Part I Chapter 1: What is Economics All About?

- Important concepts Scarcity Choice Opportunity cost

- Explained w/ production possibilities frontier/curve - The difference b/tw Microeconomics & macroeconomics Positive & normative

- Reasons economists disagree

Economics = awareness 50yrs Technology Media (forms) Political debate Education

What? Wide-ranging discipline Concerned w/ all aspects human existence social science Purpose = maximise welfare of society How people use limited (scarce) resources to satisfy unlimited needs & wants Deals w/ choices

Origin Greek Oikos (house) Nmein (manage) Science of household management concerned w/ ordinary business of life

Scarcity Limited resources/means make choices

WHICH needs/wants to satisfy Relationship w/ choice = central central elements

Economics seeks Describe; explain; analyse; predict phenomena o Economic growth; unemployment; inflation; trade; prices; poverty; wealth; money; interest rates; exchange rates; business cycles

1.1 Scarcity, choice & opportunity cost Unlimited needs & wants but limited resources w/ which to satisfy Wants = desires; unlimited; always want more/better o Individual wants o Collective wants group of people Needs = necessities; essential for survival; not absolutely unlimited Demand = willing & ABLE (enough means); purchasing power

Resources 3 types of resources o Natural (agricultural land) o Human (labour) o Man-made (machinery) Means for production o Factors of Production

Need satisfaction Some satisfied but many left unsatisfied In each case, decide which available alternatives must be sacrificed

Costs TANSTAAFL Always direct/indirect costs Other opportunities always sacrificed

Scarcity poverty Affects everyone Need for decision-making arises when resources must be allocated b/tw competing alternatives

Opportunity Cost The value to the decision-maker of the forgone best alternative Occur every time a choice is made Implicit cost

Production possibilities frontier Illustrate relationship b/tw scarcity, choice & opportunity cost graphically Different combinations of resource allocations to satisfy a community o Represent maximum amount that can be produced with all available resources o The opportunity cost is what you forgo in order to produce more/less of another product & increases more as more of other good is chosen Involves trade-offs Indicates negative slope Curve shows most efficient combinations Underneath shows attainable but inefficient utilisation Above shows unattainable utilisation Concave to origin [concave down (decreasing)]

1.2 Economics as a science Explain Predict Influence policy Nature of generalisations o Outcomes = very likely, therefore Law of Demand o Conditional law true provided all other variables remain constant Ceteris paribus Empirical science o Actual experiences are studied and measured, but measurements are far less precise

Microeconomics & macroeconomics Microeconomics focus on individual parts of the economy o Individual consumers; households; firms studied in isolation o Individual goods demand; supply; prices Macroeconomics focus on the economy as a whole o Aggregate (total) o Focus on total production; income & expenditure; general price level; economic growth; aggregate unemployment; inflation; balance of payments Mesoeconomics

Positive & normative economics Positive o Objective statement of fact

Normative o Opinion/value judgement

Why economists disagree Make different value judgments o Agree on facts but have different views on what ought to be Disagreement on facts Bias Different views on how the economy operates o Parts of the economy fit together o Speed at which certain parts react to change Different time perspectives o Short/long term objectives

1.3 Some Common Mistakes in Reasoning About Economic Issues

The economic way of thinking Structured common sense way of thinking about everyday issues

The blinkered approach (or biased thinking) Perceive world from own vantage point and therefore apply personal experiences to the whole world Make highly simplified & biased diagnoses for economic issues Over-simplified solutions

Fallacy of compositions Something that is true for a single case is not necessarily for the whole Generalise from own experience

Post hoc ergo propter hoc When 2 events follow each other consecutively & in a short space of time, people assume that the 2nd event is as a direct result/consequence of the first Need to know more than just sequence

Correlation & causation If 2 events follow one another or happen together, it does not mean that one was the cause of the other

Correlation does not imply causation o The link/association of time frame is not enough

Levels & rates of change Not the same Level implies the point at which something is o The level of a damn Rate of change implies how fast the level was reached o How quickly the water enters the damn Linked o A level cannot be reached w/out a certain rate of change Equation o (Final initial) / initial * 100 o (xf xi) / xi * 100

Chapter 2: A Closer Look at the Economic Problem

3 central economic questions are the framework What? o Output (consumers) How? o Input (producers) For whom? o Distribution (factors)

2.1 What should be produced?

Purpose of economic activity Satisfy human needs & wants using goods & services (goods) o Goods = tangible objects o Services = intangible Assume all goods serve a useful purpose & thus maximum production is desirable

Consumer goods & capital goods Consumer o Goods used/consumed by individuals/households o Final use thereof Capital o Goods used in production process of other goods

Do not themselves yield consumer satisfaction, but permit future satisfaction (indirect) Choose b/tw production of either means choosing b/tw present & future consumption o Consumer = present o Capital = future Limited lifetime Value depreciates over time

Different categories of consumer goods Non-durable o Used once only Semi-durable o Used more than once, but last for a limited period Durable o Last many years

Final goods & intermediate goods Final o Goods used/consumed by households/firms Intermediate o Goods purchased to be used as inputs for producing other goods

Private goods & public goods Private o o Public o o Consumed by households Others can be excluded Consumed by community/society at large No one can be excluded

Economic goods and free goods Economic o Good produced at cost from scarce resources o Also scarce goods Free o Not scarce & thus has no price o Certain factors result in these goods no longer being free Gifts of nature are not free Not everything that free is applied to, is really free

Homogeneous & heterogeneous goods Homogeneous o Goods that are all exactly alike o Very rare o Ounce of gold Heterogeneous o Differentiated goods o Brands; varieties; qualities

The production possibilities frontier once again Summary of What? Shows different combinations of goods that can be produced from scarce resources and available production techniques Consumer & capital goods production o More consumer goods are good for society NOW, but they may suffer in the future, causing collapse of systems o More capital goods are good for society in the future; they will achieve economic growth, but society might suffer more in the present Economic growth will help breach the gap b/tw wants & means in the economy, but cannot solve the problem of relative scarcity The decision of what involves what quantities & what not to produce o Therefore actually a decision about the allocation of scarce resources among different possible uses

2.2 How should it be produced?

Resources are scarce and must therefore be used efficiently o Factors of production that are used to produce goods

Factors of production 4 main o Primary Natural (land) Labour o Secondary Capital Entrepreneurship o Human Labour Entrepreneurship o Non-human Capital Natural

Natural resources (Land) All the gifts of nature o Mineral deposits; water; arable land; vegetation; natural forests; marine resources etc. Fixed in supply & availability cannot be increased Exploit more of the natural resources Once used, cannot be replaced o Non-renewable o Exhaustible assets Quality & quantity are important o Big countries w/ few resources & vice versa o Different areas w/in country

Labour Exercise of human mental & physical effort in the production of goods Includes human efforts in order to gain income Quantity depends on size of population and workforce o Ability & specialisation o Proportion of able-bodied workers Affected by proportion of women, children & elderly Labour force Quality = human capital Division of labour o Not one person conducting the whole production process of a single good o Each person has a specific role in the production process o Production is therefore greatly increased o Allows for specialisation of job/trade o Increases productivity o Reduces time wastage o Workers allocated to tasks they are best suited to o Enables mechanisation Automation Possibility of reducing labour force required increased unemployment o Better quality goods Enables quality control during the production process o Worker alienation o Interdependence

Capital All manufactured resources used in the production of other goods Not produced for their own sakes As a factor of production is NOT money/finance o All tangible things that are used to produce other things Depreciate over time o Lifespan o Wear & tear

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Breakage Obsolete Consumption of fixed capital

Entrepreneurship People who see opportunities and are willing to take risks by producing goods in the expectation that they will be sold, combine and organise factors of production Driving force behind production o Initiators o Innovators o Risk-bearers o Anticipation of profits, know they could suffer losses Governments are forced to take the role of entrepreneurs when there is a lack of private entrepreneurs in a country

Technology Not a factor of production, though sometimes considered as such Society has certain knowledge about the ways in which goods can be produced New ideas result in new ways technology advancement Invention = discovery of new technology Innovation = incorporation of knowledge into actual practices

Money is not a factor of production Goods cannot be produced with money Money is used in the exchange of goods; it facilitates the exchange

The choice of technique Choosing the best methods Various techniques available to produce a particular good Capital-intensive = process dominated by machines Labour-intensive = process dominated by human effort Depend on availability & quality of various factors of production & relative cost

2.3 For whom should it be produced?

How the goods are distributed amongst households in the economy Normative issue o Particularly in areas w/ highly unequal distribution Also concerned w/ relative share of different sectors and of different factors of production o Factors earn income

Rent Profit Salaries & wages Interest o Distribution among forms of income is the functional distribution of income Among individuals/household = personal o Different from distribution of wealth Income = flow Wealth = stock Linked o Will affect what goods are produced Money votes of the consumers Consumers vote by buying goods Unequal production of goods is focussed on the wealthy o Distributed unequally among countries Distribution of economic activity b/tw government (public) sector & the rest of the economy (private sector) o Geographic distribution of economic activities o Distribution b/tw primary, secondary & tertiary sectors Primary o Raw materials produced Secondary o Manufacturing part of the economy o Raw materials used to produce goods o Beneficiation of primary products o Production of consumer goods Tertiary o Services & trade sections of the economy o Services sector Early phases of economic development o Primary activities account for a large share of the total production Development proceeds o Secondary & then tertiary activities gradually become increasingly important

2.4 Solutions to the central questions: an introduction to economic systems

3 coordinating mechanisms that are used to solve the central question o Tradition o Command o Market Also mixed system

The traditional system Oldest solution is tradition Same goods are produced in the same way by each successive generation o Children take same occupations as their parents did

o Very rare in modern societies, and limited to rural, isolated regions Each participants tasks and methods of production are prescribed by custom Clear answers, but a very rigid system o Little to no economic growth o Slow adaptation o Resistance to change & innovation o Subsistence economies Governed not by economic activity, but cultural & religious customs Tradition is still prevalent in other mechanisms

The command system Socialism & communism Participants told what & how to produce by a central authority o Determines how the output is distributed Centrally planned systems Central authority decides EVERYTHING Not synonymous with socialism or communism o Command system = way in which economic activity is coordinated o Socialism & communism = ownership of factors of production Nowadays, countries claiming to be centrally planned rely increasingly on the market mechanism in order to compete globally

The market system Capitalism Adam Smith Method of coordination = very subtle & intricate Market = any interaction b/tw a potential buyer & seller o Local; regional; national; international o Conditions: At least 1 potential buyer and 1 potential seller Seller must have something to sell Exchange ratio (price) must be determined Buyer must have means w/ which to purchase Agreement must be guaranteed by law/tradition Market prices o Signals or indices of scarcity, which indicate to consumers what they must sacrifice in order to satisfy their needs/wants o Indicate how factors of production must be employed Market capitalism o Individualism o Private freedom o Private property o Property rights o Decentralised decision-making o Limited government intervention o Means of production owned by individuals, who use them in their own self-interest Invisible hand

What? Decision of consumers Money votes o How? Producers Invisible hand o Whom? Those that can afford it Incentives o Workers Harder work = more income o Firms Risks & investment = more profit Competition o Important o Not confused w/ negotiation Competition = sellers & sellers Negotiation = buyers & sellers o Not always free & fair Imperfect Buyers & sellers can influence the price

The mixed economy None based purely on one mechanism South African economy o Aspects of market o Aspects of command/socialist o Privatisation & nationalisation

Chapter 3: The interdependence between the major sectors, markets & flows in the mixed economy

Major participants o Households o Firms o Government o Foreign sector Major markets o Goods market o Factors market Major flows o Income o Production o spending

Chapter 8: Demand & Supply in Action

Supply & demand used o Analyse certain situation in economy o Emphasis: predicting WHAT will happen IF something changes Equilibrium P & Q o Demand o Supply o Simultaneous Analysis b/tw related markets Govt intervention Agriculture o Problems

# factors = market demand & supply o Any determinant EXCEPT price o SHIFT in curve

8.1 Changes in Demand (shift right) o P&Q Ceteris paribus o Result of in any determinants EXCEPT PRICE P = movement along D curve P substitute product P complement product consumer income customer preference for product Expected P of product o Supply curve remains UNCHANGED (independent) BUT Q supplied as P Upward movement along S curve E0 E1 o Excess D (market shortage) = P of product P bid up as purchasers compete obtain available Q supplied Process continues until new E reached P & Q than before (shift left) o P&Q Ceteris paribus o Result of in any determinants EXCEPT PRICE P = movement along D curve P substitute product P complement product

consumer income customer preference for product Expected in P of product S curve remains UNCHANGED BUT P of product Q supplied Downward movement ALONG curve E0 E2 Excess supply (market surplus) @ original P = P sellers compete to sell excess stocks Q supplied & Q demanded new E reached P & Q than before

8.2 Changes in Supply (shift right) Supply o P & Q exchanged Ceteris paribus o goods supplied @ ea P than before / ea Q supplied @ P than before o Result of any determinant EXCEPT PRICE P = movement ALONG S curve P alternative product P joint product P of any factors of production productivity of factors of production Technological progress cost of production o D curve remains UNCHANGED Movement along (downward) Q demanded as P of product S = excess supply @ original P P Firms compete w/ ea by P P Q demanded & Q supplied Process continues until new E reached (shift left) Supply o P&Q Ceteris paribus o Fewer goods supplied @ ea P than before / ea Q supplied @ P than before o Result of in any determinant EXCEPT PRICE P alternative product P joint product P of factors of production productivity of factors of production Raises costs of factors of production o D curve remains UNCHANGED Upward movement along D curve S excess demand @ original P Results in P of product Consumers bid up P of product in attempt to gain available Q supplied P Q demanded & Q supplied

Process continues until new E reached

8.3 Simultaneous Changes in Demand and Supply When only 1 possible to predict what will happen E P&Q in market Simultaneous precise outcome CANNOT be predicted o may work in opposite directions o Comparative statics requires only 1 variable Demand o Supply Price Uncertain Uncertain Quantity Uncertain Uncertain

Outcome depends on relative magnitudes of Could raise, remain unchanged or fall

8.4 Interaction between Related Markets Many related in 1 or another way o Some are Substitutes (in consumption) Complements (in consumption) Substitutes in production Joint products Extend the analysis Provide examples of interrelationships b/tw different markets

Fish & meat o Catholics previously allowed ONLY fish (no meat) on Fridays o Changed in 1966 o Probably impact on P & average weekly sales? Predominantly Catholic areas D fish o Shift left o P & weekly sales D meat o Shift right o P & weekly sales o Example of in consumer tastes on demand & therefore on E P&Q in substitute products case o Medically/scientifically showing fish is healthier than meat would have had the opposite effect

Motorcars & tyres o Effect on market for new tyres, ceteris paribus, if cost of producing cars ? o costs = shift left (upward) of S curve (car industry) EP&EQ o cars produced = D new tyres Shift left (downward) of D curve (new tyre industry) E P tyres & E Q o productivity of factors of production will have the opposite effect

The interaction between the foreign exchange market and the domestic market for hake o When a currency depreciates, domestic prices for imported goods o Also: profitable for export Sometimes export occurs @ domestic consumers expense Export market for hake (P demanded are much higher) almost unobtainable domestically domestic P of hake o If exporting is more profitable, domestic S curve shifts left sharply, thus much less is supplied domestically, at much higher prices o If a currency appreciates instead, the opposite effect is had

8.5 Government Intervention previously discussed will only occur if market forces of D&S are free est. E P&Q of goods & services Consumers, trade unions, farmers, business people & politicians = dissatisfied w/ P&Q determined by market D&S o Leads them to pressurise govt to intervene influence P&Q in market Price ceilings (setting max P) Price floors (setting min P) Taxation (certain products/activities)

Maximum prices (price ceilings, price control) o 1970s many goods P controlled by govt Bricks, sand, cement, sugar, firearms, television receivers, glass & metal containers, glass, yellow margarine, bread, electrical appliances, radios, tyres, sanitary wear, windows, pharmaceutical products o 1980s almost all abolished Nowadays most P determined by market forces o Govt set max P to: Keep basic foodstuffs P (part of policy to assist the poor) Avoid consumer exploitation by producers (avoid unfair prices) Combat inflation Limit production of certain G&S during wartime o If max P is set ABOVE E (market-clearing) P NO EFFECT on market P&Q Still determined by D&S o If max P is set BELOW E P significant effects

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P consumers demand Q higher than E Q BUT suppliers only willing to supply Q than is lower than E Q Market shortage (excess demand) Equal to difference b/tw QD & QS Absence of P control P until E reached Ways have to found to solve problem of excess demand Someone/thing else must to the job of the rationing function Basic problem = HOW to allocate QS available to QD o Consumers served on first come, first served basis Queues/waiting lists o Suppliers set up informal rationing systems Limiting amount sold to each customer Selling to only regular customers o Govt intro official rationing system Ration tickets/coupons submitted when purchasing product = additional govt intervention Stimulate corruption o Entail additional private costs Consumer Time (queuing) Supplier Use scarce resources to administer rationing system Development of black markets Black markets occur in any situation where market forces of S&D cannot/not allowed eliminate excess demand Ticket sales to events Not all illegal Case of max P fixing by govt = outlawed Illegal market Goods sold above max P set by govt All P controls stimulate black market activity Unsatisfied potential purchasers seek to obtain G&S desired Creates shortages Prevents market mechanism from allocating available Q among consumers Stimulates black market activity Providing incentive to obtain good & resell @ P consumers willing to pay P Implemented in belief best interest of society Honest concern welfare of poor Create problems Not as attractive as appear Abolished in time

Rent control o Best example of problem created o 1940s South Africa Introduced to protect tenants from being exploited by owners of rented accommodation during post-war housing shortage

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Production geared towards war effort during war Return of soldiers cannot afford housing & w/out accommodation Townships People not allowed to purchase land/houses Govt stopped constructing additional houses Belief blacks were temporary visitors to white areas Rentals kept low assist generally poor residents in townships Market forces prevented from fulfilling allocative & rationing functions Result in permanent shortage of rented accommodation Owners reaction Selling dwelling under sectional title Converting dwelling into offices / other forms of accommodation operating costs maintenance & repair Stop building new dwellings = supply of new rented accommodation falls Population & D Shortage All reactions aggravate shortage Alternatives found Bribery move waiting list Corruption & favouritism Black market prices finders fees / key deposits Longer controls maintained difference b/tw controlled rents & market-clearing rentals difficult to lift controls rentals soar when controls abolished No one gains w/ accommodation lucky until conditions deteriorate owners no profit & leave market w/out accommodation

The welfare costs of maximum price fixing P Supply Curve

Price per unit P1 Pm T B

R A C U Demand Curve E

Qm

Q1

Quantity per period

o o o o o o o o o

Max P (Pm) set below market-clearing P (P1) Therefore Q falls from E level (Q1) Qm @ P1 consumer surplus = P1 DE @ Pm consumer surplus = PmDRU Consumers lost A, but gained B Only Qm exchanged, but those who can obtain product now pay less B previously part of producer surplus, but now part of consumer surplus Absence of max price producer surplus = 0P1E After = 0PmU C disappears on Qm is produced & exchanged Total welfare loss = A + C Deadweight loss Too little being produced society is worse off as a result of interference in the market system

Administered prices o Govt/other public sector agencies still determine P of range of G&S in SA Administered P Indicate result of administrative processes RATHER than market forces of S&D Inflation debate o 20%+ G&S in CPI basket can be classified as administered P Medical services, petrol & diesel, communication services, electricity & education (order) Public transport services, water, licenses o Originally 1930s USA indicate private sector P determined discretionally by suppliers of G&S instead of market forces o SA indicate govt involvement in P determination Administered according to different conventions, rules & formulae o Discretion = important role Self-Fulfilling Expectations o Participants in market expect P of product will move in certain direction & incorporate assumption in all decisions Expected movement will be realised almost immediately o Except P of certain good Purchase as much as possible Suppliers hold back supplies as far as possible Only reason for = expectation P o Expect P of certain good = similar effect o Markets concerned Commodities (gold, silver, platinum, maize) Stock market All speculative expectations play an important role o Not all markets Supply cannot be adjusted simultaneously & inventory hoarded

8.6 Agricultural Prices Fluctuations in agricultural prices o Fluctuate more than manufactured goods o Supply conditions Supply varies from season to season Affected by weather, disease & product perishability o Supply varies P varies even if demand curve remains unchanged o Intensified by farmers reactions annual crops P rises sharply 1yr bad harvest Produce 2yr normal supply, ceteris paribus P P decline may leave farmers worse off than previous year Fallacy of composition

Minimum prices (price supports, price floors) o Serve as guaranteed P to producers Stable demand BUT subject to large fluctuations P fluctuate & income unstable & uncertain o If BELOW E operation of market forces undisturbed o If ABOVE E surplus Govt sets P & producers supply Q @ new P Consumers only willing to buy smaller Q @ new P o Resultant market surplus requires further govt intervention Purchase surplus & export Purchase surplus & store Introduce production quotas Limit QS to QD @ min P eliminate surplus Purchase surplus & destroy Producers destroy surplus Argue that artificially high P in consumers best interests farmers stable income keep producing products Export earn foreign exchange Exported @ loss & @ expense of domestic consumers pay artificially high P for product Dispose of surplus Additional cost to tax-payers welfare loss to society Govt fix producer P & consumer P & subsidise producers by difference Reduces/eliminates surplus BUT = additional expense to tax-payers Govt cannot sell to consumers @ P Defeats object Prevent producers from selling illegally @ P Give surplus to poor Collection & distribution = costs & seldom collected Distributors may consume some of products themselves / sell @ P QD & market surplus o Highly inefficient way helping small/poor farmers All consumers have to pay artificially high P

Bulk benefit accrues to large farmers/big companies Inefficient producers protected & manage to survive Disposal of market surplus = cost taxpayers & welfare losses to society Assistance Direct cash subsidies paid only to farmers No interference in P mechanism

The welfare costs of minimum price fixing

Supply Curve

Price per unit Pm P1 A

R B C T Demand Curve E

Qm

Q1

Quantity per period

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P1 & Q1 = original Pm = min P set by govt Producers respond to actual demand Q Qm Absence of P fixing consumer surplus = P1DE & producer surplus = 0P1E After Consumer surplus = PmDR lose A (to producers) & B (disappears) Producer surplus = 0PmRT o Gain A Total deadweight loss = B + C

Chapter 9: Elasticity

Responsiveness of QD & QS to in P other determinants of QD & QS General definition Analysis of P elasticity of demand Income elasticity of demand

Cross elasticity of demand P elasticity of supply Demand & supply curves can be used to: o Explain # eco phenomena o Predict What will happen if eco variable changes o Policy Analyse effects of decisions Interested not only in direction of change, but also MAGNITUDE o By HOW MUCH will P&Q if D&S o How affect total amount consumers plan to spend o Will = proportionally larger or smaller o Profitable to raise/lower P o Relative impact on P&Q if P control imposed Want to know o How much the Q demanded & Q supplied are to P o Info required about price elasticity of demand & supply

A general definition of elasticity o Elasticity is a measure of responsiveness or sensitivity o Two variables related, one wants to know how sensitive/responsive the dependent variable is to changes in the independent variable o Many cause-effect relationships in economics are similar o Measure of such responsiveness/sensitivity is called elasticity o Defined: percentage change in a dependent variable if the relevant independent variable changes by one percent % in dependent variable / % in independent variable o 4 types Price elasticity of demand (most NB) Income elasticity of demand Cross elasticity of demand Price elasticity of supply

9.1 The Price Elasticity of Demand Demand curve o Quantity demanded = dependent variable o Price = independent variable Percentage change in the quantity demanded if the price of the product changes by one percent, ceteris paribus

ep =

Important aspects & implications of definition

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Elasticity calculated by using percentage changes (relative changes not absolute changes) Cannot use absolute changes P expressed in monetary terms & Q in physical terms If use percentage changes units in which P & Q measured do not affect result Is a ratio of % in QD : % in P Elasticity coefficient not measured in units/percentages/anything else Enable us to compare how consumers react to in P of different G&S Cannot compare ACTUAL , but compare elasticity coefficient comparison between sensitivity of each to in P Measured P elasticity of demand has a negative sign P of product & in QD of product move in opposite directions P QD P QD Problem overcome incl - in definition of P elasticity of demand Tiresome Use absolute value instead

Calculating price elasticity of demand

( )

= gradient of a linear demand curve

represents inverse gradient of a linear

demand curve Gradient is constant represents the ratio b/tw P &Q at a specific point on the D curve Varies @ each point on D curve curve Find the gradient of the D curve Invert the gradient elasticity also varies @ each point on D

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Find the 2 point SPECIFIED Plug the values into the equation In the case of a linear D curve ep varies from infinity () *D meets y-axis] zero (0) [D meets x-axis] Move downward to the right along D ep moves from 0 where D meets y-axis (Price axis) 0 where D meets x-axis (Quantity axis) 1 exactly in the middle of D ( @ any point above midpoint ep > 1 @ any point below midpoint ep < 1 Unrealistic P seldom falls to 0 QD seldom becomes 0 Relevant range of D Arc elasticity Using a relevant range of D vary b/tw 2 values Use midpoint of 2 values
( ( ( (

Ignore the negative sign

Price elasticity of demand and total revenue (or total expenditure) o ep can be used to determine by how much the total expenditure by consumers on a product (also total revenue of firms for that product) changes when the price of the product changes o Most NB reason most business people = interested info concerning ep o Total revenue (TR) = price (P) x quantity (Q) sold o Inverse relationship b/tw P & Q Any in P in Q in opposite direction Effect of P on TR depends on relative sizes of P & Q If P proportionately greater Q demanded TR will in opposite direction to P If P equi-proportional in Q demanded TR will remain unchanged If P proportionately smaller Q demanded TR will in same direction as P

5 categories of elasticity o Perfectly inelastic demand When ep = 0 Unrealistic in practice Represented by a vertical line parallel to the P-axis Shows consumers prepared purchase fixed amount of product, regardless of P Producers can raise revenue by raising P of product

P & Q constant TR Inelastic demand %Q < %P 0 < ep < 1 Cannot draw linear D curve that represents inelastic D all along curve Elasticity varies @ each point on D curve Use steep curve to approximate Producers faced w/ inelastic D have incentive P %QD < %P No incentive to P Unit elastic demand (unitary elasticity) %QD = %P ep = 1 Cannot be represented by linear D curve Rectangular hyperbola Producers cannot TR by /P Elastic demand P proportionately greater in QD ep > 1 Cannot be represented by a unique down-ward sloping linear D curve Use relatively flat D curve Producers can TR P No incentive to P Resulting QD proportionately > P TR Perfectly elastic demand ep = Horizontal line parallel to Q-axis Consumers willing to purchase any Q @ specific P, but if P even fractionally, QD = 0 Meaning Q unchanged when P %Q < %P %Q = %P %Q > %P Indeterminate Q demanded at given P; nothing demanded at fractionally higher P Effect on total revenue (TR = PQ) when price (P) changes TR w/ P in same direction as P; incentive for suppliers to P TR in same direction as P; incentive for suppliers to P TR remains unchanged TR in opposite direction to P; incentive for suppliers to P When P , Q falls to 0; TR therefore also falls to 0

Category ep = 0 (perfectly inelastic demand) 0 < ep < 1 (inelastic demand) ep = 1 (unit elastic demand) 1 < ep < (elastic demand) ep = (perfectly inelastic demand)

Price elasticity of demand and the impact of a change in supply o TR = area bounded by: [0; 0] Q0 P0 E0

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2 D curves intersect S curve at E0 If S curve shifts right, there are new E point for EACH D1 & D2 D1 relatively elastic D curve Q > D2 relatively inelastic D curve D1 P < D2 D1 TR after S > D2 If S, the opposite will happen Comparisons only valid if we proceed from an initial point where ALL curves intersect, E0 Can be used to add to the explanation of fluctuations in agricultural P D for most agricultural products tends to be inelastic When supply fluctuates large in P concerned; Q do not much Problems in agriculture exacerbated by inelastic nature of D for agricultural goods

Determinants of the price elasticity of demand o When discussing determinants, ceteris paribus is assumed o In reality, all things can Impact of 1 determinant can be neutralised by another that works in the opposite direction Different consumers / consumer groups can react differently to P When deciding D for a good is in/elastic all relevant info must be considered o Substitution possibilities Availability of substitutes = most NB determinant of consumers reactions to P The more and better the substitutes, the greater the price elasticity of demand, ceteris paribus Beef (mutton); butter (margarine); taxis (buses, train); hamburgers (hotdogs); apples (pears) If good w/ close substitutes P, consumers will tend to switch to substitute relatively cheaper No close substitutes inelastic Salt; petrol; electricity; medicines o The degree of complementarity of the product Highly complementary goods price elasticity of demand tends to be low Sugar (tea, coffee); tyres (cars); petrol (cars); salt (food); golf balls (golf clubs); CDs (CD players) Arguable that absence of a good substitute rather than the degree of complementarity = responsible for inelastic demand of highly complementary goods not always true P product w/out close substitutes QD QD products w/ high degree of complementarity will not necessarily if P o Salt o The type of want satisfied by the product Price elasticity of demand for necessities is lower than price elasticity of demand for luxury products No concrete rule to determine whether a product is a luxury or necessity Demand for necessity tends to be relatively inelastic Demand for luxury tends to be relatively elastic o The time period under consideration

Demand tends to be more elastic long term than short term When P, consumers generally need more time to adjust to in relative P 1970s P of crude oil Airline tickets o Long term demand will be more price elastic than short term o Airlines therefore base fare structure on differences in price elasticity Price discrimination Practice of charging different P different sets of customers according to differences in P elascticities The proportion of income spent on the product Often argued that proportion of income spent on a product P elasticity of demand Matches, salt & paper clips constitute a small proportion income, therefore P has a negligible effect on QD BUT low P elasticity of demand can also be explained by lack of substitutes, degree of complementarity, type of want that is satisfied Other possible determinants of price elasticity of demand Definition of the product Broader definition = smaller measured P of elasticity of demand will tend to be Related to substitution possibilities Broader definitions reduce the number of possible substitutes o Food & specific type of food o Meat & beef o Car & specific type of car Advertising ep for a particular brand of product will be greater than ep for the product o Substitutes Producers spend a lot of $ create brand loyalty w/ customers o Convince customers that their brand has no real substitutes o To the extent that they are successful, they reduce ep for their brands Durability durable elastic demand will tend to be, ceteris paribus o Electrical appliances Non-durable goods have inelastic demand o Household cleaning products can only be used once Number of uses of the product number of uses ep o Electricity Addiction addictive ep Total addiction ep = 0 Combined effect of the determinants Each determinant discussed will probably have the effects indicated, but only if studied in isolation Sometimes they all work in the same direction Salt

No substitutes; complementary to most foodstuffs; nondurable; can only be used once; essential; small portion of most peoples incomes o ep = 0,1 Many cases counteract each other Television When deciding ep for a product, all determinants (and their relative important) must be considered Substitutability of the product is the crucial factor Inelastic demand: Salt; matches; toothpicks; cigarettes; bread; milk; petrol; electricity; water; eggs; potatoes; meat; postage stamps; medical care; legal services; car tyres Elastic demand: Cars; mutton; furniture; entertainment; restaurant meals; overseas holidays; butter; chicken; veal; apples; peaches

Applications o Many in economic analysis Pricing/policy decisions Distribution of burden of excise taxes or import tariffs Benefit of subsidies Require info about HOW QD will respond when P goods o Drug addiction, law enforcement & drug-related crime Drug addiction = serious problem Addicts resort to crime to support addiction Discourage use SA takes steps to stop inflow into country Reduce S of drugs in domestic market Demand for drugs is highly P inelastic, the result is a sharp increase in P S when demand is P inelastic TR & PQ P increased criminal activity Reduce the demand o Legalise drugs

9.2 Other Demand Elascticities QD doesnt only depend on P, therefore other demand elascticities can be calculated o Income elasticity of demand o Cross elasticity of demand

Income elasticity of demand o QD depends on income of consumers o As income QD usually , ceteris paribus How much will QD, relative to income o Income elasticity of demand (ey) measures responsiveness of QD in income

o o o

Defined: ratio b/tw %QD (dependent variable) & % consumers income (independent variable) May be positive/negative Positive = income is accompanied by QD of product concerned (or vice versa) Normal goods o Luxury goods (ey > 1) %QD > % income o Essential goods (0 < ey < 1) %QD < % income Negative = income is accompanied by QD of product concerned (or vice versa) Inferior goods NB suppliers What will happen to QD of goods they supply as consumers income Low ey of basic foodstuffs is one of the reasons that developing countries that export agricultural products fared relatively badly during post-war economic boom Consumers income BUT QD basic foodstuffs didnt same extent QD commodities income & QD manufactured goods

Cross elasticity of demand o QD of product also depends on the prices of related goods o Measures responsiveness of QD particular good to P of a related good o Defined: ratio b/tw % QD of product (dependent variable) & % P of related product (independent variable) o o o When 2 goods are UNRELATED, the cross elasticity will = 0 Substitutes ec is positive P product A QD product B in the same direction P butter QD margarine, ceteris paribus Complements ec is negative P product A QD product B in the opposite direction P cars QD tyres

9.3 The Price Elasticity of Supply

Measures the responsiveness of QS of a product to P of the product es is the ratio b/tw %QS of a product (dependent variable) & %P of the same product (independent variable) o

Different categories of supply elasticity o QS USUALLY as P (directly proportional) es is easier to interpret than ep o 5 categories Perfectly inelastic ( Same shape as perfectly inelastic D curve QS = unresponsive P Inelastic supply ( Upward-sloping linear curve intersects Q-axis Unit elastic supply ( Upward-sloping linear curve passes through the origins Elastic supply ( Upward-sloping linear curve intersects P-axis Perfectly elastic supply ( ) Any QS of a product at a given P

The determinants of the price elasticity of supply o Depends on the length of time that has elapsed since the P Short-term most supply curves = inelastic Suppliers do not have enough time to react to P Long-term most supply curves = elastic Adjust levels of production in response to P o Agricultural cycles o S may be inelastic w/ regard P short-term o P expectations = NB determinant Expectations of P S P regarded as temporary by producers inelastic in response If regarded as long-term production is adjusted elastic o Possibility of stockpiling product & existence Items that can be stockpiled = elastic supply than perishable goods Firms w/ excess production capacity respond faster P o Availability of inputs If essential inputs not available, firms cannot output in reaction to P of product

Chapter 10: Background to Demand: The Theory of Consumer Choice

Utility approach o Based on notion of cardinal utility Indifference approach o Based on notion of ordinal utility NB concepts o Utility o Marginal utility Provides justification for the law of demand

o Weighted marginal utility Marginal concepts o NB role in neoclassical economic analysis o Therefore explain difference between total, marginal & average values Indicate NB properties Indifference curves Budget line o Combine w/ indifference curves explain consumer equilibrium Consumer theory o Simplifications of reality o Not to describe reality BUT to explain, predict & analyse policy decisions

10.1 Utility Purpose of consumption satisfy wants Assumed that households attempt maximise satisfaction of wants, given available means & alternatives at their disposal Utility = consumer satisfaction o Express the degree of satisfaction that a household derives/expects to derive from the consumption of a G&S o Purpose of consumer behaviour = maximisation of utility o Degree to which it satisfies human wants o Abstract & subjective Specific product does not have a unique, measureable utility that applies to all consumers Tastes & wants differ Different amount of utility expected from a product o Cannot compare utility of one consumer w/ that of another

Cardinal & ordinal utility o Cardinal utility Involves idea that utility can be measured in some way Based on the assumption that utility is measurable on a cardinal scale & that differences in utility can be precisely quantified o Ordinal utility Involves ranking of different bundles of consumer G&S in order of preference Means satisfaction derived from different G&S can be ranked & ordered Size of utility differences cannot be established o Utility approach Based on the assumption that consumers can assign values to the amount of satisfaction obtained from each successive unit consumed Also assumed possible to compare the utility of different consumer G&S quantitatively Based on the notion of cardinal utility o Indifference approach Based on the notion of ordinal utility Only requires the ranking of different bundles of G&S in order of preference o Difference consider measurement of length

Metric scale example of cardinal scale Measure EXACT distances Ordinal scale indicates some distances are short/longer/equal than others, but cannot give the exact measurements Size relationship of ordinal numbers cannot be established

10.2 The Utility Approach: Marginal Utility and Total Utility Based on the assumption that consumers can & do subjectively assign units of value to the utility derived from the consumption of successive units of a product Only call them utils (distinguish from other products) Marginal utility = extra/additional utility that a customer derives from the consumption of one additional unit of a good Total utility = sum of all the marginal utilities Relationship b/tw marginal & total = NB in economic analysis If identical/homogenous units are consumed consecutively, the marginal utility will decline until it reaches 0 and thereafter becomes negative o Negative utility = disutility o Total utility as long as marginal utility is positive Reaches a maximum when marginal utility = 0 o Law of diminishing marginal utility The marginal utility of a G&S eventually declines are more of it is consumed during any given period Gossens first law When a consumer consumes more of a specific good, the total utility increases at a decreasing rate, ceteris paribus

10.3 Consumer Equilibrium in the Utility Approach Assumed that every consumer attempts to maximise their satisfaction of wants by consuming G&S o Aim is therefore to obtain the highest attainable level of total utility o attainable must have means in relation to P ability to afford Consumer will be in equilibrium if they obtain the maximum possible total utility In marginal utility theory, it is assumed that consumers know their wants & the utility they will derive from satisfying said wants o Assumed that each consumer is in a position to prioritise wants o Scale of preferences = a list of things consumers would prefer to purchase o Consumers make rational decisions if they have a scale of preference in mind Weighted marginal utility o To obtain consumers equilibrium position determine which combinations are affordable & @ which of these combinations the weighted marginal utility is the same for all the goods in question When the weighted marginal utilities are equal and available income is spent, equilibrium has been reached o o Is the utility derived from the last unit of money spent on the product

o o

2 conditions met for the consumer to be in equilibrium Combination of goods purchased has to be affordable Weighted marginal utilities of different goods must be equal Law of equalising the weighted marginal utilities / Gossens (improved) second law Equalising weighted marginal utilities implies consumers subjective valuation of the relative importance of two goods id the same as the objective valuation of the market, as reflected in the market prices of the goods concerned

10.4 Derivation of an individual demand curve for a product Consumers equilibrium if P of product