Solutions for all. Economics Grade 10. Learner s Book. J Luiz B Serfontein

Transcription

1

2 Solutions for all Economics Grade 10 Learner s Book Endorsed by the School of Economic and Business Sciences, Faculty of Commerce, Law and Management, University of the Witwatersrand, Johannesburg, in the interest of creating future business and societal leadership, understanding and knowledge. J Luiz B Serfontein

3 Solutions for all Economics Grade 10 Learner s Book M. Eloff, J. Luiz, D. Nel, A. Pretorius, B. Serfontein 2011 Illustrations and design Macmillan South Africa (Pty) Ltd, 2011 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, photocopying, recording, or otherwise, without the prior written permission of the copyright holder or in accordance with the provisions of the Copyright Act, 1978 (as amended). Any person who commits any unauthorised act in relation to this publication may be liable for criminal prosecution and civil claims for damages. First published Published by Macmillan South Africa (Pty) Ltd Private Bag X19 Northlands 2116 Gauteng South Africa Cover design by Deevine Design Typesetting by The Purple Turtle Publishing Services Illustrations by Michael Souter Photos from Africa Media Online The publishers have made every effort to trace the copyright holders. If they have inadvertently overlooked any, they will be pleased to make the necessary arrangements at the first opportunity. ISBN: WIP: 3054M000 It is illegal to photocopy any page of this book without written permission from the publishers. Acknowledgements The publisher and author wish to thank the following, in anticipation for their permission to reprint copyright material: South African Reserve Bank Statistics South Africa Business Day Financial Mail South African Mint Gerald Crawford Finance Week Department of Education Department of Tourism

4 Contents 1 Economics: Basic concepts Basic economic problem Circular flow and quantitative elements Circular flow...36 Quantitative elements Business cycles Dynamics of markets Production possibility curve Public sector intervention Growth, development and globalisation History of South African economic growth and development History of money and banking Population and labour force Unemployment Labour relations Economic redress Word list Bibliography

5 Topic 1 Economics: Basic concepts What will you learn about in this topic? Unpacking of economics through describing the concept and its elements The branches and approaches of economics The positive and normative statement methods of economics The scientific method of economics Difficulties faced by the social sciences The use of models to explain economics The setting of economics within the fields of accounting, business studies, commercial law and mathematics of finance Relationships with other sciences such as statistics, mathematics, information technology, law, politics, sociology and geography Career opportunities Let s talk about this topic Have you ever wondered why you cannot have everything you need and want? What is studied in economics? How does economics relate to other subjects? What is it that economists do? Economics: Basic concepts 1

6 Economics: Basic concepts What do I know already? Needs and wants All people have needs and wants, but there are only limited resources available to satisfy them. Needs and wants differ from person to person, and what one person regards as a need another will see as a want. For example, you might regard owning a cell phone as a need, but for someone who cannot afford a cell phone it is a want. Economics is the study of how people use their limited resources to satisfy their unlimited needs and wants. Check myself Do you think that being rich means that you have unlimited resources? Name some resources that you think might be limited even when you have a lot of money. Word bank A B C Needs are those goods and services we need to survive. Wants are those things other than needs that will give us satisfaction. Scarcity exists because we have limited resources with which to satisfy unlimited needs and wants. Economic efficiency occurs when we make the best use of our resources to produce goods and services. Microeconomics studies the individual parts of the economy. Macroeconomics studies the functioning of the entire economy. Phenomena are events and patterns that occur, sometimes unusual. Normative statements are statements that contain value judgements. Positive statements are statements that can be proven right or wrong. What do I still need to know? Description and elements Economics is about everyday things. It is about the things that affect you, your family, your town, your country and your planet. Economics is also about the things that happen in your everyday life. Think about the statements you just read what do you think economics is about and how is it part of your everyday life? 2 Economics: Basic concepts

7 Topic 1 Do you know about inflation? Think about how much things cost now compared with three years ago. Can you still buy the same things with the same amount of money as three years ago? Why do you think this is? Questions like these are very important in economics. This is because economics is also about the study of the causes and effects of and solutions to inflation. As a Grade 10 learner, you will soon be reaching the end of your school career. Are you thinking about your future yet? What you do after you matriculate is a very important decision because you must start preparing yourself now for the labour market. In economics, people study the dynamics of various markets, including the labour market (how it functions, how wages are determined, etc.). South Africa unfortunately has a very high unemployment rate. This means that we have a very large number of people who are looking for jobs but who cannot find any. Unemployment is one of the biggest challenges facing South Africa. Economics studies the causes and effects of and solutions for unemployment. Economics is about everyday things Can you now see how economics is about the issues that affect the quality of life of yourself, your family and friends all South Africans in fact? So why are you studying economics? Economics should be studied by everyone. Some people can use economics to make a real difference to the building of our economy and society. The study of economics can help people to become better citizens. As a young South African, you have a very important role to play in participating in and contributing to the national debate about the challenges that face South Africa. To contribute you must be economically literate. Soon you will be eligible to vote, but voting is not just about choosing a person or a party to vote for. It is about making well-informed decisions that affect your own and other people s futures. It involves understanding your society and the issues that affect it. So, it means being able to make informed and critical decisions about economic questions. As a voter, you can influence which political leaders deal with the problems South Africa faces, and how. Economics: Basic concepts 3

8 Your vote counts it says which policies you think are good, workable and right for our situation. To identify the best policies, you will need a good understanding of economics. You also need economics to help you develop a better understanding of your own actions as a human being. You are always making decisions, so you are always making choices. Sometimes these choices are not easy or popular, and sometimes the choices you make mean that you have to give up something else. This means that the choices that you have made, or are still going to make, involve a cost something is gained but something is lost. So now that you know a little about the importance of economics in your own life, let s think about what the study of economics is all about the what, who, why and how of economics. Every single human being has needs and wants. Psychologists (the people who study the way people think and act) say that every person in the world has a need for love, security and social recognition, as well as a need for necessities such as food, shelter and water. However, people have a list of needs and wants that is usually much longer than this list. As they get older and change, their list of wants and needs will also get longer and change. So we can say that people s needs and wants are continually expanding and changing. Limited resources Have you ever noticed how, once a need or Satisfying unlimited needs and wants with limited resources want has been satisfied, there is always something else to take its place? We all would like more food, more love and more free time, as what we have never seems to be enough. Even in wealthy societies, you will find that people have wants and needs that are never fully satisfied. Economics is not only concerned with needs and wants but also how best to satisfy these unlimited needs and wants. To do that we must consider how these goods and services that satisfy our needs and wants will be produced. It is when dealing with production that we are confronted with the issue of scarcity. We simply do not have enough resources to produce all the things we need and want. Unlimited needs and wants 4 Economics: Basic concepts

9 Topic 1 Because our needs and wants are unlimited and resources are scarce, we as a society must make some very hard choices. We have to decide which needs and wants and, importantly, whose needs and wants will be satisfied. We are therefore not only facing the issue of economic efficiency but also the problem of ensuring equality. Economics can therefore be defined as the study of how individuals, businesses, government and other organisations in our society choose to use scarce resources to satisfy needs and wants in a manner that is efficient and equitable. Classroom activity Did you make a choice recently for which you had to give up something? (1) 2 How do you think knowing that choices are a compromise a give-and-take situation has affected the way you view the world and the choices you make? (2) 3 Why do you think the idea of choices is important in economics? (2) 4 Why do you think it is not possible for people to have all the things they need and want? (2) What do I still need to know? Branches of economics Macroeconomics Macroeconomics Aggregate price level Unemployment Total level of production Total level of exports Economics Microeconomics Microeconomics Individual prices Unemployment in the agricultural sector Production of motor cars Exports of gold The branches of economics Economics: Basic concepts 5

10 The study of economics can be divided into two main branches called microeconomics and macroeconomics. 1. Microeconomics (micro means small) looks at the behaviour of the units of an economy the businesses (firms), households and individual consumers. It focuses on how these units make decisions. For example why households prefer one product over another, or how businesses choose to produce one product over another. Microeconomics focuses on individual markets their products, prices and outputs. 2. Macroeconomics (macro means large), on the other hand, looks at the behaviour of the economy as a whole, for instance the unemployment rate or the inflation rate of an economy. Macroeconomics is not concerned with what the individual units are doing. Macroeconomics is like an aerial photograph of a landscape where the whole picture can be seen, but the small details are invisible. But microeconomics is like a walk through the same landscape details can be seen up close but the big picture is hidden. The relationship between macro- and microeconomics It is important to realise that macroeconomics is always supported by microeconomic processes. In other words, macroeconomics is always the outcome (the result) of microeconomic behaviour. So care must be taken not to separate these two branches completely, because they support each other. Sub-branches of economics Labour economics Public economics Monetary economics Agricultural economics Some sub-branches of economics There are many other sub-branches in economics, but they are normally classified within the broad categories of micro- or macroeconomics. There are also many different kinds of specialised or expert fields of economics. Examples of the sub-branches of economics include the following: Development economics focuses on the problems of poorer countries. 6 Economics: Basic concepts

11 Topic 1 Econometrics focuses on statistical techniques in economics. Mathematical economics is the use of mathematical techniques in economics. Monetary economics examines the role of money and financial institutions in the economy. Labour economics focuses on labour markets. Public finance looks at the role of government. Environmental economics studies the impact of the economy on the environment. Agricultural economics focuses on agricultural markets. Economics is not a static discipline and new sub-branches develop continuously. For instance, there is the relatively new area of peace economics, which studies the cost of conflict and the ways in which conflict can be avoided. Classroom activity Do the following statements belong to microeconomics or macroeconomics? a) The factors that determine the demand for fried chicken pieces. (1) b) The determinants of demand for all goods and services (1) c) Changes in the inflation rate (1) d) Changes in the price of cold drinks (1) e) The reasons why engineers are unemployed (1) f) The factors that determine the total production of goods and services of a country (1) 2 Which of the sub-branches of economics do you find the most interesting? Give reasons for your answer. (2) Economics: Basic concepts 7

12 What do I still need to know? Approaches and methods of economics Economics is a social science Economics is a social science. This means that it studies people and their behaviour. And, as a social science, it is related to the other social sciences, such as sociology (the study of societies and social problems), anthropology (the study of humankind and its customs), political studies (the study of government) and psychology (the study of the human mind and behaviour). But, because it is a science, it uses a logical and scientific approach to discovering how people behave. What do you think a scientific approach means? Economists study human behaviour Difficulties faced by the social sciences Unlike natural sciences that deal with the natural world, social sciences deal with human beings. Because they deal with humans, with their motivation and desires, social scientists are faced with a number of problems. Humans are very complex beings and it is not possible to model or understand every aspect of being a human. Economists cannot do experiments in a laboratory Social scientists therefore simplify things by trying to identify the most important determinants that affect our behaviour. This may sometimes lead to oversimplification. Social scientists also cannot experiment and make use of laboratories to test their theories the way natural scientists do. They are therefore not able to test their theories and predictions under ideal conditions. Economists are also human beings with their own preferences and ideas, and this will have great impact on how an individual economist may view the 8 Economics: Basic concepts

13 Topic 1 world. Facts do not speak for themselves; they require interpretation. We may have the same facts but they will mean different things to different people. Economics uses the scientific method Economists construct (make) theories based on assumptions so as to reach certain conclusions. For example, economists have studied human behaviour and have observed that when the price of a good rises, the quantity demanded by consumers will fall. In understanding a scientific approach, it is important to first recognise a few steps: Human behaviour is first observed. On the basis of this observation, a pattern is recognised. The pattern of behaviour is then stated as a theory, i.e. as the price of a good rises so the quantity demanded thereof will fall. But, this theory is also based on two key assumptions. Firstly, that humans behave rationally. Secondly, that all other things remain the same or constant. The assumption that other things remain constant is called the ceteris paribus condition. It is an important assumption and tool in economics because it allows economists to make generalisations or theories based on what they have observed. Compare this to what happens in a science laboratory where one chemical at a time can be observed under controlled conditions. The ceteris paribus condition allows economists to do something similar to look at one thing at a time and to assume that everything else stays the same. Positive and normative statements Economics can also be categorised into positive and normative economics. They both have their place in economics and they are each used to accomplish different objectives. 1. Positive economics deals with positive statements and facts and does not make value judgements (what is right or wrong). It is concerned with making scientific statements about economic behaviour. Positive economists investigate phenomena and are concerned with how the world really works. Positive economic statements can be proven either right or wrong. 2. Normative economics, on the other hand, deals with normative statements and makes judgements about what an economy should or should not be like, and so it is more concerned with policies. The main difference between positive and normative economics is that positive economics deals with what is, and normative economics deals with what should be. Economics: Basic concepts 9

14 Whenever you see the words should or ought, you are probably looking at a normative statement. And whenever economists move from facts or theories to the policy level, they are probably moving from positive to normative economics. Note that a positive statement can be wrong. A statement such as the unemployment rate for South Africa was 3,5% in 2004 is a positive statement, but it is wrong. The unemployment rate was much higher. Economics uses models Economists observe and theorise about human behaviour to explain the world, predict outcomes and make policies based on their models. Through careful observation, economists can recognise patterns that are either caused by behaviour itself, or by the results of such behaviour. It is this skill of knowing about patterns that allows economists to make policies that will bring about certain outcomes if we do this, then that will happen. Classroom activity Are the following statements normative or positive? a) The economy grew by 2,5% in (1) b) Bafana Bafana should be the most popular soccer team in Africa. (1) c) Mr Trevor Manuel was the Minister of Finance in South Africa in (1) d) Wages should be increased in South Africa. (1) e) This economics textbook is written for Grade 10. (1) f) The unemployment rate for South Africa was 0% in (1) 2 Why is it easier to test the prediction of a theory in the natural sciences than in the social sciences? (2) What do I still need to know? Relationship with other fields of study Economics is an interesting and crucial discipline because it deals with issues that are very important to society it deals with our quality of life, poverty and wealth, and the opportunities of the present and future. It is through the study of economics that we are able to see how the world and our actions are all related and interdependent. Our social, economic and political problems cannot be solved in isolation from one another. They require an integrated approach. Economics is one of the keys to a better future for all humankind. 10 Economics: Basic concepts

15 Topic 1 Mathematics of finance Accounting Economics Commercial law Business studies Economics and other fields of study Economics also forms part of the economic sciences that deal with commercial subjects, such as accounting, business studies, commercial law and mathematics of finance. A qualification in commerce usually requires you to study these subjects, as well as economics. The field of study for economics is much broader than that of the other commercial subjects. This is because it involves the functioning of the economic system, while other subjects deal with specific components of the economic system. Accounting involves recording financial transactions and reporting this information according to certain standards in financial statements. Financial statements are there to provide information on how well a business is doing financially. While an accountant is interested in the profits that the business makes, an economist will consider issues such as the role of profits in the economy or whether it is possible to produce the same amount of goods with less costs. While an accountant will record the actual costs of the business, the economist will be concerned with the forces that determine the cost of production, as well as other factors such as pollution, which the accountant would not take into account. Much of the financial information provided by accountants is very useful for economists, and many of the techniques developed by accountants are used by economists too. Business studies is concerned with the functioning of a business enterprise and focuses on topics such as marketing, product development, management, production methods and labour relations. Business studies teaches how a business should be run and how the business world works. Economics: Basic concepts 11

16 The economy has an important impact on any business. For this reason business studies learners would do well to study economics and understand how the economy affects the survival of a business. In economics, business enterprises play an important role in solving the scarcity problem. This is because they produce the goods and services that we use to satisfy our needs and wants. Economists therefore pay very close attention to the behaviour of businesses in the economy. They analyse elements such as the impact of tax policies on business, business confidence and the competition between businesses. Commercial law concerns the rules and regulations that govern commercial or business transactions in the economy. These laws are part of the environment in which an economy functions. For an economy to work well, business contracts must be legally binding and honoured by both parties. Economists are also interested in the effects and unintended results that laws and regulations may have on the functioning of the economy. Competition law, for example, is an area where economists are very active. Mathematics of finance involves the use of applied mathematics to study and solve problems relevant to the finance sector. The techniques developed in this field are very important to economists. Not only because they study financial markets extensively, but also because they use applied mathematics in many other branches of economics. Classroom activity 1.4 Are the following statements true or false? 1 Economics is not part of the commercial subjects. (1) 2 The study field of economics is broader than other commercial subjects. (1) 3 Economists pay close attention to the behaviour of businesses. (1) 4 Commercial law involves studying the functioning of financial markets. (1) 5 For an economy to work well, transactions must be legally binding. (1) 12 Economics: Basic concepts

17 Topic 1 What do I still need to know? Relationship with other sciences and career opportunities Relationship of economics with other sciences Statistics helps us to organise numerical information and draw conclusions from the data. We do this with tables, graphs and charts and by using statistical techniques such as regression analysis, sampling and probabilities. An important branch of economics is econometrics, which is using mathematics and statistics to analyse economic data. It is through these statistical techniques that economists test many of their economic theories. Mathematics is the study of numbers, shapes, structure and change and the relationships between these concepts. In economics extensive use is made of mathematics when economic models are developed. Information technology deals with the development, implementation and support of computer-based information systems, as well as software and hardware issues. Economists use various software packages to collect, analyse and present economic theories and data. Law is a body of rules and regulations that we use to bind us together as a society and according to which we should behave. The study of law also has different branches: private law, commercial law, criminal law and customary law, etc. For an economist this is an important field of study, as it determines the environment in which economic activity and transactions take place. Politics is the study of governments and political parties. A very close relationship exists between politics and economics. The one cannot be studied without taking the other into account. An important study field in economics is public sector economics, which deals with the role of government in the economy. Economic policy-making is also closely linked to government. There is even a political business cycle where the action of government causes economic activity to increase or decrease. Sociology is part of the social sciences and so is economics. Both subjects involved the study of human society not of only individual actions but also of groups and institutions and the interaction of individuals and groups. Geography deals with the study of the earth's physical environment and human habitat. An overlap exists with the study of economics, especially Economics: Basic concepts 13

18 when dealing with population, environmental issues and the use of natural resources. Career opportunities Economics is a skill and discipline that is used in many different jobs. It can open doors in business and finance you could work as an economist at one of the big South African or international banks, or for any of our large companies in tourism, mining, agriculture, pharmaceutics, insurance, etc. You could even work in government to make public policy decisions or become the future Minister of Finance. What about a career with one of the large international development agencies, such as the United Nations, the World Bank or the International Monetary Fund? Or you could teach economics at school or university. What about becoming a financial journalist? Economists advise businesses Economics is the foundation of many career options in many different fields: Economists are used in the formulation of all government policy and hence you could end up formulating South Africa s tax or expenditure policy at national, provincial or local level. You could work in the banking industry where they use economists to predict future economic outcomes, inflation and exchange rate changes, for instance. You could work for various non-governmental organisations (NGOs) that work in the field of promoting economic development and alleviating poverty. All newspapers have an economics section, so you can also work as a journalist. There are many other career opportunities. Government departments use the advice of economists to understand how the economy may affect them and how they affect the economy in return. Likewise, major corporations rely on economists to determine how local and global economics will affect them. Classroom activity Describe the relationship between politics and economics. (3) 2 What are the different career opportunities available to economists? (3) 14 Economics: Basic concepts

19 Topic 1 Homework activities 1 Why do you think the study of economics is important? (2) 2 Define the study of economics. (4) 3 What is the difference between efficiency and equality? (2) 4 Distinguish between macroeconomics and microeconomics. (2) 5 Give an example of a positive statement and a normative statement in economics. (2) 6 Describe the relationship between economics and statistics. (2) Extra practice 1 Why are needs and wants unlimited? (2) 2 Why do we say resources are scarce? (2) 3 Is the following statement true or false: In macroeconomics we study the price level of all goods, while in microeconomics we study the price of a specific good or service. (2) 4 Can the following statement be proven correct or incorrect? The economic growth of South Africa has declined during 2010 compared to Is this a positive or normative statement? (2) 5 How does the work that accountants do differ from what economists do? (4) 6 Is it possible to give everybody in our society the same things? Should we try to give everybody the same goods and services? (2) Economics: Basic concepts 15

20 Summary We study economics to better understand how we as a society can best deal with the economic problem of satisfying unlimited needs and wants with limited resources. We must therefore not only decide what we are going to produce, but also how we are going to produce it and for whom. The study of economics is therefore not only about efficiency but also about equality. Economics is divided into the two main branches of macroeconomics and microeconomics. While macroeconomics gives us an overview of the functioning of the economy, microeconomics gives us a more detailed view. Economics is both a social and an economic science and has strong relationships with other sciences and subjects. 16 Economics: Basic concepts

21 Topic 2 Basic economic problem Topic 1 What will you learn about in this topic? Problems that all economies try to solve The problem of scarcity, both absolute and relative scarcity Alternatives, choices and opportunity cost Economic and free goods The basic economic processes of production, exchange and consumption The promotion or violation of human rights and the environment Let s talk about this topic What do you think it means when we say something is scarce? Have you ever had to choose one thing over another because you could not afford both? Have you ever wondered how we deal with the problem of scarcity? Basic economic problem 17

22 Basic economic problem What do I know already? The study field of economics Economics is the study of how we as a society (households, businesses, government and other organisations) use our scarce resources to satisfy our unlimited needs and wants. Check myself Why is it so difficult for us to satisfy all of our needs and wants? Who are the important decision makers in the economy? Word bank A B C Scarcity exists because we have insufficient resources to satisfy our needs and wants. Relative scarcity exists when something is relatively scarce compared to something else. Absolute scarcity exists when it is not possible to produce more of something. Opportunity cost is the best alternative you give up when you make a choice. Capital goods are things of value, such as machines and tools, that are used to produce other goods. Factors of production are used to produce goods and services. Primary sector has to do with natural resources. Secondary sector is where manufacturing takes place. Tertiary sector has to do with services. Factor market is where the factors of production are bought and sold. Goods and services markets are where goods and services are bought and sold. Markets bring buyers and sellers together. Market economy is an economy that uses markets to solve the problems of what to produce, how to produce and for whom to produce. 18 Basic economic problem

23 Topic 2 What do I still need to know? Scarcity problem For people to satisfy their needs and wants, they need resources to produce the goods and services to satisfy them. However, there will never be enough resources to meet everyone s needs and wants. As a result, there will be a scarcity of certain goods and services. There are over seven billion people on our planet. Imagine the long list of needs and wants for everyone. Now imagine trying to satisfy everyone s needs and wants with the resources available. For example, consider how much food seven billion people need. On earth there is only so much land available that can be used to cultivate the crops to feed everyone. And, to make matters worse, what land is available is getting smaller all the time as it is increasingly being used for other things, such as industry, cities or biofuel crops. Scarcity forces us to make choices It is because of the scarcity of resources that societies are forced to make choices. We cannot produce and consume everything we want. Any society therefore needs to answer the following fundamental economic questions: What goods and services will we produce? How will we produce these goods and services? Who are we going to produce these goods and services for? What goods and services will we produce? How will we produce these goods and services? Who are we going to produce these goods and services for? Every society must answer the three fundamental economic questions Economics gives us the tools and knowledge necessary to make these kinds of choices. It is about deciding how best to use the available resources to satisfy as many needs and wants as possible. Economics is therefore concerned with the study of choices and decision-making in a world that has very real limits. Since we live in a world of scarcity, we have to make choices all the time. Unfortunately, these choices are not always popular or easy to make. Basic economic problem 19

24 Absolute and relative scarcity Economics is mainly concerned with the issue of relative scarcity. When you decide to have one thing instead of another, you are dealing with the issue of relative scarcity. If we decide to use our resources for the production of bread, for example, they are not available anymore to increase the production of milk. Milk is therefore relatively scarce in relation to bread. Absolute scarcity exists when it is not possible to increase the supply of a good or service. It is not an issue of choice. It usually applies to goods and services that are essential for human survival, such as water and food. The concepts of relative and absolute are also used to describe poverty. Absolute poverty is a measure of the level of poverty against a certain minimum level of income that is regarded as essential to get basic goods and services. Relative poverty is a measure of the level of poverty against another group in society or the average income of the country. This deals with the distribution of the wealth of a country among its population. For instance, in rich societies a person can be regarded as poor even if the person has more than enough to satisfy basic needs and wants, but might not have a television or a two-bedroom house. While a measure of absolute poverty might be earning less than $1 a day, relative poverty in the USA might be regarded as earning less than $30 a day. Classroom activity What are the three fundamental economic questions that every society must answer? (3) 2 Why does scarcity force us to make choices? (2) What do I still need to know? Opportunity cost Because our needs and wants are greater than our resources, we must choose which needs and wants to satisfy. Once we have chosen to satisfy a particular need or want, we have made a choice. We have chosen to satisfy that particular need or want instead of some alternative need or want. We are constantly confronted by the opportunity cost of our choices 20 Basic economic problem

25 Topic 2 For instance, imagine that you want a soccer ball and soccer boots, but you do not have enough income to purchase both. If you choose to buy the soccer ball instead of the soccer boots, then the cost of your choice is the soccer boots that you gave up. Every choice we make involves giving something up, and this something else or alternative is the cost of our choice. In economics this cost is called the opportunity cost. Because of the choices we are forced to make, we are always trading off options and alternatives. For example, imagine that you have a test tomorrow, and that you only have this afternoon to study. However, you would really like to play soccer this afternoon, as you are trying to get on the school team. You therefore face a choice if you choose to play soccer, you will have less time to study, and you will probably get a lower grade for your test. If you miss playing soccer you will have more time to study and will probably get a higher grade, but you may not get a place on the soccer team. Your limited resource of time therefore puts a constraint on what you can and cannot do. Everyone faces an opportunity cost Everyone faces an opportunity cost when they make choices and decisions even the richest people in the world. Being rich may mean that you can have as much of anything as you want, but you still have to make choices, e.g. are you going to drive your new sports car or fly your helicopter to work? You cannot do both at the same time. Everyone faces an opportunity cost Can you now see that you have to make decisions and choices all the time as you try to manage your limited resources to satisfy your unlimited wants? Economics takes this one step further by looking at how a society manages its resources to satisfy its unlimited needs and wants. Government must also make choices, as it has limited resources Let s look at how these questions affect government. Government has to decide all the time how to spend limited resources (the revenue that has been raised through taxation). Decisions must be made on how to allocate this revenue Basic economic problem 21

26 between competing needs, for example housing and education. They also have to consider how it will influence how much is available for defence or health care. As you know, the state cannot increase its spending on everything, because there are limited resources available. This is what economics studies. Economists can help government officials make these decisions because economics provide the tools to quantify (measure) the costs and benefits of an action, thereby making informed decisions about the best way forward. A business also faces opportunity cost. Should it produce fried chicken pieces or fried chicken burgers? How should it produce the goods and services? Should it make use of more labour or more capital? If the business decides to produce fried chicken pieces, the cost of doing that is not producing fried chicken burgers. Opportunity cost is the cost of the best alternative To emphasise the point that all resources are scarce and that the use of resources is never without a cost, even if it is free, economists use the TANSTAAFL principle. TANSTAAFL stands for There Ain t No Such Thing As A Free Lunch. Accounting costs vs opportunity cost In economics the opportunity cost of any decision is the value of the best alternative that is given up because of that decision. It is not all the alternatives that are given up, but only that thing you really wanted but chose not to have. Even if you are given something for free it does not mean it did not cost something. We could have produced something else instead it is this something else that is the cost of the goods or service you have received for free. Can you see that opportunity cost differs from accounting costs? While the accountant calculates what something actually costs in rand, the economist estimates it in terms of the best alternative that was given up. Classroom activity What is your opportunity cost for being in the classroom? (1) 2 Provide a definition of opportunity cost. (2) 3 Give an example of an opportunity cost that a business faces. (2) 4 Why do we say in economics that nothing is free? (2) 22 Basic economic problem

27 Topic 2 What do I still need to know? Free goods and economic goods Goods refer to tangible things the things that you can see and touch, such as food, radios, gold, tractors and this book. But there are also many different types of goods. Services on the other hand are intangible you cannot see or touch them. Examples include financial services, medical services, catering services and teaching services. Free goods are useful to people and they satisfy important needs and wants, but they are not scarce. They are usually gifts of nature and there is an abundant supply, such as fresh air, sunshine and sea water. These goods do not belong to anybody and as long as there is an abundant supply of them, people will not be prepared to pay for them. Economic goods are goods that are produced using scarce resources. They can command a price in the market and are usually owned by somebody. Economic goods are also called scarce goods and we can distinguish between different kinds of goods. Consumer goods Capital goods Consumer goods Capital goods and consumer goods Consumer goods are the goods used by households to satisfy their wants, such as food, cars, clothing and appliances. There are three main categories of consumer goods: Non-durable goods are goods that can only be used once, such as food, drink and petrol. Semi-durable goods are goods that can be used more than once but last for a limited period, such as clothing and car tyres. Durable goods are goods that last for many years and include fridges, stoves, furniture and cars. Capital goods Capital goods are used for the production of other goods. Capital goods are not consumed to satisfy wants, but are used to produce other goods, e.g. the Basic economic problem 23

28 machinery used for manufacturing or farming and the buildings used for offices. They are very important goods because they allow people to produce those goods that satisfy consumer wants and needs. Private goods and public goods Private goods are consumed and owned by households. For example, if a household buys a chair, they then own it and can stop other people from using it. Can you think of some other goods that you own and can stop other people from using? Public goods are the goods that are collectively consumed and owned by communities. These goods are supplied by the government. Examples of public goods are roads and street lights. Classroom activity Differentiate between free and economic goods and give an example of each. (4) 2 Distinguish between durable, semi-durable and non-durable goods and give an example of each. (6) 3 Give examples of a consumer good, a capital good and a public good. (3) What do I still need to know? Production Goods and services must be produced to satisfy needs and wants. The ultimate aim of production is to provide society with goods and services so that they can satisfy their needs and wants. It is mainly businesses that are responsible for the production of goods and services in our country, and they must make a number of important decisions. One decision is how the goods and services will be produced. Resources Production Consumer goods Consumers The ultimate aim of production is to satisfy needs and wants 24 Basic economic problem

29 Topic 2 All goods and service need resources to be produced. These resources are called the factors of production. Through the process of production, the factors of production (the resources) are combined to produce goods and services. It is possible to produce the same product by using different combinations of factors of production. For example, a house can be built with bricks, wood, straw, concrete or even glass. Different kinds of tools can also be used to build this house; the mortar can be mixed by hand or by machines, for instance. Sometimes a decision on how to produce something is easy it is not a good idea to build a house with gold bars. But most of the time these decisions are more complicated. Should the house be built with bricks, wood or concrete blocks? Because the factors of production are scarce, these decisions are important production must be efficient and use these resources effectively. As you know, the more effectively and efficiently resources are used, the more goods and services can be produced, and the more needs and wants can be satisfied. So the efficient and effective use of the factors of production contributes to economic growth and the wealth of an economy. Factors of production There are four main factors of production: natural resources, labour, capital and entrepreneurial ability. Natural resources include land, water, mineral deposits and the environment. In other words, they are all the resources that exist naturally. Most natural resources are limited, but with the aid of technology natural resources can be made more efficient. For example, fertilisers have improved the quality of land, making more land available for agriculture. Better drilling technology has opened up oil deposits in frozen areas such as Alaska. Nevertheless, as natural resources are limited (in fixed supply), the exploitation of natural resources must be carefully considered. Over-exploitation can cause environmental damage as well as long-term economic and human suffering. Labour is the human effort that is put into the production of goods and services, and includes both physical and mental work. For example, the writing of this book took both physical work typing and mental effort using the brain for research and creativity. When we talk about labour, we need to separate it into the quality and the quantity of labour: Labour is any mental or physical effort Basic economic problem 25

30 The quantity of labour is the size of a population or the number of people who are of a working age (15 64 years old), and who are willing and able to work. The quality of labour refers to the skills, knowledge and health of workers. The quality of labour is also often called human capital. Human capital is becoming increasingly important in modern production processes. Why do you think this is? Capital is items like factory buildings, machines and tools that are used in producing other goods and services. The characteristic of a capital good that makes it different from other goods is that it is created with the specific aim of producing goods and services. Note that this is different from financial capital, which is the money needed to purchase these real capital goods. It is not money that is directly used in the production of goods and services, but these buildings, machines and tools. Entrepreneurial ability is linked to labour. Entrepreneurs are people who take calculated (planned) risks and seize opportunities as they arise. They are the people who have foresight (judgement to think and plan before an event), and so invest in new things (products, services, markets). Entrepreneurs are the people who open up new doors for humankind. They do not do this because they like to do good deeds; they do this to make profits. However, the chances they take are risky, because they can lose a lot of money by investing in untested things. The company that first developed a fax machine gave up their rights to the technology because they were unwilling to take the risk of further development they weren t sure if there was a market for their product. Today we know what a mistake this company made. But the point is that at the time, the company had no evidence that people would buy fax machines. So an entrepreneur stepped in and the rest, as they say, is history. One of the fundamental problems in the South African economy is the lack of entrepreneurs. Only about 7% of South African adults are engaged in entrepreneurial activity and working for themselves. Given the high levels of unemployment in South Africa, we will need many more entrepreneurs in the economy. Now that you know what the factors of production are, let s think about how production should occur. To do this, we must consider which factors of production are available. For example, if there is an abundance of labour but a shortage of capital, then it would be best to focus on labour-intensive rather than capital-intensive techniques. If a country has little land available for growing crops, then they would have to make sure that this land is used as intensively as possible. 26 Basic economic problem

31 Topic 2 This is why different countries in the world specialise in producing certain goods and services they try to use the factors of production available to them as efficiently and effectively as possible. The aim of using available resources efficiently is very important in any economy the more efficient an economy is in using its factors of production, the more goods and services it will be able to produce, and the more it will be able to satisfy the needs and wants of its citizens. What are we producing? Our production can be divided according to the sector of the economy it originates from: Primary sector Secondary sector Tertiary sector Activities extracting natural resources from nature Examples: Agriculture Forestry Fisheries Mining Stone quarries Resources from the primary sector are processed into a more acceptable form for human use Examples: The manufacturing sector Electricity, gas and water Construction Activities related to the supply of services Examples: Trade Transport Storage and communication Finances and insurance Community welfare and local authority services By comparing the production in the different sectors over the years, we can see how production in South Africa has changed: Primary sector The contribution of this sector declined from 49% in 1911 to 8% in The decline in the contribution of agriculture is particularly noticeable. The contribution of mining also shows a marked decline from 1911 to now. However, in contrast to many other countries, mining continues to play a major role in the South African economy today. Secondary sector This sector s contribution increased significantly from 5% in 1911 to 22% in The contribution of the manufacturing industry in particular shows a marked increase. Tertiary sector The contribution of this sector increased from 46% in 1911 to 69% in Basic economic problem 27

32 Classroom activity Name the four factors of production and give an example of each. (8) 2 Give an example of the production that occurs in the primary sector, secondary sector and tertiary sector of the economy. (3) 3 Why is it important that we make efficient use of the factors of production? (4) What do I still need to know? Exchange Our economy is mainly an exchange economy. Exchange is the phase between production and consumption and involves voluntary transactions between producers and consumers. Workers exchange their labour for income. Income is then exchanged for goods and services to satisfy needs and wants. All these exchanges take place in markets. We exchange our labour for income on the factor market and our income for goods and services on the goods and services market. A market brings buyers and sellers together to establish a price. For a market to exist there must be at least a seller who has something to sell and a buyer who wants and can afford to buy this good or service. As societies have become more sophisticated, markets too have become more complex. Markets today are linked globally. A market in Johannesburg can be linked to a market in New York. Technology now allows people to exchange goods without ever meeting or being physically present. Exchange now happens through technology or economic agents. For example, a rooibos farmer in Citrusdal sells his rooibos to an agent in Johannesburg. This agent then exports the rooibos to a wholesaler in the USA who sells the rooibos to a tea shop in New York. The tea shop sells the rooibos to customers, which is the final market, unless one of the customers runs a restaurant. Then the rooibos will be served in the restaurant and this is yet another market. Another example of a modern market is the internet. There are some auction (public sale) sites that allow sellers to auction goods and services to the highest bidder. Again, in this market buyers and sellers do not meet, but the truly interesting thing is that a market does not even have to be a physical place it can just be an abstract space such as the internet. 28 Basic economic problem

33 Topic 2 Technology has changed the way people buy and sell Not only goods are sold in markets and the service sector now makes up a large part of many economies worldwide. In some countries the value of the trade in services is more than that of goods. Examples of service sector industries are tourism, banking and insurance. Can you think of any others? A market economy is an economy dominated by buying and selling with little interference from government. It uses markets to solve the economic problem of what, how and for whom to produce. It is through the prices of goods and services that the message of what to produce, how to produce and for whom to produce is sent through the markets. And as you will see later, prices are determined by demand and supply in a market. Price changes are an important way that businesses decide on how much or how little of a product they should produce. An increase in the price of a product usually tells businesses to produce more of a product, but a decrease in the price tells businesses to produce less. Likewise, price changes also tell individuals and households if they should use more or less of a product. Usually, an increase in the price of a product tells consumers that the product is now scarcer, and that they should use less of it. A decrease in the price will tell consumers to use more of a product. Classroom activity What is the role of markets in an economy such as South Africa? (2) 2 What will producers do if the price of a product increases in a market? What will consumers do if the price increases? (4) 3 How does the market for goods differ from the market for services? (2) Basic economic problem 29

34 What do I still need to know? Consumption The aim of all production is to supply households with goods and services that they can use to satisfy their needs and wants. The process of satisfying our needs and wants is called consumption. This is why members of households are often referred to as consumers. If one looks at the statistics for household spending in South Africa for 2009, it gives us a picture of how households spend their income: 7,1 % of our income was spent on durable goods. 9,1% of our income was spent on semi-durable goods. 39,5% of our income was spent on non-durable goods. 44,3% of our income was spent on services. It is through our spending that the question of what to produce is answered. Producers produce according to what households spend their income on. As we change our spending habits, this changes the production of goods and services. Production follows the spending of income. For whom to produce A question related to consumption is how the goods and services produced are distributed among households. Another way of asking this question is to ask whose wants should be satisfied. As you can imagine, this is a sensitive issue and actually a question of normative economics. It is about how we think things should be. In a market system, people get an income by taking part in the process of production, for example by selling the factors of production to producers. So people who sell more of a resource, or who sell a resource that is more valuable, will earn a very good income. The better people s income is, the more goods and services they will be able to afford, and the more they will be able to satisfy their needs and wants. Classroom activity What do we mean if we say Production follows the spending of income? (3) 2 To satisfy their needs and wants a household needs an income. In South Africa there are many poor households. How can we help them to satisfy their needs and wants? (4) 30 Basic economic problem

35 Topic 2 What do I still need to know? Human rights and the environment Because economics is a social science that studies human needs and wants, it is not only about choices, production systems and constraints but also about people. The human side of economics is very important because all economic outcomes affect the quality of life for people and their ability to feed and educate themselves. Economics is therefore also about the dignity of all human beings. Is this sustainable? Economics can create or limit opportunities for people, and for this reason many believe that it should also be about promoting development. The overall goal of development is to create a sustainable (continuing) living standard for all. But development is slightly different from economics. Development stresses a form of economics in which production is geared towards giving people more choices and opportunities. It is about creating jobs, ensuring good health and access to quality education, guaranteeing good nutrition and thus restoring the dignity of all people. Fundamental human rights Economic development is based upon three core human rights: 1. Basic needs all people have a basic need for food, shelter and health. Without these, they cannot live. The main purpose of all economic activity must therefore be to provide as many people as possible with the means to meet these basic survival needs. 2. Self-esteem all people have the right to respect, recognition, dignity and a future. 3. Freedom all people have a basic, human right to be free from poverty, ignorance and ownership by another (slavery). How can economics be part of ensuring these fundamental human rights? The most important thing that economics can do is to contribute towards creating a better life for all by providing more opportunities. It can do so by expanding Basic economic problem 31

36 economic wealth, thereby increasing the range of choices that people have. Economics cannot make everything equal, but it can try to make sure that everyone has access to resources to satisfy their basic needs. Economics and the environment Humankind has disregarded and exploited the earth for far too long. We have taken the environment for granted, using up resources without considering the consequences. Earlier you learned about land and natural resources as a factor of production, and how natural resources are limited and nonrenewable. For example, the supply of oil is limited and once it is used up there will be no oil left. We may be able to find alternatives for many natural resources, such as alternative sources of energy, but we usually only start doing this when our planet s natural resources are almost all gone. World leaders have committed themselves to the principle of sustainable development. This means that they will ensure that progress meets the needs of the present generation without compromising the ability of future generations to meet their own needs (World Bank, 2002: 14). It recognises that all resources are limited and that if people use resources at a rate that is not sustainable, the future of our world, its people and the environment will be destroyed. The economic necessity of satisfying human wants and needs cannot and must not be done by ignoring the impact of economic activity on future generations and their ability to make and have choices. The key question that we are now confronted with is whether we are able to increase prosperity for all people without destabilising the environment. This is an enormous challenge, but one that must be faced. All economies must adopt a win-win strategy a strategy that allows us to preserve natural assets while increasing the opportunities and living standards of all people. Our choices do not have to be a case of either/or. In fact, the best way to deal with poverty is to look after the environment, because it is the only long-term sustainable solution. Classroom activity What does the following statement mean? Economic development is not just about the production of goods and services. (2) 2 Do you think the world is taking sustainable development seriously? Motivate your answer. (4) 32 Basic economic problem

37 Topic 2 Homework activities 1 Are the following statements true or false? a) Scarcity is a problem experienced only by poor countries. (1) b) Opportunity cost is the cost of the best alternative that is given up. (1) c) If government provides free education to its citizens, there is still an opportunity cost associated with the provision of education. (1) d) Capital goods are goods that are consumed by households. (1) e) A market must be in a specific place. (1) f) An ice cream is an example of a non-durable good. (1) 2 How does opportunity cost differ from accounting cost? (2) 3 What are the three fundamental economic questions? (3) 4 Differentiate between the production, exchange and consumption processes. (5) 5 What is meant by sustainable development? (4) Extra practice 1 Briefly describe how a market economy deals with the question: For whom do we produce? (2) 2 a) Did you make a choice recently for which you had to give something up? b) What was it that you had to give up? c) What is the opportunity cost of the choice you made? (2) 3 To produce a wooden table you need the following: wood, saw, carpenter, hammer, nails and a person who decides to produce and sell the table. Name the factors of production these items represent. (4) 4 Discuss the consequences for future generations if we do not take sustainable development seriously. (4) Basic economic problem 33

38 Summary All societies, poor and wealthy, face the problem of scarcity. This forces us to make choices about what to produce, how to produce and for whom to produce. Every choice we make involves a cost, the opportunity cost, which is the best alternative we give up. It is this opportunity cost that we study in economics. Economics also concentrates on the study of economic goods (also called scarce goods). Examples of economic goods are consumer goods, capital goods and public goods. In a market economy we can differentiate between three processes: production, exchange and consumption. The production of goods and services requires the factors of production and it is during this process that the question of how to produce is answered. During the exchange process the goods that were produced are consumed by households. This happens through markets. During the process of consumption, households exchange their income for goods and services, and the questions of what to produce and for whom to produce are answered. During this cycle of production, exchange and consumption the quality of life, human rights and the environment are all affected and it is important to take these effects into account. 34 Basic economic problem

39 Topic 3 Circular flow and quantitative elements What will you learn about in this topic? Who the main participants in the circular flow are Product and factor markets How real and monetary flows influence the circular flow Diagram and interactions of the circular flow model How leakages and injections influence the circular flow How the variable flows of spending, production and income influence the circular flow Definitions of gross domestic product (GDP) and gross national income (GNI) Composition, importance and comparison of GDP and GNI Let s talk about this topic Who do you think are the major role players in the economy (i.e. who makes important decisions in the economy)? How do you think the decisions by the major role players impact on the economy? Why do you think it is important to measure the performance of the economy? Who do you think is responsible for measuring economic activity? Circular flow and quantitative elements 35

40 Circular flow What do I know already? The basic economic problem The basic economic question that all societies must answer is how to use their scarce resources to satisfy their unlimited needs and wants. In a market economy this answer is provided by making use of different markets in which various participants play an important role. Check myself What are the three economic questions that must be answered by all societies? Name the four factors of production in a market economy. Word bank A B C Circular flow is the flow of production, income and spending that take place in an economy. Households are groups of people that live together and make economic decisions. Business enterprises are the producers of goods and services. The public sector consists of all levels of government and state-owned enterprises. Foreign sector are all the other countries in the world. Savings is the difference between income and spending. Investment is the creation of capital goods. Income taxes are the taxes paid by households and business enterprises on their income. Exports are goods and services we produce and sell to the rest of the world. Imports are goods and services we buy from the rest of the world. Factor market is the market where the factors of production are bought and sold. Real flows are the flows of physical goods, services and factors of production. Nominal flow is a flow of money. Goods market is the market where goods and services are bought and sold. Aggregation is adding things together. Financial market is the market where savings and loans occur. Surplus units are the savers in the economy. Deficit units are the borrowers in the economy. 36 Circular flow and quantitative elements

41 Topic 3 Flow of factors of production is the flow of labour, capital, land and entrepreneurship in the economy. Flow of income is the flow of payment in the form of wages and salaries, rent, interest and profits. Flow of spending is the flow of spending on goods and services. Flow of production is the flow of goods and services that are produced. Leakages are any factors that decrease the flow of spending. Injections are any factors that increase the flow of spending. What do I still need to know? The main participants in the circular flow An economy is a complex system and it is impossible to model or even describe all the different forces that impact on the level of economic activity. To understand what determines the level of economic activity we must simplify things by concentrating on the most important forces that shape our economy. The circular flow model is such a simplification. In this model the interaction and interdependence between the major participants (households, business enterprises, government and foreign sector) in the various markets (factor, goods and financial) are captured and explained. You will learn how the decisions that these participants make and the way in which they interact with one another impact on the economic life of every individual in our society. You will also see how the decision of one participant in the economy will impact on and cause a reaction in the behaviour of another participant, and the influence it has on the level of economic activity. The main participants The main participants in the circular flow model are households, business enterprises (also called firms), the public sector and the foreign sector: Households are all the people who live together and who make joint economic decisions. Your family is a household; a person who lives on his/her own is a household. A commune of friends who live in one house and who share their expenses is also a household. Business enterprises or firms are the units that employ the factors of production to produce the goods and services that are sold on the goods market. An important aim of a business is to make a profit through selling goods and services. There are many different forms of businesses, such as sole proprietors, partnerships and private and public companies. Circular flow and quantitative elements 37

42 Public sector is a broad term that includes all aspects of local, regional (or provincial) and national government and everything that is owned by government as the representative of the people. The foreign sector consists of all the countries in the rest of the world. It includes the international institutions that govern the flow of goods and services and the flow of funds between different countries. Households Public sector Businesses It is the decisions made by the main participants that will have a major impact on the economy and we must take a closer look at them. Foreign sector The important decision makers in the economy are households, businesses, the public sector and the foreign sector Classroom activity 3.1 Name the four major participants in the economy and give an example of each. (8) What do I still need to know? The role of households in the circular flow Households own the factors of production In a market economy, households are the biggest owners of the factors of production. They own all the labour and entrepreneurship and most of the capital and natural resources (land). Even though businesses own the capital goods (the buildings, factories, tools and machines), these businesses are in return owned by households through the shares they have in them. Some households may own only a few hundred rands worth of shares, while others may own thousands or millions of rands worth of shares in a company. The point is that businesses are legal entities 38 Circular flow and quantitative elements

43 Topic 3 that are owned by people (households). These households own a firm s capital goods and have a right to its profit in the form of dividends. Households make these factors of production available to the economy where it is used to produce goods and services. In exchange for the use of the factors of production, households receive an income in the following forms: Salaries or wages for their labour Interest on their capital Rent for natural resources such as agricultural land Profit from entrepreneurial activities. The most important source of income for households in South Africa is the wages and salaries they receive in return for their labour services. To earn an income, households must therefore take part in the production of goods and services. This is an important decision that households must make. The more factors of production a household owns, and the more valuable the factors of production, the higher the income of the household. Households use their income to buy goods and services In an economy, the primary or main aim of households is to maximise their satisfaction. Households try to maximise their satisfaction by using their income to buy consumer goods and services that satisfy their needs and wants. They are therefore not only the owners of the factors of production but also the consumers in our society. If one looks at the statistics for household spending in South Africa for 2009 it tells us that households spend: 7,1 % of their income on durable goods 9,1% of their income on semi-durable goods 39,5% of their income on non-durable goods 44,3% of their income on services. If you think back to the basic economic questions of what, for whom and how to produce, you will immediately recognise the importance of households. It is the households, through their income and spending, that determine what is produced and for whom these goods and services are produced. What households (consumers) want and can afford (their demand) determines what businesses will produce. Circular flow and quantitative elements 39

44 Households save Savings is the difference between income and spending. The part of income that a household does not spend is its savings. There are different reasons why households save. Some households save for a rainy day that is for those unforeseen events such as the car breaking down or medical expenses. Sometimes households save for specific events birthdays, graduations, holidays or for a deposit to buy a house. Another important reason why households save, and should save, is to provide for an income when working members retire. Classroom activity 3.2 Consider the following example: Asanda is a single woman living on her own and is employed by ABC Manufacturers as an accountant. Every month she is paid R10 000, of which she spends R9 000 on goods and services and saves R Is Asanda part of a household? Motivate your answer. (2) 2 What factor of production does Asanda sell to the firm? (2) 3 What kind of income does she receive from the firm? (2) 4 How much does it cost the firm to employ her? (2) 5 What does Asanda do with the income she receives from ABC Manufacturers? (2) 6 If Asanda buys a television, is it an example of durable goods, semi-durable goods or non-durable goods? (2) What do I still need to know? The role of business enterprises Business enterprises produce goods and services Business enterprises or firms are responsible for the production of goods and services. The bulk of the goods and services in South Africa are produced by privately owned businesses and they are therefore important decision-makers in our economy. Businesses do not only produce the consumer goods and services that households want. They also produce the capital goods (factories, machines and tools) that are used in the production of consumer goods and services. This creation of capital goods is known as investment. 40 Circular flow and quantitative elements

45 Topic 3 In 2009, 61,39% of gross fixed capital formation (investment) in South Africa originated from private business enterprises, which makes this a very important sector of the South African economy. One may therefore expect changes in the investment behaviour of private businesses to have a major impact on the economy. Looking back at our economic problem of what, how and for whom to produce, businesses are responsible for the how to produce and they are continuously searching for ways to make the production of goods and services more efficient. This is important, because our resources are scarce and we cannot afford to waste them. Business enterprises pay for the use of the factors of production Businesses need factors of production to produce goods and services. These factors of production are owned by households. In return for the use of the factors of production, businesses pay households wages and salaries for labour, interest for capital, rent for land and profits for the entrepreneur. This is part of the cost of production for the businesses. Classroom activity 3.3 Consider the following example: ABC Manufacturers produces clothes and Boab Industries produces machines. Are the following statements true or false? 1 Both ABC Manufacturers and Boab Industries are part of the businesses in the economy. (1) 2 ABC Manufacturers produces capital goods while Boab Industries produces consumer goods. (1) 3 If ABC Manufacturers increases its production of clothes it will employ more factors of production. (1) 4 When ABC Manufacturers employs more factors of production, the income paid to the factors of production increases. (1) Circular flow and quantitative elements 41

46 What do I still need to know? The role of government and the foreign sector Government is an important spender in the economy Government provides goods and services to households and businesses in the form of protection services, social services and economic services. Protection services consist of spending on defence and intelligence, police, prisons and justice to promote social order and stability. Social services include spending on education, health, social security and welfare, housing and community development to promote the quality of life in South Africa. Economic services include spending on infrastructure such as roads and railways to improve the productive capacity of the economy. Social services Protection services Economic services The government is a big spender in the economy In 2009 government accounted for approximately 21,10 % of the total spending in South Africa, which amounted to R million. Government taxes households and businesses To finance its spending, government needs revenue, and the most important source of revenue for government is taxes. These taxes are paid by households and businesses and we can distinguish between the following taxes: Income taxes are taxes on the income and wealth of households and businesses. Personal income taxes paid by households are a very important source of revenue for government. Taxes on goods and services are usually paid by the consumers of these goods and services. Value added tax is an example of this tax. 42 Circular flow and quantitative elements

47 Topic 3 Foreign sector Over the past few years the economies of different countries have become much more integrated and dependent on each other and we see a much higher level of interaction between countries. It can be said that the world is increasingly becoming a global village where a change in one part of the village affects many other parts of the village. Fundamental changes in trade flows (the flow of goods and services between countries), financial flows (the flow of money between countries), the exchange of technology and information, and the movement of people between countries have led to this increased level of integration and interdependence. The term globalisation is used to describe this higher level of integration between countries. South Africa is an open economy. This means that it does a lot of business with the rest of the world, and international trade therefore has a very important impact on the South African economy. We sell goods and services to the rest of the world Many goods and services produced by businesses in South Africa are sold to other countries. These goods that we sell to the rest of the world are called exports and they include minerals, cars, food and chemicals. We buy goods and services from the rest of the world Households, businesses and government also buy many goods and services from other countries. These goods that are produced in the rest of the world are called imports. South Africa s imports consist mainly of capital and intermediate (semi-final) goods, which are used to produce goods and services. Classroom activity Give an example of the protection, social and economic services that government provides to households and businesses. (2) 2 Distinguish between income taxes and taxes on goods and services. (2) 3 Explain why South Africa is regarded as an open economy. (2) 4 Distinguish between exports and imports. (2) Circular flow and quantitative elements 43

48 What do I still need to know? The major markets in the economy The major markets that play an important role in our circular flow model are: the factor market the goods and services or product market the financial market. The factor market The factor market is the market where the factors of production are exchanged for income. It is through this market that households supply businesses with the factors of production in exchange for an income in the form of wages and salaries, interest, rent and profits. Real and monetary flows in the factor market Two flows occur through the factor market a real flow and a monetary or nominal flow. The real flow is the flow of the factors of production the quantity of labour, capital, land and entrepreneurship. The monetary flow is the flow of income in terms of money. In other words, the amount that is paid in wages and salaries, interest, rent and profits. Another thing to notice is that these flows are in opposite directions. If the real flows increase (more factors of production are flowing to businesses), the monetary flow increases as well (more income is flowing to households). Goods or product market There are literally thousands of different producers of goods and services and millions of different consumers of these goods and services in the economy. In macroeconomics all these different markets for goods and services, which include both the producers and the consumers, are grouped together under the heading of the goods market. In economics this grouping together is called aggregation. Do you remember the main difference between macroeconomics and microeconomics? Macroeconomics studies the aggregate of all these markets the goods markets. Microeconomics studies each of the markets individually. It is in the goods market that households (consumers) buy their goods and services and the producers supply their goods and services. 44 Circular flow and quantitative elements

49 Topic 3 Real and monetary flows in the goods market Two flows occur through the goods market a real flow and a monetary flow. The real flow is the flow of goods and services from businesses to households, while the monetary flow, in the opposite direction, is the spending by households on the goods and services supplied by businesses. Something interesting to note is that the spending by households on goods and services becomes the revenue of the businesses (their income). Businesses then use this revenue to pay for the factors of production. The financial market This market consists of institutions such as banks, insurance companies and the Johannesburg Securities Exchange. The financial market or sector is not directly involved in the production of goods. Rather, its role is to channel (direct) funds from surplus units to deficit units in an economy. Savers Financial institution Borrowers Financial institutions channel funds from surplus units to deficit units Surplus units are those households and businesses in an economy that do not spend all their income. They are also called the savers in an economy. Deficit units are households, businesses and government in an economy that are looking for more funds, e.g. because they have overspent or because they need more money to invest. They are also the borrowers in an economy. Surplus units or savers deposit their surplus funds with institutions in the financial markets, such as banks. The institution then uses this surplus to lend money to those deficit units that qualify for credit or a loan. Circular flow and quantitative elements 45

50 Classroom activity 3.5 Indicate in which market the following takes place and whether it is a real or monetary flow: 1 Mr Dlamini decides to accept a job offer from ABC Manufacturers. (1) 2 ABC Manufacturers pays rent of R per month to Ms Naidoo. (1) 3 Mr de Klerk decides to save R150. (1) 4 ABC Manufacturers produce a new range of clothing, which they supply to the market. (1) 5 Mrs Tshaka buys clothes for her family. (1) What do I still need to know? A simple circular flow model between households and businesses Factors of production Income Businesses Figure 3.1: Flows between households and businesses From households to businesses there is a flow of factors of production in the economy, as illustrated by the top dotted purple line in Figure 3.1. Between the business and the household a flow of income occurs, as shown by the purple line in the diagram. These flows occur through the factor market, indicated by the purple circle. Note that the flow of income is in the opposite direction of the flow of the factors of production and that the flow of the factors of production is a real flow and the flow of income is a monetary flow. Between the household and the business a flow of spending occurs, as indicated by the bottom purple line in the diagram. This flow of spending by 46 Circular flow and quantitative elements

51 Topic 3 households is called consumption spending. Businesses supply households with goods and services. This is shown by the bottom dotted purple line in the diagram. Businesses are therefore part of the flow of production. This flow of spending by households and flow of production by businesses take place in the goods market, which is the black circle in the diagram. Note that the flow of spending is in the opposite direction of the flow of production. The flow of spending is a monetary flow and the flow of production is a real flow. Simplifying the model To build a manageable circular flow model that shows the interaction between all the different participants, we must simplify things a bit further by concentrating only on the monetary flows. This involves presenting Figure 3.1, which shows the real and monetary flows and the different markets, as a model showing only the monetary flows, as indicated in Figure 3.2. Remember that behind the monetary flows there is a real flow in the opposite direction and these flows occur in the factor market and the goods market. Income Households Businesses Consumption spending Figure 3.2: Monetary flow between households and businesses Classroom activity Draw the simplified circular flow model and show what happens with the flow of income and flow of spending if: a) business enterprises increase their production b) households increase their spending. (4) 2 What happens to the real flows in the goods market and the factor market if: a) business enterprises increase their production b) households increase their spending. (4) Circular flow and quantitative elements 47

52 What do I still need to know? Leakages and injections Income Households Businesses Leakage Consumption spending Injection Savings Investment Figure 3.3: Leakages and injections Savings are a leakage You have learned previously that households not only spend but also save some part of their income. The part that households save is therefore a leakage, as it decreases the spending flow. For example, if the income that households receive from businesses is R100 million and they save R20 million, then their spending is R80 million. The R20 million is a leakage, because all of their income does not return as expenditure to the spending flow. These savings by households flow to the financial market. Investment is an injection Investment is an injection and the financial market plays an important role concerning this. The financial market channels the savings from households (which are considered a leakage) to businesses in the form of loans, which they then use to finance their investment spending. Investment spending is the production of capital goods. As these goods are produced, more factors of production are employed and the income flow to households increases. Investment spending is therefore an injection into the circular flow, as it increases the spending flow. 48 Circular flow and quantitative elements

53 Topic 3 Classroom activity Given the following information, draw a circular flow model to show these flows: a) Income flow is R100 million. b) Spending flow by households is R80 million. c) Investment spending is R20 million. (6) 2 Use your circular flow model to illustrate what happens if investment spending increases by R10 million. (4) What do I still need to know? Changes in the flow of spending, production and income Business enterprises increase their production As business enterprises produce more goods and services, the flow of production in the economy increases. To increase their production, businesses will need more factors of production. Where are the businesses going to get more factors of production? They are going to buy it from the households who own the factors of production. As businesses buy more factors of production, income flows from businesses to households increase. This increase in the incomes of households will cause an increase in their spending and so the spending flow from households to businesses will increase in return. Remember that the spending of households is also the income of the businesses, which then becomes spending again to produce more goods and services. So the circular flow continues. Households increase their spending As households increase their spending, they demand more goods and services. In our diagram the spending flow increases. What do you think businesses are going to do given this increase in the demand for goods and services? They will respond by increasing the production of goods and services so that the production flow to households increases. To increase the production of goods and services, businesses will employ more factors of production. There is therefore also an increase in the flow of income from businesses to households. Circular flow and quantitative elements 49

54 Labour decides to go on a strike Labour is now withdrawing their services and consequently the level of production falls and the flow of production declines. If the principle no work no pay applies, then the flow of income to households decreases. And as we know, a decrease in the income flow leads to a decrease in the spending flow. These three examples illustrate the interaction and interdependence between businesses and households in the economy. Classroom activity 3.8 Explain why the flow of income and spending decreases if businesses produce fewer goods and services. (4) What do I still need to know? Adding government to the circular flow Disposable income Income Households Taxes Leakage Government spending Injection Businesses Leakage Savings Government Consumption spending Injection Investment Figure 3.4: Circular flow between households, businesses and government Government spending is an injection Government has to supply households and businesses with goods and services, such as education, health services, defence, law and order, roads and dams. To provide these goods and services, government buys other goods and services from businesses and the spending flow in the economy increases. As a result, businesses will produce more goods and services. For businesses to produce these goods and services, they must employ more factors of production. So the income flow to households increases because they are the owners of the factors of production. As the income flow of households increases, they in turn increase their spending flow. Government spending is therefore an injection into the circular flow. 50 Circular flow and quantitative elements

55 Topic 3 Taxation is a leakage Government needs revenue to finance its spending. It gets this revenue from taxation. There are different kinds of taxes, of which income tax is the most important. Before households can spend their income they must first pay their taxes. The income that is left after they have paid their taxes is called their disposable income. Taxation decreases the income available for households to spend. In other words, their disposable income decreases. So, there will be less income available in the circular flow. And the lower the income flow, the lower the spending flow and production flow. Taxation is therefore a leakage because it decreases the income and spending flows in the economy. Classroom activity Explain what happens to the circular flow of spending, production and income if government spending increases by R50 million. (4) 2 Explain what happens to the circular flow of spending, production and income if government collects R30 million more in taxes. (4) What do I still need to know? Adding the foreign sector to the circular flow Businesses Figure 3.5: Circular flow between households, government and the foreign sector Circular flow and quantitative elements 51

56 Up until now, our circular model represented a closed economy, i.e. an economy that is not part of or influenced by the international economy or the foreign sector. In the real world there are no closed economies. It is mainly through exports and imports that the foreign sector influences the circular flow of spending and income. Exports are an injection Exports are an injection into the circular spending and income flows when we sell more goods and services to the rest of the world, the spending on the goods and services that we produce increases. As more is spent on producing goods and services, businesses employ more factors of production, and the income of households increases. In Figure 3.5 this is indicated by the purple line that links the foreign sector with businesses (it is part of the spending flows) and is shown as exports. Imports are a leakage Imports, however, are a leakage from the circular flow. As households, businesses and government increase their spending on imported goods and services, less is spent on goods and services produced inside the country. Our spending on our own goods and services therefore declines, and so does the income flow to households. Look at Figure 3.5 to see how this can be illustrated by the broken purple lines linking the foreign sector to the households and businesses. Classroom activity Explain what happens to the circular flow of spending, production and income if exports increase. (4) 2 Explain what happens to the circular flow of spending, production and income if imports increase. (4) What do I still need to know? Complete circular flow model In our complete model presented in the following diagram there are four main participants: Households Businesses 52 Circular flow and quantitative elements

57 Topic 3 Government Foreign sector There are three markets: Factor market Goods market Financial market There are two kinds of flows: Monetary flows Real flows in the opposite direction There are three leakages: Savings Taxation Imports There are three injections: Investment Government spending Exports Households provide factors of production (a real flow) through the factor market to businesses. These factors of production are bought on the factor market and businesses use these factors of production to produce goods and services. In return they pay households an income (nominal flow) in the form of wages and salaries for labour, rent for natural resources, interest on capital and profits for entrepreneurship. The more factors of production the business uses, the higher the production is. There are subsequent increases in the income that households receive and in the income flows in the economy. Households use their income to buy goods and services on the goods market, which is part of the spending in the economy. This is called consumption spending and it is a monetary flow. The higher the income flow to households, the higher their spending on goods and services will be and the higher the spending flow will be. Households save part of their income and these savings flow to the financial sectors as a leakage. Businesses supply goods and services (a real flow) on the goods market to households, the government and the foreign sector in the form of exports. This is represented by a flow of goods and services to the goods market from the businesses. In return, businesses receive payment for these goods and services (monetary flow). The more they produce and the more they sell, the higher the production and income flows in the economy will be. Circular flow and quantitative elements 53

58 Businesses also use the savings of households for investment spending, which is an injection. This happens through the financial market. The higher the investment, the higher the spending and income flows in the economy will be. The government buys goods and services (textbooks, medicine and bricks for instance) on the goods market. This buying of goods and services is part of the flow of spending. Government then supplies households and businesses with goods and services. These include police services, education, the defence force, roads, etc. The more goods and services government buys, the higher the spending, income and production flows in the economy. To pay for these goods and services the government imposes taxes on households and businesses. Taxation is therefore part of the flow of payments to government and it is a leakage. The more taxes the government collects, the lower the flow of spending, income and production in the economy. The foreign sector buys goods and services on the goods market and it is part of the spending flow of goods and services called exports. If foreign countries buy more goods and services from South Africa, our exports increase and consequently the flows of spending, production and income in the economy increase. Exports are therefore an injection into the spending, production and income flow. Businesses Figure 3.6: The circular flow model 54 Circular flow and quantitative elements