of labour

If the wage rate is R200, which is higher than the equilibrium wage rate of R100, will this cause an
excess demand for labour or an excess supply of labour?
A wage rate higher than the equilibrium wage causes a decrease in the quantity of labour demanded, an
upward movement along the demand for labour takes place, and an increase in the quantity of labour
supplied, an upward movement along the supply curve of labour takes place. The reason for the
decrease in the quantity of labour demanded is because firms compare the marginal revenue product of
labour with the wage rate and a higher wage rate requires a higher marginal revenue product, which can
only be achieved by decreasing the quantity of labour. The quantity of labour supplied increases as the
wage rate increases since people are willing to supply more labour in return for a higher income, which
allows them to purchase more goods and services. Note that in this case the substitution effect
dominates.
Since the quantity of labour demanded is less than the quantity of labour supplied, an excess supply of
labour exists. In a competitive labour market, this will cause a decline in the wage until equilibrium is
reached where the quantity of labour demanded is equal to the quantity of labour supplied. In our
diagram, this occurs as point E.
Excess demand for labour

If the wage rate is R50, which is lower than the equilibrium wage rate of R100, will it cause an excess
demand for labour of an excess supply of labour?
A wage rate lower than the equilibrium wage causes an increase in the quantity of labour demanded
and a decrease in the quantity of labour supplied. Since the quantity of labour demanded is less than the
quantity of labour supplied, an excess demand for labour exists. In a competitive labour market, this
will cause an increase in the wage until a point is reached where the quantity of labour demanded is
equal to the quantity of labour supplied. This occurs at point E in the diagram.
230 ECS1501/002
ACTIVITY 6
Use the following diagram to indicate the following positions in this labour market:
6.1 If the wage rate is higher than the equilibrium wage.

6.2 If the wage rate is lower than the equilibrium wage.
15.6 Impact of minimum wages

• explain and illustrate the impact of a minimum wage on a competitive labour market
Read through the following extract and consider the questions that follows:
Labour experts have criticised a World Bank report that, among other things, suggests that the
introduction of a national minimum wage in South Africa would shift labour demand towards
skilled labour.
The conclusions are contained in the 11th edition of the South Africa Economic Update
released in April.
In it, the bank writes that the implementation of the minimum wage is to be set at R20 an hour,
would also deepens the intensity of capital at the expense of unskilled labour and
disproportionally affects the price of goods consumed by the poor.
231 ECS1501/002
While the bank said the effect of the legislation on inequality was not clear-cut given poor
enforcement, its microeconomic analysis suggested "that the introduction of the national
minimum wage would have a positive, but marginal, impact on reducing inequalities,
depending on its negative effect on employment".
Business Day understands that local labour institutions are planning to challenge the report and
other suggestions shared by the World Bank in a presentation entitled Overcoming Poverty and
Inequality in South Africa:
https://www.businesslive.co.za/bd/national/2018-05-10-why-the-world-bank-and-ilo-are-at-
odds-over-minimum-wage/
Questions for reflection:
1. What are the possible negative impact on employment of a national minimum wage?
2. Why would the intensity of capital deepen and how will it influence unemployment of
unskilled workers?
During 2018, the South African government introduced a national minimum wage of R20 per hour. In
the following analysis, we will make use of demand and supply analysis to determine the possible
impact of a minimum wage on a competitive labour market.
Study the following diagram of a competitive labour market and answer the questions:
o What is the equilibrium wage?

o What is the quantity of labour employed at this equilibrium wage?
The equilibrium wage is R2 500 and the equilibrium quantity of labour employed is 10 000.
232 ECS1501/002
Assume a minimum wage of R3 000, which is higher than the equilibrium wage is imposed on this
competitive labour market. This is illustrated in the following diagram:
o What is the quantity of labour hours demanded at this minimum wage of R3 000?
o What is happening to the quantity of labour supplied at this minimum wage of R3 000?
o What happens to unemployment at this minimum wage of R3 000?
o Who benefits and who loses when a minimum wage higher than an equilibrium wage is
introduced in a competitive labour market?
From the diagram, it is clear that an introduction of a minimum wage of R3 000 decreases the
quantity of labour demanded from 10 000 to 8 000, while the quantity of labour supplied increases
from 10 000 to 12 000.
Unemployment increases since firms employ less labour and more people are willing to work than
before. The people who are able to find employment at the minim wage benefits since they earn a
higher income, while the people who loses their jobs because of the minimum wage loses.
Some economists oppose increases in the minimum wage on grounds that such increases boost
unemployment. Other economists argue that the demand for unskilled labour is relatively inelastic, so a
higher minimum wage boosts the incomes of unskilled workers as a group. That gain, they say, justifies
the policy, even if it increases unemployment.
ACTIVITY 7
The table below provides data for the market for house cleaners:
Market for house cleaners
Wage rate Quantity Quantity
per day demanded supplied
50 4 000 2 000
100 3 500 2 500
150 3 000 3 000
200 2 500 3 000
250 2 000 4 000
7.1 Draw the demand and supply curve for house cleaners.
233 ECS1501/002
7.2 What is the equilibrium wage rate and the equilibrium quantity of labour?
7.3 What is the total daily income of house cleaners at the equilibrium wage?
7.4 Assume a daily minimum wage of R200 is imposed on the market.
a. How many house cleaners will be employed at the minimum wage of R200?
b. How many house cleaners will lose their jobs due to the minimum wage?
c. What is the total daily income of house cleaners at the minimum equilibrium wage?
234 ECS1501/002
ANSWERS TO THE
ACTIVITIES
Activity 1
1.1
a. False.
Marginal revenue of labour represents the contribution of an additional unit of labour to total
revenue.
b. True.
Marginal revenue product of labour = marginal product of labour x market price.
c. False.
If the price stays the same, the marginal revenue product of labour will decline as more units of
labour are employed.
1.2
Units of Total product Marginal Price per pair Marginal

labour (pairs of product (pairs of shoes revenue
shoes) of shoes) (R) product
(TP) (MPP) (MRP)
0 0 0 70 0
1 12 12 70 840
2 22 10 70 700
3 31 9 70 630
4 36 5 70 350
5 40 4 70 280
6 42 2 70 140
1.3 As more units of labour are employed, the total product rises, the marginal product falls and the
marginal revenue product falls.
1.4
a. The marginal product is unchanged.
b. The marginal product of the fourth worker is unchanged.
c. The marginal revenue product of the fourth unit of labour increase from R350 to R400 (5 x
R80).
Activity 2
2.1
a. False.
235 ECS1501/002
The marginal cost of labour is the cost associated with employing an additional unit of labour and
is equal to the wage.
b. True
c. True.
As long as the contribution of an additional unit of labour exceeds the cost of employing the
additional unit, it is profitable for the firm to employ the additional unit of labour.
d. True.
As long as the marginal revenue product of an additional unit of labour exceeds the wage, it is
profitable for the firm to employ the additional unit of labour since the additional unit contribute
more to revenue that what it costs to employ the unit.
e. False.
A negative relationship exists.
2.2 a, b and c
d. As the wage increases, the quantity of labour demanded decreases.
Activity 3
3.1
Marginal
revenue
product
(TP) (MP) (R)
(MRP)
0 0 0 70 0
1 15 15 70 1 050
2 28 13 70 910
3 40 12 70 840
4 48 8 70 560
5 55 7 70 490
6 60 5 70 350
236 ECS1501/002
3.2 It increases and will therefore shift the demand curve for labour to the right.
Activity 4
4.1 True
4.2 True
4.3 False. A higher wage will cause people to work fewer hours if the income effect dominates.
4.4 True
Activity 5
Only 4
Remember that a change in the wage rate causes a movement along the supply curve, which indicates a
change in the quantity supplied and not a change in supply.
Activity 6
6.1 If the wage rate is higher than the equilibrium wage, an excess supply of labour exists.
6.2 If the wage rate is lower than the equilibrium wage, an excess demand for labour exists.
237 ECS1501/002
Answers to activity 7
7.1
7.2 The equilibrium wage is R150 per day and the equilibrium quantity of labour is 3 000.
7.3 The total daily income for all house cleaners is R150 x 3 000 = R450 000.
7.4.
a. At a minimum wage of R200 per day, 2 500 house cleaners will be employed.
b. The number of house cleaners that will lose their jobs is 3 000 – 2 500 = 500.
c. The total daily income of house cleaners at R200 is R200 x 2 500 = R500 000.
238 ECS1501/002
CHECKLIST
Well Satis- Must

factory redo
I am able to
explain why the demand for labour is a derived demand
explain the relationship between the total product of labour, marginal
product of labour and marginal revenue product of labour
explain the negative relationship between the wage and quantity of
labour demanded
identify factors that influence the demand for labour
differentiate between the income and substitution effect with regards
to the supply of labour
explain why a positive relationship exists between the wage and the
quantity of labour supplied
identify factors the influence the supply of labour
define equilibrium in the labour market
explain an excess supply in the labour market
explain an excess demand in the labour market
explain the impact of a minimum wage in the labour market in terms
of employment, unemployment and income
Diagrams
I am able to
the market demand for labour
a change in the demand for labour
the market supply of labour
a change in the supply of labour
equilibrium in a perfectly competitive labour market
excess supply of labour
excess demand for labour
impact of a minimum wage on the labour market
239 ECS1501/002

Study Guide 002 Ecs1501

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Study Guide 002 Ecs1501

Uploaded by

Copyright:

Available Formats

© 2019 University of South Africa

All rights reserved

Printed and distributed by

Compiled by the Department of Economics

Pdf: Florida Campus

Principles of Economics (https://open.lib.umn.edu/principleseconomics/) which is adapted from a

9.1 Price ceiling and price floor

• distinguish between a price ceiling and price floor

1.1 Which one of the following is an example of a price ceiling?

9.2 Impact of a price ceiling (maximum price)

• illustrate and explain the impact of a price ceiling

This is the argument we will develop in the rest of the section.

Study the following diagram and answer the following questions:

o What is the quantity demanded at a price of R2 000? ______

 an excess demand of 20 000 apartments are created.

"Fees must fall"

Consequences of a price ceiling

How do you think this rationing should be resolved?

• illustrate and explain the impact of a price floor

Impact of a price floor (maximum price)

Market for eggs (millions)

Market for eggs (millions)

Study the above diagram and answer the questions:

Indicate whether the following statements are true or false:

Market for eggs (millions)

Consequences of a price floor (maximum price)

• consequences of a price floor

Market for eggs

How do you think the rationing should be resolved?

2.1 What is the market equilibrium fee per course?

Market for milk

Market for milk

Market for milk

Market for milk

Market for milk

Well Satis- Must

Excess supply Excess demand

Questions for reflection

10.1 What do we do when prices increase?

Which one of the following would upset you the most?

10.2 Description of price elasticity of demand

The question we are dealing with is:

a. The price elasticity of demand provides us with a measure of how sensitive or

10.3 Measurement of price elasticity of demand

• describe the measurement of price elasticity

Using symbols, this is written as follows:

Price (P) Quantity demanded (Qd)

Arch elasticity: Midpoint method

Price (P) Quantity demanded (Qd)

Step 1: Calculate the midpoints for P and (Qd)

• describe and differentiate between the different types of price elasticities

Goods and Price elasticity Goods and services Price elasticity

3.1 You are given the following information:

Goods and services Price elasticity

Relatively inelastic demand

Relatively inelastic demand

Examples are: salt, coffee, medical care and beer.

Relatively elastic demand

• If ep > 1, we have a relatively elastic demand.

Relatively elastic demand

• If ep = 1, we have a unitary elastic demand.

Perfectly inelastic demand

Perfectly inelastic demand