1 Units 1 and 2 Economics is the study of how our scarce productive resources are used to satisfy human wants. Resources available for production of goods and services are limited - wants for goods and services are unlimited. Basic Economic Problem: Scarcity, choice and opportunity cost Wants Needs Demand Opportunity Cost Social Science Natural Science Positive Statement Normative Statement Human desires for goods and services, unlimited Necessities, essential for survival Only a demand for goods and services if those who want to purchase them have the ability to do so Opportunity cost of a choice is the value of the best alternative that could have been chosen but was not chosen. Everything involves a trade-off something is given up in favour of something else. Measures the cost of the alternative. Actual experiences, value judgments or opinions (economics) Can be studied in a lab, very precise Can be proved or disproved by comparing with facts (Interest rates rose by 10% in 2006) Involves opinions or value judgments (this government is badly run) Level Level of prices Rates Rate of increases in prices (%) Three Central Economic Questions: What should be produced? Market mechanism (only produce goods and services that consumers are willing to spend their income on and which can be supplied profitably) How should it be produced? Factors of production For whom should it be produced? Distribution of income (the more valuable your contribution and that of the resources you own, the higher your income) Goods Consumer Goods used or consumed by individuals or households to satisfy wants
2 Capital Non-durable Semi-durable Durable Final Intermediate Private Public Free Economic market Homogeneous Heterogeneous Goods used in the production of other goods Only used once (diaper) Limited life-span (Battery) Normally last a number of years (Motorcar) Consumed by households and firms (Bread) Purchased to be used as inputs in producing other goods before they are sold to end users (Flour) Good consumed by individuals and households Good used by the community or society at large (Traffic lights) Not scarce and have no price (sunshine and air) Goods produced with scarce resources and can command a price in the Identical (metals, electricity, water) Differentiated goods (cereal) Factors of Production Resources used to produce goods and services 1. Capital (machines, tolls and buildings) 2. Entrepreneurship (people prepared to take calculated risks and who seize opportunities as they arise) 3. Labour (human effort put into the production o goods and services) 4. Natural Resources ( natural wealth, arable land, mineral deposits etc.) Factor Income (incomes earned by factors of production) Labour wages and salaries Land Rent Capital Interest Entrepreneurs - Profit Factor Market (services of factors of production purchased and sold in many markets) Labour Market (services are bought and sold) Markets for capital goods Production techniques Capital Intensive and Labour Intensive Income Wealth Flow earned during a period Stock of physical and financial assets
3 Economic Systems Market: Any contract or communication between potential buyesr and potential sellers of a good or a service Traditional Command Market Mixed Same goods are produced and distributed in the same way as each successive generation and each participant s tasks and methods are prescribed by tradition Participants are told what and how to produce as well as how to distribute by central authority. Centrally planned. Individual decisions and preferences are communicated and coordinated through the market mechanism. Market prices are the most important element. In reality, today, most economies will usually show a dominant set of features. Conditions for a market to exist: at least 1 buyer and 1 seller, seller must have something to sell, buyer must have means to purchase, exchange ratios or market price must be established, agreement must be guaranteed by law or tradition Privatization Nationalization Private company is owned and run by private citizens/companies (government service contracted out or sold to a private company) State owned and run institutions (government takes over ownership and running of a particular service or company) Sectors Primary Sector Secondary Sector Tertiary Sector Raw materials produced (mining, forestry, fishing) Manufacturing (canning fruit) Beneficiation of primary goods, consumer goods and capital goods Services and trade (trade, transport, education) Microeconomics Macroeconomics Concerned with issues that involve the economic behavior of individual consumers, individual decision makers in households, firms and other organizations Concerned with the economic issues that involve the overall performance of the economy (total production, income and expenditure, economic growth, aggregate employment)
4 Production Possibilities curve Useful way of illustrating scarcity, choice and opportunity cost Indicates the combinations of any two goods or services that are attainable when the society s resources are fully and efficiently employed Y- Product X Good X a total of X0 can be produced Y a total of Y0 can be produced To produce more Y, a decline in X is required The opportunity cost of producing extra units of Y rises as more of it is produced (A) Scarcity - requires more resources or efficiency of production (B) Choice - Intermediate combination using all the resources (C) Choice - Intermediate combination using all the resources (D) Opportunity Cost - Possible but implies that not all resources are being used fully
5 Unit 3 Circular Flows Three Major Flows in the economy: Production, Income and Spending Two basic markets: Goods and factors market An increase in the production of goods and services leads to an increase in income which in turn increases spending Total Production = Total Income Consumption Goods = C Investment Goods = I Government Spending = G Exports = X Imports = Z Total Spending = C + I + G + X - Z Circular flow of goods and services Households (owners of the factors of production) offer their factors of production for sale on the factor market Firms purchase these factors of production and use them to produce consumer goods and services these are offered on sale on the goods market where they are purchased by households Circular flow of income and spending (monetary flow opposite direction) Firms purchase factors of production on the factor market from households spending by firms represents the income (wages, salaries etc.) of the households Households, in turn, spend their income by purchasing goods and services in the goods market spending by households represents the income of the firms
6 Stocks Wealth Assets Liabilities Capital Population Balance in savings account Unemployment Gold reserves held by SA reserve bank Flows Income Profit Loss Investment Number of births & deaths Savings Demand for labour Gold sales & production
7 Unit 4 Demand, Supply and Prices 1. Demand Law of demand states that other things being equal (ie ceteris paribus), the higher the price of a good, the lower is the quantity demanded, and visa versa Demand is not affected by availability or supply!! Graphical depiction of a demand schedule shows quantity demanded of a product during specified period of time will change as the price of the product changes Downward sloping, indicating that between the price of the product and the quantity demanded a negative or inverse relationship exists. As the price declines, the quantity demanded increases and visa versa The position of the demand curve is determined by other factors such as price of related products, total income Demand Curve, DD
8 P = Q = Price of cold drink (independent variable) Quantity of cold drinks (dependent variable) Movement along a demand curve is caused by change in the price and is referred to as change in quantity demanded Shift of the demand curve refers to change in demand Rightward shift at each price a higher quantity is demanded than before Leftward shift at each price a lower quantity is demanded than before Factors that cause a shift: change in price related goods, change in income of consumers, change in consumers tastes, change in population and a change in expected future prices Change in the price of related goods Substitutes A good that can be used in the place of another good E.g. butter and margarine, beef and mutton, tea and coffee An increase in the price of a substitute (butter) will ceteris paribus lead to an increase in the demand for the good concerned (margarine), and the demand curve shifts to the right Complements Goods that tend to be used jointly E.g. Fish and chips, pap and wors, tea and sugar An increase in the price of a complementary good (fish) decreases the demand for the product (chips), and the demand curve for the product (chips) shifts to the left. It is now more expensive to use the combined products.
9 a. Increase in the price of related goods b. Decrease in the price of complementary goods Change in Income a. Normal Goods If the average income of consumers increases, they will buy more of certain goods even if the price of theses goods is unchanged. A Rightward shift of the demand curve takes place. A decrease in the income of producers causes a leftward shift. b. Inferior Goods Demand decreases when income increases. Poor consumers may, for example, reduce their consumption of bread when their income increases. The demand curve shifts to the left.
10 a. Normal Goods b. Inferior Goods Change in expected future prices If consumers expect that the price of a product will rise relative to prices of other products, their demand for the product will rise in the hope that they will avoid the higher price in the future. This causes the demand curve to shift to the right. The current demand for a product will decline if a decrease in the price is expected. By not buying the product now consumers hope to buy it later at a lower price. This causes a leftward shift. 2. Supply The law of supply states that other things being equal (ceteris paribus), the higher the price of a good, the higher is the quantity supplied, and visa versa. Supply Curve graphical depiction of a supply schedule
11 Shows how quantity supplied of some product during a specified period of time will change as the price of that product changes. Shows minimum price producers will accept to provide a given quantity of a good or a service. Upward sloping, indicating that between the price of the product and the quantity supplied, a positive relationship exists. P = Q = Price of cold drink Quantity of cold drinks Movement along a given supply curve is caused by a change in price and is referred to as a change in quantity supplied Change in supply refers to a shift in the entire supply schedule. A rightward shift indicates that at each price a higher quantity is supplied than before A leftward shift indicates that at each price a lower quantity is supplied than before Factors that cause a shift: prices of alternative products, prices of joint products, prices of inputs, expected future prices, technology and number of firms Prices of alternative products When producers decide what to produce, they always consider the prices of alternative outputs that they can produce with the same resources. (More profitable to produce soya beans versus corn?) Prices of joint products Some products are produced jointly (e.g. sugar and molasses, wheat and bran, lead and zinc). An increase in the production of one item will also imply an increase in the production of another. Prices of inputs For producers to make a profit, they need to cover their cost of production. An increase in any of the cost components, for instance the cost of labour, implies that it will cost more to produce the product. Producers will be less willing and able to supply the same quantity at the given prices.
12 Expected future prices The higher the expected price of a product, the higher the planned production of th product. Technologies Represents the knowledge of how inputs (labour, raw materials etc.) can be combined to produce products. New technologies which enable firms to produce more goods with a given level of inputs will shift the supply curve outward to the right. Number of firms A given supply curve is derived for a given number of suppliers. An increase in the number of firms supplying the product will cause an increase in the quantity supplied at each price and the supply curve shifts outwards to the right. 3. Market Equilibrium An excess supply causes the price to decrease and an excess demand causes the price to increase The market is in equilibrium when the quantity demanded is equal to quantity supplied equilibrium price and equilibrium quantity DD = Demand Curve SS = Supply Curve E = Equilibrium Po = Equilibrium Price Qo = Quantity Equilibrium Disequilibrium a. Excess Demand quantity demanded exceeds quantity supplied b. Excess Supply quantity supplied exceeds the quantity demanded a. b.
13 Unit 5 Changes in Demand and Supply In the event of an excess demand for a product, the price will rise; and in the event of an excess supply of the product, the price will decline 1. Changes in Demand a. Increase will result in an increase in the price of the product and an increase in the quantity exchanged. Supply remains unchanged, but the quantity supplied increases as the price of the product increases (upward movement along supply curve) P Q b. Decrease will result in a decrease in the price of the product and a decrease in the quantity exchanged. Supply remains unchanged, but the quantity supplied decreases as the price of the product decreases. P Q a. b. 2. Changes in supply a. Increase will result in a decrease of the price of the product and an increase in the quantity exchanged. Demand remains unchanged, but the quantity demanded increases as the price of the product decreases (downward movement along curve) P Q b. Decrease will result in an increase in the price of the product and a decrease in the quantity exchanged. Demand remains unchanged, but the quantity demanded decreases as he price of the product increases. P Q
14 a. b. 3. Simultaneous changes in demand and supply Increase in demand and increase in supply DD D1D1 P Q SS S1S1 P Q Increase in equilibrium quantity (uncertain) Increase in demand and a decrease in supply DD D1D1 P Q SS S1S1 P Q Increase in equilibrium quantity (uncertain) Decrease in demand and an increase in supply DD D1D1 P Q SS S1S1 P Q Decrease in equilibrium price (uncertain) Decrease in demand and a decrease in supply DD D1D1 P Q SS S1S1 P Q Decrease in equilibrium (uncertain) Interaction between Markets Many products are related in some way. Some are substitutes and some are complements. An increase in the price of a substitute will lead to an increase in the demand for the other good concerned (demand curve for the good shifts to the right causing an increase in equilibrium quantity and price). Opposite when substitute good decreases.
15 An increase in the price of a complement good decreases the demand for the other product, and the demand curve shifts to the left, causing a decrease in equilibrium quantity and price. Opposite happens when the price of a complement decreases. Price ceilings and Price Floors Price Ceiling maximum price that may be charged for a good, product or service. Governments often set maximum prices with the intention to protect consumers against exploitation, however it usually leads to cases where the maximum price is lower than the equilibrium price (market clearing price). A shortage develops persistent shortage Black Market develops Price charged on Black Market is higher than equilibrium price in a free market A portion of the price falls into the hands of the black market supplier Investment in the industry declines
16 Price Floor minimum price that may be charged for a product, good or service. Governments prevent prices from falling below a certain level, usually to protect producers (farmers). It usually leads to the following consequences where the minimum price is higher than the equilibrium price. A persistent surplus develops (excess supply) Consumers, including households, have to pay artificially high prices Inefficient producers are protected and manage to survive The disposal of the market surpluses usually entails further cost to tax payers and welfare losses to the society To avoid these the government is forced to increase its intervention in the market and thus impose more costs on the system
17 Demand Factors Prices of substitute goods Prices of complementary products Consumer income Consumer preferences Expected changes in product future prices Population Supply factors Prices of substitutes Prices of joint products Prices of inputs / factors of production Expected future prices Technology changes Number of firms How excess demand can be allocated between consumers: First come first served in shops Informal rationing Government can incur official rationing (tickets or coupons) How government can get rid of a market surplus: Government purchases excess and exports it Non-perishables can be purchased by government and stored for future use Quotas to limit quantity sold at minimum price Producers or government destroy surplus
18 Unit 6 Elasticity Measure of the sensitivity or responsiveness between two variables that are related. Indicates that a cause and effect reaction exists between the two variables. E.g. price elasticity of demand and supply, income elasticity of demand, cross elasticity and interest elasticity of investment. Price elasticity (ep) provides an indication of how sensitive or responsive the quantity demanded is for a change in the price. If the quantity demanded by consumers responds strongly to change a price, the demand is elastic, while the concept inelastic is used when the quanityt demanded is not very responsive to a change in the price. Percentage change in Percentage change in the price Price elasticity quantity demanded
19 Assume quantity demanded increases from 50 to 60 when the price declines from R15 to R10 50 as a basis 60 as a basis Average 10/50 x 100 = 20% 10/60 x 100 = 16,66% (50+60)/2 = 55 10/55 x 100 = 18,18% Quantity demanded Assume quantity demanded increases from 50 to 60 when the price declines from R15 to R10 R10 basis R15 basis Average 5/10 x 100 = 50% 5/15 x 100 = 33,33% (10+15)/2 = 12,5 5/12.5 x 100 = 40% Percentage change in price Q 10/55 x 100 = 18,18% P 5/12.5 x 100 = 40% 18,18 = 0,45 40% Price elastic demand (ep > 1) Percentage change in quantity demanded is larger than the percentage change in the price (Q>P) Assume that the quantity demand decreases from 100 to 70 when the price increases from R8 to R10 Percentage change in Quantity demanded Percentage change in Price ( )/2 = 85 (8 + 10)/2 = 9 30/85 x 100 = 35,29% 2/9 x 100 = 22,22% Price inelastic demand (ep<1) Percentage change in the quantity demanded is smaller than the percentage change in the price (Q<P) Assume that the quantity demand decreases from 100 to 10 when the price increases from R8 to R10 Percentage change in Quantity demanded Percentage change in Price ( )/2 = 95 (8 + 10)/2 = 9 10/95 x 100 = 10,52% 2/9 x 100 = 22,22%
20 Price elasticity and total revenue Total revenue (TR) of a firm is a function of the price the firm gets for its product and the quantity sold. TR = Price x Quantity = Px Q If demand is elastic, total revenue decreases as the price increases. If demand is inelastic, total revenue increases when the price rises. 1. Price elastic demand and total revenue An increase in the price from R16 to R20 decreases total revenue from R96000 to R80000 Increase in price decreases total revenue A decrease in the price from R20 to R16 increases total revenue from R80000 to R96000 Decrease in price increases total revenue Price Quantity Total Revenue (PxQ) % Change in quantity % Change in price Price Elasticity R R % 22,22% 1,8 R R80000 If the price a firm gets for its product is R16 and the corresponding quantity that is sold at this price is 6000, the total revenue of the firm is equal to R16 x 6000 = R (red rectangle). An increase in the price to R20, dcreases, according to the law of demand, the quantity demanded to Total revenue is now R20 x 4000 = R (orange rectangle).
21 2. Price inelastic demand and revenue An increase in the price from R16 to R20 increases total revenue from R96000 to R Increase in price increases total revenue A decrease in the price from R20 to R16 decreases total revenue from R to R96000 Decrease in price decreases total revenue Price Quantity Total Revenue (PxQ) % Change in quantity % Change in price Price Elasticity R R ,18% 22,22% 0,81 R R80000 If the price a firm gets for its product is R16 and the corresponding quantity that is sold at this price is 6000, the total revenue of the firm is equal to R16 x 6000 = R (red rectangle). An increase in the price to R20, dcreases, according to the law of demand, the quantity demanded to Total revenue is now R20 x 5000 = R (orange rectangle). Five categories of price elasticity of demand 1 Perfectly inelastic demand ep = 0 2 Inelastic demand ep lies between 0 and 1 3 Unit elastic demand ep = 1 4 Elastic demand ep lies between 1 and infinity 5 Perfectly elastic demand ep = infinity Meaning Q does not change when P changes % change in Q is smaller than % change in P % change in Q is = to % change in P % change in Q is greater than % change in P Indeterminate Q at given P. 0 will be demanded at even fractional change in P Effect of TR when P changes TR changes with P (incentive to suppliers to raise prices) TR changes in same direction as P TR remains unchanged TR changes in opposite direction to P (incentive for suppliers to lower prices) When P increases, Q falls to 0; therefor TR also falls to 0
22 Unit 7 Background to demand: The theory of consumer choice Utility Approach Utility refers to the degree of satisfaction that a household or consumer derives or expects from the consumption of a good or service. 1. Law of diminishing marginal utility (Gossens first law) The law of diminishing marginal utility states that as more of a good or service is consumed during any given period the marginal utility of it eventually declines. This is because each subsequent unit of a good is valued less, since it provides less satisfaction, than the previous one As long as marginal utility is positive total utility increases. Each successive unit adds to the total satisfaction derived from consuming the product. An increase consumption from Q5 to Q6 units decreases the marginal utility from 8 utils to 6 utils and increases total utility with 6 utils. (more) Negative marginal utility or marginal disutility occurs when the consumption of an additional unit decreases total utility. Disutility
23 2. Weighted marginal utility Marginal utility per unti divided by the price per unit (MU/P). Gives consumers some idea of the value of money they get from a unit of a good or a service. A consumer is said to be in equiibrium when he or she has allocated her income between different goods and services in such a way that the weighted marginal utilities of the goods and services are equal (the last rand spent on each product yields the same amount of extra (marginal) utility). Also known as Gossens second law. Total and marginal utility The information contained in the table and diagram represent the marginal and total utility (measured in utils) Peter derives from drinking coke. Drinking one can of coke provides him with 50 utils and his marginal and total utility is therefore 50. Drinking a second can of coke only provides him with 40 utils and his marginal utility derived from the second can of coke is therefore 40 utils while the total utility from drinking two cans of coke is 90 utils (that is 50 utils for the first can of coke plus 40 utils for the second can of coke). Drinking a third can of coke gives him a a marginal utility of 28 utils and a total utility of 118. The fourth can of coke gives him a marginal utility of 14 utils and a total utility of 132 utils. Cokes Consumed Marginal Utility (MU) Total Utility (TU) Point a Point b Point c Point d Point e Point f
24 Unit 8 Background to Supply: The theory of productionand cost Law of diminishing returns The law of diminishing returns states that as more of a variable input is combined with one or more fixed inputs in a production process, the marginal product of the variable input will eventually decline. The decline in the marginal product of the variable input is followed by a decrease in the average product and lastly by a decrease in te total product. According to the short-run production function, diminishing returns take place in the range where total product increases at a decreasing rate. The marginal product (MP) of the variable input is the number of additional units of output produced by adding one additional unit (the marginal unit) of the variable output. It measures the contribution of an additional unit of the variable input to total production. According to the law of diminishing returns the contribution of the variable input to total production will eventually decrease as more and more of the variable input is used. The average product (AP) of the variable input is the average number of units of output produced per unit of the variable input. Calculation of the average product and the marginal product: The average product (AP) of the variable input is the average number of units of output produced per unit of the variable input. It is obtained by dividing total product by the units of labour that are employed to produce the total product. The marginal product (MP) of the variable input is the number of additional units of output produced by adding one additional unit (the marginal unit) of the variable output. The marginal
25 product of labour is obtained by subtracting the total product produced by the n-1 units from the production produced by n units. According to the diagram, which is based on the information in the table, the marginal product (MP) increases until it reaches a maximum, and then it decreases. The average product (AP) increases, reaches a maximum later than the marginal product and starts to decrease. As long as the marginal product is greater than the average product, the average product will rise. When the marginal product is smaller than the average product, the average product declines. The marginal product is equal to the average product when the average product reaches a maximum.
26 Short run production function The short run is defined as the period during which at least one of the inputs is fixed. According to the following short-run production function, labour is the only variable input while the rest of the inputs are regarded as fixed. A production function shows the relationship between the quantity of inputs and the maximum output that can be obtained from these inputs, given the state of technology. The short term indicates that the quantity of the variable output changes while the fixed inputs are unchanged. In the case where the variable input is labour and the rest of the inputs are regarded as fixed, the function can be written as: Y = F(N,...) where Y is the total output (or total product TP), N the quantity of labour, while the dots indicate that all the other factors are fixed. By changing the quantity of the variable input, in this case labour, we can derive different corresponding levels of output. This relationship between different levels of variable input and total output (total product) is described by the law of diminishing returns. a range where the total product increases at an increasing rate; a range where the total product increases at a diminishing rate; a range where total product is unchanged and then begins to decline Cost of production 1. Total Cost (TC) The total cost of production (TC) consists of the total fixed cost (TFC) plus the total variable cost (TVC): Total cost = fixed cost + variable cost TC = FC + VC
27 Fixed cost is the cost that remains constant irrespective of the quantity of output produced. In the short run some factors of production cannot be varied and they are known as fixed factors and the costs associated with them as fixed costs. Variable cost is the cost that changes when total ouptut changes - - it represents the cost of the variable inputs. It is also known as direct costs, prime costs or avoidable costs. In the short run these are the costs associated with the variable factor of production. Marginal cost (MC) is the increase in total cost when one additional unit of output is produced 2. Fixed Cost Fixed cost is the cost that remains constant irrespective of the quantity of output produced. It is also called overhead costs. Even if no output is produced, this cost must be borne. In the short run some factors of production cannot be varied and they are known as fixed factors and the costs associated with them as fixed costs. Examples of fixed cost are: the building cost of a factory, rent on buildings, interest payments on past borrowings and cost of machines. Average fixed cost (AFC) is the total fixed cost divided by the total product and decreases steadily as more units are produced.
28 3. Variable Cost Variable cost is the cost that changes when total output changes - - it represents the cost of the variable inputs. It is also known as direct costs, prime costs or avoidable costs. At an output level of zero the variable cost is also zero. As output increases, variable cost increases as well. Examples of variable costs are labour cost, raw material costs, fuel and power. As more of a good is produced more of these factors are used. Average variable cost is the total variable cost divided by the total product. It falls, reaches a minimum and then increases.
29 4. Marginal Cost Marginal cost (MC) is the increase in total cost when one additional unit of output is produced. Since total fixed cost remains unchanged when total product increases, marginal fixed cost is zero and therefore maginal cost is aways equal to marginal variable cost. As total product increases, marginal cost first decreases, reaches a minimum and then increases. Behind this shape of the marginal cost curve is the marginal product curve.
30 5. Marginal cost, average cost and average variable cost Marginal cost (MC) is the increase in total cost when one additional unit of ouptput is produced. Average variable cost (AVC) is the total variable cost divided by the total product. It falls, reaches a minimum and then increases.(more) Average cost (AC) is the total cost divided by the total product. It falls, reaches a minimum and increases again. (more) MC, AVC and AC are U-shaped. In other words, as TP increases from zero, they start at high values, decline at decreasing rates, reach minimum points and then increase at increasing rates. (more) Marginal cost cuts average cost (AC) and average variable cost AVC) at their minimum values. 6. Relationship between production and cost A firm's cost structure depends on the productivity of its inputs (given the prices of the inputs). In other words, the shape of the unit cost curves is determined by the shape of the unit product curves. The shape of the unit cost curves and the unit product curves is grounded in the law of diminishing returns. When marginal product (MP) is increasing, the marginal cost (MC) of producing a good is falling, but when MP declines MC increases.
32 Unit 9 Perfect Competition Competitive firm and its demand curve One of the requirements of perfect competition is that there must be a large number of buyers and sellers -- the number must be so extensive that no individual buyer or seller can affect the market price. This implies that an individual firm is a price taker. It has no choice but to accept the price that has been determined in the market. A perfectly competitive firm cannot charge a price higher than the current market price since it will lose all its customers to the competition. Neither will a competitive firm charge a price lower than the current market price since it can get the market price for its product. A perfectly competitive firm therefore faces a horizontal (or perfect elastic) demand curve. This means it can increase its sales without affecting the current price of the product and it also implies that it cannot charge a price higher than the current market price. Since the firm faces a horizontal demand curve its average revenue (AR) and marginal revenue (MR) are both equal to the market price. Deriving the firms demand curve In the market the equilibrium market price, P1, is determined by the interaction between demand, which is downward sloping, and supply, which is upward sloping. By extending this price to the graph for the firm, the firm's demand curve, which is horizontal, can be derived. This horizontal demand curve indicates that the firm can supply any quantity (a,b or c) without affecting the price of the product since its output in relation to the market output is too small.
33 The competitive firm is a price taker. It cannot sell its product for a price higher than the market price since customers can purchase the product from other suppliers at the market price. Nor will the firm charge a lower price than the market price, P1, since it can sell all its output at the market price. Total revenue, average revenue and marginal revenue The total revenue of the firm is equal to the price times the quantity and is represented by the yellow rectangular. Average revenue is equal to total revenue divided by the number of units, which is equal to the price per unit. Since the price is fixed, AR = P1 for all quantities. Marginal revenue (MR) is the increase in total revenue obtained by selling one additional unit. Since the price is fixed, total revenue will increase by an amount equal to the price of the product. Suppose the market price is R20 and the quantity sold by the firm is 4 units. The total revenue is therefore equal to R20 x 4 = R80. The average revenue is R80/4 units = R20, which is the price per unit. Marginal revenue is equal to the increase in total revenue obtained by selling one additional unit. Total revenue for 4 units = R80 and the total revenue for 5 units = R100. MR = R100 - R80 = R20 = price per unit. Competitive firm and its total revenue Total revenue (TR) is equal to price (P) times the quantity (Q): TR = PQ Under perfect competition the firm is a price taker. The price is therefore given and the firm's total revenue (TR) increases by a constant amount for each additional unit sold. Total revenue is thus a straight line through the origin with a slope equal to the price (P). A perfectly competitive firm cannot charge a price higher than the market price since it will lose all its customers to the competition. Neither will a competitive firm charge a price lower than the market price since it can get the market price for its product.
34 Competitive firm and profit maximisation Profit maximising rule Under perfect competition the firm is a price taker. The firm can only decide to sell or not to sell at the ruling price. This means that the firm does not have to make any pricing decisions - - it can only choose the level of output (quantity) at which it will maximise its profits (or minimise its losses). The profit-maximising rule states that profits are maximised; where the positive difference between total revenue (TR) and total cost (TC) is at a maximum or where marginal revenue (MR) is equal to marginal cost (MC) Whether or not a firm should continue production will depend on the level of average revenue relative to the firm's average variable cost AVC. Shut down point Whether or not a firm should continue production will depend on the level of average revenue AR relative to the firm's average variable cost AVC. Given a market price of P3 and a quantity of Q3 the total revenue of the firm is the blue area 0P3E3Q3. At an output level of Q3 average variable cost per unit is AVC3 and the total variable cost is equal to the yellow area 0AVC3NQ3. Total revenue exceeds total variable cost and the firm should conitnue with its operation. At a market price of P4 the firm should shut down since total revenue (the blue area) is lower than the total variable cost (the yellow area).
35 Total revenue and total cost Economic profit is the difference between TR and TC and is represented by the vertical distance between the TR curve and the TC curve. At point a with an output level of Q1, TR = TC and the firm's total economic profit is zero. At levels of output below Q1, TR (point c) < TC (point b) and the firm therefore incurs economic losses. This is indicated by the red area. At levels of output above Q1, TR (point d) > TC (point e) and the firm therefore incurs economic profits. This is indicated by the yellow area. The firm's profits will be maximised where the positive vertical difference between TR and TC is the greatest. This point can be determined by drawing a tangent to the TC curve, parallel to the TR curve. At the point of tangency the vertical difference (ie total profit) will be at a maximum. Given the total revenue and total cost curves, this particular firm will maximise profits by producing a quantity of Q4.
36 Marginal revenue and marginal cost The marginal revenue (MR) of a firm in a perfectly competitive market is equal to the market price (P) of the product. The profit-maximising rule can therefore also be stated as P= MC since MR = P. Marginal cost is U-shaped but only the rising part of MC is relevant for determining the quantity at which profits are maximised. In the figure, profits are maximised at point a where MR = P = MC and the quantity at which profits are maximised is Q4. Econimic profit, normal profit and economic loss Economic profit is the difference between total revenue from the sale of the firm's product(s) and total explicit and implicit costs (ie the total economic, or opportunity, costs of all resources). As long as average revenue (AR) is larger than average cost (AC), the firm is earning an economic profit. Normal profit is equal to the best return that the firm's self-owned, self-employed resources could earn elsewhere. It includes the cost of the owner's time and capital and is included in the firm's economic costs. When average revenue (AR) is equal to average cost (AC) the firm only earns a normal profit. An economic loss occurs when average revenue (AR) is lower than average cost (AC). Economic profit AR > AC
37 Normal profit AR = AC Economic loss AR < AC Profit is maximised (or loss minimised) when a firm produces an output where marginal revenue equals marginal cost, provided marginal cost is rising and lies above minimum average variable cost. The supply curve of the firm and the market supply curve The rising part of the firm's marginal cost curve above the minimum of average variable cost (AVC) can be regarded as the firm's supply curve.(more) The supply curve is upward sloping because the marginal cost curve is upward sloping, ie because marginal cost increases as output increases. The marginal cost curve, in turn, slopes upwards because the marginal product curve slopes downwards -- on account of the law of diminishing returns. The market supply curve is obtained by adding the supply curves of the individual firms horizontally. The supply will change if the number of firms changes or if the price of the factors of production (eg labour) changes.
38 Supply curve Profit is maximised (or loss minimised) when a firm produces an output where marginal revenue equals marginal cost (more), provided marginal cost is rising and lies above minimum average variable cost AVC. Under perfect competition, price P is equal to marginal revenue MR and average revenue AR (more). The firm will therefore produce the quantity where P is equal to MC, provided that this occurs where P is equal to, or greater than, AVC (more). If the price is P5, the firm will not produce at all as it cannot cover its variable costs. If the price is P4, the firm will be at its close-down point (b) and it is immaterial if it shuts down or continues operations. If the price is P3 the firm will minimise its economic losses by producing a quantity Q3, corresponding to point c. If the price is P2, the firm will make normal profit (ie it will break even) at point d, which corresponds to a quantity Q2. If the price is P1, the firm will maximise economic profit at point e, ie it will produce a quantity Q1.
39 Long-run equilibrium of the firm and the industry under perfect competition Economic profits and economic losses are not sustainable in the long run under conditions of perfect competition. When firms are making economic profits (more), this will induce new firms to enter the industry and when this happens, the market (or industry) supply will increase, thus reducing the market price, ceteris paribus. Firms making economic losses (more) will leave the industry in the long run, thus reducing market (or industry) supply and raising the market price, ceteris paribus. The industry will only be in equilibrium in the long run if all firms are making normal profits. Economic Profit The initial market demand and supply curves are D1 and S1 respectively and the market price is P1. The individual firm makes an economic profit at E1 (ie at price P1) since AR>AC. Because the existing firms are making economic profits, new firms enter the industry. As new firms enter the market, supply increases causing the price to decrease and economic profits start to decline. This process will continue until the new supply curve is S2, and the market price is P2 (corresponding to the equilibrium point E2). At a price of P2 the individual firm earns no economic profit since AR = AC. The industry and each individual firm is in equilibrium at point E2 and earns only normal profits. <>
40 Economic Losses The initial market demand and supply curves are D1 and S1 respectively and the market price is P1. The individual firm makes an economic loss at E1 (ie at price P1) since AR<AC. Because the existing firms are making economic losses, some firms leave the industry. As firms leave, the market supply decreases causing the price to increase and economic losses start to decline. This process will continue until the new supply curve is S2, and the market price is P2 (corresponding to the equilibrium point E2). At a price of P2 the individual firm earns a normal profit only and there is no reason for more firms to leave the market. The industry and each individual firm is in equilibrium at point E2.
41 Normal Profits Equilibrium occurs when the price determined in the market is just sufficient for the individual firm to earn a normal profit. This occurs at a price of P2 where MR=MC and AR=AC. The firm covers all its cost (including the opportunity cost of self-owned, self-employed resources). The firm is doing just as well as it could if its resources were employed elsewhere. Therefore there is no incentive for existing firms to leave the industry or for new firms to enter the market.
42 Unit 10 Imperfect Competition Monopoly Since the monopoly is the only supplier of the product of the industry, the demand curve for the product of a monopolistic firm is the market demand curve for the product of the industry. The downward-sloping demand curve is also the average revenue curve AR. Because the market demand curve slopes downward, the monoploy can only sell an additional quantity of output if it lowers the price of its output. The lower price will usually apply to all units of output, which means that the marginal revenue from the sale of an extra unit of output is less than the price at which all units of the product are sold. The marginal revenue curve MR is therefore also downward-sloping and lies halfway between the AR curve and the price axis.
43 Unit 11 The Labour Market Supply of labour Each individual has to decide how to divide his or her time between work and leisure. If the individual decides to work more hours, he or she will receive more income with which more goods and services can be bought. Working more hours, however, implies that the individual has less time available for leisure. The individual labour supply decision therefore involves a trade-off between working hours and time available for leisure. In the diagram, quantity of labour supplied (ie the number of working hours offered by a worker) is measured on the horizontal axis and the wage rate as rands per hour is measured on the vertical axis. As the wage rate rises, the quantity of labour supplied (ie the number of working hours offered by a worker) will rise, but only up to a certain point. Further increases in the wage rate cause the quantity of labour supplied to decrease. This is called the backward-bending supply curve of labour. Demand for labour The demand for labour is a derived demand. It is determined by the demand for the products that is to be produced by labour and the cost of employing labour. Behind the demand for labour curve is the law of diminishing returns. For the firm this means that as more workers are employed, the marginal physical product of labour (MPP) - that is the physical value to the firm of employing an additional unit of labour - eventually declines. Firms are however not only interested in the physical amount an additonal unit of labour contributes to total production, but also what this contribution means in terms of its total
44 revenue. This is called the marginal revenue product of labour (MRP) and is calculated as follows: MRP = MPP x P or marginal revenue product = marginal physical product x price of the product Given a fixed price for the product, the marginal revenue product declines as more workers are employed since the marginal physical product declines due to the law of diminishing returns. (more) To determine whether or not it will be profitable to employ an additional unit of labour, the firm compares the MRP to the wage rate. As long as the MRP is greater than the wage rate (w), ie as long as each additional worker's contribution is greater than the cost of hiring the worker, it will be profitable to expand employment. When the MRP is less than the wage rate (w), it will not be profitable to employ more workers, since the additional worker contributes less to total revenue than it cost the firm to employ him Labour Market Equilibrium The market supply curve for labour has a positive slope indicating that as the wage rate increases, the quantity of labour supplied will increase as more people will enter the labour market and supply their services.
45 The market demand curve for labour has a negative slope indicating that as the wage rate decreases, the quantity of labour demanded increases as firms are willing to employ more workers. Equilibrium occurs where the quantity of labour demanded is equal to the quantity supplied. This occurs at a wage rate of we with a quantity demanded and quantity supplied of Ne. The imposition of a minimum wage higher than the equilibrium wage causes a decrease in employment of labour. Equilibrium forces At a wage rate higher than the equilibrium wage of we, for instance w1, the quantity demanded is N1 and the quantity supplied is N2. An excess supply of labour exists and in a competitive market, competition between labour to get hold of work will cause the wage rate to decline. As the wage rate declines, firms are willing to employ more labour and the quantity of labour demanded increases, while the quantity of labour supplied decreases. A movement towards equilibrium takes place. At a wage rate lower than the equilibrium wage of we, say w2, the quantity demanded is N2 and the quantity supplied is N1. An excess demand for labour exists. In a competitive market,
46 competition between firms to get hold of labour will cause the wage rate to increase. As the wage rate increases, a movement towards equilibrium occurs. Minimum wages The demand for labour is represented by DD and the supply of labour by SS. The equilibrium wage rate is we and the equilibrium quantity of labour employed is Ne. The imposition of a minimum wage wm above the equilibrium wage causes an excess supply of labour to develop. This is due to two reasons: The higher wage rate causes firms to employ less labour. At a wage rate of wm employment is now equal to Nm, which is lower than the equilibrium level of employment Ne. The higer wage rate causes an increase in quantity of labour supplied to N1.