Generic-Microeconomic Essentials

MICROECONOMIC ESSENTIALS
Module Guide
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MANCOSA
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This module guide,
Microeconomic Essentials(NQF Level 5)
will be used across the following programmes:
Bachelor of Business Administration
Bachelor of Commerce in Accounting
Bachelor of Commerce in Entrepreneurship
Bachelor of Commerce in Financial Management
Bachelor of Commerce in Human Resource

Management
Bachelor of Commerce in Information and

Technology Management
Bachelor of Commerce in International Business
Bachelor of Commerce in Marketing Management
Bachelor of Commerce in Project Management
Bachelor of Commerce in Retail Management
Bachelor of Commerce in Supply Chain

Management
Bachelor of Public Administration

Microeconomic Essentials
Table of Contents
Preface 2
Unit 1: Introduction to Microeconomics 9
Unit 2: A Closer Look at the Economic Problem of Scarcity 16
Unit 3: The Circular Flow of Income and Spending 25
Unit 4: Demand, Supply and Prices 30
Unit 5: Demand and Supply in Action 49
Unit 6: Elasticity 64
Unit 7: The Theory of Production and Cost (Background To Supply) 83
Unit 8: Perfect Competition 97
Unit 9: Imperfect Competition 110
Bibliography 123
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Preface
A. Welcome
Dear Student
It is a great pleasure to welcome you to Microeconomic Essentials (MIE5). To make sure that you
share our passion about this area of study, we encourage you to read this overview thoroughly. Refer
to it as often as you need to, since it will certainly make studying this module a lot easier. The
intention of this module is to develop both your confidence and proficiency in this module.
The field of Economics is extremely dynamic and challenging. The learning content, activities and
self- study questions contained in this guide will therefore provide you with opportunities to explore
the latest developments in this field and help you to discover the field of Economics as it is practiced
today.
This is a distance-learning module. Since you do not have a tutor standing next to you while you
study, you need to apply self-discipline. You will have the opportunity to collaborate with each other
via social media tools. Your study skills will include self-direction and responsibility. However, you will
gain a lot from the experience! These study skills will contribute to your life skills, which will help you
to succeed in all areas of life.
Please note that some Activities, Think Points and Revision Questions may not have answers
available, where answers are not available this can be further discussed with your lecturer at
the webinars.
We hope you enjoy the module.
-------
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must obtain permission from the copyright owner.
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B. Module Overview
The module is a 15 credit module at NQF level 5
Aims of this module:
Understand what is meant by microeconomics

Understand the economic problem of scarcity
Understand the interdependence of major sectors in the economy
Analyse how market forces of demand and supply determine equilibrium
Understand the concept of price and income elasticity
Understand the theory of production and costs
Understand the different market structures
Compare the salient features of each market structure
Understand the equilibrium position of each market structure
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C. Learning Outcomes and Associated Assessment Criteria of the Module
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5
D. How to Use this Module

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

a simple, easy-to-learn format. You should read ahead during your course. Make a point of it to re-
read the learning content in your module textbook. This will increase your retention of important
concepts and skills. You may wish to read more widely than just the Module Guide and the
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prescribed and recommended textbooks/readings, the Bibliography and Reference list provides you
with additional reading.
The prescribed and recommended textbooks/readings for this module is:
Prescribed Reading(s) / Textbook(s)
Mohr, P. and Fourie, L. (2020). Economics for South African Students. Sixth Edition. Pretoria,
South Africa: Van Schaik.
Recommended Reading(s)
Begg, D.K.H. and Ward, D. (2020). Economics for Business. Sixth Edition. New York: McGraw
Hill.
Schiller, B.R. (2023). Essentials of Economics. Twelfth Edition. New York: McGraw Hill.
Van Rensburg, J. J, McConnell, C.R., Brue, S.L. and Flynn, S.M. (2021). Economics: A Southern
African Context. Third Edition. University of Pretoria, Stellenbosch: McGraw Hill.
G. Special Features
In the Module Guide, you will find the following icons together with a description. These are designed to
help you study. It is imperative that you work through them as they also provide guidelines for
examination purposes.
~~~~~~~~~~~~~~
Special Feature Icon Description
The Learning Outcomes indicate what aspects of the particular

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

ASSOCIATED
understanding with respect to agreed-upon outcomes. The
ASSESSMENT
Criteria set the standard for the successful demonstration of the
CRITERIA
understanding of a concept or skill.
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A think point asks you to stop and think about an issue.

THINK POINT Sometimes you are asked to apply a concept to your own
experience or to think of an example.
You may come across activities that ask you to carry out specific
tasks. In most cases, there are no right or wrong answers to
ACTIVITY
these activities. The aim of the activities is to give you an
opportunity to apply what you have learned.
At this point, you should read the reference supplied. If you are
unable to acquire the suggested readings, then you are
READINGS
welcome to consult any current source that deals with the
subject. This constitutes research.
PRACTICAL
Real examples or cases will be discussed to enhance
APPLICATION
understanding of this Module Guide.
OR EXAMPLES
You may come across knowledge check questions at the end of

KNOWLEDGE
each Unit in the form of Multiple-choice questions (MCQ’s) that
CHECK
will test your knowledge. You should refer to the module for the
QUESTIONS
answers or your textbook(s).
You may come across self-assessment questions that test your

REVISION understanding of what you have learned so far. These may be
QUESTIONS attempted with the aid of your textbooks, journal articles and
Module Guide.
Case studies are included in different sections in this module

CASE STUDY guide. This activity provides students with the opportunity to
apply theory to practice.
VIDEO You may come across links to videos as well as instructions on

ACTIVITY activities to attend to after watching the video.
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Unit
1: Introduction to Microeconomics
Unit 1: Introduction to Microeconomics
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Unit Learning Outcomes
Prescribed Textbook

Mohr, P. and Fourie, L. (2020). Economics for South African Students.
Sixth Edition. Pretoria, South Africa: Van Schaik.
Begg, D.K.H. and Ward, D. (2020). Economics for Business. Sixth
Edition. New York: McGraw Hill.
Schiller, B.R. (2023). Essentials of Economics. Twelfth Edition. New

York: McGraw Hill.
Van Rensburg, J. J, McConnell, C.R., Brue, S.L. and Flynn, S.M. (2021).
Economics: A Southern African Context. Third Edition. University of
Pretoria, Stellenbosch: McGraw Hill.
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1.1 Introduction
Economics is a social science that studies human behaviour as a relationship between ends and
scarce means which have alternative uses. Consequently, economics examines the problems that
arise when individuals and firms have consumption desires that are constrained by access to
resources. This problem is often referred to as infinite wants and finite resources.
1.2 Macroeconomics versus Microeconomics

Microeconomics, on the one hand, focuses on the individual participants in the economy:
producers, workers, employers and consumers. Microeconomic policies focus on specific markets.
Macroeconomics on the other hand is concerned with the economy as a whole. It focuses on
aspects such as the stability of the general price level (commonly known as inflation), the
maintenance of full employment, economic growth, the distribution of income, government spending,
and the nation’s money supply.
Activity 1.1
a) During the last 12 months average car prices have fallen
b) Inflation for the past 12 months has been 3.5%
c) Strong sales in the housing market have prevented the South African
Reserve Bank from reducing interest rates
1.3 Limited Resources

Before we continue, we need to distinguish between wants, needs and demand:
Wants are our desires for goods and services, and are unlimited – we all want everything!
Needs are necessities, essential for our survival, examples include food, water, shelter.
Demand differs from wants, desires or needs. For there to be demand for a good or service,
those who want to purchase it must have the necessary means to do so. They must have the
purchasing power. (Mohr and Fourie, 2015:6)
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1.4 The Problem of Scarcity

Now that we have distinguished between wants, needs and demand, attention should now be on the
economic problem of scarcity.
People’s unlimited wants cannot be met with the limited resources available, as such choices
need to be made. But what are these resources which are in limited supply? Resources are used to
produce goods and services and are referred to as factors of production. Since the factors of
production (resources) used in the production of goods and services are limited, it follows that the
goods and services which can be produced with them are also limited.
Factors of production are divided into four main categories:
natural resources (land, minerals)

labour
capital
entrepreneurship
Natural resources and labour are also known as primary factors of production, whilst capital and
entrepreneurship are called secondary factors.
As these factors of production are scarce, we are forced to make difficult choices. The use of scarce
resources to produce a certain good or service, means that those resources are not available to
produce other goods or services. Stated differently, a decision to produce more of one good means
that less of another good can be produced. Because resources are scarce, their use is never
costless. This point is captured in the economic saying, “there ain’t no such thing as a free lunch”.
There are always costs involved. This leads us to the principle of opportunity cost.
Think Point 1.1

Consider whether it is ever possible to solve the problem of scarcity
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1.5 Opportunity Costs

“The opportunity cost of a choice is the value to the decision maker of the best alternative that
could have been chosen but was not chosen. In other words, the opportunity cost of a choice is the
value of the best forgone opportunity” (Mohr and Fourie, 2015:7).
Every time we make a choice, we incur opportunity costs. Economist use opportunity cost to
measure the costs incurred in choices. Opportunity cost is a key concept in economics as it captures
the essence of scarcity and choice. The economic principles of scarcity, choice and opportunity cost
are captured in the production possibilities curve.
Note: Scarcity should not be confused with poverty. Scarcity affects everyone.
Activity 1.2
List goods or services that compete for your income. Similarly, list activities
that compete for your time. In deciding what you will spend your income on
and how you will allocate your time, do you minimise your opportunity cost?
1.6 The Production Possibility Curve

“No matter how an economy is organized, there’s a limit to how much it can produce. The most
evident limit is the amount of resources available for producing goods and services.
One reason the United States can produce so much is that it has over 3 million acres of land. Tonga,
with less than 500 acres of land, will never produce as much. The U.S also has a population of over
300 million people. That’s a lot less than China (1.3 billion), but far larger than 200 other nations
(Tonga has a population of less than 125, 000).So an abundance of resources gives us (U.S) the
potential to produce a lot of output. But that greater production capacity isn’t enough to satisfy all our
desires.” (Schiller, 2013)
As previously noted, the economic principles of scarcity, choice and opportunity cost are captured in
the production possibilities curve. The production possibility curve (Figure 1-1) shows the
maximum amount of production that can be produced by an economy with a given amount of
resources.
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Figure 1-1 A production possibilities curve for the Wild Coast community
(Mohr and Fourie, 2015:6)
The production possibility frontier (PPF) in Figure 1-1, shows the maximum amounts of potatoes and
fish that can be produced by a rural community when the community uses its resources fully and
efficiently (refer to text for detailed description).
At A, 100kg of potatoes can be produced per day by devoting all their time and available resources
to gardening. Likewise, at F, 5 baskets of fish can be produced per working day, if all time and
available resources are devoted to fishing. By shifting resources from one production possibility to
the other, the community can enjoy a diet of both fish and potatoes.
In our example, in moving from C to D, the community actually transforms part of the production of
potatoes into fish. Combinations on the PPF represent the maximum amounts that can be produced
by efficiently using all available resources. The PPF demonstrates graphically, the principle of
opportunity cost. In our example, the opportunity cost of producing 40kg of potatoes is the basket of
fish forgone. Similarly, the opportunity cost of producing 4 baskets of fish is the 60kg of potatoes
forgone. All points to the right of the curve, such as G are unattainable. G is unattainable due to
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scarcity, a lack of resources to achieve that level of production.
Choice is illustrated by the need to choose between the combinations available, and opportunity cost
is illustrated by the negative slope of the curve. The negative slope, showing that more of one
good can only be obtained by sacrificing the other good. Opportunity cost increases as we move
along the PPF. This can be seen by paying attention to the concave shape of the curve.
1.7 Why do Opportunity Costs Increase Along the PPF?

This occurs for the most part, because it is difficult to move resources from one industry to another.
Resources do not adapt easily. Workers may not have the same skills across the industries, so as we
move them from one industry to the other we get fewer of one good for every other good that is given
up.
There are difficulties in transferring labour, skills, capital and entrepreneurship between industries.
These difficulties are so well known that they are often referred to as the law of increasing
opportunity cost. The law states that ever-increasing quantities of other goods and services need to
be given up in order to get more of a particular good. This law is not solely based on the lack of
movement of skilled labour.
The mix of factors required to make a certain good is also a factor. One good may require a more
capital intensive production process as opposed to the other (Schiller, 2013: 8).
YOU ARE NOW READY TO ANSWER THE QUESTIONS FOUND IN THE WORKBOOK RELATING
TO THIS STUDY UNIT
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Unit
2: A Closer Look at the Economic
Problem of Scarcity
Unit 2: A Closer Look at the Economic Problem of Scarcity
16
Prescribed Textbook:


York: McGraw Hill.
17
2.1 Improved Techniques or Increased Resources

Recall our example on the rural community who could either produce fish, or potatoes, or a
combination of the two.
Figure 2-1 The production possibilities curve once again
Figure 2-1. With a given level of resources and a given state of technology, the community can
produce various combinations of fish and potato output. However, they cannot move beyond the
points ABCDEF (AF for short). This is why the curve is sometimes called a production possibility
boundary of frontier.
It shows the maximum attainable combinations of goods that can be produced, or potential output. Its
concave shape (from the origin) indicates increasing opportunity costs. Any combination within the
frontier is attainable, however, such combinations are inefficient because either available
resources are not being used to their full potential (inefficiently) or some of them are left idle
(unemployment).
In the event that the economy is operating at less than potential output (actual output is therefore
less than potential output), this would be illustrated as a point inside the production possibility
curve/frontier (PPF). Some of the available resources are either unemployed or not employed
efficiently.
Point H in figure 2-1 is an example of this. At a point such as H, more output of one good would not
require less output of the other, there would be no opportunity cost when output is expanded. It is
therefore possible to expand production by simply using the existing resources fully and more
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efficiently (given the state of technology).
We need to fully and efficiently utilize scarce resources. This will occur when production is taking
place on the production possibilities curve. Actual output is equal to potential output when
production takes place on the production possibilities curve. Furthermore, when we are on it, it is
impossible to produce more of one good without sacrificing some production of the other good.
“Production efficiency means more output of one good can be obtained only by sacrificing output of
other goods” (Begg, Fischer and Dornbusch, 2014:7).
A point such as G in figure 2-1 is unattainable. Any point beyond AF is unattainable. With the given
available resources and current production techniques, achieving a combination such as G or any
combination outside of AF is impossible. However, if over time the quantity of available resources
increase, and/or production techniques improve, then points beyond AF will be attainable. If this
happens then the PPF will shift outwards. Outward movements of the PPF illustrate economic
growth.
Figure 2-2 Improved technique for producing capital goods
Referring to Figure 2-2, an improved technique for producing capital goods has been developed. It
is now possible to produce more capital with the available factors of production. Assuming the
available factors of production and the technology for producing consumer goods remain the same,
then maximum production of consumer goods will remain at A.
If all available resource were used in the production of capital goods, then maximum production of
capital goods would increase from B to C, and the new PPF is AC. With the exception of point A, it is
now possible to produce more of both goods.
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Production of both goods has increased, with the exception of the intercept point A. Remember, an
improved technique implies that less resources are required to produce the same level of
output.
Therefore, if there is an improved technique for producing capital goods, then for any given level of
capital production, more resources could be moved over to the production of consumer goods.
Likewise, with the same levels of resources, we can now produce more capital goods. Therefore, as
we move resources over to capital goods production, we produce more output than we previously
could have.
Figure 2-3 Improved technique for producing consumer goods
Referring to Figure 2-3. Similarly, new technique for producing consumer goods is developed.
Available resources and the technique for producing capital remains the same. Maximum potential
output for consumer goods will increase. PPF swivels around point B so the new PPF is DB. Except
at point B, it is possible to produce more of both goods.
Figure 2-4 below illustrates a shift in the PPF from AB to EF. A shift in the PPF occurs if the amount
of available resources (e.g.: labour, raw materials) and/or the productivity of available resources
increase. There is now the possibility of producing more of both capital and consumer goods.
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Potential output has increased.
Figure 2-4 Increase in the quantity or productivity of the available resources
In the case where the amount of resources or their productivity (efficiency) decrease, there will be a
decline in potential output. This decline can be illustrated by an inward shift of the PPF. In our case it
would result in a reversal of Figures 2-2, 2-3 and 2-4.
The PPF illustrates potential output, however, it does not indicate which of the possible combinations
of output should be produced. The final choice will depend on the preferences of society.
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Activity 2.1
1. Consider an economy produces two goods, Ferrari cars and Ray-Ban

sunglasses. Using a production possibility frontier, assess what will happen to
the production of Ferrari cars if the production of Ray-ban sunglasses
decreases
2. The same Ferrari and Ray-Ban economy receives an influx of migrant

workers. What do you think will happen to the production possibility frontier for
this economy?
2.2 The Three Central Economic Questions

The three central questions (What? How? For whom?) are used to introduce a variety of concepts,
distinctions, factors of production, and economic systems.
2.2.1 What should be produced?
The purpose of economic activity is to satisfy human wants. Goods and services satisfy most wants.
Goods are tangible objects like food, clothing, houses and books. Services are intangible things
like medical services and legal services. We assume that all goods and services are useful and as
such maximum production is desirable. Please refer to prescribed text (Mohr and Fourie:2015:18-19)
for definition of capital and consumer goods and final and intermediate goods. You are required to
know these for future reference in the module.
2.2.2. How it should be produced?
After deciding what goods and services are to be produced, the next step is to decide how the goods
and services will be produced.
Scarce resources have to be used efficiently. What are these resources?
Resources used to produce goods and services are called factors of production. There are four
main factors of production:
natural resources (land, minerals) – primary

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

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

Good and services are produced for government (the public sector) and the rest of the economy (the
private sector). There is also a geographical distribution of the income between regions of a country
and between sectors (known as primary, secondary and tertiary sectors).
TO THIS STUDY UNIT
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Unit
3: The Circular Flow of Income and
Spending
Unit 3: The Circular Flow of Income and Spending
25


York: McGraw Hill.
26
3.1 Introduction
The circular Flow of Income shows the flow of inputs, outputs and payments between households
and firms within an economy. This model captures the essential essence of macroeconomic activity.
The economy is seen as nothing more than:
A revolving flow of goods,

Production resources, and
Financial payments.
3.2 A Simple Circular Flow Model of Income and Spending
Figure 3.1 The three major flows
(Mohr & Fourie: 2015:41)
The circular flow model illustrates the mechanism by which income is generated from goods and
services and how this income is spent. This is best understood by analysing the diagram below:
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Figure 3.2 A Simple Circular Flow Model of Income and Spending

(Mohr & Fourie: 2015:51)
Firstly, let us consider households who are buyers, and firms who are producers and sellers of goods
and services in the goods and services market: Firms are buyers of factors of production and
households become sellers of factors of production in the factor market.
The next participant that we introduce into the model is the government. The government is
responsible for providing public goods and services, such as roads, bridges, etc. for usage by
households and firms.
In order for government to provide these public goods and services, it receives tax revenue from
households and firms. Hence, again we have flow of income in the form of tax paid by firms and
consumers and tax received by the government. In addition, government provides subsidies to firms
and households - flow of income.
Next, we introduce the financial sector, which mainly comprises of financial institutions, where
consumers and firms deposit funds and earn interest on savings. In addition, firms and consumers
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take loans to invest in capital goods and assets, and have to pay interest on loans. Finally, we
introduce the foreign sector. In the foreign sector, importing countries pay using foreign exchange for
imported goods and services, and exporting countries earn foreign currency for exporting goods and
services.
This simple circular flow model of income, output and spending represents the workings of a simple
economy, and illustrates the importance of economic interdependence. It further highlights the
mutual dependence between the micro economy and the macro economy.
Activity 3.1
Identify the leakages and injections components of aggregate expenditure in

your circular flow diagram
TO THIS STUDY UNIT
29
Unit
4: Demand, Supply and
Prices
Unit 4: Demand, Supply and Prices
30


York: McGraw Hill.
31
4.1 Introduction
This is an important study unit, as it lays the foundation for most of the economic analysis in
Economics 1A
4.2 Demand
In economics, demand for a good or service means that there is both the intent to buy it and the
means (i.e. purchasing power) to do so.
Therefore, demand refers to the quantities of a good or service that potential buyers are willing
and able to buy. Furthermore, demand relates to the plans of households, firms and other
participants in the economy. It does not relate to events which have already occurred. As demand is
concerned with plans and not events which have occurred, this means that the quantity demanded
and the quantity actually bought may differ.
Quantity demanded may in fact be equal to, greater than, or less than the quantity bought.
4.2.1 Individual demand
We will use the case of Anne Smith, (Mohr and Fourie:2015:61) an imaginary consumer who
demands tomatoes.
What are the determinants and properties that will determine the quantity of tomatoes that Anne
plans to purchase in a particular period?
The price of the product
Anne will be willing and able to buy a larger amount of tomatoes the lower the price, ceteris paribus.
The prices of related products.
The price of related products will also influence Anne’s decision on how many tomatoes to purchase.
In the case of related products, we have to distinguish between complements and substitutes
Complements are goods that are used together with the good concerned. In our case bread (for
sandwiches) and onions (for cooking) are examples of goods that would complement tomatoes.
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Substitutes are goods that can be used instead of using the good concerned. For example,
tomatoes can be replaced with other ingredients in a salad.
The income of the consumer.
Income also affects Anne’s plans as it determines her purchasing power (her ability to purchase). A
higher income means that she can afford (plan) to buy more tomatoes
The taste (or preference) of the consumer.
Anne’s decision on how many tomatoes to purchase will also be influenced by her tastes. If Anne
has a liking for tomatoes or foods which require tomato then she will plan to buy more tomatoes.
However, if she doesn’t like tomatoes, or if she has been ordered not to eat them by a doctor, this too
will affect her decision. These influences are non-measurable and are lumped together under “taste”.
They may also have a negative or positive impact on the quantity demanded.
The size of the household.
As households grow in size, they tend to purchase more goods and services. Likewise, smaller
households tend to purchase less.
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Figure 4-1 Anne Smith`s weekly demand for tomatoes
(Mohr and Fourie, 2015: 63)
In figure 4-1 above, the price of tomatoes (rand per kg) is on the vertical (y) axis and the quantity of
tomatoes demanded (kg per week) is listed on the horizontal (x) axis.
Note, it is crucial that you label the axis of these graphs correctly as they form the basis of the
diagram. Each point on the diagram represents a combination of both price and quantity demanded.
For example, at point a, 6kg of tomatoes will be demanded if the price of tomatoes is R1 per kg.
By joining all the various points which express the relationship between the price of a good and the
quantity demanded, we obtain the demand curve.
The negative slope of the demand curve (point e to point a), indicates that there exists a negative
or inverse relationship between price and quantity demanded (i.e. the law of demand).
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The negative relationship between price and quantity demanded is often exploited by businesses.
For example, a “buy one get one free” offer. Firms use such offers because they are sometimes
reluctant to reduce the price of their products. This is because explicit price reductions could lead to
retaliatory price wars from rivals. Lower prices may also provide a signal; to the market that the
product is of an inferior quality. A ‘buy one get one free’ offer allows the published price to stay the
same but the effective price for consumers is halved. Under such an offer, consumers are more
willing to demand the product and, not surprisingly, companies use such promotions to boost sales
and gain market share.
Furthermore, we all like end-of-season sales at our favourite clothing retailers, but sales simply
represent an attempt by the retailers to shift products that we, as consumers, would not buy at the
higher price and are, therefore, another example of the demand curve in action.
We plot the demand curve for a good or service on the assumption that, all other determinants are
constant (i.e. ceteris paribus).
Market Demand
The market demand curve is simply the sum of all of the individual demand curves for a particular
good or service. Therefore, in a situation where the market consists of three prospective buyers,
Anne Smith, Helen Rantho and Purvi Bhana, to obtain the market demand curve we would add all
their demand curves together.
The market demand curve is therefore obtained by adding the individual demand curves horizontally
(i.e. at a price of R5 Anne demands 2 tomatoes, Helen 0 and Purvi 1, therefore market demand at
R5 = 3 tomatoes demanded). This process of adding up the demand curves horizontally is
demonstrated in figure 4-2 below, where the individual demand curves are shown to the left and the
market demand curve (the sum of the individual curves) is on the right.
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Figure 4-2 The market demand curve

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

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

Related goods fall into two categories, substitutes and complements.
Substitutes, are exactly what the name suggest, they are products that can be used in the place of
another good to satisfy the consumer’s wants. Examples of substitutes include Nike and reebok
shoes, butter and margarine, beef and mutton. Differences in the prices of these goods will
determine, to an extent, the level of demand for the product in question.
Ceteris paribus, an increase in the price of a substitute will result in an increase in the quantity
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demanded for the product in question.
This will result in a shift of the demand curve to the right, indicating that there is a greater
quantity demanded of the product at each price range. Increases in the prices of substitutes are
therefore displayed as shifts of the demand curve to the right for the product concerned, likewise,
decreases in the prices of substitutes are displayed as shifts to the left. Remember, this is under the
ceteris paribus condition, all demand curves are plotted under this condition. Figure 4-4 below shows
a graphical representation of how an increase in the price of a substitute shifts the demand curve for
the product concerned to the right.
Figure 4-4 Two substitutes: butter and margarine
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Have you ever felt for ice-cream on a hot day and as a result bought yourself an ice-cream cone?
Although you may not think it at the time, these are two separate goods that are complementing each
other. You are therefore using these two goods jointly to satisfy your want. This is the nature of
complements, goods that tend to be used jointly to satisfy the want of the consumer.
Other examples are golf clubs and golf balls, motorcars and petrol, and DVD players and DVDs. In
the case of a complement, a fall in the price of a complementary good result in an increase in
demand for the good concerned, ceteris paribus.
Graphically, this is shown as a shift to the right of the demand curve for the product. The opposite is
true for an increase in the price of a complementary good, in this case the demand curve for the
good will shift to the left.
Remember, shifts in the demand curve indicate that the quantity demanded has changed at every
price, i.e. there is more/less quantity demanded of the good at every price.
It was mentioned earlier that we all have infinite wants, but these wants need to be distinguished
from demand. For there to be demand, the consumer must be willing and able to purchase the
product. Clearly, our ability to purchase affects the amount of goods we purchase.
4.4.2 Changes in income
In the case where consumer income changes, there will be a change in demand. Changes in
income are shown graphically as shifts in the demand curve. Ceteris paribus, an increase in
income will lead to an increase in demand and a decrease in income will lead to a decrease in
demand. Therefore, increases in income are shown graphically as shifts of the demand curve to the
right and decreases in income are shown as shifts to the left.
4.4.3 Tastes and preferences
Whereas changes in the prices of related products and changes in the incomes of consumers are
rather obvious determinants of demand, a less obvious determinant is consumer tastes and
preferences. Preferring Nike shoes to Reebok is a good example of tastes and preferences. As
these tastes and preferences change, so too does demand. Many things can affect your tastes and
preferences, advertising, a doctor’s advice or maybe a conversation with a friend. In all cases, the
demand curve responds by shifting either to the left or right. For example, a negative change in
tastes for pizza, due to an increase in the popularity of spaghetti, would shift the demand curve for
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pizza to the left, whereas a positive change would do the opposite.
4.4.4 Household / population size
The demand for a product also depends on the size of the population that the market is serving. The
larger the population, the greater will be the demand for the product in question, ceteris
paribus. The smaller the population, the smaller the demand for the product, ceteris paribus.
Graphically this can be illustrated as follows: an increase in the population will shift the demand
curve to the right, ceteris paribus. A decrease in the population would shift the demand curve to the
left, ceteris paribus.
4.4.5 Other possible determinants
Expectations
Other important variables that influence demand are changes in expected future prices and the
distribution of income. Consumers’ expectations about future events form a critical part of economics,
as expectations of future events often translate into realities. In this case, should consumers
expectations about any of the determinants of demand change, then demand for the product
can change. Should consumers expect that the future price of a good will fall, ceteris paribus, they
will tend to reduce present consumption. The expectation of the future price decrease means that if
consumption is put on hold now, the good can be purchased cheaper at a later stage.
Present consumption is therefore reduced. Graphically this will be displayed as a shift of the demand
curve (for the product) to the left, indicating that quantity demanded has decreased at all prices. If
consumers expect future prices to rise, ceteris paribus, then the opposite will occur. Present demand
will be increased to maximize the opportunity to purchase the good cheaply (shift to the right).
Activity 4.1
There must have been a time when you expected a sale at a store you liked
and decided to wait for it, waiting to purchase whatever item it is you wanted.
This is the same concept. These are things that we do on a daily basis, all that
is happening here is that it is given structure and form.
Try to relate to the concepts you read about
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Distribution of Income
Changing the distribution of income among the households in the economy may also change
demand. Redistributing income from households with high incomes to households with low incomes
changes the nature of demand. Goods which are demanded by low-income households will increase
(rightward shift) while goods which are demanded by high-income households will decrease
(leftward shift), ceteris paribus.
Distributing income influences the structure of the market, remember, the market serves us through
the pricing mechanism (for a market economy), and therefore those with money determine the
composition.
Summary of movements along a demand curve and shift in the demand curve
Figure 4-5 Movements and Shifts of the demand curve
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4.5 Supply
The focus is now on supply. When dealing with supply it is useful to remember that supply has to do
with producers, so try to relate to it as if you were the business man/woman.
Supply is defined as, the quantities of a good or service that producers plan to sell at each
price during a period.
Just as demand refers to the plans of consumers who are willing and able to purchase, supply
refers to the plans of producers who are willing and able to supply the quantities of the product
concerned.
Worth noting is the fact that producers are not guaranteed to sell the quantity that they supply, as this
depends to a large extent on demand.
4.5.1 What determines supply?
Individual supply is determined by a few factors; these include:
The prices of alternative products:

The decision to produce is not only dependent on the price of the product in question, it is also
dependent on the prices of alternative products. A producer will have to decide which products to
produce with the given resources. Resources may be used to produce more than one product
and as a result decisions have to be made as to how much of a product to produce given the
alternatives
Expected future prices:

Production decisions are not made over a period or periods of time and as a result plans have to
be made with the future in mind. Plans to produce are therefore made with the future in mind, i.e.
producers make decisions not only on the current market price but also on the prices they expect
to receive in the future
The state of technology:

Technology plays an important role in the production process as it impacts directly on the cost of
production. Should there be technological developments which allow producers to produce at
lower cost, then the quantity supplied will increase at every price level
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Figure 4-6 Johnny`s annual supply of tomatoes
The positive slope in the graph above indicates that more goods/services will be supplied to the
market as the price of the goods/services increase.
Remember what was said earlier, price is an indicator of profitability, producers use prices as an
indicator of market activity. Figure 4-6 is simply a graphical representation of this relationship.
Figure 4-6 graphically illustrates the law of supply, which states that the relationship between
price and supply is a positive one. More goods will be supplied at higher prices and fewer
goods will be supplied at lower prices, ceteris paribus.
4.5.2 Market Supply
Like we did in the case of market demand, to obtain the market supply we simply add the individual
supply curves horizontally. So if Peter, Jack and Paul are willing to supply 10, 20 and 30 pairs of
shoes if the market price is R100, then to obtain the market supply we simply add these values for
the price of R100. Therefore, at a price of R100, the market supply will be 60 pairs of shoes. This can
be done at all prices. The market supply is the relationship between the price of the product and the
quantities supplied, by all firms, over a specific period.
Market supply and individual supply are therefore very much the same, with the major difference
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being that market supply refers to all the prospective sellers of a product in a particular market.
4.5.3 Movements along the supply curve and shifts of the curve
As can be seen in the diagram below (Figure 4-7), at a price of P1 the quantity supplied is Q1, these
two values are represented by point a on the graph. Should the price of the good concerned
increase to P2 then the quantity supplied will increase to Q2, point b. As can be seen, price changes
result in movements along the supply curve, just as price changes result in movements along the
demand curve. Remember, movements along the supply curve due to price changes, are subject to
the ceteris paribus assumption. Changes in price therefore result in a change in quantity supplied.
Figure 4-7 A movement along a supply curve: change in quantity supplied
Shifts of the supply curve however, are not as a result of price changes, but are due to changes in
the other determinants of supply. Shifts in the supply curve are therefore due to changes in factors
other than price.Recall what was said earlier about the supply function and the factors which
determine it. Therefore, should a factor like technology change, and a more efficient process of
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production is discovered, this would shift the supply curve to the right, ceteris paribus. What this shift
indicates is that there will be a greater amount of the good supplied at each price level. We refer to
this as a change in supply.
Changes in supply can be both positive and negative and as such should there be a negative
change in a determining factor, other than the price of the product, then the supply curve will shift to
the left. Remember, changes in any of the determinants of quantity supplied, except for the price of
the product, will result in a shift of the supply curve.
Table 4-5 in the prescribed text (Mohr and Fourie:2015:75) gives a good summary of what has
been discussed.Figure 4-8 below is a graphical illustration of shifts in the supply curve.
Note: How at a price of P1 the quantity supplied differs for each supply curve. The question that you
should ask yourself is: At a given price (P1 in this example) what will a change in a determinant
(other than the price of the product) do to the quantity supplied?
Figure 4-8 Shift of the supply curve: changes in supply
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4.6 Market Equilibrium

Remember, a market occurs where there is any contact or communication between potential buyers
and potential sellers of a good or service. It follows that markets therefore bring the forces of demand
and supply in contact with each other.Market equilibrium occurs where the quantity of a
good/service demanded is equal to the quantity supplied of that good/service. Equilibrium between
households (demanders) and firms (suppliers) will occur at a certain price, known as the equilibrium
price.
At the equilibrium price, the plans of households and the plans of firms will be one and the same, in
that households will plan to purchase X amount of a good/service and firms will plan to sell the same
amount of the good/service. The result of this matching of plans is that the market will come to a state
of rest, this state occurs as the two opposing forces (demand and supply) are in a state of balance.
As such, there will be no tendency for the conditions to change. However, should the underlying
forces change, the balance in the market will be upset and the market will adjust accordingly. To
understand how the market arrives at a state of equilibrium we need to understand disequilibrium.
Disequilibrium occurs when the price charged is at a level other than the equilibrium price level, i.e.
any price other than the equilibrium price will bring about disequilibrium in the market.
Figure 4-9 Demand, supply and market equilibrium

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As can be seen in Figure 4-9 above, should a price above or below R5/kg be charged for tomatoes,
then demand and supply will not be equal (disequilibrium). At a price above R5/kg, the quantity
supplied will be greater than the quantity demanded, there will therefore be excess supply at prices
above R5/kg.
This occurs as the higher price encourages producers to increase supply in the hope of making
greater profits, however, at prices greater than R5/kg consumers plan to purchase less of the good
than they would have at R5/kg. The result is that there will be more of the good on the market than
consumers are willing and able to purchase, excess supply. Similarly should the price fall below
R5/kg then the quantity demanded will exceed the quantity supplied. This occurs because (as you
know) cheaper prices result in more of the good being demanded, ceteris paribus (the law of
demand).
Whereas consumers are demanding more, producers are now producing less than they would have
if the good was R5/kg (low prices signal low demand and less profits), there is now an excess
demand in the market.
When the market is in disequilibrium, it goes through a process which leads it back to equilibrium. In
the case of excess demand there are too few goods on the market. Firms have therefore sold their
total production but households have not obtained the quantity of the good that they demanded at
the particular price. As households wish to obtain more of the good (at the going price) they offer
more money for the product (i.e. prices higher than the market price) in an effort to outbid other
households. The result is that the price of the product rises.
As the price starts to rise firms realise that they can obtain a higher price for their product and
therefore increase their production of the good. However, as the price rises demand starts to slow
down (law of demand), and with it the rising price, production will slow with demand and the process
ends when equilibrium is obtained.
In the case of excess supply, there is not enough demand for the amount of goods on the market.
Firms are therefore unable to sell their products and as such are left with a surplus of unsold goods
(market surplus). These unsold stocks are also known as inventories, and as the level of inventories
rise, firms cut their production of the product in an attempt to sell off the rising levels of stock and to
compete with the other firms for the limited demand.
By reducing their level of production, firms lower their cost and as a result can charge lower prices in
order to compete. Graphically, this can be shown as a movement down the supply curve towards the
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point of equilibrium. At the same time, demand will increase as the price decreases and producers
and consumers will move toward the point where quantity demanded and quantity supplied are
equal to each other.
Market equilibrium therefore occurs at the intersection of the demand and supply curves. This point
is characteristic of both buyers and sellers agreeing upon both the quantity of goods that will be
exchanged on the market and the price which these goods will be exchanged for. At equilibrium,
there is no tendency for change.
TO THIS STUDY UNIT
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Unit
5: Demand and Supply in
Action
Unit 5: Demand and Supply in Action
49


York: McGraw Hill.
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5.1 Changes in Demand

As discussed earlier, should there be a change in any of the determinants of demand (except for the
price) then the demand curve will shift.
Recall that to shift the demand curve to the right, there would need to be a change in any of the
determinants to this effect:
1. increase in the price of a substitute, or

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

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

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

If we are dealing with changes in demand or supply, then it is possible to predict what will happen to
equilibrium prices and equilibrium quantities in the market. However, should both demand and
supply change simultaneously, then the precise outcome cannot be predicted.
For example, should there be an increase in demand (due to a positive change in preferences
toward the product), accompanied by a decrease in supply (due to an increase in the price of the
factors of production), then the only thing that is certain is that the price of the product will rise. This is
due to the fact that both of the changes result in an increase in the equilibrium price in the market.
What the equilibrium quantity will be however is uncertain. This is because as far as equilibrium
quantity is concerned, the two forces work in opposition to each other. An increase in demand works
to raise the equilibrium quantity, ceteris paribus, whilst a decrease in supply lowers the equilibrium
quantity, ceteris paribus.
The outcome in the market therefore depends on the relative magnitudes of the changes. (Mohr and
Fourie, 2015: 88). The reader is referred to Mohr and Fourie (2015:87-89) for a more detailed
account of the topic.
5.4 Government Intervention

Markets are not always free to determine what the equilibrium prices and quantities will be.
Governments have various methods available with which to intervene in the market. This intervention
can take the form of:
setting maximum prices (also known as price ceilings)

setting minimum prices (also known as price floors)
subsidising certain products or activities
taxing certain products or activities
We will deal with the first two interventions (price ceilings and floors) on our list of four.
Maximum prices (price ceilings) are often set for certain goods and not on the market as a whole.
Governments can set maximum prices with the intention of:
keeping the prices of basic foodstuffs low (this may form part of policy to assist the poor)
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avoiding the exploitation of consumers by producers (producers may be charging “unfair” prices)
combating inflation
limiting the amount production of certain goods and services in times of war
Should the maximum price be set above the market clearing price (equilibrium price), then the
intervention will not have any effect on the outcome of the market. The market will therefore arrive at
the equilibrium price and equilibrium quantity. However, when the maximum price is set below the
market clearing (equilibrium price), the intervention disrupts the market mechanism (price
mechanism) and therefore causes instability in the market.
In figure 5-3 below, we can see that if the market were left alone the forces of demand and supply
(remember, excess demand and excess supply) will result in the market achieving equilibrium with a
price P0 and a quantity supplied of Q0.
Figure 5-3 Maximum prices
In Figure 5-3 above, the government has set a maximum price of Pm which is below the equilibrium
price of P0. At the price Pm producers are willing to sell Q1 units whilst consumers are demanding a
quantity of Q2, this can be seen if we follow the line Pm across to the supply curve (point a) and then
57
across to the demand curve (point b). The quantity demanded by consumers at a price of Pm is
clearly greater than the quantity which producers are willing to produce (Q1). As such there is now
excess demand in the market (market shortage) and this excess demand is equal to the difference
between Q2 and Q1, i.e. Q2 – Q1.
If the market were left alone then the market mechanism would raise the price until this excess
demand was eliminated (remember the example of excess demand earlier). However, as the price
has been pegged artificially this process cannot occur.
We are therefore left with the problem of how to allocate Q1 worth of product amongst people who
demand Q2?
There are various ways for this allocation to take place, these are:
1. Consumers are served on a “first come first served”, the result is queues and waiting lists.
2. An informal rationing system may be set up by suppliers. This system can take the form of limiting
the amount of goods sold to each customer or only selling goods to regular customers.
3. Government itself may introduce an official rationing system. This can be done by issuing tickets
or coupons, which have to be submitted when purchasing the product.
To summarise, should the government set a maximum price below the equilibrium price of a product
it would:
1. cause excess demand in the market

2. prevent the market from allocating the quantity of product available among consumers
3. result in black market activity occurring in the market. A black market is an illegal market that
occurs when goods are sold at prices which are above the maximum price set by government.
If we refer to figure 5-4 we can see that at a quantity of Q1 (the quantity which will be supplied), the
price which a consumer is willing and able to pay for the product is P1 and this price is clearly greater
than Pm. Therefore, those who have the product can charge prices in excess of Pm to those who are
looking to purchase.
What should also be mentioned is the fact that setting the maximum price below the equilibrium price
level results in welfare costs to society.
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Consider the case below, figure 5-4. In this case the government has set a price of Pm which is below
the equilibrium price of P1. The result is similar to that outlined earlier, there is excess demand in the
market with the quantity sold falling from Q1 to Qm.
In figure 5-4, at the equilibrium price of P1 consumer surplus is represented by the area DP1E and
producer surplus is represented by the area 0P1E. However, when the government implements the
maximum price on the market these areas change. Consumer surplus is now represented by the
area DRUPm and producer surplus is now represented by the area 0PmU. Consumer surplus is the
area below the demand curve, above the price line and with the quantity supplied. Likewise,
producer surplus is the area above the supply curve, below the price line and within the quantity
supplied). With the price maximum imposed, consumers have now lost the area indicated by triangle
A but have gained the area B. The loss of triangle A occurs because of the decrease in the quantity
supplied from Q1 to Qm, whereas the gain of the rectangle B occurs from the fact that the those who
obtain the product now pay less for it.
Figure 5-4 The welfare cost of maximum price fixing

In the case of the new producer surplus, we have shown that the new producer surplus is now
represented by the area 0PmU as opposed to the area 0P1E. Producers have therefore lost the area
represented by triangle C as a result of the loss of production and the rectangular area B as a result
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of it being transferred to consumers. The end result is that the total welfare loss to society is
represented by both triangles A and C, and this is referred to as a deadweight loss. Worth noting is
the fact that this area was not transferred, unlike the area represented by rectangle B which was
transferred from producers to consumers.
The area made up of triangles A and C has been lost to society and this comes about due to the fact
that less is being produced in society, and society itself is made up of both producers and
consumers.
We now turn our attention to the case of minimum prices (price floors). In the case where a minimum
price is set by government, the minimum price will not impact on the outcome of the market if the
price is set below the market equilibrium price. However, should the minimum price be set above the
equilibrium price then there will be excess supply of products in the market. To illustrate the case of a
minimum price set above the equilibrium price, your attention should now be on figure 5-5 below.
Figure 5-5 A Minimum price
In Figure 5-5 above, the market is at equilibrium at a price of R30 per kilogram and at this price a
quantity of 7 million kilograms is being sold. The government sets a minimum price (price floor) of
R40 per kilogram on the product. At a price of R40 per kilogram consumers demand a quantity of 4
million kilograms, however producers are producing 9 million kilograms of beef. Therefore, there is a
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surplus of 5 million kilograms of beef in the market (the difference between point a and point b). By
setting a minimum price above the equilibrium market price (market clearing price) the government
creates an excess supply in the market. This excess supply will usually require further government
intervention and the result may be one of the following:
The surplus product may be purchased by government and exported

The surplus product may be purchased by government and stored (provided it can be stored)
Production quotas are introduced by government to limit the quantity supplied to the quantity
demanded (at the minimum price). In our example government would try to limit production of
beef to 4 million kilograms. In doing so the surplus is illuminated
The surplus is purchased and destroyed by government
Producers destroy the surplus
(Mohr and Fourie, 2015: 94-95)
The setting of minimum prices is often a characteristic of agricultural markets as these markets are
characterized by large fluctuations in supply. Although demand for agricultural products is stable, the
large fluctuations in supply result in the incomes of farmers being unstable as the prices received for
the product fluctuate as well. Governments therefore tend to set minimum prices to stabilize the
incomes of farmers. However, this is not an efficient way of assisting small or poorer farmers.
Minimum prices are inefficient due to the following facts:
All the consumers in the market have to pay artificially high prices (this includes the poor)
Large farmers receive the bulk of the benefits which are forthcoming
Firms that are inefficient are now protected by the minimum price and manage to survive
Disposal of the surplus which is generated from the minimum price usually imposes a further cost
to tax payers and results in welfare losses
The case of the welfare costs to society which occur as a result of the minimum price is similar to that
of the costs of the maximum price which was discussed earlier. Consider the case below, figure 5-6.
In this case the government has set a minimum price of Pm which is above the equilibrium price of
P1. We will assume that producers respond by supplying the market with the amount which is
actually demanded (Qm).
In figure 5-6, at the equilibrium price of P1 consumer surplus is represented by the area DP1E and
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producer surplus is represented by the area 0P1E. However, when the government implements the
minimum price on the market these areas change. Consumer surplus is now represented by the
area DRPm and producer surplus is now represented by the area 0PmRT. (Remember, consumer
surplus is the area below the demand curve, above the price line and within the quantity supplied.
Likewise producer surplus is the area above the supply curve, below the price line and within the
quantity supplied). With the minimum price imposed, consumers have now lost the area indicated by
the rectangle A and triangle B. The loss of triangle B occurs as a result of the decrease in the
quantity supplied from Q1 to Qm, and the loss of the rectangle A occurs as a result of the fact that the
those who used to obtain the product at a price of P1 now pay a price of Pm.
Figure 5-6 The welfare costs of minimum price fixing
In the case of the new producer surplus, we have shown that the new producer surplus is now
represented by the area 0PmRT as opposed to the area 0P1E. Producers have therefore lost the
area represented by triangle C as a result of the loss of production, but gained the rectangular area
A at the expense of the consumers. The end result is that the total welfare loss to society is
represented by both triangles B and C, this is referred to as the deadweight loss. The area made up
of triangles B and C has been lost to society and this comes about due to the fact that less is being
produced in society, and society itself is made up of both producers and consumers.
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Activity 5.1
1. Explain the difference between market surplus and market shortage
2. Draw a diagram to illustrate a market surplus and a market shortage
TO THIS STUDY UNIT
63
Unit
6:
Elasticity
Unit 6: Elasticity
64


York: McGraw Hill.
65
6.1 Introduction
When we speak about elasticity, we are in fact referring to the responsiveness or sensitivity of a
dependent variable to changes in an independent variable.
The best known elasticity concept is price elasticity of demand, which is a measure of the
responsiveness of the quantity demanded to changes in price of the product. The measured price
elasticity has a negative sign, since the change in the price of a product and the change in the
quantity demanded move in opposite direction. According to Mohr and Fourie (2015: 106) we ignore
the negative sign and simply concentrate on the absolute value of price elasticity of demand. Price
elasticity of demand is calculated as follows:
ep = % change in the quantity demanded of a product
% change in the price of a product
Where ep = price elasticity of demand
6.1.1 Calculation of price elasticity of demand
Example 1
Now let us assume that an increase of 60% on the price of Samsung tablets resulted in a decline in
the purchase of Samsung tablet by 15%. Using the above-mentioned formula, the calculation of price
elasticity of demand can be done as follows:
Price Elasticity of Demand Formula= Percentage change in quantity demanded / Percentage

change in price
Price Elasticity of Demand Formula= 15% ÷ 60%
Price Elasticity of Demand Formula= 0.25
Example 2
When the price of DVD increased from R20 to R22, the quantity of DVDs demanded decreased from
100 to 87.
What is the price elasticity of demand for DVDs?

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Calculating a Percentage
The price increases from R20 to R22. Therefore % change = (2/20) x 100 = 10%
Quantity fell by 100- 87 = 13. Therefore % change = 13/100 = 0.13 (13%)
Therefore, PED = 13/10
= 1.3
In this case, demand is price elastic. Therefore, demand is elastic.
Elastic demand occurs when % change in quantity is greater than % change in price; when PED >1
Activity 6.1
The demand schedule for coffee beans is shown in Table 1

Price of beans (p) Quantity demanded (kg)
20 10
22 9
Calculate the price elasticity of demand for coffee beans
Price elasticity of demand at different points along a linear demand curve

As can be seen in figure 6-1 below, the price elasticity of demand (ep) varies from a infinity (∞) to
zero.
The value of price elasticity of demand (ep) is infinity where the demand curve intersects (meets) the
price axis and zero where the demand curve intersects the quantity axis.
If we move down the demand curve, from left to right, the price elasticity of demand falls from infinity
(∞) to zero. It is worth noting that this will be the case for any demand curve which intersects both the
price and quantity axis (regardless of slope: this can be seen in figure 6-1).
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In the case of any demand curve which intersects both axis, the value of the ep will be infinity (∞)
where the graph intersects the price axis, one in the middle of the curve (midpoint) and zero where
the curve intersects the quantity axis.
Figure 6-16 Price elasticity of demand at different points along a linear demand curve
Mohr and Fourie (2015
For a numerical example on how to obtain the different values of price elasticity of demand (ep), the
reader is referred to Mohr and Fourie (2015: 106).
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6.2 Price Elasticity of Demand and Total Revenue

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

There are five categories into which we can place our price elasticity of demand (ep) values, these
five categories are:
ep = 0 –––> perfectly inelastic demand

0 < ep < 1 (i.e., ep is greater than 0 but less than 1) –––> inelastic demand
ep = 1 –––> unit elastic demand or unitary elasticity of demand
1 < ep < ∞ (i.e., ep is greater than 1 but less than infinity [∞]) –––> elastic demand
ep = ∞ –––> perfectly elastic demand
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In the case of perfectly inelastic demand (ep = 0), consumers will plan to purchase a fixed amount
of the product regardless of the price which is charged. This can be shown graphically by drawing
the demand curve as a vertical line, as illustrated in figure 6-3 (a). In this case, producers can raise
their revenue by increasing the price charged for the product. As the quantity demanded does not
change, raising price results in an increase in total revenue. Remember TR = PQ.
In the case of inelastic demand (0 < ep < 1), the percentage change in quantity demanded is
smaller than the percentage change in price (remember, in the opposite direction!). The demand
curve which illustrates this case is that of a steeply sloped demand curve (figure 6-3 b). The steep
slope of the demand curve serves to illustrate the fact that the percentage change in quantity is
smaller than that of the price change. As a result of the fact that the quantity demanded changes
proportionately less than the change in price, producers have an incentive to raise their prices in
order to increase their revenue (remember what was said earlier). Likewise, there is no reason why
producers would decrease the price of their product as the revenue received from the increase in
quantity demanded will not offset the revenue lost due to the decrease in price.
In the case of unitary elasticity (ep = 1), the demand curve used to illustrate the properties of
unitary elasticity is a rectangular hyperbola, as illustrated in figure 6-3 (c). What this graph illustrates
is that the percentage change in quantity demand is equal to percentage change in the price of the
product. In this case, as the proportional (ie percentage) changes in quantity demanded and price
are the same, producers would not gain anything by increasing or decreasing the price of the
product.
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72
Figure 6-3 The different categories of price elasticity of demand
Elastic demand (1 < ep < ∞), is illustrated by a relatively flat demand curve (Figure 6-3 d). The
demand curve graphically illustrates the property of elastic demand, this being the fact that the
percentage change is quantity demanded is greater than the percentage change in price. When
producers are faced with elastic demand, decreasing the price of the product will raise the total
revenue received by producers (this is as a result of the property of elastic demand, also remember
TR = PQ). There is no incentive to raise the price charges for the product as this would decrease
total revue (the opposite of decreasing the price will occur).
Perfectly elastic demand ( ep = ∞) is the case where consumers are willing to purchase any
quantity of goods at a certain price, raising the price of the good will result in the quantity demanded
falling to zero (even if the price is only raised slightly). Perfectly elastic demand is shown graphically
as a horizontal line, as in figure 6-3 (e).
Note: It should be kept in mind that an increase in total revenue (TR) is not the same as an increase
in total profit. Total revenue is simply the income received from selling a certain amount of product
(Q) at a price of (P), that is why TR = PQ. Total profit however, is not only a function of these two
variables, but also a function of cost, which can change with output.
6.4 Determinants of the Price Elasticity of Demand

In what follows, the determinants of price elasticity of demand will be discussed.
These are some of the determinants of elasticity:

6.4.1 Number of substitutes
6.4.2 Degree of complementarity
6.4.3 Type of want satisfied
6.4.4 Time
6.4.5 Proportion of income spent
6.4.6 Definition of the market
6.4.1 Number of substitutes
A key determinant in the price elasticity of demand for a product is the availability of substitutes. If
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there are a large number of substitutes for a product, and if these substitutes are close in quality (or
better in quality), then the price elasticity of demand will be large.
Therefore, the larger the amount of substitutes available, and the closer these substitutes are to the
product (or the better they are), the greater will be the price elasticity of demand, ceteris paribus. The
end result is that if a product has close substitutes, and the price of the product is increased, then
consumers will tend to switch to the substitutes available (this occurs as the substitutes have now
become cheaper in relation to the product, ie when compared to the product). The product will
therefore have an elastic demand.
Examples of goods which tend to be close substitutes for each other include: mutton and beef,
hamburgers and hot dogs, Nike – Adidas and Reebok shoes, and bus and taxi services. In the same
way that goods with close substitutes tend to have elastic price elasticity of demand, goods with no
close substitutes will tend to have demand which is inelastic.
6.4.2 Degree of complementarity
The degree of complementarity of the product is another determinant in the elasticity of the product.
You may not have noticed, but there are products which we use jointly with others (rather than on
their own), for example salt and food, petrol and cars, and DVDs and DVD players. In the case of
complements, the price elasticity of demand for a good tends to be low (inelastic), i.e. changes in
quantity are not very responsive to changes in price.
Take salt for example, salt is used jointly with food, you do not purchase salt only for the purpose of
consuming salt on its own. As a result your demand for salt will not only depend on the fact that you
want to consume salt, but it will depend on other factors as well (it will also depend on your desire to
consume other goods). As such, you will not simply reduce your consumption of salt if the price of
salt increases as there are a host of factors which go hand in hand with its consumption (i.e.
complements). The result is that your demand will be inelastic.
6.4.3 Type of want satisfied
The type of want satisfied by the product also plays a role in determining the how responsive
demand will be to a change in price, i.e. what the price elasticity of demand will be. Demand for
necessities tends to be inelastic whilst demand for luxury goods and services tends to be elastic.
There are no set rules for whether a goods or service is a necessity or a luxury good, however what
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can be stated is that if a good or service has a relatively inelastic demand it is considered a necessity
and if it has a relatively elastic demand it is considered a luxury good. Examples of necessities
include basic foods, electricity, petrol and medical care. Examples of luxury goods include swimming
pools, recreational activities and motor vehicles. (Mohr and Fourie, 2008: 164)
6.4.4 Time
In the long run the price elasticity of demand for a product tends to be more price elastic. We
therefore have to be mindful of the time period under consideration. Price changes may take a while
before their effects are fully felt by the market.
Take petrol for example, when the price of petrol changes people will not immediately cut back on
their consumption of petrol, rather they will stick to their current usage of petrol. As time passes
however, the full effects of the price rise will be felt (people now realize the effect of the increase on
their spending money), and then people will start to adjust their habits to lessen their petrol
consumption. The price elasticity of demand will therefore be more elastic in the long run. A good
example of why elasticity is low (demand is unresponsive) in the short run is the case of airline
tickets.
If you had to fly out on short notice (maybe it is an emergency), you will be desperate to obtain a
ticket for travel as shopping around may not be an option or the matter may be very urgent. In this
case you will not be choosy on what the price may be as you will want to secure a ticket, i.e. your
demand for the ticket will be price inelastic. In the long run however you can consider other options
to flying (bus, taxi, car) or spend more time looking for a better deal, therefore your demand will be
price elastic.
6.4.5 Proportion of income spent
The proportion of income spent on the product also plays a role in determining the price elasticity of
demand of a product. The reasoning behind this is that as the proportion of income spent on the
product increases, so too does the price elasticity of demand for that product. Therefore, as a greater
percentage (proportion) of income is spent on the product, price changes for that product have
greater effects on the consumer’s budget and therefore the consumer will be more likely to be
sensitive to changes. Similarly, products which make up a small percentage of the consumer’s
budget are said to have lower elasticity’s (hardly any change in quantity demanded), as the impact of
a price change for the product would have a small effect on the budget.
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Take matches for example, even if you are a smoker, matches contribute such a small portion of the
budget (at 50 cents, even if 10 boxes are bought every month it is still only R5) that should the price
of matches change (say by 10%), your consumption (usage) of matches is unlikely to change (you
are now spending R5.50, still a small amount).
6.4.6 Definition of the market
A broad definition of the market tends to make demand for the product more inelastic. For example,
as price of cars increase, consumers still continue to buy cars, because they still find cars a better
alternative to motor cycles.
6.5 Other Elasticities

6.5.1 Income elasticity of demand
The quantity demanded of a product depends on the income of the consumers. As consumers’
incomes rise, the quantity demanded usually increases, ceteris paribus. The question is, by how
much will the quantity demanded change, relative to the change in income? The income elasticity
of demand (ey) measures the responsiveness of the quantity demanded to changes in income.
Applying our general definition of elasticity, it is defined as the ratio between the percentage change
in the quantity demanded (the dependent variable) and the percentage change in consumers’
income (the independent variable), that is,
Suppose consumer incomes were to increase. How would hamburger consumption be affected?
Figure 6.4 provides an answer.
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Figure 6.4: Income elasticity
Before change in income, consumers demanded 6 000 hamburgers at R14 per hamburger. With
more income to spend, they could increase their eating capacity. The new demand curve (D2)
suggests that consumers will now purchase a greater quantity of hamburgers at every price. The
increase in income has caused a rightward shift in demand.
If hamburgers continue to sell at R14 each, consumers will now buy 10 000 hamburgers (point B)
rather than 6 000 hamburgers (point A). The income elasticity of demand measures this response
of demand to a change in income.
Computing income elasticity
As was the case with price elasticity, income elasticity is computed with average values for changes
in quantity and income. Suppose that the shift illustrated in Figure 6.4 occurred when income for a
group of consumers increased from R1 000 per week to R1 200 per week. Income elasticity would
then be computed as follows:
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Hamburger purchases are very sensitive to changes in income. When incomes rise by 18,2 percent
(R200 ÷ R1100), hamburger sales increase by a whopping 50,6 percent (that is 18,2 % X 2,78). The
computed elasticity of 2,78 summarizes this relationship.
Normal versus inferior goods
Income elasticity of demand may be positive or negative. A positive income elasticity of demand
means that anincrease in income is accompanied by an increase in the quantity demanded of the
product concerned (or that a decrease in income is accompanied by a decrease in the quantity
demanded). Goods with a positive income elasticity of demand are called normal goods. A
negative income elasticity of demand means that an increase in income leads to a decrease in the
quantity demanded of the good concerned (or that a decrease in income leads to an increase in the
quantity demanded). Goods with a negative income elasticity of demand are called inferior
goods.
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Activity 6.2
1. An example of a product with positive income elasticity could be Ferraris.

Let's say the economy is booming and everyone's income rises by 60%.
Because people have extra money, the quantity of Ferraris demanded
increases by 15%. Calculate the income elasticity of Ferrari car
Activity 6.3
1. An example of a good with negative income elasticity could be cheap

shoes. Let's again assume the economy is doing well and everyone's income
rises by 30%. Because people have extra money and can afford nicer shoes,
the quantity of cheap shoes demanded decreases by 10%
6.5.2 Cross elasticity of demand
The quantity demanded of a particular good also depends on the prices of related goods. The
cross elasticity of demand measures the responsiveness of the quantity demanded of a particular
good to changes in the price of a related good. Applying our general definition of elasticity, we can
define the cross elasticity of demand (ec) as the ratio between the percentage change in the quantity
demanded of a product (the dependent variable) (Mohr and Fourie, 2015: 116) and the percentage
change in the price of a related product (the independent variable), that is,
Suppose the price of these other goods were to fall. Imagine that toasted sandwiches were put on
sale for R5, rather than the usual R8. Would this price reduction on toasted sandwiches affect the
consumption of hamburgers? Figure 6.5 provides an answer.
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Figure 6.5: Cross-price elasticity
Source: Berg and Ward (2016)
According to Figure 6.5, the demand for hamburgers might decrease if the price of toasted
sandwiches fell. The leftward shift of the demand curve from D1 to D2 indicates that consumers now
demand fewer hamburgers at every price. At R14 per hamburger, consumers now demand only 8
000 hamburgers (point R) rather than the previous 12 000 (point F). In other words, a decrease in
the price of toasted sandwiches has caused a reduction in the demand for hamburgers. Hence,
sandwiches and hamburgers are substitute goods - when the price of one decreases, the demand
for the other decreases.
In the case of complementary goods, the reduction in the price of one good (e.g. Coco-Cola) leads
to an increase in the demand for hamburgers. Hamburger demand shifts to the right (to D3) when
the price of a complementary good falls. The concept of complementary goods also explains why the
demand for cars decreases when the price of petrol increases.
Substitutes and complements
When two goods are unrelated (e.g. motorcar tyres and margarine) the cross elasticity of demand
will be zero. In the case of substitutes (e.g. butter and margarine) the cross elasticity of demand is
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positive. A change in the price of the one product (e.g. butter) will lead to a change in the same
direction in the quantity demanded of the substitute product. For example, when the price of butter
increases, more margarine will be demanded, ceteris paribus, as consumers switch to the relatively
cheaper margarine.
In the case of complements, the cross elasticity of demand is negative. A change in the price of the
one product (e.g. motorcars) will lead to a change in the opposite direction in the quantity demanded
of the complementary product (e.g. motorcar tyres). For example, if the price of motorcars falls, the
quantity of motorcars demanded will
increase and as a result more motorcar tyres will be demanded
The cross-price elasticity of demand makes it easy to distinguish substitute and complementary
goods. If cross-price elasticity is positive, the two goods are substitutes; if the cross-price elasticity is
negative, the two goods are complements.
Activity 6.4
Are DVD players and VCRs substitute goods or complementary goods?

1. Give a reason for your answer
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Activity 6.5
As an economic consultant of the SAFA (South African Football Association)

you have been requested to draw an analysis of demand for soccer tickets for
the Soweto derby.
Explain, using appropriate graphs/illustrations, how the up-coming match will
affect the demand curve for soccer tickets, hence, the market price if supply
remains constant.
1.1 If the price elasticity of demand for the Soweto derby tickets is 2.5; would
a 30% increase in price raise revenue or reduce revenue? Justify your
answer.
1.2 Suppose in a given year the income of the population increases by 20%,
and demand for the Soweto derby tickets increases by 15%:
1.2.1 What is the value of the population’s income elasticity?
1.2.2 Would you regard soccer tickets as a normal or inferior good? Justify
your answer.
TO THIS STUDY UNIT
82
Unit
7: The Theory of Production and Cost
(Background To Supply)
Unit 7: The Theory of P r o d u c t i o n a n d C o s t ( B a c k g r o u n d T o S u p p l y )
83


York: McGraw Hill.
84
7.1 Introduction
This study unit deals with the fundamental income, cost and production concepts required to analyse
the decisions of firms about the quantities to supply at various prices. This is an important study unit
which lays the foundation for the analysis of the equilibrium position of firms under perfect and
imperfect competition for study units 8 and 9.
7.2 Types of Firms

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

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

Total revenue(TR) is defined as the total value of sales and is equal to price (P) multiplied by
quantity(Q).
Average revenue is equal to total revenue (TR) divided by the quantity.
Marginal revenue (MR) is the additional revenue earned by selling an additional unit of the product.
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7.5 The Concept of Costs

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

Profit is the difference between revenue and cost:
Profit = Revenue - Cost
In other words, a firm's profit is the difference between the revenue it earns by selling its product and
the cost of producing it. The economist's definition of profit is, however, not the same as the
accountant's definition of profit.
As economists, we distinguish between total (or accounting) profit, normal profit and economic profit:
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Total (or accounting) profit is the difference between total revenue from the sale of the firm's
product(s) and total explicit costs;
Normal profit is equal to the best return that the firm's self-owned, self-employed resources
could earn elsewhere;
Economic profit is the difference between total revenue from the sale of the firm's product(s) and
total explicit and implicit costs (i.e. the total economic, or opportunity,costs of all resources)
Therefore, it can be stated that
7.6 Production
Production is the physical transformation of inputs into output.
7.6.1 Fixed and variable inputs
Firms use fixed inputs and variable inputs.
A fixed input is defined as an input of which the quantity cannot be altered in the short-run. By
contrast, a variable input is one of which the quantity can be changed in the short-run.
In the long-run there are no fixed inputs - all the inputs are variable. In other words, the long-run is a
period that is long enough to change the quantity of all the inputs into the relevant production
process.
In the short-run, a firm can expand output only by increasing the quantity of its variable inputs. The
relationship between inputs and output is called a production function.
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7.6.2 The short-run production function
In a given state of technology, there is a relationship between the quantity of inputs and the
maximum output that can be obtained from these inputs. This relationship is called a production
function and can be expressed in the form of a table (or schedule), an algebraic equation or a graph.
A maize farmer's simple production function is presented as a schedule in Table 7.1
Table 7.1 Production schedule of a maize farmer with one variable input
The production function (or schedule) shows that if no labour is applied to the 20 units of land, no
maize will be produced. The production function further illustrates that if one unit of labour is
employed, 16 tons of maize can be produced.
The production schedule can also be represented in the form of a graph. The total product of labour
in Table 7.1 is presented graphically in Figure 7.1 (a). To facilitate reference, Figures 7.1(a) and
7.1(b) are presented together.
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9Figure 7-1: Total, average and marginal product of labour
The table and graph show that as the quantity of labour is increased, total product (TP) increases
from zero at an increasing rate, then starts increasing at a decreasing rate until a maximum point is
reached, after which TP declines. This S-shape of the total product curve reflects the law of
diminishing returns, or the law of diminishing marginal returns.
To formulate the law of diminishing returns, we need to first explain average product and marginal
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product.
7.6.3 Average and marginal product
The average product (AP) of the variable input is simply the average number of units of output
produced per unit of the variable input. It is obtained by dividing total output (TP) by the quantity of
the variable input (N). The calculation of AP is illustrated in Table 7.2
2Table 7.2: Production schedule of a maize farmer with one variable input
The highest average product (29 tons) is reached when 5 units of labour are employed. The
figures in column 4 clearly show that AP increases until the fifth labourer is employed and
then declines to only 18,70 tons when 10 labourers are employed.
The marginal product (MP) of the variable input is the number of additional units of output produced
by adding one additional unit (the marginal unit) of the variable input.
The highest marginal product shown in Table 7.2, namely 35 tons, occurs when the fourth unit of
labour is employed. The marginal product of the fifth unit of labour is less than 35 tons. Once the
maximum marginal product is reached, it keeps on declining. The marginal product of 9 units is
equal to zero. The marginal products of additional units of labour are negative, which means that
their employment causes total product to decline. Once a limit is achieved, the workers get in each
other's way, are given jobs too specialised to keep them occupied each day, or get on each other's
nerves.
The information in columns 4 and 5 of Table 7.2 are depicted in Figure 7.1(b). From Figure 7.1 and
Table 7.1 it is clear that:
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The law of diminishing returns states that as more of a variable input is combined with one or
more fixed inputs in a production process, points will eventually be reached where first the
marginal product, then the average product and finally the total product start to decline.
7.6.4 Comparison of total, average and marginal product
The total, average and marginal product of labour are all based on the same basic information and
are, therefore, interrelated.
TP is S-shaped. In other words, as the variable input is increased, TP increases from zero at an
increasing rate, then at a decreasing rate, reaches a unique maximum point and then decreases.
AP and MP are shaped like inverted "U"s, i.e. as the variable input is increased, they rise at
declining rates, reach maximum points and then decrease at increasing rates.
MP reaches its maximum before AP reaches its maximum. (Figure 7.2)
0Figure 7-2: Marginal product and average product
Before AP reaches a maximum, MP lies above AP.

MP equals AP at its maximum point.
After the maximum point of AP is reached, MP lies below AP.
MP equals zero where TP reaches its unique maximum.
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7.7 Production and Costs in the Long Run

In the long run there are no fixed inputs – all the inputs (including all the factors of production) are
variable. In the long run there are thus no fixed costs – all the costs are variable. Moreover, the law of
diminishing returns does not apply.
In production theory the long run is defined as a period that is long enough for the firm to change the
quantities of all the inputs in the production process as well as the process itself. That would mean,
for example, that there is enough time for the firm to build a new factory, to install new machines
and to use new techniques of production.
The actual time period required to vary all the inputs or to adopt new production techniques depends
on the characteristics of the firm, the production processes and the institutional environment, and it
may differ quite significantly from case to case. A street hawker, for example, might be able to vary all
inputs (e.g. the stock for sale, the location and the hours worked) on a daily basis. A clothing
manufacturer will take longer, while a cement producer or an aluminum producer might require
several years to expand production by extending an existing factory or building an additional one.
In the long run, a firm has to take decisions about the scale of its operations, the location of its
operations and the techniques of production it will use. All these decisions will affect the cost of
production
7.7.1 Returns to scale
The term “returns to scale” refers to the long-run relationship between inputs and output. Returns to
scale are measured by varying all the inputs by a certain percentage and comparing the resulting
percentage change in production with the percentage change in the inputs. Three possible situations
can be distinguished:
Constant returns to scale. This is where a given percentage increase in inputs will give rise to the
same percentage increase in output (e.g. a doubling of the inputs leads to a doubling in output).
Increasing returns to scale. This is where a given percentage increase in inputs will lead to a larger
percentage increase in output (e.g. a doubling of the inputs leads to a trebling of output).
Decreasing returns to scale. This is where a given percentage increase in inputs will give rise to a
smaller percentage increase in output (e.g., a 100% increase in the inputs leads to a 50% increase in
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output).
Returns to scale refer to a situation in which all inputs increase by the same proportion. Decreasing
returns
to scale (a long-run concept) should therefore not be confused with diminishing marginal returns (a
short-run
concept). Remember that in the case of diminishing marginal returns only the variable input
increases. The concept of increasing returns to scale is closely linked to that of economies of scale,
a related but different
concept
Economies of scale
A firm experiences economies of scale if costs per unit of output fall as the scale of production
increases. If a firm experiences increasing returns to scale from its inputs, it means that the firm will
be using smaller and smaller amounts of inputs per unit of output as it expands. Ceteris paribus, this
means that unit cost will decrease as output increases. In other words, economies of scale will be
experienced.
A firm might also experience diseconomies of scale. This occurs when unit costs rise as output
increases.
7.8 Cost
A firm's costs consist of fixed and variable costs.
7.8.1 Fixed and variable costs
A fixed input cannot be altered in the short-run. Since the number of units of land is fixed and the
price (rental) of using a unit of land is given, the cost of using the land is fixed. Fixed costs remain
constant irrespective of the quantity of output produced.
The quantity of the variable input can be varied in the short-run. In the case of the maize farmer,
labour is the variable input. The cost of labour to the firm for the relevant period can, therefore, be
calculated by multiplying the number of units of labour employed, by the price per unit of labour.
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Variable cost is defined as cost that changes when total product changes - it represents the cost of
the variable input(s).
Table 7.3 illustrates the relationship between the short-run production function and the short-run total
cost function of the maize farmer.
Table 7.3:Total, fixed and variable cost schedules of a maize farmer
Assume that the cost of a unit of the fixed input (land) for the growth season is R450. Therefore, the
cost of twenty units is 20 x R450 = R9 000, irrespective of the quantity of maize produced during the
growth season or the quantity of the variable input (labour) used. This represents the total fixed cost
(TFC) of producing the various quantities of output indicated in Table 7.3.
Suppose the price of a unit of labour for the full growth season is R2 400. To obtain the cost of
labour, we have to multiply the units of labour (e.g. 3) by the price per unit of labour (e.g. 3 x R2 400
= R7 200).
The total cost (TC) is the sum of the total fixed cost (TFC) and the total variable cost (TVC)
associated with each level of production.
The three cost schedules can be represented in graphical form (Figure 7.3) as cost functions or cost
curves.
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Figure 7-3: Three total cost curves
The total fixed cost function or curve (TFC) is a horizontal line with an intercept of
R9 000 irrespective of total product.
The total variable cost function or curve (TVC) has a reversed S-shape. It starts at the origin and
increases at a decreasing rate up to a point. Thereafter TVC increases at an increasing rate.
The total cost function or curve (TC) has the same shape as the variable cost function, but does not
start at the origin. It starts above the origin at the point on the vertical axis which represents the total
fixed cost. Total cost equals total fixed cost plus total variable cost.
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YOU ARE REQUIRED TO UNDERSTAND HOW TO CALCULATE THE FIGURES ON PAGE 155 OF
THE PRESCRIBED TEXT
Activity 7.1
Fill in the blanks and missing formulae in the following table

Table 7.3: A Guide to Costs
A quick reference to key measures of cost
Total costs of production are comprised of _____1____ and _____2___:
TC = ______3_____
Dividing total costs by the quantity of output yields the ______4_______
ATC = _____5______ which also equals the sum of _______6_______
and _______7_______ATC = _____8______
The most important measure of changes in cost is _______9________,
which equals the increase in total costs when an additional unit of
output is produced:
MC = _____10____.
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Unit
8:
Perfect Competition
U n i t 8 : P e r f e c t C o m p e t i t i o n
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York: McGraw Hill.
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8.1 Introduction
Since perfect competition is the benchmark against which all other market structures or types of
competition are measured, this is an important study unit.
This study unit explains what perfect competition means, and analyses the decisions of an individual
firm operating under conditions of perfect competition as well as the equilibrium position of a
perfectly competitive firm.
8.2 Defining Perfect Competition

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

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

The position of the individual firm under perfect competition is illustrated in Figure 8.1.
Figure 8-1: The demand curve for the product of the firm under perfect competition
The graph on the left shows that the price of the product is determined in the market by demand and
supply. The firm can sell its whole output at that price. This is indicated by the horizontal line on the
right. This line is the demand curve for the product of the firm.
It is also called the firm's sales curve, the firm's demand curve, or the total demand curve facing the
firm. The firm's average revenue (AR) and marginal revenue (MR) are equal to the price of the
product (MR = AR = P). The firm's total revenue can be represented graphically by a straight line
which starts at the origin and which has a slope equal to the price of the product, as shown in Figure
8.2
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Figure 8-2: The total revenue curve
8.5 The Short Run Equilibrium of the Firm Under Perfect Competition
We now examine the short run equilibrium (or profit-maximising) position of the firm under conditions
of perfect competition.
Since the firm under perfect competition does not have to make any pricing decisions (price-taker) -
it can only choose the output at which it will maximise its profits, i.e. where MR = MC or where the
positive difference between TR and TC is at its maximum.
8.5.1 Equilibrium in terms of total revenue and total cost
The total cost curve is shaped like a reversed S, as illustrated in Figure 8.3. In the short-run, the total
cost curve does not start at the origin, since part of the firm's cost is fixed.
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Figure 8-3: Total short-run costs of the firm
Total revenue of the firm under perfect competition was illustrated in Figure 8.2 as a straight line with
a positive slope which starts at the origin and has a slope equal to the price of the product. In Figure
8.4, we combine such a total revenue (TR) curve with the total cost (TC) curve.
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Figure 8-4: Total revenue, total cost and total economic profit
Economic profit is the difference between TR and TC. Graphically, it is measured by the vertical
distance between the TR curve and the TC curve. At levels of output below Q1 in Figure 8.4, TC is
greater than TR and the firm, therefore, incurs economic losses (indicated by the shaded area). At
Q1, the firm's total economic profit is zero (since TR = TC). Between Q1 and Q2, the firm makes an
economic profit at each level of output (indicated by the shaded area), since TR > TC.
At Q2, total economic profit is zero once more and at higher levels of output the firm again incurs
economic losses.The firm's profit will be maximised where the positive vertical distance between TR
and TC is the greatest (i.e. somewhere between Q1 and Q2).
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8.6 Equilibrium in Terms of Marginal Revenue and Marginal Cost

It has been explained earlier that any firm maximises its profits where marginal revenue (MR) is
equal to marginal cost (MC). In Figure 8.1 we showed that the firm's marginal revenue (MR) is equal
to the market price (P) of the product. The profit maximising rule in the case of a perfectly
competitive firm can, therefore, also be stated as P = MC (since MR = P). This rule is further clarified
in Figure 8.5 below.
Figure 8-5: Marginal revenue and marginal cost of a firm operating in a perfectly competitive
market
Marginal revenue (MR) is equal to the price (P) of the product. Marginal cost (MC) increases as
more units of the product are produced. Profit is maximised where MR (or P) = MC, i.e. at an output
level of 4 units. At lower levels of production, profit can be increased by expanding production. If
more than 4 units of the product are produced, profits start falling.
The firm's profit position can be illustrated clearly by adding average cost (AC) to the diagram
showing average revenue (AR), marginal revenue (MR) and marginal cost (MC). A firm's profit per
unit of output (or average profit) is equal to the difference between average revenue (AR) and
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average cost (AC).
As long as AR is greater than AC, the firm is earning an economic profit. When AR is equal to AC,
the firm only earns a normal profit. The normal profit is the opportunity cost of self-employed
resources (such as the owner's time and capital) and that normal profit is included in the firm's cost.
In Figure 8-6, there are three different possibilities. The same set of unit cost curves is used
throughout, but there are three different market prices, and, therefore, three different AR and MR
curves.
Figure 8-6: Different possible short run equilibrium positions of the firm under perfect
competition
27Figure 8-6 (a): Surplus (Economic) Profit
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Figure 8-6 (b): Normal Profit
Figure 8-6 (c): Loss
In Figure 8-6 (a), the market price is P1 which is equal to the firm's AR and MR. Profit is maximised
where MR (= P1) is equal to MC. This occurs at a quantity of Q1. At Q1, the firm's average revenue
AR (=P1) is greater than its average total cost AC (C1). The firm thus makes an economic profit per
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unit of production of P1 - C1.
The firm's total profit is given by the shaded area C1P1E1M which is equal to the profit per unit of
output (P1- C1) multiplied by the quantity produced (Q1). Alternatively, the area representing total
profit can be obtained by subtracting the firm's total cost from its total revenue. The firm's total
revenue is equal to the price of the product P1 multiplied by the quantity produced (and sold) Q1.
This is equal to the area OP1E1Q1. Similarly, the firm's total cost is obtained by multiplying its
average cost C1 by the quantity produced Q1. This is equal to the area OC1MQ1. The difference
between these two areas is the shaded area C1P1E1M, which represents the firm's total economic
profit.
In Figure 8-6 (b), the market price is P2. It is equal to MC at the point where MC intersects AC. The
corresponding level of output is Q2. At that level of output AR is equal to AC and the firm does not
earn an economic profit. It does, however, earn a normal profit since all its costs, including the
opportunity cost of self-owned, self-employed resources are fully covered. Point E2 in Figure 8-6 (b)
is called the break-even point.
In Figure 8-6 (c) the market price (firm's AR and MR) is equal to P3. MR or price is equal to MC at a
quantity of Q3. At Q3, the firm's average revenue AR is lower than its average cost AC. It, therefore,
makes an economic loss per unit of output, equal to the difference between C3 and P3. If the price
P (=AR) lies above the minimum AVC (not shown in diagram), the firm will continue production in the
short-run. If it lies below the minimum AVC, the firm will close down.
The equilibrium condition of the firm under perfect competition may be summarised as follows:
Profit is maximised when a firm produces an output where marginal revenue equals marginal
cost, provided that marginal cost is rising and lies above the minimum average variable cost.
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8.7 The Supply Curve of the Firm and the Market Supply Curve
The rising part of the firm's MC curve above the minimum of AVC is the firm's supply curve. In
Figure 8-7, this is illustrated by the part of the MC curve above point b.
Figure 8-7: The supply curve of the firm
The rising portion of the firm's marginal cost curve above the minimum of its average variable cost
curve at point b is the firm's supply curve. If the price is P5, the firm will not produce at all. If the price
is P4, the firm will be at its close-down point (b) and it is immaterial if it shuts down or continues
production. If the price is P3, the firm will minimise its economic losses by producing a quantity Q3,
corresponding to point c. If the price is P2, the firm will make normal profit (i.e. it will break even) at
point d, which corresponds to a quantity Q2. If the price is P1, the firm will maximise economic profit
at point e, i.e. it will produce a quantity Q1.
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8.8 The Equilibrium of the Industry Under Perfect Competition

To conclude the analysis of perfect competition, we refer briefly to the equilibrium of the industry (i.e.
the collection of firms that supply a specific product in the market). The industry will only be in
equilibrium in the long-run if all the firms are making normal profits. Only then will there be no
inducement for new firms to enter the industry or for existing firms to leave the industry. With
complete freedom of entry and exit, there will always be some movement (i.e. disequilibrium) in the
industry when firms are making economic profits or losses.
TO THIS STUDY UNIT
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Unit
9:
Imperfect Competition
Unit 9: Imperfect Competition
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York: McGraw Hill.
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9.1 Introduction
In the previous study unit, we examined the behaviour of a firm in a perfectly competitive market.
Perfect competition is a theoretical construct, which serves as a standard, or norm against which we
can compare other types of markets. In the real world, there are many different types of markets.
Economists distinguish between four broad sets of markets (or different types of competition):
perfect competition, monopoly, monopolistic competition and oligopoly.
In this section, we examine the last three types, which are usually collectively referred to as
imperfect competition.
The theory of the behaviour of firms (i.e. the theory of the supply side of the goods market) is called
the theory of the firm. This theory is usually based on the assumption that all firms seek to
maximise their profits.
In this section, we examine the behaviour of firms under conditions of imperfect competition.
Imperfect competition refers to a situation in which at least one of the conditions of perfect
competition listed in 8.3 is not satisfied.
The three broad categories of imperfect competition are
Monopoly
Monopolistic competition
Oligopoly
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9.2 The Different Market Structures

The key features of the four different types of market structure are summarised in Table 9.1.
4Table 9.1: Summary of market structure
9.2.1 Monopoly
In its pure form, monopoly is a market structure in which there is only one seller of a good or
service that has no close substitutes. Another requirement is that entry to the market should be
completely blocked. The single seller is called a monopolist and the firm is called a monopoly.
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The equilibrium (or profit-maximising) position of a monopoly

In principle, the profit maximising decision of a monopoly is exactly the same as that of any other
firm. Like any other firm, a monopoly should produce where marginal revenue (MR) is equal to
marginal cost (MC) - (the profit maximising rule), provided that average revenue (AR) is greater
than minimum average variable cost (AVC) - (the shut-down rule)
Total, average and marginal revenue under monopolySince the monopoly is the only supplier
of the product of the industry, the demand curve for the product of a monopolistic firm is the
market demand curve for the product of the industry. Since the market demand curve slopes
downward, the monopoly can only sell an additional quantity of output if it lowers the price of its
product. (See Table 9.2)
Table 9.2: Average, total and marginal revenue when the demand curve for a firm's product
slopes downward
Figure 9.1 demonstrates that under monopoly, a firm faces a downward-sloping demand curve which
is also its average revenue curve AR, as shown in (a).
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Figure 9-1: Marginal, average and total revenue under monopoly (or any other form of
imperfect competition
The marginal revenue curve MR is also downward-sloping and lies halfway between the AR curve
and the price axis. The corresponding total revenue curve TR is shown in (b). When MR is positive,
TR increases; when MR is zero, TR remains unchanged; and when MR is negative, TR falls. These
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relationships apply to all forms of imperfect competition.
The equilibrium of the firm under a monopoly

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

Between the extremes of monopoly and perfect competition, there is a range of actual market
organisations. Some industries (like the brick manufacturing industry) consist of a few large firms
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and a large number of small ones. Other industries (like motor manufacturing) consist of a few large
firms only. In some industries (like the clothing industry), there are many firms producing a variety of
similar products. In other industries (like the cement industry), a few large firms produce virtually
identical products.
The first type of market in the spectrum between the extremes of perfect competition and monopoly
is monopolistic competition. The conditions for monopolistic competition can be summarised as
follows:
Each firm produces a distinctive, differentiated product;

Each firm, therefore, faces a downward-sloping demand curve for its particular product;
There is a large number of firms in the industry; and
There are no barriers to entry (or exit)
9.3.1 The equilibrium of the firm under monopolistic competition
The short-run equilibrium and the long-run equilibrium of a monopolistically competitive firm is
illustrated in Figure 9-4.
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Figure 9-4: The equilibrium of the firm under monopolistic competition
Short-run and long-run equilibrium positions of a monopolistically competitive firm are illustrated in
(a) and (b), respectively. In both cases, D is the demand curve for the product of the firm (or average
revenue AR), MR is marginal revenue, MC is marginal cost and AC is average cost. The firm is in
equilibrium where MR = MC. In the short-run conditions illustrated in (a), the firm is in equilibrium at
output Q1 and price P1. The firm's total profit is illustrated by the shaded rectangle.
In the long-run, however, the firm only makes a normal profit at an output of Qe and a price of Pe. At
that price-output combination, AR is tangent to AC, MR = MC and AR = AC.
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9.3.2 Monopolistic competition versus perfect competition
A market structure is efficient if marginal cost MC is equal to price P and if production occurs where
average cost AC is at its minimum. These two types of efficiency are called allocative efficiency
and productive efficiency. The long-run equilibrium of a monopolistically competitive firm occurs
when only normal profits are made. In this respect, there is no difference between monopolistic
competition and perfect competition.
However, in long-run equilibrium, illustrated in Figure 9.4 (b), the monopolistically competitive firm
produces where price is higher than marginal cost and where average cost is not at a minimum.
Therefore, monopolistic competition is neither allocatively nor productively efficient. Although the
monopolistically competitive firms do not make economic profits in the long-run (as monopolists do),
monopolistic competition is also characterised by an inefficient use of resources. Consumers pay a
higher price and less output is produced than under perfect competition.
9.4 Oligopoly
Under oligopoly, a few large firms dominate the market. A duopoly exists when there are only two
firms in the industry. The product may be homogeneous (e.g. steel, cement, petrol) but it is mostly
heterogeneous (e.g. motorcars, cigarettes, household appliances, electronic equipment, household
detergents). When the product is homogeneous, the market is described as a pure oligopoly, and
when the product is heterogeneous (or differentiated) the market is called a differentiated
oligopoly.
Oligopoly is the most common market form in modern economies. When people talk about "big
business" and "market power", they are usually referring to oligopolists.
The main feature of oligopoly is the high degree of interdependence between the firms. Each
oligopolist, therefore, always has to consider how its rivals will react to any action that it takes. The
other important feature of oligopoly is uncertainty. To reduce this uncertainty, oligopolistic firms
often collude (enter into agreements) about prices and output.
Like a monopolist and a monopolistic competitor, the oligopolist faces a downward-sloping demand
curve. However, the slope of the curve is uncertain, since this depends on how its competitors will
react to price changes - they may decide to follow or not to follow any price change. Since oligopoly
is dominated by a small number of powerful firms, the entry of new firms is more difficult than under
perfect competition or monopolistic competition. However, in contrast to monopoly, entry is possible.
Competition is often intense, although it tends to be non-price competition, rather than price
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competition. The more intensely oligopolists compete, the closer they are likely to come to perfectly
competitive output.
9.4.1 A theory of oligopolistic behaviour: The kinked demand curve
Different oligopoly models are not discussed in this module, but to give you some idea of what
oligopoly models are, one of the classic oligopolistic theories (the kinked demand curve) is outlined.
The kinked demand curve, as illustrated in Figure 9.5, does not explain how price and output are
determined under oligopoly, but it does illustrate the importance of interdependence a n d
uncertainty in oligopolistic markets. It is one of the possible explanations for the observed degree of
relative price stability under oligopoly.
Figure 9-5: The kinked demand curve
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The kink in the demand curve is at the market price P1 with the amount which the firm produces at
Q1; this is the point of profit maximisation. The significance of P1 is that oligopolists will be wary of
moving away from it individually because they cannot be certain of the reactions of their rivals. The
curve is relatively elastic above P1 and inelastic below it. Hence, if firms raise prices and their rivals
do not follow, they will lose market share; if they cut prices, their rivals will follow to protect their own
position, which means that all firms will end up with lower prices and profits on unchanged market
shares. Consequently, prices will be inflexible at P1.
There are three inferences that can be made:
There is unlikely to be permanent price competition under oligopoly;

Firms will compete through non-price methods such as advertising, promotions and product
development; and
Firms may engage in collusive agreements and form cartels or consent to price leadership
arrangements
9.4.2 The shortcomings of the kinked demand curve model are as follows:
The theory is difficult to test effectively because it does not actually explain how the price is
initially determined;
The model takes no account of non-price competition which is an important feature of the market;
and
There are other reasons for infrequency of price adjustments such as their cost and lost customer
goodwill which may be as equally important as the more specific market pressures
TO THIS STUDY UNIT
122
Bibliography
Berg, D. and Ward, D. (2016) Economics for Business. Fifth Edition. United Kingdom: Mcgraw-
Hill Education. This is the latest edition of the textbook that is available
Mohr, P. and Fourie, L. (2020) Economics for South African Students. Sixth Edition. Pretoria: Van
Schaik. This is the latest edition of the textbook that is available
Schiller, B.R., (2013) Essentials of Economics. Thirteenth Edition. New York: Irwin Mcgraw–Hill.
This is the latest edition of the textbook that is available
123
124

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MICROECONOMIC ESSENTIALS

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We hope you enjoy the module.

Aims of this module:

Understand what is meant by microeconomics

C. Learning Outcomes and Associated Assessment Criteria of the Module

D. How to Use this Module

The prescribed and recommended readings/textbooks presents a tremendous amount of material in

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

Prescribed Reading(s) / Textbook(s)

Special Feature Icon Description

The Learning Outcomes indicate what aspects of the particular

The Associated Assessment Criteria is the evaluation of student

A think point asks you to stop and think about an issue.

You may come across knowledge check questions at the end of

You may come across self-assessment questions that test your

Case studies are included in different sections in this module

VIDEO You may come across links to videos as well as instructions on

Unit 1: Introduction to Microeconomics

Unit Learning Outcomes

Prescribed Reading(s) / Textbook(s)

Schiller, B.R. (2023). Essentials of Economics. Twelfth Edition. New

1.2 Macroeconomics versus Microeconomics

a) During the last 12 months average car prices have fallen

b) Inflation for the past 12 months has been 3.5%

1.3 Limited Resources

1.4 The Problem of Scarcity

Factors of production are divided into four main categories:

natural resources (land, minerals)

Think Point 1.1

1.5 Opportunity Costs

1.6 The Production Possibility Curve

(Mohr and Fourie, 2015:6)

scarcity, a lack of resources to achieve that level of production.

1.7 Why do Opportunity Costs Increase Along the PPF?

Unit 2: A Closer Look at the Economic Problem of Scarcity

Unit Learning Outcomes

Prescribed Reading(s) / Textbook(s)

Schiller, B.R. (2023). Essentials of Economics. Twelfth Edition. New

2.1 Improved Techniques or Increased Resources

Figure 2-1 The production possibilities curve once again

(Mohr and Fourie, 2015:6)

efficiently (given the state of technology).

Figure 2-2 Improved technique for producing capital goods

(Mohr and Fourie, 2015:9)

Figure 2-3 Improved technique for producing consumer goods

(Mohr and Fourie, 2015:10)

Potential output has increased.

Figure 2-4 Increase in the quantity or productivity of the available resources

(Mohr and Fourie, 2015:10)

1. Consider an economy produces two goods, Ferrari cars and Ray-Ban

2. The same Ferrari and Ray-Ban economy receives an influx of migrant

2.2 The Three Central Economic Questions