Adele Breytenbach
Cecilia J van Zyl
Department of Economics
University of Sol.Ith Africa, Pretoria
© 2019 University of South Africa
All rights reserved
Printed and published by the
University of South Africa
Muckleneuk, Pretoria
Compiled by the Department of Economics
ECS1500/1/2020–2022
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Editor and Styler
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IMPORTANT INFORMATION
This study guide contains important information about the module.
ACKNOWLEDGMENTS
The following Unisa staff members contributed to this learning guide for Economics 1500.
Ms Adele Breytenbach: Lecturer, Department of Economics
Ms Cecelia J van Zyl: Senior lecturer, Department of Economics
Prof Truida Oosthuizen: Associate Professor, Department of Economics
Dr Anneke Venter: Education Consultant from DCDT
Louis Kotzé: Language Practitioner
Dawid Kaths: Graphic Artist from Production
Tilla Malherbe: Electronic Originator from Production
CONTENTS
Introduction and welcome
Outcomes for economics 1500
(v)
(vii)
Layout of the Module
(ix)
Specific learning themes for ECS1500
LEARNING UNIT 1: The Economic Problem
(xi)
LEARNING UNIT 2:
Understanding Economic Graphs
20
LEARNING UNIT 3:
Demand, Supply and Price Determination
36
LEARNING UNIT 4:
Changes in Demand and Supply
70
LEARNING UNIT 5:
Elasticity
87
LEARNING UNIT 6:
Measuring Economic Performance
107
LEARNING UNIT 7:
Selected Economic Indicators
132
LEARNING UNIT 8:
The Public Sector
160
LEARNING UNIT 9:
The Financial Sector
184
1
LEARNING UNIT 10: The Foreign Sector
List of references
208
232
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(iii)
INTRODUCTION AND WELCOME
It is with pleasure that we welcome you to Economics 1500. We hope that this module in
Economics will convince you that the field and study of Economics can be an interesting
and rewarding experience!
The module is offered in a semester and carries 12 credits towards your qualification. We
will use the myUnisa module website and this study guide to direct you through the
curriculum.
The purpose of Economics 1500 is to prepare you for your further studies in the field of
economics and management sciences. This module will allow you to reflect on the skills you
already have and the resources you require to manage your own learning development. You
will acquire a broader vision of the South African economy and understand how its markets
function. Moreover, you will be able to identify your own position and role, and that of the
workplace, within this broader economic environment.
ECS1500/1
(v)
OUTCOMES FOR ECONOMICS
1500
The main outcomes for Economics 1500 are:
● To have an informed understanding of the economic problem of scarcity in societies
and to be able to explain how this problem is addressed in various economic systems
● To be able to explain the role and relationship between different economic participants
● To be able to use graphs, equations and tables to represent and illustrate relevant
economic theory
● To be able to use key concepts, such as demand and supply analysis and elasticity, to
analyse microeconomic problems
● To be able to appraise the South African economy in terms of macroeconomic objectives, and to propose and analyse policy measures that can be used to attain such
objectives
ECS1500/1
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LAYOUT OF THE MODULE
ECS1500/1
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SPECIFIC LEARNING THEMES
FOR ECS1500
Specific theme 1: Introduction to the economic environment
Once you have studied learning unit 1 you should be able to:
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Explain what the basic economic problem is;
Explain what the subject Economics covers;
Compare a market economy with other economic systems;
Understand the functions performed by markets and prices; and
Use a model to describe how a simple market economy functions.
Once you have studied learning unit 2 you should be able to:
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Understand all the graphs in the learning units;
Plot the data of two related economic variables in two-dimensional space;
Distinguish between linear and non-linear curves;
Distinguish between positive and negative sloping curves; and
Use graphs to illustrate important economic concepts.
Specific theme 2: Price determination in a market economy
Once you have studied learning unit 3 you should be able to:
● Identify the factors which determine the demand for and supply of a product;
● Formulate the laws of demand and supply and the economic rationale behind each;
● Derive the individual demand and supply curves with the aid of appropriate demand and supply
schedules; and
● Distinguish between a movement along a curve and a shift of a curve.
Once you have studied learning unit 4 you should be able to:
● Illustrate how changes in demand and supply influence market equilibrium;
● Understand the ceteris paribus condition; and
● Analyse the effect of simultaneous changes in demand and supply on market equilibrium.
Once you have studied learning unit 5 you should be able to:
● Explain the meaning and significance of price elasticity of demand;
● Distinguish between the five categories of price elasticity of demand;
● Explain the determinants of price elasticity of demand (in other words, explain why price elasticity
varies among different products);
● Calculate price elasticity of demand;
● Define and calculate income elasticity of demand, and explain the significance;
● Define and calculate cross elasticity of demand and explain the significance; and
● Define and calculate price elasticity of supply, and explain the significance
Specific theme 3: A macroeconomic perspective of the South African
economy
Once you have studied learning unit 6 you should be able to:
● Appreciate the importance of national accounting;
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SPECIFIC LEARNING THEMES FOR ECS1500
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Distinguish between microeconomics and macroeconomics;
Discuss the main macroeconomic objectives;
Define and explain the calculation of the gross domestic product (GDP) in South Africa;
Distinguish between real and nominal values and their importance in the calculation of economic
growth;
● Explain the meaning of double counting; and
● List the major shortcomings of the GDP.
Once you have studied learning unit 7 you should be able to:
● Explain what inflation is, and how it affects the economy
● Explain how the consumer price index (CPI) and the producer price index (PPI) are calculated, and
used to measure inflation;
● Define unemployment and discuss the measurement of unemployment in South Africa;
● Discuss income distribution in South Africa and explain how the Lorenz curve and the Gini coefficient are used to measure income distribution;
● Understand the importance of business cycles in the South African economy; and
● Distinguish between the different measures of economic growth in South Africa.
Specific theme 4: Three important sectors of the economy
Once you have studied learning unit 8 you should be able to:
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Describe the role of the public sector in a market economy;
List the main components of the public sector;
Explain why market failures have to be corrected through government action;
Discuss the main functions of government;
Give an overview of the South African government’s revenue and expenditure programmes (the
Budget);
● Identify the characteristics of a good tax system; and
● Appreciate the importance of lags in the execution of fiscal policy.
Once you have studied learning unit 9 you should be able to:
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Discuss the main functions of money;
Define the different measures of the money supply in South Africa;
Differentiate between the concepts of stock and flow;
Define the concept of financial intermediation;
Discuss the functions of the South African Reserve Bank;
Distinguish between the different participants, institutions, securities and markets in the financial
system; and
● Know why interest rates play an important role in the economy.
Once you have studied learning unit 10 you should be able to:
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(xii)
Explain the rationale behind international trade (why countries trade with each other);
Give a comprehensive overview of South Africa’s foreign trade relations;
Explain the importance of exchange rates and differentiate between the various methods of quotation;
Show how demand and supply determine exchange rates on the foreign exchange market; and
Discuss the components of South Africa’s balance of payments and their importance for the economy.
LEARNING UNIT 1
The Economic Problem
CONTENTS
1.1
1.2
1.3
1.4
1.5
INTRODUCTION
1.1.1
Unlimited wants vs. limited means
1.1.2
Choice and opportunity cost
1.1.3
Important decision-makers in the economy
DIFFERENT ECONOMIC SYSTEMS
1.2.1
The traditional economy
1.2.2
The command economy
1.2.3
The market economy
1.2.4
The mixed economy
THE MIRACLE OF THE MARKET ECONOMY
1.3.1
Markets
1.3.2
Prices
A MODEL OF THE MARKET ECONOMY
1.4.1
Developing a model
1.4.2
Limitations of the model
ECONOMICS AND ETHICS
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Mind map of the economic problem
Econosavvity
In this section in each learning unit, we are going to list the words that you have to
understand to be able to discuss basic economic problems and solutions. You should
make sure you understand what each of these concepts mean, as this will enable you to
participate meaningfully in economic discussions. To pass this module, you will also be
expected to understand these concepts and apply them to economic situations:
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2
the basic economic problem
traditional economy
command economy
market economy
mixed economy
factors of production
circular-flow model
economic systems
opportunity cost
aggregation
LEARNING UNIT 1:
1.1
The Economic Problem
INTRODUCTION
In Economics, we basically study various solutions to the economic problem. The economic
problem refers to the tension that exists between all the needs and wants we have as a
society versus the resources we have available to satisfy these wants and needs.
We try to find a solution to the basic economic problem by answering the following
questions:
If you think carefully about it, these questions really express the essential problems that
communities all over the world are faced with. If we can provide the correct answers to
these questions, most of the problems we face when economic decisions have to be made
will be solved. Let us look at a few practical examples relating to the provision of housing
in South Africa.
What should be produced?
We are all aware of the pressing shortage of housing in South Africa today. But do we
really know whether we should build houses or rather concentrate on providing food for
everyone? Is the production of food not perhaps more important than providing houses
for the needy? Do we know how much more food can be produced if we build fewer
houses?
How should it be produced?
If we decide to build houses, should we rather build fewer houses using unskilled labour
(of which there is an excess supply in South Africa), or should we build more houses by
means of sophisticated building techniques requiring large capital outlays (which are
scarce in South Africa)?
For whom should it be produced?
Once the houses have been built, who should qualify to live in them? Should the largest
or the poorest families be given preferential treatment, or should only those who can afford to pay the instalments on a home loan be considered?
It is immediately clear that there are no easy answers to these questions. Why are they
difficult to answer? They are difficult to answer because inherent in all of them is the element
of scarcity. Scarcity means that too few goods and services can be produced with the
available resources to cope with the amount that people would like to have or consume. More
formally, we can state that scarcity exists when the resources are insufficient to
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satisfy everyone’s needs and wants. This is the basic fact of economic life and the focus of
our studies in Economics.
How to deal with the problem of scarcity is precisely what the study of Economics is all
about.
.................................................................................................................................................................
In Economics, we study how people use their limited resources to gain the greatest
possible satisfaction of their unlimited needs.
.................................................................................................................................................................
This definition is another way of saying that in Economics, we seek answers to the three
basic questions referred to above, namely what, how and for whom should it be
produced? In this sense, Economics may also be described as the science of choice.
1.1.1
Unlimited wants vs. limited means
We live in a world of scarcity, because the quantity of goods and services that people would
like to consume will always exceed the quantity that can be produced with the available
resources. Scarcity applies to everyone and every society in the world. Since scarcity is a
relative concept, there will always be wants that are not fully satisfied, even among the most
affluent societies. This is because people's wants are continually expanding and changing.
Once their basic human needs (e.g. for food, water, clothing and shelter) have been satisfied,
there will be a growing desire for more luxury articles like cars, fridges, stoves and many of
the goods regarded as essential in highly developed countries.
We must be careful to distinguish between wants and needs. Wants are human desires for
goods and services, which are continuously evolving and expanding (unlimited). Needs are
necessities for survival, like food, water and shelter.
Even if people are given limitless spending power, scarcity will still exist, because time is
limited. Not even the wealthiest person in the world is free of the problem of scarcity,
because no one has the time to enjoy all the travelling, holidaying and art that he or she
would like to have. Time is a prime example of a limited resource.
Although wants are unlimited, the means or resources to satisfy those wants are limited.
There are three types of resources:
● Natural resources, such as mineral wealth, fertile soil and fishing resources
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● Human resources, in the form of brain power and muscle power, that is, labour
resources
● Manufactured resources, like machines, equipment and tools
Because these economic resources are available in limited quantities, the quantity of goods
and services that can be produced with them is also limited. Economic resources may be
labelled as the inputs that are used in the production process. In Economics, these different
resources or inputs are called factors of production and can be classified into four main
categories. The four factors of production are:
(i) Labour, which refers to all intellectual, physical or other human productive effort.
Labour therefore refers not only to manual labour, but also to the services of those
who follow a profession (e.g. doctors, lawyers and teachers).
(ii) Capital, which refers to the means of production (equipment, tools, buildings, etc).
This includes the entire range of durable equipment from hammers, saws and other
simple tools, to machines and computers. If the economist refers to capital, he or she
means "real" capital equipment, and not money. Money is not a resource that can be
used in the production process. (Money does, however, fulfil other important
functions which are discussed later.)
(iii) Land or natural resources, which are the gifts of nature and include factors such as
climate, mineral resources and the quality of soil.
(iv) The entrepreneur, which refers to the person or entity that has the vision or idea or
expertise to combine natural resources, labour and capital in the production process.
Without the vision of the entrepreneur, the other resources would remain largely unrealised potential. The entrepreneur is also the innovator who comes to the fore with
new goods or new production techniques. That is why the entrepreneur is at the same
time the bearer of risk – the entrepreneur's time, effort, reputation and own funds, and
those of others, are at stake should the innovation or business venture fail.
Capable, energetic and imaginative entrepreneurs are perhaps the most crucial of the four
productive resources.
1.1.2
Choice and opportunity cost
As mentioned earlier, people have unlimited wants which they strive to fulfil. The individual
is continually confronted with choices – the problem of choice arising from unlimited
wants that have to be satisfied with limited means.
At any time, an individual must decide which wants must be satisfied immediately and which
can be postponed or cannot be satisfied at all. One will have to be satisfied with less of one
thing if one wants more of another. If, for example, you decide to buy a car, your holiday
(or something else) falls victim to this decision. If a ticket to a rugby or soccer game costs
the equivalent of ten loaves of bread, then the cost of attending the game is equivalent to
the ten loaves of bread that have to be sacrificed.
It is not only the individual who is forced to make choices due to scarcity – every business
firm has to decide between various alternatives. It has to decide how many labourers or
other inputs have to be employed in order to produce goods and services (i.e. the output
of the firm).
The South African government also has to decide how to spend money, for example on
reconstruction and development projects. It strives to provide houses, electricity,
running water, public health services and infrastructure to all South Africans. But, because
resources are limited, it will have to decide what must be done first and what will have to
be postponed until later.
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Factors of production are scarce, and when they are used for the production of a certain
good, it means that these factors cannot be used for the production of another good or
other goods. A decision to produce more of one good also means that less of another good
can be produced. The goods which are "sacrificed" – in other words, not produced – can
also be seen as the cost of those goods which are produced. This is known as opportunity
cost. In Economics, we always consider opportunity cost when we make choices; we do
not only consider the direct cost of a good or service, but also the cost in terms of the goods
or other services we have to give up.
We can define opportunity cost as follows:
.................................................................................................................................................................
Opportunity cost measures the cost of obtaining (producing) a certain quantity of a good in terms of
the quantity of another good (or other goods) that could have been obtained (produced) in its place, in other
words, opportunity cost is the value of the best forgone opportunity.
.................................................................................................................................................................
Opportunity cost is one of the most important concepts in Economics, because it captures
the essence of the problems of scarcity and choice. If Daniel spends R30 on a movie ticket,
an accountant and most other people would calculate the total cost of the movie as R30.
An economist, however, would also measure the cost of the movie in terms of the next best
thing that Daniel could have done. If the next best thing was to buy a hamburger and chips,
the satisfaction that Daniel would have experienced from eating that meal should be added
to the cost of going to the movies. If the next best thing that he could have done was to
study for his Economics exam, the benefit that is lost by not studying should be added to
the cost of going to the movies. In other words, the economists measure the cost of the
movie in terms of both explicit and implicit costs.
1.1.3
Important decision-makers in the economy
We have seen that when a community is faced with the problem of scarcity, it has to make
choices. The three most important decision-makers in an economy are the following:
i. Households are individuals, groups or families that act as a single decision-making
unit and are also known as consumers. The most obvious example of a household is
the family living together in a home. It could, however, also be a single person or a
group of friends sharing their income and a living space. The important element of a
household is that it operates as a single decision-making unit.
Households take decisions on what to buy, from whom, when and at what
price. It also takes decisions on where and how to earn their income and at
what price.
ii. Firms are organisations responsible for the production and distribution of economic
goods and are also known as producers. Firms can be sole proprietorships, partnerships, close corporations or companies. Their main function is the processing of
production factors into goods and services which can satisfy wants and needs.
Firms take decisions on what, how and when to produce and at what price.
iii. Governments can take many different forms, but are essentially responsible for legislation, regulation and the provision of public goods (such as policing, water, roads,
etc).
iv. The most significant functions that governments perform are the following:
● They make laws according to which households and firms must behave.
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● They tax households and firms in order to provide essential services such as defence and law and order.
● They make payments to households or firms to finance their expenditure and to
bring about nationally desired economic objectives.
Interactions between these decision-makers take place in various markets, which will be
described in more detail in section 1.3.1.
The decisions taken by households, firms and the government will in many cases be in
conflict with each other. Households (consumers) would like to pay as little as possible for
goods and services, while firms would like to receive as much as possible for the goods
and services they sell. Governments provide essential community services but must impose
unpopular taxes on the other groups to provide these services. The question we must now
ask ourselves is how communities have organised themselves in order to deal with these
conflicting objectives.
LEARNING ACTIVITY 1.1
Discussion forum
Please read the following extracts from an article written by PROFESSOR DAMTEW
TEFERRA that appeared on The Conversation webpage on 11 February 2016:
Source: https://theconversation.com/why-free-education-is-a-folly-in-an-unequal-society-54515
Visit the discussion forum for learning activity 1.1 on myUnisa and air your opinion on
the following issues:
(a) Can higher education be free?
(b) Discuss the opportunity cost of free higher education.
1.2
DIFFERENT ECONOMIC SYSTEMS
Given the above discussion of the elements of the economic problem and three main
decision-makers, we can make a further distinction between the production problem and
the distribution problem.
i. The production problem: the scarcity of resources makes it impossible to produce
all the goods people want. First, every community has to decide what goods to
produce
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and what not to produce. It therefore has to decide how the scarce resources are going
to be allocated. Once the community has determined what goods are going to be
produced, it must, in the second place, decide on the quantities to be produced. Third,
it must decide how production must take place, because various techniques are
possible. Is more labour or more capital going to be used in the production proc- ess?
In other words, is the process going to be more labour intensive, or more capital
intensive? Fourth, it must decide who is going to produce what – the fact that people
have different interests, abilities, and so forth, should be considered. Fifth, the
community must decide where and when production should take place. The whole
production problem must therefore be approached systematically.
ii. The distribution problem : once the production problem has been solved, the
problem of how the total production of goods and services is going to be distributed
among the members and organisations in the community still remains. In other
words, the distribution problem must also be solved in a systematic way. Should the
goods be distributed equally, or should they be assigned on the basis of a person’s or
an organisation’s contribution to total production? What part should go to the state?
And so on.
It is important that both production and distribution take place in an orderly fashion.
Communities must provide an economic order to answer the questions and problems arising
from production and distribution. There are as many types of economic orders as there are
communities, but for the sake of convenience they can be divided into two types, namely
the command economy and the market economy.
1.2.1
The traditional economy
Traditionally, customs and beliefs determined decisions regarding production and
distribution. The community as a whole, or a traditional leader, will be responsible for taking
economic decisions. Traditional farming methods are used, and production in such a
traditional economy will mainly be based in the agricultural sector and aimed at producing
enough for survival. Traditional economies will mainly be found in lesser developed
countries. Trade activity will mainly consist of barter.
Examples of such traditional economies will usually be found in remote areas of the world
that is hard to reach. The Pygmies in the Congo region in Central Africa, the Inuit people
in Greenland, Canada and Alaska and certain island communities, such as Haiti, are
examples of communities where the economy operates according to tradition.
1.2.2
The command economy
In the command economy, all decisions about what, how and for whom goods and services
are produced are taken by a central authority or ruling body. To be able to function, the
authority in a command economy has to have the necessary power to act with force if
necessary. It therefore follows that the politics and Economics of a command economy are
to a large extent intertwined.
In a complex command economy, the answers to the economic problems of production
and distribution are provided by a central plan comprising the typical decisions that have to
be taken in such situations.
A decision has to be taken on how, where and for what purpose every labourer, every piece
of land and all capital goods are to be applied. Other examples are the distribution of raw
materials, how many houses to build, what consumer goods to produce, how these goods
are to be divided among consumers, what proportions of the economic resources should
be used to produce capital goods and consumer goods, and so on.
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Obviously, these decisions cannot all be made by one person, or even one committee. In
fact, economic decisions are based on the advice of numerous subordinate committees
appointed on a regional or activity basis. This does not mean that such decisions are always
implemented very efficiently in a centrally controlled community, since there is considerable
scope for wrong decisions and malpractice owing to the complexity of the economic system.
1.2.3
The market economy
In the market economy, the decisions about the what, how and for whom goods and
services are produced are determined by markets and prices. This is called the market
mechanism. Such an economy is motivated by the self-interest of individuals and is regulated
by competition between the different economic role players.
The market mechanism depends on each role player acting in accordance with what is to
his or her own advantage, that is, being motivated by self-interest. The buyer who seeks to
buy cheaply, the seller who tries to sell at the highest price, the businessman who attempts
to maximise profit and the employee who looks for the highest wage are all motivated by
self-interest. This conduct does not, however, lead to chaos or anarchy because selfinterest is made subservient to the common interest through the market mechanism and
competition. Because competitive markets are composed of many buyers and sellers, no
single person is in a position to exploit anyone. Furthermore, competition will see to it that
no firm makes excessive profits.
1.2.4
The mixed economy
In reality, no country was or is completely centrally planned nor is there any economy that
could be described as a pure market economy in which the market mechanism governs all
economic actions. Even the former Soviet Union had to use markets in certain sectors,
meaning that the USSR should rather have been described as a mixed-command economy .
A mixed-command economy is a planned economy that makes limited use of markets.
Similarly, there is no country in the world today that has a pure market economy.
Imperfections inherent in the market mechanism necessitate government action to ensure
greater efficiency. The way in which governments intervene in the market economy is dealt
with in learning unit 8.
Therefore, we can say that in the real world all market economies involve some degree of
government intervention, and it would be more correct to refer to them as mixed-market
economies. This implies that the market, in conjunction with the government, decides on
what, how and for whom to produce.
What about South Africa?
So how is the South African economy composed in terms of government and the market?
Government involvement in the economy has always been quite substantial in South Africa.
A number of enterprises were or are still directly or indirectly controlled by the government
– think of Eskom, Postbank, Telkom, the SABC, state hospitals, forestry activities and many
more. The government also fixes certain prices, as in the case of petrol, or controls them
indirectly, as in the case of certain food items (e. g. wheat and maize). Therefore, the South
African economy can be described as a mixed-market economy.
Because the economic system in South Africa may be described as largely market-oriented,
we will concentrate on the functioning of the market economy in the rest of this learning
unit.
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LEARNING ACTIVITY 1.2
Discussion forum
Please read the following extracts from an article written by JONATHAN ECKART that
appeared on The World Economic Forum webpage on 23 June 2016. Note that GDP stands
for gross domestic product, and is a measurement of total production in a country:
Source: https://www.weforum.org/agenda/2016/06/8-facts-about-chinas-economy/
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Visit the discussion forum for learning activity 1.2 on myUnisa and indicate if you agree
with the following statements:
(a) China is moving from a command economy to a market economy.
(b) The growth of the Chinese economy can mainly be attributed to private sector
companies.
1.3
THE MIRACLE OF THE MARKET ECONOMY
Have you ever wondered how things function in our economic system? Let us take the City
of Johannesburg as an example:
Apart from the millions who live there, thousands travel to and from this metropolitan hive of activity every day. All these people must be able to buy food, obtain
transport, find accommodation and have access to hundreds of services on a daily basis in order to survive. How is it possible that the residents of greater Johannesburg
can sleep peacefully without fearing some breakdown in the economic services on
which their lives depend? Who makes such a massive but efficient organisation possible? Who is the master organiser behind all this?
The answer to all these questions is in fact that no single authority or organisation is
responsible for the smooth functioning of the market economic system. The millions of
actions by consumers, producers and businesses are directed and coordinated by a system
of markets and the prices that are established in them. The coordination occurs invisibly in
the sense that nobody is consciously aware of the coordinating process. By pursuing their
own interests, every player in the economic process ensures the wellbeing of the community
at large. Samuelson and Nordhaus (2005:26) sum up this process in the following way:
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.................................................................................................................................................................
A market economy is an elaborate mechanism for the unconscious coordination of people,
activities and businesses through a system of prices and markets. It is a communication
device for pooling the knowledge and actions of millions of diverse individuals. Without
central intelligence or computation, it solves a problem that the largest super-computer
could not solve today, involving millions of unknown variables and relations. Nobody
designed the market; yet it functions remarkably well.
.................................................................................................................................................................
The two crucial words in this quotation are markets and prices . What magical qualities do
these two concepts possess to perform such a seemingly impossible task? Let us look at
their specific roles more closely.
1.3.1
Markets
There is a market for every good, service or factor of production which can be traded. A
market is any situation where potential buyers and sellers come into contact or communicate
with one another in order to establish the price and quantity of a good or service that will be
bought and sold. Most people think of a market as a visible, physical object, such as a specific
building, for example, the fresh produce market in Pretoria or an informal market place such
as the one shown in the photo on the left. However, a market need not necessarily be a
specific place or building – it may also be invisible or abstract, as in the case of the labour
market. Furthermore, a market does not have to be local, because all potential buyers and
sellers throughout the world can communicate by post, telephone, fax or the internet, as in
the case of foreign exchange markets, as well as the markets for gold, diamonds and certain
raw materials. In these cases, we can speak of world markets. The photo in the middle
provide an example of a computer screen which shows details for a market where shares are
exchanged. Markets exist for primary products, such as agricultural products that have not
been processed, such as those shown in the photo on the right. However, markets also exist
for manufactured products and services.
Although no specific locality is associated with these markets, they bring together buyers
and sellers so that the price and quantity of the good or service can be established.
Keep in mind that the market consists of thousands of buyers and sellers, thousands of
households and thousands of firms.
1.3.2
Prices
Although markets form a vital part of the solution to the economic problem, it is really the
prices that are established on these markets that provide the essential signals or impulses to
which the various economic participants react voluntarily (and in their own interest) to bring
about a seemingly organised economic order.
Prices represent the value of products in monetary terms. The specific price of a
commodity established on a market reflects the terms under which the buyer and the seller
12
LEARNING UNIT 1:
The Economic Problem
are willing to exchange the product. Any movement in the price of a product reflects
changes in the underlying demand and supply conditions and indicates to prospective
producers how viable it is to produce the product. A decrease in price is normally associated
with either a lack of demand or too much produced (excess supply). This warns producers
against expanding their production. At the same time, consumers might want to benefit
from the lower price level by going on a spending spree. An increase in price would suggest
exactly the opposite. It is quite easy to visualise how these signals will bring about voluntary
responses from the different market participants (producers and consumers) so that greater
balance between demanders and suppliers of goods and services in the system is achieved.
When there is balance between the demand for and the supply of a specific product, we
refer to this as a situation of market equilibrium . Equilibrium thus implies a balance
between buyers and sellers at a certain price level. When a market is in equilibrium, there
are no market forces at work to change the existing price level, because the quantity
demanded is exactly equal to the quantity supplied at that price. Any other price will cause
either an oversupply on the market (if the price is higher) or a severe shortage of the product
(if the price is lower).
It is important to realise that buyers and sellers do not compete with each other, but instead
negotiate on a price. Competition takes place among buyers as a group, and among sellers
as another group. In learning units 3 and 4, we give a more formal explanation of the
interaction between demand and supply, which will further explain the concept of market
equilibrium.
1.4
A MODEL OF THE MARKET ECONOMY
1.4.1
Developing a model
To improve our understanding of a market, we need to construct a model. An economic
model is a simplified representation of the real world, and includes only those factors
necessary to study the essence of the specific problem. Naturally, in any simplification,
certain aspects of reality are ignored. You could think of a model as a map which shows you
only the essential details to indicate the correct way to get to a destination.
The model of the market economy which we develop here is known as the economic
circuit or the circular-flow model. In order to keep the model as simple as possible, we
have to make certain assumptions. The first simplifying assumption is to ignore the
government sector and to concentrate only on the other two decisionmakers mentioned
earlier, namely households and firms. Second, we consider only two markets in our
economy, namely the market for consumer goods and services and the market for
factors of production .
Do you remember that we already mentioned that each market consists of thousands of
consumers and thousands of producers? Therefore, to enable us to discuss the circularflow model, we are combining separate or individual markets into a whole, which we then
treat as a single entity. In Economics, this process of combining smaller parts into a bigger
whole is called aggregation. The separate markets for all goods and services (literally
thousands of small individual markets) are aggregated into one single market for consumer
goods and services. Likewise, the different factors of production (labour, capital, land, etc.)
are all combined into a single market for factors of production. Although our model cannot
provide any information on these individual markets, it does provide us with an overall view
of the economic system as a whole.
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LEARNING UNIT 1:
THE ECONOMIC PROBLEM
A graphical representation (or a model) of such an economy is given in figure 1.1 where we
focus only on the features that are most relevant for our present purpose.
The simple market economy operates in the following way:
Households are the owners of the factors of production and offer their labour, natural
resources and capital to the firms via the market for factors of production. In return, they
receive income (wages and salaries, interest, rent and profit), via the market for factors of
production, from the firms (business enterprises). Hence there is a flow of services from
the households to the firms (the dotted line from households to business enterprises), and
a reverse flow of money from the firms to the households (solid line from business
enterprises to households).
The firms process the factors of production into consumer goods and supply these final
products to the market for consumer goods. The households, in turn, come to the market
for consumer goods with their earnings (from the sale of their factors of production) to buy
goods for the satisfaction of their wants (dotted line from business enterprises to
households). In return, there is a money flow from the households to the firms (solid line
from households to business enterprises), thereby completing the circular flow of goods
and money in the economic process.
FIGURE 1.1
Circular-flow model of the economy
Source: Mohr & Associates. Economics for South African students. 2015:50–51.
In figure 1.1, we therefore find a money flow (solid line in the inner circle running anticlockwise) and a flow of goods and services (dotted line in the outer circle running
clockwise) moving through the economy. Note that the expenditure (or costs) of one
market participant simultaneously represents the income of the other market participants.
The circular-flow model can also be used to explain some of the basic economic
magnitudes.
First, if we add together the prices of all goods and services that flow through the market for
consumer goods in one year, we can calculate the total value of all goods and services
produced, which is the total production of the economy (P).
14
LEARNING UNIT 1:
The Economic Problem
Second , if we add the value of the money stream going through the market for consumer
goods in one year, then we can calculate the total expenditure of the economy (E).
Third, if we add the value of the money stream going through the market for production
factors, we can calculate the total income earned in the economy (I). This is also the
sum of the remuneration paid to all the factors of production in one year – that is, the sum
of all wages, interest, rent and profit.
Because we are working with a closed circle, the value of the streams must be equal. It,
therefore, follows that total production (P) is equal to the total expenditure (E) and equal to
total income (I):
P = E = I.
These three flows and their interdependence form the basis of our studies in this module.
Limitations of the model
Keep in mind that the model represented in figure 1.1 is a simplified version of the real
world. As stated earlier, various markets and role players have not been included in the
circular flow model. For instance:
i. No provision is made in our simplified model for the role of government. We know
that government also influences markets by buying consumer goods and factors of
production. Government also influences economic life directly by providing certain
services, such as defence, police, health and education. To finance these services, it
taxes both firms and individual households. These actions are not revealed in our
model. More about the role of government will follow in learning unit 8.
ii. The foreign sector (i.e. the rest of the world) is another important participant not included in our simplified model. Its influence is revealed mainly through a country's
imports and exports.
Imports of goods and services may be regarded as an additional supply of goods on
the various markets, in return for which a reverse flow of money will go to the foreign
sector.
Exports of goods and services would mean a flow of goods to foreign economies,
with a corresponding inflow of money into the domestic economy. These factors will
be dealt with in more detail in learning unit 10.
iii. Yet another sector which does not feature in our simplified model is the financial
sector. In addition to the two physical (or real) markets for consumer goods and factors of production which appear in figure 1.1, we could also make provision for the
financial market, where financial intermediaries such as banks, stock exchanges and
insurance companies compete for the savings of the community. The influence of the
financial sector will be discussed in learning unit 9.
LEARNING ACTIVITY 1.3
Discussion forum
On 6 June 2017, the Huffington Post reported that South Africa was officially in a recession,
as two consecutive quarters of negative growth had been experienced. The following
diagram based on data obtained from Stats SA shows that the percentage change in real
gross GDP in the last quarter of 2016 and the first quarter of 2017 were
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LEARNING UNIT 1:
THE ECONOMIC PROBLEM
negative, which means that the economy was producing less than previously. GDP is the
term we use to describe production in the economy (P in the above equation):
Note: If you are not able to understand this diagram, you may have to revisit this activity
after you have worked through learning unit 2. In that unit, you will learn more about how
to interpret a diagram.
Let's now look at real gross expenditure for the same period (E in the equation above):
Visit the discussion forum for learning activity 1.3 on myUnisa and do the following:
Compare the information in the two diagrams and discuss the relationship between
income and expenditure. Consider the following issues:
(a) Why do you think the spending by households declines if the production in the
economy declines?
(b) What would your household do if the income of your household increases?
(c) What would firms do if households decrease their spending on goods and services?
16
LEARNING UNIT 1:
1.5
The Economic Problem
ECONOMICS AND ETHICS
In layman terms, Economics is often regarded to mainly deal with supply and demand, thus
mainly with the market economy. While it is important to understand how a market economy
operates, and how prices are determined in the market economy, that is not all that
Economics is about. As we explained in section 1.1, Economics is mainly about decisions
that has to be taken on the allocation of scarce resources in order to ensure maximum
satisfaction. How satisfaction is defined is a question of ethics. One may argue that for a
company, maximum satisfaction will refer to the situation where maximum profit is made.
For an individual, it may refer to the situation where the individual will gain maximum
benefit, for example, where an individual may earn the biggest amount of money.
However, since resources are scarce, we can argue that it is not ethically correct to only
consider the benefit or satisfaction of an individual person or company. Ubuntu, humaneness
and community are three concepts that identify indigenous African philosophy (Ramose
2004:149). Ubuntu has to do with the fact that a person is not a person on his or her own,
but that we are all part of a greater community, and that you cannot be a person without
being part of a community. Humaneness refers to the ethical dimension of being a human
being (Ramose 2004:150). According to Ramose (2004:157), this implies that "human dignity
and well-being supersedes the preservation of disposable wealth at the expense of human
life".
This implies that economic decisions should aim to address the needs of society as a whole.
Economic decision makers should not only aim to advance only their own well-being or the
well-being of their company, but that of the greater society that they belong to. We urge you
to keep this in mind when you are studying Economics. Economic decision should not only
be about maximum profit, but should aim to use all resources in a responsible manner taking
into account the cost and benefit to individual persons and institutions, the cost and benefits
to current society as a whole, and also the cost and benefits to future generations. This
implies that the decisions that will currently be the least expensive or yield the largest profit,
may not be the best one as it may put the rest of society or future generations at risk.
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THE ECONOMIC PROBLEM
LEARNING ACTIVITY 1.4
Quiz on learning unit 1
Note that you can also do this quiz on myUnisa to get immediate feedback. The answers to
the quiz will also become available on myUnisa under Additional Resources at the end of
the week allocated to studying learning unit 1.
Indicate whether each of the following statements is TRUE or FALSE:
STATEMENT
1.
The opportunity cost of a choice is the value of the best
foregone opportunity.
2.
If Sipho resigns from his salary-earning job to open his
own business, the salary he previously earned must be
included in the opportunity cost of the business.
3.
Economics studies human behaviour and is therefore
classified as a social science.
4.
Economics studies human behaviour, and is therefore
classified as a natural science
5.
The purpose of an economic system is to answer the
three central economic questions (What? How? and For
whom?).
6.
Economic systems are based on any or a combination of
three coordinating mechanisms: tradition, command and
the market.
7.
The distinction between a market economy and a command economy lies in the type of coordinating
mechanism used to answer the economic questions.
8.
For a market to exist, there must be physical contact between the prospective buyers and the prospective sellers
of the good or service in question.
9.
Households are responsible for the spending on consumer goods.
10.
Firms are mainly involved in consumption, while households are mainly involved in production.
TRUE
FALSE
LEARNING ACTIVITY 1.5
Short questions on learning unit 1
Note that you can also do these short questions on myUnisa to get immediate feedback. The
answers to the questions will also become available on myUnisa under Additional
Resources at the end of the week allocated to studying learning unit 1.
1. Briefly explain the basic economic problem in your own words.
2. Briefly explain the difference between a command system and a market system.
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LEARNING UNIT 1:
The Economic Problem
3. Explain in which type of system (market or command) you are likely to find the following situations:
3.1
3.2
3.3
3.4
The government department of planning sets targets for infrastructure development for the next five years.
Due to the fall in the wheat harvest in 2015, the price of bread will increase
considerably.
The government does not vary from the legislated price of bread, despite the
fall in the wheat harvest.
Investors can buy shares in both domestic and international companies.
4. Describe each of the factors of production listed below:
4.1
4.2
4.3
4.4
Land
Capital
Labour
Entrepreneurship
5. Classify each of the following in terms of a factor of production:
5.1
5.2
5.3
5.4
5.5
5.6
5.7
A bio-scientist working on a vaccine for Ebola
A South African R200 banknote
The technology that transforms coal into electricity
The physical labour of a builder
The milk used to make cheese
A person buying clothing at a factory store and selling it again
A professional soccer player
ADDITIONAL RESOURCES THAT CAN BE CONSULTED
If you are interested to find out more about the topics covered in this learning unit, you
can consult the following sources:
Mohr, P & Associates. 2015 (or other editions). Economics for South African students. Pretoria:
Van Schaik: Chapters 1 to 3.
Janse van Rensburg, J, McConnell, CR & Brue, SL. 2011. Economics: Southern African Edition.
Berkshire: McGraw-Hill: Chapters 1 to 2.
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LEARNING UNIT 2
Understanding Economic Graphs
CONTENTS
2.1
INTRODUCTION
22
2.2
THE AXES OF A GRAPH
23
2.3
OTHER TYPES OF GRAPHS
27
2.3.1
Variables with a positive relationship
27
2.3.2
Variables with a negative relationship
30
2.3.3
Variables that are unrelated
31
2.4
20
Relationships and causation
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LEARNING UNIT 2:
Understanding Economic Graphs
Mind map of understanding economic graphs
Econosavvity
In this section, we list the words that you have to understand to be able to discuss basic
economic problems and solutions. You should make sure you understand what each of
these concepts mean, as this will enable you to participate meaningfully in economic
discussions. To pass this module, you will also be expected to understand these concepts and apply them to economic situations:
● axes
● two-dimensional space
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LEARNING UNIT 2:
●
●
●
●
●
●
●
2.1
UNDERSTANDING ECONOMIC GRAPHS
slope of a curve
direct (positive) relationship
inverse (negative) relationship
linear relationship
non-linear relationship
unrelated variables
causation
INTRODUCTION
In learning unit 1, you already saw that we make use of graphs or diagrams to explain and
visualise economic data. We also use diagrams to explain and visualise the relationships
between economic variables in economic models. This unit will help you grow your
competence in interpreting the relevant diagrams and understanding the meaning behind
them, and how to use the correct diagram to represent certain data or relationships. Although
graphs are normally associated with mathematics, you do not require any mathematical
background beyond Grade 9 Mathematics to understand this learning unit.
In Economics, we usually show the relationship between two or more variables on a graph.
A variable is any unit or factor that can change, for example, the price or the quantity
demanded of a product, or the quantity supplied of a service, or any other economic variable.
A considerable portion of your studies in Economics will be concerned with establishing
how a change in one economic variable will influence another variable, or other variables.
Due to the large number of variables in any economy it is, however, necessary to isolate two
variables at a time and “pretend” that other variables will not change (will stay constant)
while we look at the two variables we are interested in. For example, if we want to examine
the relationship between the price of red pens and the quantity of red pens supplied, we
need to ignore the possible effect of taxes, inflation, and so forth on the decision to produce
the pens. We therefore look at the quantity of a product and its price in isolation and pretend
that the rest of the variables remain constant. We refer to this as the ceteris paribus1 principle.
Typical examples of the relationships we study in Economics are:
How does a change in theprice of a product influence the quantity demanded of that
product?
If the supply of product A increases, how will this influence the price of A?
What effect will a decrease in income have on thespending of an individual?
How will a decrease in government spending influence total employment in a country?
1. Pronunciation: [ke:teri:s pa:ribus] roughly KAY-teh-rees PAH-ree-boos
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LEARNING UNIT 2:
Understanding Economic Graphs
In the rest of the learning unit, we will examine how the relationship between two variables
may be presented in the form of a graph.
2.2
THE AXES OF A GRAPH
Because we normally have two variables which we want to relate to each other, our graphs
must be drawn in a two-dimensional space. For this, we need two lines (also called axes) on
which to measure the values of each variable. In figure 2.1, both axes start from the same
point of origin (0), and are drawn horizontally and vertically respectively. On the horizontal
axis, the values of X are measured, and the value of X will increase when you move further
away from the origin, in the direction of the arrow. On the vertical axis, the values of Y are
measured, and the value of Y increases when you move upwards away from the origin, in
the direction of the vertical arrow. The shaded area provides us with the space in which to
indicate the relationship between these two variables.
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UNDERSTANDING ECONOMIC GRAPHS
FIGURE 2.1
A two-dimensional space
Let us see how we can use this two-dimensional space. Suppose that when the value of Y
is 20, the value of X is 6. This is shown by point A in figure 2.2. When the value of Y
increases to 30, the value of X increases to 8. This is shown by point B in figure 2.2. It is a
two-dimensional space because we show the relationship between the two variables on the
X and Y axes.
FIGURE 2.2
Values in a two-dimensional space
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LEARNING UNIT 2:
Understanding Economic Graphs
To show how we use the two-dimensional space created by these two axes, a time-series
graph will now be drawn. A time-series graph is very common in economics. It measures
time (e.g. days, weeks or years) on the horizontal axis and any other variable (or variables)
which we want to relate to time on the vertical axis. Table 2.1 denotes the production figures
for South Africa. The figures show an increasing trend, but this is difficult to identify by
just looking at the figures. It will be helpful to see the figures visually.
TABLE 2.1
Production (GDP) in South Africa, 2007–2017
Year
Production (GDP)
Rand (billions)
2007
2 120
2008
2 369
2009
2 508
2010
2 748
2011
3 024
2012
3 254
2013
3 540
2014
3 805
2015
4 051
2016
4 350
2017
4 652
Source: South African Reserve Bank, https://www.resbank.co.za/Research/Statistics/Pages/OnlineDownloadFacility.aspx
By plotting the information contained in the table on a two-dimensional graph, we are able
to gain a much better idea of the production pattern. In figure 2.3, production (gross
domestic product or GDP) is measured on the vertical axis and the different years are
marked out on the horizontal axis. Each year's value is plotted on the graph by measuring
the value of production on the vertical axis in line with the corresponding years on the
horizontal axis. For example, production for 2007 (R2 110 billion) is obtained by measuring
a vertical distance of R2 110 billion from the horizontal axis. This is done for each year's
production. For example, a value of R2 369 billion corresponds with the year 2008, R3 254
billion with 2012 and R4 652 billion with 2017 and so forth.
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LEARNING UNIT 2:
UNDERSTANDING ECONOMIC GRAPHS
FIGURE 2.3
Production (GDP) of South Africa, 2007–2017
LE
LEARNING ACTIVITY 2.1
Draw your own graph
Use the information in the following table to draw your own diagram showing the levels of
saving from 2007 to 2017 in South Africa:
Year
26
Gross domestic saving
R millions
2007
329 127
2008
417 270
2009
450 794
2010
494 973
2011
529 233
2012
482 714
2013
544 344
2014
587 111
2015
663 892
2016
720 732
2017
751 003
LEARNING UNIT 2:
2.3
Understanding Economic Graphs
OTHER TYPES OF GRAPHS
Time-series graphs are not the only type of graph we use in Economics. Using graphs allows
us to present the relationship between two economic variables in a meaningful manner.
From this type of graph, it is relatively easy to establish whether a general pattern, or trend,
exists between two variables.
Typical patterns that are found in Economics are the following:
● variables that move up or down together
● variables that move in opposite directions, that is, when one goes up the other goes
down
● variables that are not related to each other in any way
We will now explain these relationships in detail by using practical examples.
2.3.1
Variables with a positive relationship
If two variables move together in the same direction, we say that there is a positive or a
direct relationship between them. An example of a positive relationship is that between
speed and distance travelled. The higher your speed , the greater the distance you can travel
in 5 hours. This is illustrated in figure 2.4, where a straight line is drawn to show the
relationship between speed and distance travelled in 8 hours.
FIGURE 2.4
Example of a linear positive (direct) relationship
Because the relationship is a straight line, we call this a linear relationship. Furthermore,
because the line rises from left to right, the slope or gradient of the line is positive. In
Economics, any line in a graph is called a curve, irrespective of whether it is a straight line
or not.
Another example of a positive relationship is that between the number of bakers per day
and the number of loaves of bread that are baked. Note that the line in figure 2.5 is not a
straight line, but a curved line. Although the relationship is still positive, it is a non-linear
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LEARNING UNIT 2:
UNDERSTANDING ECONOMIC GRAPHS
relationship. It is reasonable to assume that bakers per day will not influence production in
a linear fashion, but that the curve will begin to flatten somewhat as more loaves of bread
are produced per day. This means that when all the best bakers have been hired, the
additional bakers that will be hired will produce fewer loaves of bread extra, thus production
still increases when additional bakers are hired, but by less. In other words, the slope of the
curve becomes less steep as more loaves of bread are produced. Too many bakers can even
reduce production. The slope or gradient of the curve in figure 2.5 is positive, because the
relationship between the two variables is positive.
FIGURE 2.5
Example of a non-linear positive (direct) relationship
Let's calculate the value of the slope of the line in figure 2.4 using this formula. The diagram
shows that when the speed increases from 60 to 120 (shown on the vertical axis), the distance
travelled in 5 hours increases from 300 to 600 (shown on the horizontal axis):
Slope of line =
Slope of line =
Difference in values on the vertical axis
Difference in values on the horizontal axis
120 – 60
600 – 300
=
60
= 0,2
300
Note that we subtract the end values from the beginning values. Speed increases from 60
to 120, thus we subtract 60 from 120. Distance travelled increases from 300 to 600, thus we
subtract 300 from 600. The slope of this line is equal to 0,2. The positive value indicates
that the value on the horizontal axis changes in the same direction as the value on the
vertical axis, that is, when the speed at which travelling takes place increases, the distance
covered in 5 hours also increases.
You can calculate the slope of this line when the speed increases from 20 to 60.
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LEARNING UNIT 2:
Understanding Economic Graphs
Is your answer 0,2? That is because this is a straight line and the value of the slope will be
the same everywhere on this line. However, this will not apply to the curve in figure 2.5. The
value of the slope changes as we move along the curve; therefore, this relationship is not
depicted by a straight line. The value will, however, be positive everywhere on the curve
because the curve slopes upwards.
LEARNING ACTIVITY 2.2
Draw a diagram and calculate
(a) The following table shows the relationship between domestic savings and income for
the imaginary Country Catonia. Please draw the diagram that illustrates this relationship and answer the questions that follow:
Domestic savings at different levels of income in Catonia
i.
ii.
iii.
iv.
v.
Savings ($)
Income ($)
40 000
100 000
60 000
150 000
80 000
200 000
100 000
250 000
Is the relationship between domestic savings and income in Catonia a linear
relationship? Explain your answer.
Calculate the slope of the line between an income of $150 000 and $200 000.
Calculate the slope of the line between an income of $200 000 and $250 000.
Does the slope of the line stay the same?
How is your answer to question (iv) related to the answer to question (i)?
(b) The following table shows the relationship between domestic investment and income
for the imaginary Country Catonia. Please draw the diagram that illustrates this relationship and answer the questions that follow:
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LEARNING UNIT 2:
UNDERSTANDING ECONOMIC GRAPHS
Domestic investment at different levels of income in Catonia
Investment ($)
Income ($)
60 000
100 000
100 000
150 000
130 000
200 000
150 000
250 000
(i) Is the relationship between domestic investment and income in Catonia a linear relationship? Explain your answer.
(ii) Calculate the slope of the line between an income of $150 000 and $200 000.
(iii) Calculate the slope of the line between an income of $200 000 and $250 000.
(iv) Does the slope of the line stay the same?
(v) How is your answer to question (iv) related to the answer to question (i)?
2.3.2
Variables with a negative relationship
A relationship between two variables that move in opposite directions is called a negative
or an inverse relationship. An example of a negative relationship is that between the time
one spends travelling to work and back, and the leisure time at one's disposal: the more time
spent on the road, the less leisure time at one's disposal. Here we can again assume a linear
relationship between travelling time and leisure time, as is shown in figure 2.6. Also note
that the slope of the curve is now negative (like going down a hill) because of the negative
(inverse) relationship between the two variables.
FIGURE 2.6
Example of a linear negative (inverse) relationship
Let's calculate the value of the slope of the line in figure 2.6 using the formula for
calculating the slope of a line. The diagram shows that when travel time to work increases
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LEARNING UNIT 2:
Understanding Economic Graphs
from 3 to 4 hours (shown on the horizontal axis), leisure time decreases from 4 to 3
hours (shown on the vertical axis):
Slope of line =
Slope of line =
Difference in values on the vertical axis
Difference in values on the horizontal axis
3–4
=
4–3
–1
=–1
1
Note that the value on the vertical axis changes from 4 to 3 hours; we subtract the initial
value from the final value, thus 3 minus 4 hours = -1 hour. The leisure time therefore
decreases by one hour. The value on the horizontal axis changes from 3 to 4 hours; we
subtract the initial value from the final value, thus 4 minus 3 hours = 1 hour. The slope of
this line is equal to -1. The negative value indicates that the value on the vertical axis changes
in the opposite direction as the value on the horizontal axis, that is, when travelling time to
work increases, leisure time decreases.
LEARNING ACTIVITY 2.3
Draw a diagram and calculate
The following table shows the relationship between the number of coffees sold per day and
the price of a cup of coffee for Coffee Fix Shop. Please draw the diagram that illustrates
this relationship and answer the questions that follow:
Number of coffees sold per day at different price levels by Coffee Fix Shop
Price (R)
Number of cups sold
6,00
350
7,00
320
8,00
300
9,00
250
10,00
150
Is the relationship between the number of coffees sold per day and the price of a cup of
coffee positive or negative? Explain your answer.
Is the relationship between the number of coffees sold per day and the price of a cup of
coffee a linear relationship? Explain your answer.
Calculate the slope of the line between an income of R6,00 and R7,00.
Calculate the slope of the line between an income of R7,00 and R8,00.
Does the slope of the line stay the same?
How is your answer to question (e) related to the answer to question (b)?
2.3.3
Variables that are unrelated
There are many things that are totally unrelated to each other. The price of oranges will
have no influence on the marks we obtain for a Unisa assignment. Nor will the rainfall in
South Africa have any influence on coal production in Wales. Examples of unrelated
variables are given in figure 2.7. Note that the non-relationship in these cases is denoted by
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LEARNING UNIT 2:
UNDERSTANDING ECONOMIC GRAPHS
either a horizontal or a vertical line. The slopes of these curves are either zero (in the case
of a horizontal line) or infinitely large (in the case of a vertical curve). In both cases, the
value of one of the variables does not influence the other variable at all.
FIGURE 2.7
Horizontal and vertical curves
LEARNING ACTIVITY 2.4
Discussion forum
There is a positive relationship between ice cream sales in Gauteng and the number of
drownings in Gauteng. Can we therefore conclude that higher ice-cream sales lead to
drownings? Discuss this on the discussion forum for learning activity 2.4 on myUnisa.
2.4
RELATIONSHIPS AND CAUSATION
Causation has to do with the causal relationship between two variables, that is, will a change
in X result in (or cause) a change in Y, or will a change in Y result in a change in X? Sometimes
it is easy to identify this relationship, for example, if we look at figure 2.4, it is easy to see
that when you travel at a faster speed, a larger distance will be travelled. Thus, causation is
from speed to distance. However, in Economics, it is not always so easy to identify such a
causal relationship. For example, figure 2.8 shows both savings and investment in South
Africa. From the diagram, it seems that a higher level of savings can be associated with a
higher level of investment. However, we are not sure what the reason is for this: does a
higher level of savings result in a higher level of investment, or does a higher level of
investment result in a higher level of saving, or is there another variable that affects both
savings and investment? To explain the causal relationship, we have to formulate a theory to
explain the direction of causality between the two variables, and we have to test if this theory
is true. There are certain statistical techniques that can be used to test such a relationship.
32
LEARNING UNIT 2:
Understanding Economic Graphs
FIGURE 2.8
Savings and investment in South Africa
When a relationship between two variables is identified, it is therefore necessary to exercise
caution and think carefully about the causal relationship between the two variables.
LEARNING ACTIVITY 2.5
Quiz on learning unit 2
Note that you can also do this quiz on myUnisa to get immediate feedback. The answers to
the quiz will also become available on myUnisa under Additional Resources at the end of
the week allocated to studying learning unit 2.
Indicate whether each of the following statements is TRUE or FALSE:
STATEMENT
ECS1500/1
1.
The origin is the point where a graph starts.
2.
A graph showing a positive relationship between
stock prices and the nation’s production means that
an increase in stock prices causes an increase in
production.
3.
If the graph of the relationship between two variables slopes upward to the right, the relationship
between the variables is positive.
4.
Graphing things that are unrelated on one diagram is
not possible.
5.
The slope of a straight line is calculated by dividing
the change in the value of the variable measured on
the horizontal axis by the change in the value of the
variable measured on the vertical axis.
6.
For a straight line, if a large change in y is associated
with a small change in x, the line is steep.
TRUE
FALSE
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LEARNING UNIT 2:
UNDERSTANDING ECONOMIC GRAPHS
7.
The slope of a curved line is not constant.
8.
Ceteris paribus means “everything else changes”.
9.
Demonstrating how an economic variable changes
from one year to the next is best illustrated by a timeseries graph.
10. If variables X and Y move up and down together,
they are positively related.
LEARNING ACTIVITY 2.6
Short questions on learning unit 2
Note that you can also do these short questions on myUnisa to get immediate feedback. The
answers to the questions will also become available on myUnisa under Additional
Resources at the end of the week allocated to studying learning unit 2.
(a) If the total amount of goods produced in South Africa has generally increased, on a
time-series graph illustrating the total amount produced, explain if you would expect
to find
(i) an upward trend?
(ii) a linear relationship?
(b) Choose the correct answer of the two options between brackets:
(i) If the relationship between two variables, X and Y, is a vertical line, then X
and Y are (positively correlated/not related).
(ii) A linear relationship (always has a constant slope/always slopes up to the
right).
(c) Use the figure below to answer the following questions:
(i) What is the slope of the line between Q = 100 and Q = 140?
34
LEARNING UNIT 2:
Understanding Economic Graphs
(ii) How does the slope of the line between Q = 140 and Q = 180 compare with
the slope between Q = 100 and Q = 140?
(d) Use the data in the table below to answer the following questions:
x
y
1
20
2
40
3
60
4
80
5
70
6
60
(i) Draw a graph to show the relationship between x and y.
(ii) Over what range of values for x is this relationship positive? Over what range
is it negative?
(iii) Calculate the slope between x = 1 and x = 2.
(iv) Calculate the slope between x = 5 and x = 6.
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LEARNING UNIT 3
Demand, Supply and Price Determination
CONTENTS
3.1
3.2
3.3
3.4
36
DEMAND
DEMAND
38
39
3.2.1
The demand curve
40
3.2.2
Reasons for the law of demand
3.2.2.1 The substitution effect
3.2.2.2 The income effect
42
42
42
3.2.3
A change in demand
43
SUPPLY
PRICE DETERMINATION
51
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LEARNING UNIT 3:
Demand, Supply and Price Determination
Mind map of demand, supply and price determination
Econosavvity
To pass this module, you will be expected to understand the following concepts and
apply them to economic situations:
●
●
●
●
●
●
●
●
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law of demand
demand curve
law of supply
supply curve
excess demand and supply
demand and supply schedules
movements along curves
shift of a curve
37
LEARNING UNIT 3:
3.1
DEMAND, SUPPLY AND PRICE DETERMINATION
INTRODUCTION
.................................................................................................................................................................
In the usual and ordinary course of things, the demand for all commodities precedes their
supply.
David Ricardo (1772–1823)
.................................................................................................................................................................
In learning unit 1, you were introduced to the economic problem. We explained that all
economic actions arise from scarcity and that our wants exceed the productive resources
at our disposal to satisfy them. In order to solve this basic economic problem, important
decisions about what to produce, how to produce and for whom to produce have to be
taken.
In a market economy, these decisions are resolved mainly by the market mechanism
whereby prices are established. These prices reflect the terms under which buyers and sellers
are willing to exchange goods and services. The success or failure of any market economy
therefore depends on how efficiently these price signals are conveyed to producers and
consumers of products.
The purpose of this learning unit is to explain how prices are established in a market
economy through the interaction of demand and supply.
Figure 3.1 illustrates how households sell their factors of production to firms. Firms use
these factors to produce goods and services that are sold in the goods market to households,
who use their income to buy the goods and services. In the goods markets, firms thus
determine the supply (S), while households determine the demand (D). The interaction of
supply and demand determines the equilibrium price (P1) and equilibrium quantity (Q1) of
each good or service.
FIGURE 3.1
The interaction between households and firms
Source: Mohr et al (2008:49), author’s own illustration
38
LEARNING UNIT 3:
3.2
Demand, Supply and Price Determination
DEMAND
Let us begin our study of demand and supply by building a model of demand. The demand
for a good or service must be clearly distinguished from wants. We saw in learning unit 1
that wants are unlimited desires or wishes people have for goods and services. In contrast
to this, the quantity of a certain good that people demand is the quantity they actually plan
and are able to buy during a certain period. Therefore, the quantity we demand reflects a
decision about which wants are going to be satisfied. Unlike wants, the demand for a good
or service has to be backed up by buying power. Without buying power (income), there can
be no demand.
LEARNING ACTIVITY 3.1
True/False question
Indicate if the following statements are true or false:
Statement
True
False
a. Demand is simply another term for wants. In other words, if a
consumer demands a good, it simply means that he or she wants
the good.
b. The demand for a product refers to the quantities of the product
that potential buyers are willing and able to buy.
c. You intend starting a business that supplies chicken burgers in your
area. A friend of yours mentions that he thinks it is a good idea
because he knows that in this area there are 5 000 people who like
chicken burgers. This information is sufficient to conclude that
there is a high demand for chicken burgers in this area.
What determines the quantity demanded?
Each one of us is a consumer of goods and services. Each day we require certain goods and
services to stay alive. The quantity of any particular good we plan to buy depends on many
diverse factors, including:
● the price of the product or good
● the prices of related goods
– complements
– substitutes
● the income of the consumer
● the taste (or preferences) of the consumer
● the size of the household
Of all these factors, the most important is probably the price of the particular good or
service. Although all the other factors, such as our income and the prices of related goods,
play a very important role in our demand for a specific product, they can never overshadow
the price of the good itself. In the light of this, we have to ask what the relationship is
between the quantity demanded and the price of a good.
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LEARNING UNIT 3:
DEMAND, SUPPLY AND PRICE DETERMINATION
The answer to this important question is provided by the law of demand .
.................................................................................................................................................................
The law of demand states that the higher the price of a good or service (all other things
remaining the same), the lower the quantity demanded, and the lower the price of a good
or service (all other things remaining the same), the greater the quantity demanded.
.................................................................................................................................................................
Obviously this law will apply only if all the other factors we have listed (income, preferences,
weather, etc.) remain unchanged. The well-known Latin expression for “everything else
remaining the same” is ceteris paribus . It is not possible to study the effect of a price change
on the quantity demanded if these other factors are changing at the same time. Thus, the
law of demand states that there is a definite relationship between the market price of a
product and the quantity demanded of that product, if the ceteris paribus condition holds. This
relationship between price and quantity demanded is called the demand schedule and can
be represented by means of a demand curve. Note that the ceteris paribus principle implies
that all the other factors that may also affect the quantity demanded of the good, remains
the same – only the price changes.
In table 3.1, a hypothetical example of a demand schedule for potatoes is given. At a specific
price, for instance R5 a bag, a certain quantity of potatoes will be demanded by consumers
in the market – in this case 9 000 bags per month. At a lower price, for instance R4 per bag,
the quantity demanded increases to 10 000 bags. From table 3.1, we can determine the
quantity demanded at any particular price by comparing column (2) with column (1).
TABLE 3.1
The demand schedule shows the relationship between quantity demanded and price
3.2.1
(1)
(2)
Price (P) (R and per bag)
Quantity demanded (Q) (bags
per month)
A
5
9 000
B
4
10 000
C
3
12 000
D
2
15 000
E
1
20 000
The demand curve
As we know from learning unit 2, the information in table 3.1 can also be represented
graphically. In figure 3.2, the different prices for potatoes, measured in rand per bag, are
shown on the vertical axis. The horizontal axis measures the quantities of potatoes (number
of bags) demanded per month. We make use of the information in table 3.1 to draw figure
3.2. Point A in figure 3.2 corresponds to a price (P) of R5 and a quantity (Q) of 9 000 bags
of potatoes, as can be read off from the vertical and horizontal axes respectively. In order
to draw point B, we obtain the point which represents a price of R4 and a quantity of 10
000. Points C, D and E are obtained in the same manner. By connecting these points, we
obtain a line, shown as dd.
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LEARNING UNIT 3:
Demand, Supply and Price Determination
This representation of the demand schedule is called the demand curve. Note that an
inverse relationship exists between price and quantity: Q increases when P decreases. An
important property of the demand curve is that it slopes down from left to right, which
reflects this inverse relationship. This representation illustrates the law of demand which, in
fact, applies to all goods – potatoes, meat, pizzas, hamburgers – and also services, such as
those offered by hairstylists, medical practitioners and architects.
Therefore, a change in the price of a good will lead to a change in the quantity
demanded of that good and will result in a movement along the demand curve, for
example, from point B to C.
FIGURE 3.2
The demand curve
Let's differentiate between the effect of an increase in the price level and a decrease in the
price level. Figure 3.3(a) illustrates a decrease in the price level and Figure 3.3(b) illustrates
an increase in the price level.
When the price decreases from R4 to R3, a downward movement along the demand curve
dd in Figure 3.3(a) takes place from point A to B. At the lower price of R3 the quantity of
potatoes demanded is higher. It increases from 10 000 bags to 12 000 bags.
Figure 3.3(b) illustrates an increase in the price from R3 to R4. Due to the increase in the
price the quantity demanded of potatoes decreases from 12 000 bags to 10 000 bags. An
upward movement along the demand curve dd takes place from B to A.
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LEARNING UNIT 3:
DEMAND, SUPPLY AND PRICE DETERMINATION
FIGURE 3.3
Changes in the quantity demanded
3.2.2
Reasons for the law of demand
This law is based on common sense and has been known since early times, albeit in a less
formal way. In theory, however, there are two reasons for the existence of this law.
3.2.2.1 The substitution effect
It is important to realise that when the price of a good rises, other things remaining the
same, its price rises relative to all other prices. Because there are substitutes for most goods
(e.g. coffee for tea) consumers will try to buy less of the product that is now more expensive
and more of its substitutes.
3.2.2.2 The income effect
If the price of a product increases, the price of that product rises relative to the income of
consumers. If income remains unchanged, any increase in the price of a product will make
consumers poorer. They will therefore be forced to reduce the quantities demanded of at
least some goods and services. In all probability consumers will reduce their demand for the
product of which the price has increased.
Both the substitution effect and the income effect substantiate the law of demand.
LEARNING ACTIVITY 3.2
Choose the correct answer
1. Which of the following is a factor that determines the quantity of ice cream
demanded?
i.
ii.
iii.
42
The price of ice cream
The income of households
The availability of ice cream
LEARNING UNIT 3:
Demand, Supply and Price Determination
iv.
A change in the taste and preference for ice cream due to an advertising
campaign for ice cream
2. The law of demand represents the relationship between the
.
i.
ii.
iii.
iv.
price of related goods; quantity supplied
price of a good or service; quantity supplied
income of households; quantity demanded
price of a good or service; quantity demanded
3. The law of demand states that a
i.
ii.
iii.
iv.
v.
and the
.
higher price leads to a higher quantity demanded for the good, ceteris paribus
lower price leads to a lower quantity demanded for the good, ceteris paribus
lower price leads to a higher quantity demanded for the good, ceteris paribus
higher price leads to a lower quantity demanded for the good, ceteris paribus
change in the price has no impact on the quantity demanded
LEARNING ACTIVITY 3.3
Discussion forum
A friend of yours who owns a flower-selling business has the following opinion about the
law of demand: She does not think that the law of demand is valid for red roses, because
during February, when the price of red roses was very high, she sold many more. It therefore
seems that there is a positive relationship between the price of red roses and the quantity
demanded of it. Visit the discussion forum for learning activity 3.3 on myUnisa and share
your opinion on your friend's view on the discussion forum.
3.2.3
A change in demand
So far, we have established a negative relationship between the price of a good and the
quantity demanded of that good. This relationship was represented in the demand schedule
and the downward-sloping shape of the demand curve. In addition to the price of the
product we have also listed various other factors which may influence the quantity
demanded of the product. From the example provided in learning activity 3.3, it is clear that
although price is an important determinant of the quantity demanded of a good, there are
also other factors that play a role.
We shall now expand our analysis by trying to determine how all other factors, such as the
income of consumers, consumer preferences or the prices of related goods, will influence
the demand for a specific product.
Assume an increase in the income of households in South Africa. How will this influence
the demand for potatoes in the country? When income increases (other things remaining
the same), consumers normally buy more of most goods and services, and when income
decreases, they normally buy less of most goods and services. We can therefore expect to
see an increase in the demand for potatoes as well. Such an increase in the demand for
potatoes can also result if a substitute product such as rice has become more expensive, or
if the size of the South African population has increased significantly, or simply because
people's preferences have changed in favour of potatoes.
The result of all these possible influences is that more potatoes will be bought at each price
on a demand schedule.
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LEARNING UNIT 3:
DEMAND, SUPPLY AND PRICE DETERMINATION
TABLE 3.2
The demand schedule shows the old and new relation-ship between quantity
demanded and price
Price
(rand per bag)
Quantity demanded
(bags per month)
New quantity demanded
(bags per month)
A
5
9 000
13 500
B
4
10 000
15 000
C
3
12 000
18 000
D
2
15 000
22 500
E
1
20 000
30 000
When we plot this new information on the same graph as the original demand schedule, we
see that the entire demand curve has shifted to the right. In reality, we obtain a new demand
curve.
This is shown in figure 3.4, where the previous demand curve of figure 3.2 is repeated and
the new demand curve is shown as d'd'. It should be clear that according to the new demand
curve, at each price, more potatoes will be bought. For example, at a price of R4 per bag
the quantity demanded increases from 10 000 bags per month to 15 000 bags per month.
FIGURE 3.4
A shift of the demand curve
The situation illustrated in figure 3.4 is called an increase in demand or a shift to the right
of a demand curve. In similar fashion, any decrease in demand (e. g. due to a fall in the
income of households) will result in a shift to the left of the demand curve. This implies
that at each price level fewer potatoes will be demanded than before.
Therefore, a change in the demand due to income or any other reason except price,
will lead to a movement or a shift of the curve itself.
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LEARNING UNIT 3:
Demand, Supply and Price Determination
When demand increases, a rightward shift of the demand curve takes place as illustrated in
figure 3.5(a). The demand curve shifts from dd to d1d1. A decrease in demand is illustrated
by a leftward shift of the demand curve as illustrated in figure 3.5(b). The demand curve
shifts from dd to d2d2.
FIGURE 3.5
Changes in demand
What can we now conclude about the position and the shape (or slope) of the demand
curve?
i. Any change in the price of the product will cause a movement along the demand curve
to the new price level. If the price decreases, more of the product will be de- manded
(moving down along the demand curve). In figure 3.2, this is shown by a movement
from point A to point B to point C and so on. An increase in price leads to a reduction
in the quantity demanded as we move from point E to point D to point C on the dd
curve in figure 3.2. A movement along the demand curve as a re- sult of price changes
is referred to as an increase or decrease in the quantity demanded , but does not
signify any change in demand as such because there was no shift of the demand curve
itself.
ii. A change in any of the other factors (income, price of substitutes, preferences, population, etc.) will lead to a shift of the demand curve itself. This is referred to as a
change in the demand for the product. The shift of the demand curve can be to either the left or the right, depending on the circumstances. A shift to the right (figure
3.5 (a)) means an increase in demand, while a shift to the left (figure 3.5 (b)) implies a
decrease in demand.
It is very important to understand the difference between a movement along the demand
curve and a shift of the demand curve. Figure 3.6 illustrates an increase in the quantity
demanded, due to a decrease in the price, while Figure 3.6(b) illustrates an increase in
demand, e. g. due to an increase in income. Make sure you are also able to differentiate
between a decrease in the quantity demanded (illustrated in Figure 3.3 (b) above) and a
decrease in demand (illustrated in Figure 3.5(b) above).
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LEARNING UNIT 3:
DEMAND, SUPPLY AND PRICE DETERMINATION
FIGURE 3.6
A change in the quantity demanded versus a change in demand
A change in quantity demanded is always due to a change in the price of the product, and is
represented by a movement along the same demand curve. If any one of the other factors
(except price) which influence demand changes, there is a change in demand, which is
represented by a shift of the demand curve.
Table 3.3 below provides a summary of the different variables that can affect demand and
the quantity demanded.
TABLE 3.3 (a)
The effect of a change in the price of a good on the market demand curve
Determinant
Change
Effect on market
demand curve
Correct description of effect
Increase
Upward movement
along the demand
curve
A fall in the quantity demanded
Decrease
Downward movement
along the demand
curve
An increase in the
quantity demanded
Price of the good
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LEARNING UNIT 3:
Demand, Supply and Price Determination
TABLE 3.3 (b)
The effect of changes in other variables on the market demand curve
Prices of goods
that are substitutes in
consumption
Prices of goods
that are complements in
consumption
Income (normal
good)
Taste/
preferences
Population
Expected future
price of the good
Increase
Rightward shift of the
demand curve
An increase in
demand
Decrease
Leftward shift of the
demand curve
A fall in demand
Increase
Leftward shift of the
demand curve
A fall in demand
Decrease
Rightward shift of the
demand curve
An increase in
demand
Increase
Rightward shift of the
demand curve
An increase in
demand
Decrease
Leftward shift of the
demand curve
A fall in demand
An increased desire to buy
Rightward shift of the
demand curve
An increase in
demand
A reduced desire
to buy
Leftward shift of the
demand curve
A fall in demand
Increase
Rightward shift of the
demand curve
An increase in
demand
Decrease
Leftward shift of the
demand curve
A fall in demand
Price is expected
to increase
Rightward shift of the
demand curve
An increase in
demand
Price is expected
to fall
Leftward shift of the
demand curve
A fall in demand
Source: Mohr et al (2008:120)
You should be able to understand the effect of a change in price on quantity demanded
(table 3.3(a)), as we have discussed this in detail above. We will now discuss how each of the
other variables, except price, that are summarised in table 3.3(b) will influence demand.
If two goods are substitutes in consumption, it means that consumers can replace the one
good with the other good. Potatoes and rice are both popular starchy foods, and therefore
rice can be regarded as a substitute in consumption for potatoes. If the price of rice increases,
this will result in a decrease in the quantity of rice that consumer will demand. This is
illustrated in figure 3.7 (a). Since potatoes is a substitute for rice, the demand for potatoes
will now increase. This increase in demand can be illustrated by a rightward shift of the
demand for potatoes curve as shown in figure 3.7(b). Similarly, you should be able to explain
that a decrease in the price of rice will result in a decrease in the demand for potatoes (i.e. a
leftward shift of the demand curve), as potatoes is a substitute in consumption for rice.
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LEARNING UNIT 3:
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FIGURE 3.7
The effect of a change in the price of a substitute in consumption
If two goods are complements in consumption, it means that they are used together. Fish
and chips is a very popular combination; therefore, we can say that fish and potatoes (that
are used to make chips) are complements in consumption That will mean that when more
fish is bought, more chips will also be required, thus more potatoes will be needed to make
the chips. If the price of fish increases, this will result in a decrease in the quantity of fish
that will be demanded. This is illustrated in figure 3.8(a). Since less chips will now be needed,
the demand for potatoes will decrease. This is illustrated by a leftward shift of the demand
for potatoes in figure 3.8 (b). Similarly, you should be able to explain that a decrease in the
price of fish will result in an increase in the demand for potatoes (i. e. a rightward shift of the
demand curve), as potatoes is a complement in consumption for fish.
FIGURE 3.8
The effect of a change in the price of a complement in consumption
We have already explained that an increase in income will mean that more of every good
that consumers buy can now be afforded, and therefore the demand for most goods will
increase.
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LEARNING UNIT 3:
Demand, Supply and Price Determination
There are certain goods that consumers buy when their income is low, because they cannot
afford to buy other more expensive goods. A good South African example of such a good
is maize meal. Many consumers buy a lot of maize meal because they cannot afford to buy
any other food. When their income increases, they still buy maize meal, but because they can
now afford to buy other types of foods, such as meat, vegetables and fruit, they buy less
maize meal than before the increase in income. We call such goods inferior goods – the
demand for such inferior goods will decrease when income increases. You will learn more
about inferior goods in learning unit 5 when we study elasticity. However, for normal goods,
the demand will increase when income increases, and this will be illustrated by a rightward
shift of the demand curve. A decrease in income will result in a decrease in demand, thus a
leftward shift of the demand curve.
A change in consumers’ preferences or taste may result in a change in demand. Suppose
that new research shows that potatoes contain health benefits that were previously
unknown, and this is publicised widely, this will result in an increase in the demand for
potatoes, which is illustrated by a rightward shift of the demand curve. Similarly, if a large
percentage of the population decides to follow the Banting diet that does not allow for the
eating of potatoes, the demand for potatoes will decrease, which we can illustrate with a
leftward shift of the demand curve for potatoes.
When the population of the country increases, it will mean that there are now more people
who want to eat potatoes, and therefore the demand for potatoes will increase, illustrated by
a rightward shift of the demand curve. Similarly, a decrease in the population will result in a
decrease in demand, and this is illustrated with a leftward shift of the demand curve.
When the price of a product is expected to increase in the future, and it does not have to
be consumed immediately (i.e. you can keep it for a while), consumers will buy more of the
good now in order to avoid paying higher prices in the future. Therefore, at the current
price, the demand will increase, illustrated by a rightward shift of the demand curve.
Similarly, when the price of a product is expected to fall, people will try to buy as little of
this now and wait until the price has fallen before they buy it; therefore, the current demand
will decrease, illustrated by a leftward shift of the demand curve.
LEARNING ACTIVITY 3.4
Choose the correct answer
(a) Indicate by ticking in the correct block, what the result will be of each of the following in the market for new car tyres, which is a normal good:
Event
Decrease
in quantity
demanded
Increase
in quantity demanded
Decrease
in
demand
Increase
in
demand
(i) Increase in price of
new car tyres
(ii) Income of consumers
increases
(iii) Price of retreaded car
tyres, which is a substitute in consump-
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LEARNING UNIT 3:
DEMAND, SUPPLY AND PRICE DETERMINATION
tion for new tyres,
increases
(iv) Price of cars, which is
a complement in
consumption for new
tyres, increases
(v) The price of new tyres
is
expected
to
increase substantially
in three months' time
(vi) Due to regular strikes
in the public transport industry, the
number of persons
who
drive
cars
increases
(b) Indicate by ticking in the correct block, how each of the following events in the market for new car tyres, which is a normal good, will be illustrated:
Event
(i) Increase in price of
new car tyres.
(ii) Income of consumers
increases
(iii) Price of retreaded car
tyres, which is a substitute in consumption for new tyres,
increases
(iv) Price of cars, which is
a complement in
consumption for new
tyres, increases
(v) The price of new tyres
is
expected
to
increase substantially
in three months' time
(vi) Due to regular strikes
in the public transport industry, the
number of persons
who
drive
cars
increases
50
Upward
movement
along the
demand
curve
Downward
movement
along the
demand
curve
Leftward
shift of
the demand
curve
Rightward shift
of the demand
curve
LEARNING UNIT 3:
3.3
Demand, Supply and Price Determination
SUPPLY
We can now shift our attention from demand to supply. The demand schedule indicated
the relationship between prices and the quantities consumers wish to buy. How is the supply
schedule defined?
The supply schedule (or supply curve) shows the relationship between the market price of
a product and the quantities of those product producers are willing to supply on the market.
TABLE 3.4
The supply schedule shows the relationship between price and quantity supplied
Price (rand per bag)
Quantity supplied (bags
per month)
A
5
18 000
B
4
16 000
C
3
12 000
D
2
7 000
E
1
0
From the supply schedule in table 3.4 and the resultant supply curve in figure 3.9, we can
derive the law of supply.
.................................................................................................................................................................
The law of supply states that the higher the price of a good, the greater the quantity
supplied, or the lower the price the smaller the quantity supplied (all other things
remaining the same).
.................................................................................................................................................................
Figure 3.9 clearly shows that more bags of potatoes will be offered only at higher prices. If
the price drops to R1 per bag, no potatoes will be produced. This is presumably because
the production cost per bag is more than R1.
As was the case with demand, we again look just at the relationship between the price of
the product and the quantity supplied.
Clearly the amount producers plan to sell on the market will depend on a variety of factors,
such as:
●
●
●
●
●
●
the price of the product
the price of alternative products
the price (or cost) of factors of production
expected future prices
the state of technology
weather conditions
Apart from the first factor (the price of the product), all the other factors are basically
concerned with the cost of production. The supply of a product depends on the cost of
production.
As with the demand curve, any change in the price of the product will result in a movement
along the supply curve to a new price level. There will be a change in the quantity
supplied.
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LEARNING UNIT 3:
DEMAND, SUPPLY AND PRICE DETERMINATION
FIGURE 3.9
The supply curve
If the price of potatoes were to increase, farmers would utilise more and more of their
available land at these higher prices for the cultivation of potatoes. They would also be able
to afford more fertilisers, tractors and so forth. Some of them would even use new land,
which previously had been used for other purposes, for the cultivation of potatoes. All this
will lead to a movement along the supply curve in figure 3.9 and an increase in the quantity
supplied.
However, if technological advances in agriculture lead to cheaper production costs in the
potato industry, farmers are in a position to supply more bags of potatoes at each price
level. This leads to a shift in the supply curve to the right, which is illustrated with the aid
of table 3.5 and figure 3.10. As a result of the reduction in costs, the supply curve shifts to
the right from SS to S'S'.
TABLE 3.5
The supply schedule shows the old and new relation-ship between price and quantity
supplied
Price (rand
per bag)
52
Old quantity
plied
(bags
month)
supper
New quantity supplied
(bags per month)
A
5
18 000
27 000
B
4
16 000
24 000
C
3
12 000
20 000
LEARNING UNIT 3:
Demand, Supply and Price Determination
D
2
7 000
16 000
E
1
0
8 000
Any situation which causes production costs to rise (i.e. higher input prices) will cause an
upward shift (to the left) of the supply curve. This implies that less will be supplied at each
price level than before.
FIGURE 3.10
A shift in the supply curve
A change in the price of a good will result in a change in the quantity supplied and a
movement along the supply curve. An increase in the price of a product means that more
suppliers will be able to supply the product profitably; therefore, the quantity supplied of
the product can be expected to increase when the price of the product increases. We can
illustrate this by a rightward shift along the supply curve, as in figure 3.11(a) from point A
to point B.
A decrease in the price of the good means that fewer suppliers will find it profitable to
produce the good, and therefore the quantity supplied will decrease as illustrated in figure
3.11(b) by the movement from point B to point A along the same supply curve.
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LEARNING UNIT 3:
DEMAND, SUPPLY AND PRICE DETERMINATION
FIGURE 3.11
Changes in quantity supplied due to a change in the price of a product
When it becomes more expensive to produce a particular product, it will mean that suppliers
will only be willing to supply every quantity of a good at a higher price. At the same price,
for example, P1 in figure 3.12(a), suppliers will be willing to supply less of the product, for
example, Q2. Therefore, we call this a decrease in supply and it is illustrated
by a leftward shift of the demand curve, for example, from S to S1 in figure 3.12(a).
When the cost of supplying a particular product decreases, it means that suppliers will now
be willing to supply every quantity of that good at a lower price. We call this an increase in
supply and it is illustrated by a downward shift of the supply curve to the right, for
example, from S to S2 in figure 3.12(b). At the same price, P1 suppliers will be willing to
produce more products, for example, Q2.. Suppliers will be willing to supply the same
quantity of a particular good, for example, Q1 at a lower price, for example, P2, than before
the decrease in the cost.
FIGURE 3.12
A change in supply
54
LEARNING UNIT 3:
Demand, Supply and Price Determination
It is important to distinguish between a change in supply and a change in the quantity
supplied. A change in the quantity supplied takes place due to a change in the price of the
good, and is illustrated by a movement along the same supply curve. Figure 3.13 (a) illustrates
a decrease in the quantity supplied due to a decrease in the price. A change in supply can be
due to any other factor, except price, that will affect the supply of a product. A decrease in
supply means that circumstances have changed so that suppliers will be willing to supply less
of particular good at the same price, and is illustrated by a leftward and upward shift of the
supply curve. You should also be able to explain an illustrate the difference between an
increase in quantity supplied and an increase in supply.
FIGURE 3.13
A change in the quantity supplied versus a change in supply
Table 3.6 summarises which changes will result in a shift of the supply curve and which will
cause a movement along the supply curve. We shall now discuss the factors that can result
in a change in supply, or a shift of the supply curve.
Substitutes in production are products that can be produced instead of the other. For
example, potatoes and carrots can be grown using the same resources; therefore, potatoes
and carrots are substitutes in production. When the price of carrots increases, farmers will be
able to make more profit by planting carrots instead of potatoes. Therefore, the quantity of
carrots supplied will increase. In figure 3.14 (a), this is illustrated by a movement along the
supply curve of carrots, and the quantity of carrots increases from Q1
to Q2 when the price increases from P1 to P2.
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LEARNING UNIT 3:
DEMAND, SUPPLY AND PRICE DETERMINATION
TABLE 3.6 (a)
The effect of a change in the price of a good on the market supply curve
Determinant
Price of the
good
Effect on market
supply curve
Correct description of
effect
Increase
Upward movement
along the supply curve
An increase in the quantity supplied
Decrease
Downward movement
along the supply curve
A decrease in the quantity supplied
Change
TABLE 3.6 (b)
The effect of changes in other variables on the market supply curve
Price of alternative goods
(substitutes in
production)
Prices of joint
products
(complements
in production)
Prices of
inputs
Expected
future prices
Technology
Number of
firms (sellers)
Increase
Leftward shift of the
supply curve
A decrease in
supply
Decrease
Rightward shift of the
supply curve
An increase in
supply
Increase
Rightward shift of the
supply curve
An increase in
supply
Decrease
Leftward shift of the
supply curve
A decrease in
supply
Increase
Leftward shift of the
supply curve
A decrease in
supply
Decrease
Rightward shift of the
supply curve
An increase in
supply
Price is expected
to increase
Rightward shift of the
supply curve
An increase in
supply
Price is expected
to fall
Leftward shift of the
supply curve
A decrease in
supply
Cost-reducing improvement in
technology
Rightward shift of the
supply curve
Cost-increasing
changes in
technology
Leftward shift of the
supply curve
More firms enter
market
Rightward shift of the
supply curve
An increase in
supply
Firms leave
market
Leftward shift of the
supply curve
A decrease in
supply
Source: Mohr et al (2008:126)
56
An increase in
supply
A decrease in
supply
LEARNING UNIT 3:
Demand, Supply and Price Determination
FIGURE 3.14
The effect of a change in the price of a substitute in production
Since the resources are now used to produce carrots, the supply of potatoes will decrease. Less
potatoes will be produced at every price level because the resources are being used to
produce carrots instead. This is illustrated by a leftward shift of the supply of potatoes curve
as illustrated in figure 3.14 (b). Similarly, a decrease in the price of a substitute in production
will result in an increase in demand for the product concerned. You should be able to explain
and illustrate such a situation as well.
Complements in production are products that are produced jointly, for example, beef and
leather. When a farmer who is farming cattle to supply beef to the market increases the
production of beef, more leather becomes available to the market at the same time. Leather
and beef are therefore complements in production. When the price of beef increases, the
supply of beef will increase. This is illustrated by an upward shift along the supply curve of
beef. The quantity of beef supplied increases, for example from Q1 to Q2
in figure 3.15(a). Because more leather becomes available when more beef is produced, the
supply of leather will increase. This is illustrated by a rightward shift of the supply of leather
curve to S1 Leather in figure 3.15(b). You should also be able to explain and illustrate how a
decrease in the price of a complement in production will influence the supply of the
complementary product.
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LEARNING UNIT 3:
DEMAND, SUPPLY AND PRICE DETERMINATION
FIGURE 3.15
The effect of a change in the price of a complement in production
When the price of the inputs that are used to produce a particular product increases, this will
mean that each quantity of the product can now only be produced at a higher price, and
therefore the supply curve will shift upwards. For example, in figure 3.16, quantity Q1 of
potatoes could be supplied at a price of P1. Suppose that the average wage rate of labour in
the potato industry now increases. This means that the cost of producing quantity Q1 has
now increased, and suppliers will therefore only be willing to sell this quantity at a higher
price, namely P2. This will apply to every quantity; therefore, the whole supply curve will
shift upwards and to the left to S1 as illustrated in figure 3.16. This is called a decrease in
supply. A decrease in the price of inputs will mean that suppliers will be willing to supply
every quantity at a lower price; therefore, the supply curve will shift downwards and to the
right. This will be called an increase in supply.
FIGURE 3.16
The effect of an increase in the price of inputs on supply
58
LEARNING UNIT 3:
Demand, Supply and Price Determination
When the price of the product is expected to increase in the future, this will mean that
suppliers will be expecting to make more profit by selling the product at a higher price in
the future. Therefore, there will be more suppliers that will be willing to sell the good, and
therefore the supply of the good will increase. This will be illustrated by a rightward shift of
the supply curve. Similarly, an expected decrease in the price of a product will mean that
fewer suppliers will be willing to supply the product; therefore, supply will decrease and this
can be illustrated by a leftward shift of the supply curve.
When technology improves so that it will now be possible to produce more of a good at a
certain cost, this is an increase in supply and will be illustrated by a rightward shift of the
supply curve. When technology changes so that it becomes more expensive to produce a
product, this is a decrease in supply and we can illustrate this with a leftward shift of the
supply curve.
When more firms enter into a specific market, it will mean that more of that particular good
can be supplied at every price level. The supply will increase and we can illustrate this with
a rightward shift of the supply curve. When firms leave the market, the opposite will take
place – less of a good can now be supplied at every price level, which means that supply has
decreased, and this is illustrated by means of a leftward shift of the supply curve.
LEARNING ACTIVITY 3.5
Choose the correct answer
(a) Indicate if the following statements are true or false:
Statement
True
False
i. Suppliers supply products to the market because they like to do good deeds.
ii. If there is a demand for a product, it will be
supplied.
iii. Supply refers to the quantity of a good that
is available in a particular shop.
iv. Supply refers to the quantities of a good or
service that producers plan to sell at different
prices.
(b) Choose the correct option in brackets to describe the law of supply.
Given that all other things (remain the same; change), if the price of a good or service
increases, the quantity supplied will (decrease; increase), and if the price of a good or
service decreases, the quantity supplied will (increase; decrease). This indicates that a
(negative; positive) relationship exists between the price of the good and the quantity
supplied.
(c) Indicate, by ticking the correct block, what the result will be of each of the following
in the market for new car tyres, which is a normal good:
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LEARNING UNIT 3:
DEMAND, SUPPLY AND PRICE DETERMINATION
Event
(i) The price of new
car
tyres
increases.
(ii) The price of
cement which
also uses rubber in production, and is a
substitute in
production for
tyres, decreases.
(iii) The price of
rubber boots,
which is made
from off fall
rubber from
the tyre production process, increases.
(iv) The wages of
labourers in
the tyre manufacturing industry increases.
(v) The price of
tyres is expected to increase
in three
months' time.
(vi) New technology makes it
possible to
produce tyres
twice as fast
as previously
with the same
number of
workers.
(vii) Due to high
profits in the
tyre industry, a
few new firms
enter
the
industry.
60
Decrease in
quantity
supplied
Increase in
quantity
supplied
Decrease in Increase in
supply
supply
LEARNING UNIT 3:
Demand, Supply and Price Determination
(d) Indicate by ticking the correct block, how the each of the following events in the
market for new car tyres, which is a normal good, can be illustrated:
Event
Downward
movement
along the
supply curve
Upward
movement
along the
supply
curve
Leftward
shift of the
supply
curve
Rightward
shift of the
supply
curve
(i) The price of
new car tyres
increases.
(ii) The price of
cement,
which
also
uses rubber in
production and is a
substitute in
production for
tyres, decreases.
(iii) The price of
rubber boots,
which is made
from off fall
rubber from
the tyre production process,
increases.
(iv) The wages of
labourers in
the tyre
manufacturing industry increases.
(v) The price of
tyres is expected to increase
in three
months' time.
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LEARNING UNIT 3:
DEMAND, SUPPLY AND PRICE DETERMINATION
(vi) New technology makes it
possible
to
produce tyres
twice as fast as
previously
with the same
number
of
workers.
(vi- Due to high
i) profits in the tyre
industry, a few
new
firms
enter
the
industry.
3.4
PRICE DETERMINATION
.................................................................................................................................................................
There are two fools in every market; one asks too little, and one asks too much.
Russian proverb
.................................................................................................................................................................
We now know what demand and supply curves look like, but when examining figure 3.2 or
figure 3.9, we still do not know precisely at what price the potatoes will be traded on the
market. We have only analysed various hypothetical prices to see how consumers (as
demanders) and producers (as suppliers) will react to them – but at exactly what prices
transactions will be concluded has yet to be determined.
There are other things we do not know either. For instance, when the demand increases, as
is indicated in figure 3.4, will the price of potatoes increase or decrease? Or when the supply
increases, as is shown in figure 3.10, what will happen to the price of potatoes?
The answer to all these questions lies in the fact that we have to combine our analysis of
demand and supply to see how price is determined in a free-market situation. The
combining of demand and supply, which is perhaps the most important principle in
Economics, appears in table 3.7. Thus far, we have considered all prices as possible. We, in
fact, said "If the price is such and such, the sales will be so and so". However, up to what
level will prices actually move? How much will then be produced and consumed?
62
LEARNING UNIT 3:
Demand, Supply and Price Determination
TABLE 3.7
The market equilibrium schedule
Price per
bag
Quantity
demanded
Quantity
supplied
Pressure on
price
(1)
(2)
(3)
(4)
A
5
9 000
18 000
Downward ↓
B
4
10 000
16 000
Downward ↓
C
3
12 000
12 000
Neutral -
D
2
15 000
7 000
Upward ↑
E
1
2 000
0
Upward ↑
Let's consider what the contents of table 3.7 tells us. It shows how much will be produced
at every price level and also how much will be supplied at that price level. When we look at
situation A in table 3.5, we see that when potatoes sell at a price of R5 per bag, the producers
will supply 18 000 bags on the market each month, as can be seen from column (3). The
quantity demanded by consumers will, however, be only 9 000 bags per month, as is
indicated in column (2). As large stocks of potatoes pile up, competing suppliers will be
inclined to reduce their prices in order to sell the excess stock. Thus, as column (4) shows,
the price will tend to decrease when suppliers hold excess stock. Therefore, a price of R5
will not be a stable situation that can continue. We say that R5 is not an equilibrium price.
To explain the situation further, we now look at point D, where the price is only R2 per bag
of potatoes. Can this price persist? Once again, the answer is no, since a comparison of
columns (2) and (3) shows that at that price, quantity demanded will exceed production.
There will be a shortage on the market, and disappointed buyers who really want potatoes
will tend to bid the price up. If the price falls further to R1 per bag, we see that no potatoes
will be produced. This upward pressure on prices is shown in column (4) by the rising arrow.
We could go on to try other prices, but by now the answer should be obvious.
A state of balance between suppliers and consumers can be reached only at point C. At the
price of R3 per bag, the quantity demanded equals the quantity supplied. In Economics, we
refer to such a point as the equilibrium. At this point, none of the participants has any
incentive to change their behaviour, because they are totally content with the situation.
.................................................................................................................................................................
The equilibrium price is the only price which can persist in the long run. It is the price at
which the quantity voluntarily supplied and the quantity voluntarily demanded are equal.
Competitive equilibrium must be at the point where the quantity demanded and
quantity supplied are the same.
.................................................................................................................................................................
Only at point C, at a price of R3, will the quantity demanded by the consumers, that is, 12
000 bags per month, be exactly equal to the quantity supplied by the producers. This is the
equilibrium price since there is no tendency for the price to fall or to rise. In all probability,
this equilibrium price will not be reached immediately and oscillation around the right level
may occur until equilibrium is finally reached and the quantity demanded is equal to the
quantity supplied.
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LEARNING UNIT 3:
DEMAND, SUPPLY AND PRICE DETERMINATION
The equilibrium situation is very neatly shown in graphical form in figure 3.17. The demand
and supply curves, which both appear in the diagram, intersect at only one point (the curves
are not drawn exactly according to scale in the figure). This point represents the equilibrium
price and quantity. The diagram shows that at a higher price (more than R3), quantity supply
exceeds quantity demand. The arrows point downwards to show the direction in which the
price will move because of the competition between sellers. At a price lower than the
equilibrium price of R3, the quantity demanded is greater than the quantity supplied, as
shown in the diagram. The anxiousness of buyers to buy the product will put upward
pressure on the price, as the arrows indicate. Only at the point of intersection will the
upward and downward forces be in balance.
FIGURE 3.17
Market equilibrium where demand and supply curves intersect
LEARNING ACTIVITY 3.6
Choose the correct answer
(a) Indicate if the following statements are true or false:
Statement
(i) A market is in equilibrium if the quantity demanded is equal to the quantity supplied.
(ii) At any price above the equilibrium price, there
will be an excess demand for the good in
question.
(iii) Excess demand for a good will put downward
pressure on the price of the good.
64
True
False
LEARNING UNIT 3:
Demand, Supply and Price Determination
(iv) If the price of television sets is lower than the
equilibrium price, there will be an excess demand for television sets.
(v) If the price of running shoes is above the
equilibrium price, there will be an excess supply of running shoes.
(b) Complete the table that provides information on the market for CoolCat, a new kind
of soft drink, by indicating in column 4 whether excess demand, excess supply or
equilibrium exists, and indicating in column 5 the pressure on prices (downward, upward or neutral).
1
PRICE
(R)
2
QUANTITY
DEMANDED
3
QUANTITY
SUPPLIED
10
100
900
9
200
800
8
300
700
7
400
600
6
500
500
5
600
400
4
700
300
3
800
200
4
Excess demand/equilibrium/ excess
supply
5
Pressure on prices (downward/
upward/neutral)
LEARNING ACTIVITY 3.7
Draw your own graph
Use the information in the table above and draw the demand curve and the supply curve
for CoolCat. Clearly label the axes and the curves, and indicate the equilibrium price and
quantity in the graph.
NOTE
The demand and supply curves which we have used in our analysis are, strictly speaking,
applicable to a perfectly competitive market where a reasonably standardised product such
as potatoes is sold and where a great number of buyers and sellers play a role. The curves
that were used are important tools which reflect the operation of such a market. Very few
markets can be regarded as being perfectly competitive. As we will see in the learning unit
dealing with the public sector, elements such as market imperfections and monopolistic
powers can also play a role, which makes it necessary to adapt our model. Consequently, it
is necessary to be aware of the fact that the world is a mixture of competition and market
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LEARNING UNIT 3:
DEMAND, SUPPLY AND PRICE DETERMINATION
imperfections. Nonetheless, with the necessary assumptions and reservation, our model
remains an indispensable tool to analyse the real world.
LEARNING ACTIVITY 3.8
Quiz on learning unit 3
Note that you can also do this quiz on myUnisa to get immediate feedback. The answers to
the quiz will also become available on myUnisa under Additional Resources at the end of
the week allocated to studying learning unit 3.
66
LEARNING UNIT 3:
Demand, Supply and Price Determination
Indicate whether each of the following statements is TRUE or FALSE:
STATEMENT
TRUE
FALSE
1. The determinants of demand include a range of factors, such as the price of the product, the prices of
other products and the income of households.
2. If the demand curve for good B shifts if there is a
change in the price of good A, good B can be either
a complement of or a substitute for good A.
3. An upward movement along a given demand curve
is referred to as a decrease in quantity demanded.
4. If A and B are complements, a fall in the price of A
will lead to an increase in the demand for B, that is,
the demand curve for B will shift to the right, ceteris paribus.
5. An increase in the income of households is one of the
possible causes of a rightward shift of a demand
curve.
6. Supply refers to the quantities of a good or service
that producers plan to sell at different prices.
7. A supply curve is an illustration of the quantities
supplied at different prices, on the assumption that
all other factors that can influence the quantity supplied remain unchanged.
8. An increase in the price of any of the factors of production will result in an upward (leftward) shift of
the supply curve.
9. In their supply decisions, producers take account of
the prices of all the alternative products they can
produce.
10. An increase in the price of potatoes will lead to an
increase in the quantity of potatoes supplied, ceteris
paribus.
11. A market can be in equilibrium only if demand is
equal to supply.
12. A market can be in equilibrium only if the quantity
demanded is equal to the quantity supplied.
13. At any price above the equilibrium price, there will
be an excess demand for the good in question.
14. Excess demand for a good will put downward pressure on the price of the good.
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LEARNING UNIT 3:
DEMAND, SUPPLY AND PRICE DETERMINATION
LEARNING ACTIVITY 3.9
Short questions on learning unit 3
1. The law of demand applies only when the price of other products
.
2. The relationship between quantity demanded and price is called a demand schedule,
and can be represented by means of a
.
3. An increase in income will result in a movement (along/of) the demand curve.
4. The supply curve slopes (upwards/downwards) from left to right.
5. A change in the price of a product will result in a (movement along/shift of) the demand curve.
6. A change in the cost structure of a firm will be reflected in a
of the supply
curve.
7. Consider the market for coffee in Utopia. For each of the following statements, explain whether it could be illustrated by a movement along the demand curve or by a
shift of the demand curve. If the latter, would the curve shift to the left or to the right?
7.1 The price of tea, a substitute for coffee, increases.
7.2 The price of coffee decreases because of a large increase in coffee bean
harvesting.
7.3 The average household income in Utopia increases.
7.4 The price of coffee in the domestic market increases because farmers want to
export as many coffee beans as possible.
7.5 The media reports widely on the medical advantages of coffee.
8. Consider the demand for wireless speakers in South Africa. For each of the following
statements, explain whether it could be illustrated by a movement along the demand
curve or by a shift of the demand curve. If the latter, would the curve shift to the left
or to the right?
8.1 Due to low-cost Chinese imports, the price of wireless speakers decreases
sharply.
8.2 More people decide to use wireless speakers, due to the convenience.
8.3 The quality of speakers built into cell phones improves, so that wireless spea=
kers are no longer required to play music.
8.4 The price of wireless speakers decreases due to improved production
techniques.
9. Consider the supply of cotton in Mali. For each of the following statements, explain
whether it could be illustrated by a movement along the supply curve or by a shift of
the supply curve. If the latter, would the curve shift to the left or to the right?
9.1 A severe drought hits the cotton-producing areas in the Mali.
9.2 Genetically modified seeds allow farmers to greatly increase the production of
cotton.
9.3 The government imposes minimum wage legislation on agricultural labour in
Mali, which results in a 60% increase in the average wage of cotton farm
workers.
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LEARNING UNIT 3:
Demand, Supply and Price Determination
ADDITIONAL RESOURCES THAT CAN BE CONSULTED
If you are interested to find out more about the topics covered in this learning unit, you
can consult the following sources:
Mohr, P & Associates. 2015 (or other editions). Economics for South African students. Pretoria:
Van Schaik: Chapter 4.
Janse van Rensburg, J, McConnell, CR & Brue, SL. 2011. Economics: Southern African Edition.
Berkshire: McGraw-Hill: Chapter 3, page 51–63.
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69
LEARNING UNIT 4
Changes in Demand and Supply
CONTENTS
4.1
INTRODUCTION
71
4.2
Changes in demand
71
4.3
CHANGES IN SUPPLY
75
4.4
THE CETERIS PARIBUS CONDITION
80
4.5
SIMULTANEOUS CHANGE IN DEMAND AND SUPPLY
80
Mind map of changes in demand and supply
70
LEARNING UNIT 4:
Changes in Demand and Supply
Econosavvity
To pass this module, you will be expected to understand the following concepts and
apply them to economic situations:
●
●
●
●
●
●
4.1
change in demand
change in supply
change in quantity demanded
change in quantity supplied
change in equilibrium price
change in equilibrium quantity
INTRODUCTION
We are now in a position to analyse the effects of changes in demand and supply on prices.
In this learning unit, the difference between movements along a curve and shifts of a curve
becomes very important. From experience, we know that a sudden reduction in the supply
of a product (e.g. as a result of a severe drought affecting agricultural production) leads to
an increase in food prices. Similarly, technological advances together with a drop in
production costs lead to an increase in the availability of computer equipment and a
consequent reduction in prices.
4.2
CHANGES IN DEMAND
We start with the effect of changes in demand on the price level. Figure 4.1(i) illustrates
how an increase in demand (shift from DD to D1 D1 – arrow (1)) leads to an increase in
price from P to P1 on the vertical axis. At the same time, there is a movement along the
supply curve from E to E1 (arrow (2). Also note that the equilibrium quantity sold on the
market (measured on the horizontal axis) increased from Q to Q1.
FIGURE 4.1
The effect of a change in demand
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LEARNING UNIT 4:
CHANGES IN DEMAND AND SUPPLY
In figure 4.1 (ii), we see the effect of a decrease in demand on the equilibrium price and
quantity. Unlike when there is an increase in demand, there is now a decline in both the
price and quantity sold on the market. Note that in both figure 4.1(i) and (ii), the change in
the price level is accompanied by a change in the quantity in the same direction. This must
be the case because the SS curve (which does not change in the analysis above) has a positive
slope.
In table 3.3 (b), we showed how several factors may affect demand. Let's now consider how
changes in some of those factors will affect the equilibrium income level and the equilibrium
price level. Suppose that the market for roast chicken take-away meals in a small town is in
equilibrium at a price of R35 a meal and that 1 500 meals will be sold per month at that
price. This equilibrium position is represented by E0 in figure 4.2.
Suppose that the income level in the small town now increases. The increase in income
means that inhabitants of the town can now buy more take-away meals, thus the demand
for roast chicken meals increases. We illustrate this by means of a rightward shift of the
demand curve from D to D'. At the original price of R35, the quantity demanded of roast
chicken take-away meals will now be 2 500 meals, while suppliers are willing to supply
1 500 roast chicken meals. This means that there will now be excess demand for roast
chicken meals. This will result in upward pressure on the price level. As illustrated in figure
4.2, the price will go up to R40, where the quantity demanded of 2 000 is once again equal
to the quantity supplied.
So to recap: due to the increase in income, demand increases. This results in an increase in
the equilibrium price and an increase in the equilibrium quantity in the market for roast
chicken take-away meals.
FIGURE 4.2
The effect of an increase in income on equilibrium in the market for roast chicken takeaway meals
Let us consider another example of a change in demand. Suppose hamburger take-away
meals and roast chicken take-away meals are close substitutes. The price of roast chicken
72
LEARNING UNIT 4:
Changes in Demand and Supply
take-away meals now decreases. This will result in an increase in the quantity of roast
chicken take-away meals that will be bought (a movement along the demand curve for roast
chicken take-away meals). As hamburger take-away meals is a close substitute for roast
chicken take-away meals, consumers will now want to buy less (of the relatively more
expensive) hamburger take-away meals. This is illustrated by a leftward shift of the demand
curve for hamburger take-away meals, as illustrated by the shift from D to D' in figure 4.3.
At the original price of R34 for a hamburger take-away meal, there will now be excess supply
of hamburger take-away meals. This results in downward pressure on prices. When the price
has decreased to R30, quantity demanded will once again equal quantity supplied.
The decrease in the price of roast chicken take-away meals therefore resulted in decrease in
demand for hamburger take-away meals. This results in equilibrium at a lower price for
hamburger take-away meals, and the equilibrium quantity that will be sold in this market is
also now lower.
FIGURE 4.3
The effect of a decrease in the price of a substitute on equilibrium in the market for
hamburger take-away meals
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LEARNING UNIT 4:
CHANGES IN DEMAND AND SUPPLY
Make sure that you will be able to explain the effect of each of the factors listed in table
3.3(b) on the equilibrium price and equilibrium quantity.
LEARNING ACTIVITY 4.1
Choose the correct answer
Questions a and b are based on the following figure:
74
LEARNING UNIT 4:
Changes in Demand and Supply
(a) The rightward shift of the demand curve from D to D1 is the result of a(n)
i. increase in supply
ii. increase in demand
iii. decrease in supply
iv. decrease in demand
.
(b) Which of the following factors would explain a shift of the demand curve from D to
D1? Select ALL of the answers that are relevant.
i. an increase in the number of suppliers
ii. an increase in the number of households
iii. a decrease in the price
iv. a decrease in income
v. a decrease in the cost of production
vi. an increase in the taste and preference for the product
LEARNING ACTIVITY 4.2
Draw your own graph and discuss it
The inhabitants of the small country Zumenia mainly uses potatoes to make chips.
Therefore, they need oil to fry the chips. Explain with the aid of diagrams how the
equilibrium price and quantity of oil will be affected when the price of potatoes decreases.
4.3
CHANGES IN SUPPLY
In figure 4.4, the effect of changes in supply (due to changes in the cost structure of firms)
is shown. Figure 4.4 (i) shows us what might have been happening in the computer industry
during the past decade or more. As a result of technological factors (i. e. microchip
production), the supply of computers increased from SS to S1S1. This rightward
shift in supply resulted in a price reduction from P to P1. At the same time, the quantity of
computers sold increased from Q to Q1. You will notice immediately that the change in
the quantity sold is in the opposite direction to that of the price change. This is obviously
because the demand curve (which does not change) has a negative slope.
In figure 4.4(ii), the situation of an increase in costs (e.g. because of wage increases) and the
resultant upward shift of the supply curve from SS to S1S1 is shown. Once again, the change
in price is in the opposite direction to that of the change in quantity.
It is immediately clear that a situation such as the one depicted in figure 4.4 (ii) is highly
unsatisfactory, since the increase in prices is accompanied by lower production levels. If
such a situation is prevalent in all the firms of the economy, we have what is known as
stagflation. The name is derived from the fact that we are faced with stagnation in
production combined with inflation (price increases).
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LEARNING UNIT 4:
CHANGES IN DEMAND AND SUPPLY
FIGURE 4.4
The effect of a change in supply
Table 3.6(b) shows various factors that may affect the position of the supply curve. Let's
look at two examples to make sure we understand how changes in the factors that determine
the position of the supply curve may affect the equilibrium position in the economy.
Point E0 in figure 4.5 shows that the market for solar geysers in a small country is in
equilibrium at a price of R12 000 for a 150 litre solar geyser. At this price, 15 000 solar
geysers are sold annually. Suppose it becomes known that the price of solar geysers will be
expected to fall in future because new technology is going to be introduced. What will
now happen in the market for solar geysers and how will we illustrate it?
Because the price of solar geysers is expected to fall, some suppliers may feel that it will no
longer be viable to produce solar geysers, and they may leave this market. This will result in
a decrease in supply. A decrease in supply is illustrated by a leftward or upward shift of the
supply curve, for example from S to S' in figure 4.5.
The result is that the decrease in supply results in excess demand at the current price of R12
000. Supply is only equal to 5 000 but the current demand is 15 000 units. This results in
upward pressure on the price. This price increase will continue until the quantity demanded
and quantity supplied are once again equal. Point E1 in figure 4.5 shows the
new equilibrium position, at a higher price and a lower quantity. This change is due to the
change in supply which was caused by an expectation of a decrease in the price of solar
geysers in the future.
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LEARNING UNIT 4:
Changes in Demand and Supply
FIGURE 4.5
The effect of an expected decrease in the price of solar geysers on equilibrium in the
market for solar geysers
Let us now suppose that an improvement in technology takes place that makes it cheaper
to produce solar geysers. This means that more solar geysers can be produced at the same
price, and we can illustrate this by a rightward shift of the supply curve, as shown by the
shift from S to S' in figure 4.6. The increase in supply means that there will be excess supply
at the original equilibrium price of R17 000. This results in downward pressure on the price
level. At a price of R14 000, the quantity demanded and the quantity supplied will once again
be equal; therefore, E2 is the new equilibrium position in the market for solar
geysers. The price is lower and the equilibrium quantity higher than prior to the
improvement in technology.
FIGURE 4.6
The effect of an improvement in production technology on equilibrium in the market for
solar geysers
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LEARNING UNIT 4:
CHANGES IN DEMAND AND SUPPLY
Please make sure you are able to illustrate how a change in each of the determinants
mentioned in table 3.6(b) will affect the equilibrium position in a market.
LEARNING ACTIVITY 4.3
Choose the correct answer
Questions (a) and (b) are based on the following diagram:
(a) The rightward shift from S to S1 is the result of a(n) …
i.
ii.
iii.
iv.
78
increase in supply.
increase in demand.
decrease in supply.
decrease in demand.
LEARNING UNIT 4:
Changes in Demand and Supply
(b) Which of the following factors would explain a rightward shift of the supply curve
from S to S1? Select ALL of the relevant choices.
i.
ii.
iii.
iv.
v.
vi.
vii.
an increase in the number of suppliers
an increase in the number of households
a decrease in the price
a decrease in income
a decrease in the cost of production
an increase in the taste and preference for the product
an improvement in the technology used
LEARNING ACTIVITY 4.4
Discussion forum
Have a look at the following two pictures. Visit the discussion forum for learning activity
4.4 on myUnisa and explain how demand and/or supply will be affected first by the situation
illustrated in picture (a) and then by the situation illustrated in picture (b). See if you agree
with your fellow students' viewpoint.
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LEARNING UNIT 4:
4.4
CHANGES IN DEMAND AND SUPPLY
THE CETERIS PARIBUS CONDITION
You may have wondered why we used the expression "all other things remaining the same"
when we discussed the demand schedule and the demand curve. For instance, the law of
demand was defined specifically with reference to the ceteris paribus condition.
In order to derive the demand schedule for potatoes, we varied the price of potatoes and
observed what would happen to the quantity bought in a specific time period when no other
factors are allowed to change. This implied that when the price of potatoes changes, other
factors such as income, the population size, the price of competing products or people's
tastes were not allowed to change at the same time, since all these factors would give rise to
a shift of the demand curve. Why did we do this? Because we wanted to isolate the effect of
just a single factor, which in this case is the change in P, and determine how it influences Q.
If all other things had changed at the same time, we would not have been able to say what
the relationship between P and Q is.
4.5
SIMULTANEOUS CHANGE IN DEMAND AND SUPPLY
The importance of the ceteris paribus condition becomes even more apparent if we consider
the possibility of a simultaneous shift in the demand and the supply curve.
We know that an increase in demand leads to an increase in price and an increase in quantity.
We also know that a decrease in supply leads to an increase in price but a decrease in the
quantity. When demand and supply changes simultaneously we can, however, not always be
certain of the direction of the changes. Let’s look at examples.
Let’s consider the situation when we have a simultaneous increase in demand and supply.
We are sure that the quantity will increase as both curves will shift to the right, but the change
in the price level will depend on the extent of the changes in demand and supply.
Figure 4.7 illustrates this:
FIGURE 4.7
Simultaneous increase in demand and supply
In panel (a), the increase in demand is relatively larger than the increase in supply, and this
results in an increase in price. In panel (b), the increase in supply is relatively larger than the
increase in demand, and this results in a decrease in the price level. It is therefore not
possible to predict whether the price level will increase, decrease or stay the same when
both demand and supply increase, unless we know the extent of the changes.
Similarly, the direction of the change in the price cannot be predicted when both demand
and supply decrease. As both the decrease in demand and a decrease in supply are
80
LEARNING UNIT 4:
Changes in Demand and Supply
illustrated by a leftward shift of the curves, we can predict with certainty that the equilibrium
quantity will decrease. However, as shown in figure 4.8, the direction of the change in the
price will once again depend on the relative changes in demand and supply:
FIGURE 4.8
Simultaneous decrease in demand and supply
When demand and supply change in opposite directions, the direction of price can be
predicted with certainty. Both a decrease in demand and an increase in supply result in a
decrease in price, while both in increase in demand and a decrease in supply result in an
increase in the price. However, as we will now illustrate, the direction of the change in
quantity will be uncertain.
Figure 4.9 illustrates a decrease in demand and an increase in supply. The extent of the
decrease in demand is larger in (a) than in (b), while the extent of the increase in supply is
larger in (b) than in (a):
FIGURE 4.9
A simultaneous decrease in demand and an increase in supply
In both panels, the equilibrium price decreases, but in panel (a), the equilibrium quantity
decreases while it increases in panel (b).
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LEARNING UNIT 4:
CHANGES IN DEMAND AND SUPPLY
Similarly, we can show that when there is a simultaneous increase in demand and a decrease
in supply, the price will always increase but that the direction of the change in the
equilibrium quantity cannot be predicted, as it will depend on the relative changes in demand
and supply.
Figure 4.10 illustrates this:
FIGURE 4.10
Simultaneous increase in demand and a decrease in supply
The following table provides a summary of the outcome if there are simultaneous shifts in
both curves:
TABLE 4.1
Simultaneous shifts in the demand and supply curves
Change in
demand
Change in supply
Change in price
Change in
quantity
Increase
Increase
Uncertain
Increase
Increase
Decrease
Increase
Uncertain
Decrease
Increase
Decrease
Uncertain
Decrease
Decrease
Uncertain
Decrease
Source: Mohr et al (2008:139)
LEARNING ACTIVITY 4.5
Choose the correct answer
(a) An increase in demand for accommodation in Cape Town will result in which of the
following? Choose the correct option(s).
i.
ii.
iii.
iv.
82
an increase in the equilibrium quantity
a decrease in the equilibrium quantity
a direction of change in equilibrium quantity that is unpredictable
an increase in the equilibrium price
LEARNING UNIT 4:
Changes in Demand and Supply
v.
vi.
a decrease in the equilibrium price
a direction of change in equilibrium price that is unpredictable
(b) An increase in the supply of accommodation in Cape Town will result in which of the
following? Choose the correct option(s).
i.
ii.
iii.
iv.
v.
vi.
an increase in the equilibrium quantity
a decrease in the equilibrium quantity
a direction of change in equilibrium quantity that is unpredictable
an increase in the equilibrium price
a decrease in the equilibrium price
a direction of change in equilibrium price that is unpredictable
(c) A simultaneous increase in demand and supply for accommodation in Cape Town will
result in which of the following? Choose the correct option(s).
i. an increase in the equilibrium quantity
ii. a decrease in the equilibrium quantity
iii. a direction of change in equilibrium quantity that is unpredictable
iv. an increase in the equilibrium price
v. a decrease in the equilibrium price
vi. a direction of change in equilibrium price that is unpredictable
(d) If the supply of textbooks were to decrease, and the demand for textbooks were to
increase simultaneously, the result would be an increase in the price of textbooks, but
the direction of the change in the equilibrium quantity of textbooks cannot be predicted without more information.
i.
ii.
True
False
(e) Which of the following will cause a decrease in the quantity demanded of mattresses
while leaving demand unchanged?
i.
ii.
iii.
iv.
an decrease in the price of mattresses
an increase in the price of blankets
an increase in the price of mattresses
an increase in income if mattresses are an inferior good
(f) Suppose the market for fried chicken is in equilibrium – which of the following will
always result in an increase in the equilibrium price of fried chicken?
[1]
[2]
[3]
[4]
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a decrease in supply and an increase in demand
a decrease in both the supply and demand
an increase in both the supply and demand
a decrease in demand and an increase in supply
83
LEARNING UNIT 4:
CHANGES IN DEMAND AND SUPPLY
LEARNING ACTIVITY 4.6
Quiz on learning unit 4
Note that you can also do this quiz on myUnisa to get immediate feedback. The answers to
the quiz will also become available on myUnisa under Additional Resources at the end of
the week allocated to studying learning unit 4.
Indicate whether each of the following statements is TRUE or FALSE:
STATEMENT
1. If the demand for watermelons were to increase, there would be a decrease in the
price of watermelons, ceteris paribus.
2. An increase in the income of households
will lead to an increase in the price of
meat, ceteris paribus.
3. If the supply of oranges decreases, there will
be an increase in the price of oranges,
ceteris paribus.
4. An increase in the wages of workers in the
clothing industry will lead to an in- crease
in the price of clothing, ceteris paribus.
5. An increase in the productivity of workers
in the motor vehicle industry will lead to a
fall in the price of new motor vehicles,
ceteris paribus.
84
TRUE
FALSE
LEARNING UNIT 4:
Changes in Demand and Supply
STATEMENT
TRUE
FALSE
6. If the supply of peaches were to increase
and the demand for them were to decrease
simultaneously, there would be a decrease
in the price of peaches, but the direction of
the change in the equilibrium quantity of
peaches would be impossible to predict
accurately.
7. If the supply of and demand for bananas
were to decrease simultaneously, both the
equilibrium price of bananas and the equilibrium quantity would definitely decrease
simultaneously.
8. A lower milk price (complement of tea)
will shift the demand curve for tea to the
left.
9. A higher coffee price (substitute for tea)
will shift the demand curve for tea to the
right.
10. A lower coffee price (substitute for tea) will
shift the demand curve for tea to the right.
LEARNING ACTIVITY 4.7
Short questions on learning unit 4
1. At a price higher than the equilibrium price, supply will be (greater/smaller) than
demand.
2. At a price lower than the equilibrium price, demand will be (greater/smaller) than
supply.
3. If an excess demand exists in the market, the eagerness of buyers to buy the product
will result in the price moving
.
4. Equilibrium implies that market forces are in
with each other.
5. Consider the market for wheat. Using the standard notions of demand and supply,
explain how the equilibrium price and quantity would change in each of the following situations, ceteris paribus:
5.1
5.2
5.3
5.4
Due to the new Tim Noakes diet, people decide to eat less bread. (Wheat is
one of the main ingredients in bread.)
Farmers are growing more genetically modified wheat on a large scale, resulting in a significant rise in the wheat harvest.
The price of wheat is expected to increase.
A large portion of the wheat harvest is destroyed by floods, while average
consumer income increases at the same time.
ADDITIONAL RESOURCES THAT CAN BE CONSULTED
If you are interested to find out more about the topics covered in this learning unit, you
can consult the following sources:
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LEARNING UNIT 4:
CHANGES IN DEMAND AND SUPPLY
Janse van Rensburg, J, McConnell, CR & Brue, SL. 2011. Economics: Southern African Edition.
Berkshire: McGraw-Hill: Chapter 3, page 63–69.
Mohr, P & Associates. 2015 (or other editions). Economics for South African students. Pretoria:
Van Schaik: Chapter 5.
86
LEARNING UNIT 5
Elasticity
CONTENTS
5.1
INTRODUCTION
88
5.2
WHAT IS ELASTICITY?
88
5.3
WHY ECONOMISTS USE ELASTICITY
89
5.4
PRICE ELASTICITY OF DEMAND
89
5.5
INCOME ELASTICITY OF DEMAND
93
5.6
CROSS ELASTICITY OF DEMAND
95
5.7
PRICE ELASTICITY OF SUPPLY
98
5.8
THE PRICE ELASTICITY OF DEMAND AND SUPPLY CURVES
100
Mindmap of elasticity
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LEARNING UNIT 5:
ELASTICITY
Econosavvity
To pass this module, you will be expected to understand the following concepts and
apply them to economic situations:
●
●
●
●
●
●
●
5.1
elasticity
price elasticity of demand
income elasticity of demand
cross elasticity of demand
price elasticity of supply
inelastic demand and supply
elastic demand and supply
INTRODUCTION
In this learning unit, we will focus on the responsiveness of the quantity demanded and the
quantity supplied to changes in the price and other determinants of the quantity demanded
and supplied. We know that changes in demand and supply will lead to different responses
in the market equilibrium and price, and we will now determine what the absolute or relative
sizes of these changes in price and quantity are.
5.2
WHAT IS ELASTICITY?
Elasticity can be defined as the measure of responsiveness or sensitivity . When two
variables are related, we want to measure the absolute or relative size of the percentage
change in one variable that results from a 1% change in another variable. For instance, when
the price rises by 1%, quantity demanded might fall by 5%. Therefore, the price elasticity of
demand is -5.
In this learning unit, we look at two different types of price elasticity, namely price elasticity
of demand and price elasticity of supply. The price elasticity of demand measures how
sensitive the quantity demanded is to a change in the price of the good, while price elasticity
of supply measures how sensitive the quantity supplied is to a change in the price of the
good.
We also consider elasticity of demand with regard to other factors, namely changes in
income and changes in prices of related goods.
Examples of demand elasticities
● When the price of petrol rises by 1%, the quantity demanded falls by 0,2%, so petrol
demand is not very price sensitive. In this case, the price elasticity of demand is 0,2.
● When the price of gold rises by 1%, the quantity demanded falls by 2,6%, so gold demand is very price sensitive and the price elasticity of demand is 2,6.
Examples of supply elasticities
● When the price of Michelangelo paintings increases by 1%, the quantity supplied doesn't
change at all, so the quantity supplied of Michelangelo paintings is completely insensitive
to the price. Price elasticity of supply is therefore 0.
● When the price of cheese increases by 1%, the quantity supplied increases by 5%, so
cheese supply is very price sensitive and the price elasticity of supply is 5.
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LEARNING UNIT 5:
5.3
Elasticity
WHY ECONOMISTS USE ELASTICITY
Economists use elasticity because:
● they want to compare the price sensitivities of different products with each other
● they want to determine whether one market is more price sensitive than another, for
example, whether the oil market’s demand is more price sensitive than wheat demand, or
whether the labour supply of women is more wage sensitive than the labour supply of
men
● elasticity is a unit-free measure
● if they compare markets using elasticities, it does not matter how they measure the
price or the quantity in the two markets
● elasticities allow economists to quantify the differences among markets without standardising the units of measurement
Examples of unit-free comparisons
● Petrol and gold
It doesn't matter that petrol is sold by the litre for about R10,00 and gold is sold by the
ounce for about $1 659,89. We compare the demand elasticities of 0,2 (petrol) and 2,6
(gold). Gold demand is therefore more price sensitive.
● Paintings and cheese
It doesn't matter that classical paintings are sold by the canvas for millions of dollars
each while cheese is sold by the kilogram for about R69,99. We compare the supply
elasticities of 0 (classical paintings) and 5 (cheese). Cheese supply is therefore more price
sensitive.
Inelastic economic relations
When an elasticity is small (between 0 and 1 in absolute value), we call the relation that it
describes inelastic.
● Inelastic demand means that the quantity demanded is not very sensitive to change in
the price. In other words, the quantity demanded will not change a lot when the price
changes.
● Inelastic supply means that the quantity supplied is not very sensitive to change in the
price. In other words, the quantity supplied will not change a lot when the price changes.
Elastic economic relations
When an elasticity is large (greater than 1 in absolute value), we call the relation that it
describes elastic.
● Elastic demand means that the quantity demanded is sensitive to changes in the price.
In other words, the quantity demanded will change quite a lot when the price changes.
● Elastic supply means that the quantity supplied is sensitive to changes in the price. In
other words, the quantity supplied will change quite a lot when the price changes.
5.4
PRICE ELASTICITY OF DEMAND
.................................................................................................................................................................
The price elasticity of demand measures the responsiveness of the quantity demanded
to changes in the price of the product.
.................................................................................................................................................................
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LEARNING UNIT 5:
ELASTICITY
How we react to a price change depends to a large degree on what kind of good or service
it is and by how much the price increase.
In the past, an increase in the price of bread in Iran has caused massive protests, an increase
in public transport fares in Brazil led to violent protests, and in South Africa a rise in the
price of petrol usually leads to strong verbal protests from motorists and taxi commuters.
Which one of the following would upset you the most?
● an increase in the price of petrol
● an increase in the price of ice cream
Most people will be more upset if the price of petrol rises than if the price of ice cream
rises.
Think for a moment why are people more upset if the price of petrol rises than if the price
of ice cream rises. Is it because …
● it is the government’s fault the price of petrol rises.
● it is extremely difficult for people to decrease the quantity of petrol they use.
● it is easier to decrease the quantity of ice cream bought than the quantity of petrol
bought.
The most important reason is probably that it is easier to eat less ice cream than to use less
petrol. As the price of petrol increases, it is very difficult to decrease the quantity of petrol
we demand in the short run. That is probably why we get more upset if the price of petrol
rises, than if the price of ice cream rises.
We say that the demand for petrol is less price elastic than the demand for ice cream. We
can easily adjust the amount of ice cream we buy, but we cannot adjust the amount of petrol
we have to use so easily. We use a formula to measure the price elasticity of demand:
General formula for price elasticity of demand
Price elasticity of demand (ep)
=
Percentage change in quantity demanded of a product
Percentage change in price of the product
The elasticity measures the percentage change of one variable (e.g. Q) in terms of another
(e.g. P). The price elasticity of demand is always negative. We refer to the price elasticity of
demand by its absolute value (ignore the minus sign).
So, even though the formula says that the price elasticity of demand is negative, we would
say the price elasticity of demand for oil is 0,2 and that for gold 2,6.
Let's look at an example:
Suppose that the quantity demanded of bottled water increase from 5 000 units per month
to 6 000 units per month when the price of the water decreases from R5,00 to R4,50.
To calculate the price elasticity of demand:
ep =
90
Percentage change in quantity demanded of bottled water
Percentage change in price of bottled water
LEARNING UNIT 5:
Elasticity
The percentage change in the quantity demanded of bottled water can be calculated as
follows:
change in quantity demanded
Percentage change in quantity demanded =
=
quantity before change
1 000
5 000
x 100
x 100 = 20%
The percentage change in the price of bottled water can be calculated as follows:
Percentage change in price =
change in price
price before change
=
– 0,50
5,00
x 100
x 100 = 10%
Now we can calculate the price elasticity of demand:
ep =
Percentage change in quantity demanded of bottled water
Percentage change in price of bottled water
=
20%
– 10%
=–2
As mentioned above, we ignore the minus sign. Therefore, we can say that the price
elasticity of demand for bottled water is 2. This means that when the price of bottled water
decreases by 1%, the quantity demanded of bottled water will increase by 2%.
There are five categories of price elasticity of demand:
● Perfectly inelastic demand: ep = 0
● Inelastic demand: ep lies between 0 and 1
● Unit elastic demand or unitary elasticity of demand: ep = 1
● Elastic demand: ep lies between 1 and infinite ∞
● Perfectly elastic demand: ep = ∞
When demand is inelastic, it means that the quantity demanded will not change much when
the price level changes. Perfectly inelastic demand means that the quantity demanded does
not change at all when there is a change in the price. When demand is elastic, the quantity
demanded will be sensitive to a change in the price level. The larger the elasticity, the more
the quantity demanded will change due to a certain change in the price level. Unitary
elasticity of demand means that the percentage change in the quantity demanded will be
exactly equal to the percentage change in the price level. Perfectly elastic demand means
that the change in the quantity demanded due to a price change is very large, close to infinity.
For example, when the price of a particular brand of coffee increases, it may happen that
no consumer now wants to buy that coffee as there are so many other brands of coffee
available. The percentage change in the quantity of coffee demanded will thus be very large
(100%).
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LEARNING ACTIVITY 5.1
Do calculations and discuss
You have the following information:
Price (P)
Quantity demanded (Qd)
8
100
10
90
(a) Assume the price increases from R8 to R10:
(i) Calculate the percentage increase in price.
(ii) Calculate the percentage decrease in quantity demanded.
(iii) Calculate the price elasticity of demand coefficient, using the answers to the
above question.
(b) Assume the price decreases from R10 to R8:
(i) Calculate the percentage decrease in price.
(ii) Calculate the percentage increase in quantity demanded.
(iii) Calculate the price elasticity of demand coefficient, using the answers to the
above question.
LEARNING ACTIVITY 5.2
Discussion forum
Visit the discussion forum for learning activity 5.2 on myUnisa and answer the following
question:
Can you explain why the answers in (a) of learning activity 5.1 are different from the answers in (b)? Discuss your answer on the discussion forum.
LEARNING ACTIVITY 5.3
Choose the correct answer
(a) If a 12% change in price leads to a 6% change in quantity demanded, the demand is
...
i.
ii.
iii.
relatively price inelastic.
relatively price elastic.
unitary price elastic.
(b) A relatively elastic demand implies that …
i.
ii.
iii.
the % change in price is greater than the % change in quantity demanded.
the % change in price is smaller than the % change in quantity demanded.
the % change in price is equal to the % change in quantity demanded.
(c) Assume that the price of maize decreases from R1 000 per ton to R850 per ton while
the quantity demanded increases from 1 million tons to 1,1 million tons. The price
elasticity of demand for maize is:
92
Elasticity
LEARNING UNIT 5:
i.
ii.
iii.
iv.
5.5
0,0004
0,04
1,5
0,67
INCOME ELASTICITY OF DEMAND
.................................................................................................................................................................
The income elasticity of demand measures the responsiveness of the quantity
demanded to changes in income.
.................................................................................................................................................................
When income increases, we will usually expect that consumers will buy more of most types
of goods, for example, if we consider the demand for red meat, we can expect that
consumers will buy more red meat. The income elasticity provides an indication of the
increase in the quantity of a good we can expect when income increases.
We use the following formula to calculate income elasticity of demand:
General formula for income elasticity of demand
Income elasticity of demand (ep) =
Percentage change in quantity demanded of a product
Percentage change in income
Let's look at an example:
When the income level of a consumer is R400 000 a year, he buys 20 kg of red meat a
month. When his income increases to R600 000 a year, the consumer buys 50 kg red meat
a month.
30 kg
Percentage change in quantity of meat demanded =
Percentage change in income =
R200 000
R400 000
ey =
20 kg
x 100 = 150%
x 100 = 50%
150%
50%
=3
Goods with a positive income elasticity of demand are called normal goods (ey > 0).
Normal goods are further classified as either luxury or essential goods. If the income
elasticity of demand is greater than 1, the good is called a luxury good (ey > 1). Since income
elasticity of demand is larger than 1, it means that the percentage increase in the
quantity demanded of such luxury goods is larger than the percentage increase in income.
If the income elasticity of demand is positive but less than 1, the good is called an essential
good (ey < 1). This means that the percentage increase in the quantity demanded of this
essential good is smaller than the percentage change in income.
In our example, the income elasticity of demand for red meat was calculated to be 3, which
shows that this consumer regards red meat as a luxury good.
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There are some goods that people buy because they cannot afford to buy other more
expensive goods. When their income increases, they are able to buy other more expensive
goods and they buy less of the goods they purchased when they were poorer. Such goods
are called inferior goods. Maize meal can be an example of an inferior good in South Africa.
Poor households purchase a lot of maize meal because it is a relatively cheap type of food.
When their income increases, they can afford to buy other more expensive types of food,
and they purchase less maize meal. Let's look at an example:
When the income level of a consumer is R40 000 a year, he buys 50 kg of maize meal a
month. When his income increases to R60 000 a year, the consumer only buys 30 kg of
maize meal a month.
– 20 kg
Percentage change in quantity of maize meal demanded =
R20 000
Percentage change in income =
R40 000
ey =
50 kg
x 100 = – 40%
x 100 = 50%
– 40%
50%
= – 0,8
Note that the percentage change in maize meal is negative (-40%), because the quantity
demanded of maize meal decreases when income increases. Therefore, the income elasticity
of maize meal is also negative.
Goods with a negative income elasticity of demand are called inferior goods (ey < 0).
LEARNING ACTIVITY 5.4
Choose the correct answer
(a) Income in the small island economy of Cherona increases by 20%. Due to this increase, we find the following changes in the quantities demanded of fried chicken, soap
and corn:
Product
Quantity demanded before
increase in income
Quantity demanded after increase in income
Fried chicken
1 500 units a week
2 000 units a week
Soap
500 units a week
550 units a week
Corn
1 200 units a week
1 000 units a week
Calculate the income elasticity for each of the products and answer the following
questions:
(i) Fried chicken is a:
1. luxury good
2. essential good
3. inferior good
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LEARNING UNIT 5:
Elasticity
(ii) Soap is a:
1. luxury good
2. essential good
3. inferior good
(iii) Corn is a:
1. luxury good
2. essential good
3. inferior good
(b) Betty owns a travel agency. She is concerned because the Minister of Finance said in
his annual budget speech that the average income of South Africans will decrease in
the coming year. She is concerned because the demand for her services as a travel
agent can be expected to be:
i. relatively income inelastic
ii. relatively income elastic
iii. unitary price elastic
(c) A 10% increase in income causes a 20% increase in the quantity demanded for craft
beer. It can be concluded that .
i.
ii.
iii.
iv.
the price elasticity is greater than 1
the income elasticity of demand is negative
craft beer is a necessity
craft beer is a luxury
(d) An increase in income tends to cause a decrease in the demand for margarine. It can
be concluded that the .
i. price elasticity of demand is less than 1
ii. price elasticity of demand is more than 1
iii. income elasticity of demand is negative
iv. income elasticity of demand is positive
5.6
CROSS ELASTICITY OF DEMAND
The demand for goods is also affected by the prices of other goods. In section 3.2.3, we
explained goods that are complements in consumption (such as potatoes and fish) and
goods that are substitutes in consumption (such as potatoes and rice). We will now consider
the effect of a change in the price of the one good on the quantity demanded of the related
good.
Suppose that the price of fish increases, this will result in a decrease in the quantity demanded
of fish (a movement along the demand curve for fish as illustrated in figure 3.8 (a). Because
fish and potatoes are consumed together, the demand for potatoes now decreases (a leftward
shift of the demand for potatoes curve as illustrated in figure 3.8(b). This decrease in demand
results in a decrease in the quantity demanded of potatoes. The relationship between the
percentage change in the price of fish and the percentage change in the quantity demanded
of potatoes is called cross elasticity of demand. Since the increase in the price of fish results
in a decrease in the quantity demanded of potatoes, the cross elasticity of demand will be
negative.
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LEARNING UNIT 5:
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Let us now provide a formal definition for cross elasticity of demand:
.................................................................................................................................................................
The cross elasticity of demand measures the responsiveness of the quantity demanded
of a particular good to changes in the price of a related good.
.................................................................................................................................................................
General formula for cross elasticity
Cross elasticity of demand (ec) =
Percentage change in quantity demanded of product A
Percentage change in price of product B
Suppose that a 10% increase in the price of fish results in a 5% decrease in the quantity
demanded of potatoes. The cross elasticity can be calculated as follows:
Cross elasticity of demand (ec) =
Cross elasticity of demand (ec =
Percentage change in quantity demanded of potatoes
Percentage change in price of fish
– 5%
10%
= – 0,5
This means that for every one percent that fish increases in price, the quantity demanded
of potatoes will decrease by 0,5%. We know that the quantity demanded of potatoes will
decrease because the cross elasticity has a negative value.
In the case of complements , the cross elasticity of demand will always be negative (ec <
0), since a change in the price of one of the products will lead to a change in the opposite
direction in the quantity demanded of the complementary product.
Let us now consider cross elasticity of goods that are substitutes. In section 3.2.3, we
provided the example of potatoes and rice that are substitutes in consumption, as both are
starchy foods that are relatively easy to cook. When the price of rice increases, the quantity
demanded of rice will decrease (illustrated by an upward movement along the demand curve
for rice as illustrated in figure 3.7a). Since potatoes is a substitute for rice, the demand for
potatoes will increase (illustrated by a rightward shift of the demand curve for potatoes as
illustrated in figure 3.7b). The increase in the demand for potatoes will result in an increase
in the equilibrium quantity of potatoes sold in the market for potatoes. If a 10% increase in
the price of rice results in an 8% increase in the demand for potatoes, we can calculate the
cross elasticity as follows:
Cross elasticity of demand (ec) =
Cross elasticticity of demand (ec =
Percentage change in quantity demanded of potatoes
Percentage change in price of rice
8%
10%
= 0,8
This value of 0,8 means that the quantity demanded of potatoes will increase by 0,8% for
every one percent increase in the price of rice.
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LEARNING UNIT 5:
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In the case of substitutes (e. g. butter and margarine), the cross elasticity of demand is
positive (ec > 0), since a change in the price of one of the products will lead to a change in
the same direction in the quantity demanded of the substitute product.
Suppose that the price of butter increases from R50 a kilogram to R60 a kilogram. Due to
this, the quantity demanded of margarine increases from 800 000 tubs to 900 000 tubs per
month. Let's calculate the cross elasticity of demand:
100 000
Percentage change in quantity of margarine demanded =
R10
Percentage change in price of butter =
x 100 = 12,50%
x 100 = 20%
R50
ec =
800 000
12,5%
= 0,625
20%
Butter and margarine are substitutes. That is why the cross elasticity of demand is positive.
Suppose that the quantity of hot-cross buns demanded decreases from 300 000 per month
to 250 000 per month due to the increase in the price of butter. Let’s calculate the cross
elasticity for this change:
–50 000
Percentage change in quantity of hot-cross buns demanded =
R10
Percentage change in price of butter =
x 100 = –16,67%
x 100 = 20%
R50
ec =
300 000
–16,67%
20%
= - 0,834
Note that the quantity of hot-cross buns demanded decreased; therefore, the percentage
change in the quantity of hot-cross buns demanded has a negative value. The negative value
of the cross-elasticity of demand indicates that butter and hot-cross buns are complements,
that is, goods that are used together.
Let's now consider the cross elasticity of demand between butter and bicycles. Butter and
bicycles are not related products at all. Therefore, we can expect that the cross elasticity of
demand between butter and bicycle will be equal to zero. When the price of butter increases
by 20%, the quantity demanded of bicycles does not change at all, thus 0% change. We can
calculate the cross elasticity of demand:
ec =
0%
20%
=0
Thus, when the cross elasticity of demand is equal to zero, it means the products are not
related at all.
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LEARNING ACTIVITY 5.5
Choose the correct answer
(a) When the price of proteas increases from R45 to R50 a bunch, the quantity demanded of proteas in the Western Cape decreases from 1 200 bunches a day to
1 000 bunches a day. The quantity of carnations sold increases from 600 to 800 per
day, and the quantity of fynbos sold decreases from 800 bunches to 700 bunches per
day.
Use this information to complete the following table:
Value of cross
elasticity of demand
Type of relationship
(complements or
substitutes)
Relationship between
proteas and carnations
Relationship between
proteas and fynbos
(b) Suppose the cross-elasticity of demand between two products, A and B, is negative. If
the price of product A increases as a result of a decrease in the number of firms
supplying the product, the quantity demanded will .
i.
ii.
iii.
iv.
increase for both products A and B
fall for both products A and B
increase for product A and fall for product B
fall for product A and increase for product B
(c) Suppose the cross-elasticity of demand between two products, A and B, is positive.
If there is a fall in the cost of producing good B, the quantity demanded will
.
i.
ii.
iii.
iv.
5.7
increase for both goods
decrease for both goods
increase for good A and decrease for good B
decrease for good A and increase for good B
PRICE ELASTICITY OF SUPPLY
Suppliers are also affected by changes in the prices of goods. We know that the quantity
supplied of a good will increase when the price of a good increases. Elasticity of supply
provides an indication of the size by which quantity supplied can be expected to change
when the price of a good changes. Let's define it formally:
.................................................................................................................................................................
The price elasticity of supply measures the responsiveness of the quantity supplied of a
product to changes in the price of the product.
.................................................................................................................................................................
General formula for price elasticity of supply
Price elasticity of supply (es) =
98
Percentage change in quantity supplied of a produce
Percentage change in price of the product
LEARNING UNIT 5:
Elasticity
There are five categories of price elasticity of supply:
●
●
●
●
●
Perfectly inelastic supply: es = 0
Inelastic supply: es greater than 0 but smaller than 1
Unit elastic supply or unitary elasticity of supply: es = 1
Elastic supply: es > 1
Perfectly elastic supply: es = ∞
Let’s consider an example. When the price of Fido Dog Food increases from R50 per bag
to R55 a bag, the supply of Fido Dog Food increases from 500 000 units to 510 000 units
per week.
The value of the price elasticity of Fido Dog Food indicates that the supply of the dog food
is inelastic. The value is greater than 0 but less than 1. This means that the supply of Fido
Dog Food is not very sensitive to price changes. The reasons for this may be that the factory
cannot expand production in the short run due to capacity constraints. In the long run, the
situation may be different.
LEARNING ACTIVITY 5.6
Choose the correct answer
(a) The quantity of coal supplied changes from 45 000 tons a month to 50 000 tons a
month when the price changes from R1 500 to R1 600. Based on this information,
which of the following statements are correct?
a. The percentage change in the quantity of coal supplied is larger than the percentage change in the price of coal.
b. The percentage change in the quantity of coal supplied is smaller than the percentage change in the price of coal.
c. The supply of coal is price elastic.
d. The supply of coal is not price elastic.
[1]
[2]
[3]
[4]
ac
ad
bc
bd
(b) It has been determined that the price elasticity of supply for a certain product is 0,1.
Should the firm, which is producing this product, be concerned about this?
[1] No, it implies that the firm will be able to increase its revenue by increasing the
price of the product.
[2] Yes, as it means that the demand for this product is increasing at a slow rate.
[3] No, because it implies that there are few substitutes for this product.
[4] Yes, because it means that the firm cannot adjust the quantity it produces easily
when demand changes.
[5] No, because it means that the demand for this product is not very sensitive to
price changes.
LEARNING ACTIVITY 5.7
Discussion forum
You are provided with the following information:
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LEARNING UNIT 5:
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Price sensitivity of the demand for golf balls = –3
Price sensitivity of the demand for electricity = –0,3
Price sensitivity of the supply of golf balls = 0,3
Price sensitivity of the supply of electricity = 3
Visit the discussion forum for learning activity 5.7 in myUnisa and explain the following:
(i) Why can the price sensitivity of the demand for golf balls be expected to have a larger absolute value than the price sensitivity of the demand for electricity?
(ii) Why can the price sensitivity of the supply of golf balls be expected to have a smaller
value than the price sensitivity of the supply of electricity?
5.8
THE PRICE ELASTICITY OF DEMAND AND SUPPLY CURVES
The demand for some products is more sensitive to price changes than the demand for
others. When the price of pepper decreases significantly, people will probably not buy more
pepper just to take advantage of the price reduction. Would anyone you know buy a huge
bag of pepper just because there had been a drop in its price? One can therefore say that the
demand for pepper is relatively insensitive to price changes. On the other hand, should the
price of meat decrease drastically, one could expect the quantity demanded to increase
significantly. Many people who could not afford to buy meat previously would probably start
buying meat.
The shape of the demand curve or supply curve for a certain good provides a graphic
illustration of the elasticity of such a curve. The most significant feature in this regard is the
difference in the slope (or gradient) of the curves. Demand and supply curves will normally
have the same shape, falling from left to right in the case of demand (according to the law
of demand ), and rising from left to right in the case of supply (according to the law of
supply ), but the slope or gradient of both curves may vary from being vertical parallel to
the price axis to being horizontal parallel to the quantity axis. The vast majority of curves
will not be linear, but will really be curved (non-linear), as the name suggests.
In figure 5.1, we show the different linear shapes the demand curve may have. You will notice
that we use the economic term “elasticity” to describe the differently sloped curves. This is
because the slope of the demand curve provides an indication of the sensitivity of the
quantity demanded of that product to changes in the price. A vertical demand curve is
perfectly price inelastic because any change in the price level has no effect on the quantity
demanded. On the other hand, a demand curve that is horizontal (parallel to the quantity
axis) is perfectly price elastic because the quantity demanded can change i n f i n i t e l y
without any change in the price level. If we compare demand curves D3 and D2, we can see
that the same change in price from P0 to P1 results in a larger change in the quantity
demanded on the flatter demand curve (D3) than on the steeper demand curve D2. The
flatter the demand curve, the smaller the slope of the curve. The slope of D4 is even smaller
than the slope of D3, and on this curve the same increase in price from P0 to P1 results in an
even larger decrease in the quantity demanded. We therefore say that demand curve D4 is
more elastic than demand curve D3. The flatter a demand curve, the larger the change in
quantity demanded due to a certain change in price, and therefore the more elastic that
demand curve.
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LEARNING UNIT 5:
Elasticity
FIGURE 5.1
Different price elasticities of demand curves
Figure 5.2 shows different supply curves with different price elasticities. When supply is
perfectly inelastic, the quantity supplied does not change at all when the price changes, for
example, from P0 to P1. Supply curve S3 in figure 5.2 is unitary elastic. This means that the
percentage change in quantity supplied will be exactly equal to the percentage change in
price. Supply curve S2 is inelastic. This means that if there is a change in the price of the
good, this will result in a change in quantity supplied, and the percentage change in the
quantity supplied will be smaller than the percentage change in the price. Supply curve S4
is elastic. This means that if there is a change in the price of the good, this will result in a
change in quantity supplied, and the percentage change in the quantity supplied will be larger
than the percentage change in the price. If we compare supply curve S2 which is
inelastic, to supply curve S4, which is elastic, it means a certain percentage change in price
will result in a larger percentage increase in quantity supplied on S4 than on S2.
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LEARNING UNIT 5:
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FIGURE 5.2
Different price elasticities of supply curves
In figure 5.3, we see the effect of a change in supply (shift in the supply curve) on two
products with different price elasticities of demand. The demand curves for product a and
product b are shown. Product a has a relatively inelastic demand curve and product b has a
relatively elastic demand curve.
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LEARNING UNIT 5:
Elasticity
FIGURE 5.3
The effect of different price elasticities of demand
The sales of product a with the inelastic demand curve increase from Q to Qa only with a
large drop in the price level from P to Pa.
The sales of product b with the elastic demand curve increase substantially from Q to Qb
with a small drop in the price level from P to Pb.
Numerous reasons can be given for differences in the price elasticity of products, but the
most important is the availability of substitutes for the product. The more substitutes there
are for the specific product, the more price elastic its demand curve will be, ceteris paribus.
Examples of products and their substitutes are butter and margarine, apples and pears, beef
and mutton and bus tickets and Metrorail tickets. The closer the degree of substitution, the
more elastic the demand for the product. Obviously, the absence of substitutes will make the
demand for a product inelastic – people have to buy the product, irrespective of the price.
Complementary products (i. e. products that are used together with other products), on
the other hand, tend to have a low price elasticity of demand. The demand curve for these
products will normally be fairly steep. Examples of complementary products are car tyres
and cars and Play Stations and Play Station games.
Another general observation one can make is that the demand for goods which form part
of the basic needs of people, for example, staple foods such as bread, rice or potatoes, tends
to be less elastic than the demand for luxury or non-basic goods; hence the relatively inelastic
shape of the demand for many agricultural products.
The price elasticity of supply measures the way in which the supply of a product reacts
to a change in the price of the product. What is critically important here is the length of
time
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between the price change and the resultant change in supply. In the short run, most supply
curves are inelastic (steep) because producers are unable to react immediately to price
changes. To increase production normally takes time. In the long run, the production
capacity of most firms can be increased or decreased in response to a price increase or
decrease.
LEARNING ACTIVITY 5.8
Quiz on learning unit 5
Note that you can also do this quiz on myUnisa to get immediate feedback. The answers to
the quiz will also become available on myUnisa under Additional Resources at the end of
the week allocated to studying learning unit 5.
Indicate whether each of the following statements is TRUE or FALSE:
STATEMENT
1. If the price elasticity of the demand for chocolates is greater than 1, then the manufacturers of
chocolates can increase their total revenue by
raising the price of chocolate.
2. The producers of a product with an elastic demand will have a strong incentive to reduce the
price of their product.
3. If a 10% increase in the price of good A results
in a 5% reduction in the quantity of A demanded, then the price elasticity of the demand
for A is more than 1.
4. Necessities tend to have a low price elasticity of
demand, while luxury goods tend to have a high
price elasticity of demand.
104
TRUE
FALSE
LEARNING UNIT 5:
Elasticity
STATEMENT
TRUE
FALSE
5. The price elasticity of the demand for steak will
be greater than the price elasticity of the demand for meat.
6. Income elasticity of demand is a measure of the
responsiveness of quantity demanded to
changes in consumers’ incomes.
7. A good with an income elasticity of demand that
is positive but less than 1 is classified as an
inferior good.
8. When two goods are totally unrelated, the cross
elasticity of demand value will be negative.
9. Apples and pears are substitute goods for each
other. The cross elasticity value for apples and
pears will be negative.
1- If there is an increase in the price of electricity,
0. a complement in consumption to T-shirts, then the
quantity of T-shirts demanded will decrease and
the cross elasticity value for these two goods
will be negative.
LEARNING ACTIVITY 5.9
Short questions on learning unit 5
1. Define each of the following terms:
1.1
1.2
1.3
1.4
Price elasticity of demand
Income elasticity of demand
Cross-price elasticity of demand
Price elasticity of supply
2. State the numerical values of the price elasticity of demand for which the demand is:
2.1
2.2
2.3
2.4
2.5
perfectly elastic
relatively inelastic
relatively elastic
unit elastic
perfectly inelastic
3. The income elasticity coefficients of demand for motor cars and branded clothing
have been estimated to be +3,4 and +2,0 respectively. Explain these coefficients.
4. Consider two goods, product A and product Q. The price of product A increases from
R6 to R8 per unit, and as a result the quantity demanded of product Q de- creases
from 200 to 190 units.
4.1
4.2
4.3
ECS1500/1
Calculate the cross-price elasticity of demand given the information above.
Are product A and product Q substitutes or complements?
What are possible real-life examples of goods such as product A and product
Q?
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LEARNING UNIT 5:
ELASTICITY
ADDITIONAL RESOURCES THAT CAN BE CONSULTED
If you are interested to find out more about the topics covered in this learning unit, you
can consult the following sources:
Janse van Rensburg, J, McConnell, CR & Brue, SL. 2011. Economics: Southern African Edition.
Berkshire: McGraw-Hill: Chapter 4.
Mohr, P & Associates. 2015 (or other editions). Economics for South African students. Pretoria:
Van Schaik: Chapter 6.
106
LEARNING UNIT 6
Measuring Economic Performance
CONTENTS
6.1
6.2
INTRODUCTION
109
6.1.1
6.1.2
Microeconomics as opposed to Macroeconomics
Macroeconomic objectives
109
110
6.1.3
Measuring macroeconomic performance
112
THE MEASUREMENT OF PRODUCTION
113
6.2.1
The importance of national accounts
113
6.2.2
Gross domestic product (GDP)
6.2.2.1 Double counting and how to avoid it
6.2.2.2 Three methods to calculate GDP
113
114
115
6.2.3
Real versus nominal values
117
6.2.4
Calculation of economic growth
119
6.2.5
The composition of the GDP
6.2.5.1 The origin of the GDP
6.2.5.2 The components of total expenditure
Shortcomings of the GDP
120
120
121
124
6.2.6
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Mind map of measuring economic performance
Econosavvity
To pass this module, you will also be expected to understand the following concepts
and apply them to economic situations:
●
●
●
●
●
●
●
●
108
Microeconomics
Macroeconomics
macroeconomic objectives
gross domestic product (GDP)
double counting
real vs. nominal values
shortcomings of GDP
implicit GDP deflator
LEARNING UNIT 6:
6.1
Measuring Economic Performance
INTRODUCTION
.................................................................................................................................................................
When you can measure what you are speaking about and express it in numbers, you know
something about it; when you cannot measure it, when you cannot express it in numbers,
your knowledge is of a meagre and unsatisfactory kind; it may be the beginning of
knowledge, but you have scarcely, in your thoughts, advanced to the stage of science.
Lord Kelvin .................................................................................................................................................................
6.1.1
Microeconomics as opposed to Macroeconomics
Before going any further, it is important to make a clear distinction between the two main
areas of study in Economics, namely Macroeconomics and Microeconomics . In the
previous units, we did not refer to them specifically. Although Macroeconomics and
Microeconomics can almost be viewed as two separate branches of Economics, we need
some knowledge of Microeconomics and the basic instruments for analysing it before we
are able to understand Macroeconomics properly. Aspects of the macroeconomy will also
affect the microeconomic decisions of firms and consumers. Therefore, it is clear that the
macroeconomic environment and the microeconomic environment affect and are affected
by each other.
The two areas of study can be defined as follows:
.................................................................................................................................................................
In Microeconomics , the prices and quantities of specific goods and services are studied in individual
markets and an attempt is made to explain changes in these markets.
.................................................................................................................................................................
The prefix "micro” is derived from the Greek word mikro, meaning small . Microeconomics
is therefore not concerned with the big picture or the economy as a whole, but instead
concentrates on decisions of individual consumers or firms. This definition can easily be
identified in the content of the previous units, as there we looked at the factors that
determine the equilibrium price and quantities of individual goods and services. We saw how
the forces of supply and demand come into play in determining how much of a good or
service will be bought or sold and at what price the transaction will take place. Because the
emphasis in Microeconomics is mainly on the prices of goods and services, it is also known
as price theory.
.................................................................................................................................................................
In Macroeconomics, we study the economy as a whole. Here we look at global economic
magnitudes such as the total production of a country, total employment and the inflation
rate.
.................................................................................................................................................................
The prefix "macro" is derived from the Greek word makro, meaning large. Once more, it
should be clear that the economic environment as we described it in the first learning unit
is approached from a macroeconomic perspective. The fact that we combined individual
markets to form global markets such as the market for consumer goods and the market
for factors of production clearly indicates the macroeconomic element of that learning unit.
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In Microeconomics it would, for example, be possible to look at events in specific markets
without having to worry about their possible impact on the rest of the economy. We could
analyse the effect of a sudden decrease in the supply of potatoes on the price of potatoes
without having to study the effects on South Africa's export achievements or total
agricultural production.
LEARNING ACTIVITY 6.1
Choose the correct answer
Indicate which of the following can be regarded to be microeconomic issues, and which will
be macroeconomic issues:
Description
Microeconomic
issue
Macroeconomic
issue
(a) An increase in the cost of maize production due to higher cost of seed and
fertiliser
(b)
A decrease in exports to the USA due to
new international trade arrangements
(c) A decrease in exports of motor cars to
Australia due to new international trade
arrangements
(d) An increase in total expenditure in a
country due to a more positive investment climate
(e) A decrease in investment in the mining
industry due to uncertainty with regard to
regulation that governs ownership in this
sector
6.1.2
Macroeconomic objectives
As you will realise, it is difficult to observe the detailed effects of events in one particular
market on the whole economy. Determining the resulting influences of the effect of prices
and quantities on the whole range of goods and services produced in a country is an almost
impossible task. In an attempt to solve this problem, macroeconomists have tried to simplify
the economic system by means of aggregation. Aggregation, which means "combining",
enables us to combine separate markets and then to view the whole as a single market or
system. This allows us to identify different facets of the economy more easily. The degree
of aggregation will depend on the specific macroeconomic problem we wish to investigate.
It has, for example, become useful to divide the total production in a country into the
contributions by sectors such as agriculture, mining and manufacturing. It is just as useful
to group the various actors in the economic process according to their activities as
households or consumers, business enterprises, the authorities and so on, so that their
actions or reactions can be observed individually. By making use of combined markets , to
which reference has already been made, we can limit the number of markets to a controllable
few.
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Owing to the fact that we work with aggregates in a market economy and that the welfare
of a country's population is closely related to these aggregates, we can expect that the
government in a market economy will strive to achieve certain macroeconomic objectives.
The field of study of Macroeconomics is therefore heavily involved with economic policy.
Greater priority is given to policy in Macroeconomics than in Microeconomics. The task of
the macroeconomist, who is concerned with policy, is to show how the different policy
instruments, such as fiscal and monetary policy (which will be discussed further in learning
units 8 and 9), can be applied to achieve certain objectives.
A balanced economic policy framework usually takes the following important policy
objectives into account:
i. Full employment. It is of the utmost importance to ensure that the available factors
of production are used to their full capacity. Apart from the material poverty that the
unemployed suffer, there is also the socio-economic effect of such. In South Africa,
as in most other countries, unemployment poses a serious threat to social and political stability. Full employment can rightfully be regarded as South Africa's most
important economic objective.
ii. Price stability. Even though the desirability of a low rate of inflation is less clear
than the objective of full employment, it is generally accepted as being one of the most
important aims of macroeconomic policy makers. Rising prices are not a prob- lem in
themselves, but their effects on certain sectors and groups are viewed as being
undesirable. We will examine this more closely in the next unit.
iii. External equilibrium. All countries strive to reach a certain level of trade relations
with other countries in order to increase their welfare. One of the most notable characteristics of the South African economy is precisely the country's dependence on the
outside world (in terms of both imports and exports) to maintain a healthy level of
economic growth. A balance between the value of imports and exports is of the utmost
importance to ensure that the country will be able to pay for necessary im- ports. Policy
must therefore ensure that the balance of payments (a statement of all transactions
with foreigners) is in equilibrium and that the exchange rate (the value of the currency
against foreign currencies) remains relatively stable as a result of this. We will pay more
attention to these factors in learning unit 10.
iv. Economic growth . Because of the positive relationship between economic growth
and employment, this objective is often included in the objective of full employment.
The aims of economic growth are probably traditionally viewed separately because
they are associated with longer-term problems. Here the emphasis is more on the climate that will encourage growth rather than on the measures to stabilise aggregate
demand over shorter periods and, in so doing, achieve an acceptable level of employment. As opposed to the other two objectives, price stability and external equilibrium,
which are sometimes incompatible with the achievement of full employment, economic growth is complementary to higher employment and should therefore enjoy a
high priority in the South African context. We will discuss the calculation of economic growth later in this learning unit and in the next one.
v. Equitable distribution of income and wealth. The distribution of income and
wealth refers to the way in which earning in a country and total existing wealth is distributed among the population of a country. Except for the obvious fact that it is not
fair that a small percentage of a country's population should live in luxury, while the
majority are poor and find it difficult to make ends meet, there are other advantages
to a more equitable distribution of income. It contributes to economic growth, as
more participants in the economy has resources available to participate actively in the
economy by investing and starting new business ventures. It should also contrib- ute
to economic development, as more participants in the economy will be able to afford
housing, schooling and good medical services.
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Every country will naturally have certain characteristics of its own that will pose special
challenges for policy-makers. South Africa has no shortage of such unique circumstances.
We can mention quite a few important areas which must each be considered carefully when
policy is being formulated: the gold mining industry and the unique role that gold plays in
the South African economy; the agricultural sector, which because of climatic conditions has
always demanded special treatment; and certain aspects of South Africa's political and
community problems, such as the unequal distribution of income, which still poses a huge
problem despite political reforms that have taken place.
6.1.3
Measuring macroeconomic performance
To determine which macroeconomic objectives policy-makers should focus on, it is
necessary to measure the degree to which the macroeconomic objectives have been
achieved (or not achieved).
The various objectives identified above are meaningless unless there is some or other
yardstick against which they can be measured. Owing to the activities of institutions in the
public sector which have been allocated this task, there is a lot of sufficiently reliable
information on the above-mentioned variables in the macro economy. In this learning unit,
we are mainly going to discuss how economic growth can be measured. In learning unit 7,
we shall discuss how the level of employment and unemployment, price stability, external
stability and the distribution of income can be measured.
The objectives of external balance and price stability are measured by means of yardsticks
such as the balance of payments and price indices such as the consumer price index
respectively. Unfortunately, information on the level of employment in South Africa is not
very accurate, as we have a large informal economy. In other countries such as the USA,
where reliable unemployment figures exist, the level of employment (i.e. the percentage of
the total economically active population) can be measured relatively accurately. Although
South African unemployment statistics are published annually, they are incomplete, as they
include only the registered unemployed (more on this in learning unit 7).
The most important need in Macroeconomics is to have a means of measuring the total
economic activity in a country. You often hear questions such as: What is happening in the
economy? What is the economic growth going to be this year? All these questions are related
to the level of economic activity in a country. Economic activity is best reflected by the total
production that takes place in an economy. The more that is produced, the higher economic
growth will be, and the closer the economy will be to full employment. In the rest of this
learning unit, we discuss how production may be measured, and the challenges related to
measuring it.
LEARNING ACTIVITY 6.2
Choose the correct answer
i.
Which of the following can be regarded as macro-economic policy objectives?
Choose ALL possible correct options.
i.
ii.
iii.
iv.
v.
112
stable prices
strong economic growth
full employment
balance of payment stability
low petrol price
LEARNING UNIT 6:
ii.
Measuring Economic Performance
Which one of the following is not an example of a macroeconomic policy objective?
i.
ii.
iii.
iv.
price stability
full employment
equitable distribution of income
market equilibrium
6.2
THE MEASUREMENT OF PRODUCTION
6.2.1
The importance of national accounts
The national accounts provide information on the total production over a particular
period. The compilation of these accounts is the responsibility of the South African Reserve
Bank (SARB) and Statistics SA. These institutions can, in other words, be regarded as the
“bookkeepers” of the economy, seeing that the accounts provide a full record of the total
production, income and spending that takes place in a country.
The more important national accounts variables estimated by these institutions are:
i. gross domestic product (GDP)
ii. gross national income (GNI)
iii. gross domestic expenditure (GDE)
iv. disposable income of households
v. gross and net capital formation
This information enables the government to formulate sensible economic policies which
can encourage the macroeconomic objectives mentioned above. The most comprehensive
macroeconomic measure of total production (and therefore economic activity) is the gross
domestic product (GDP). Even though this measure has a number of shortcomings, it is
still the best measure of economic activity in South Africa. The next section is devoted to
the measurement of the GDP.
6.2.2
Gross domestic product (GDP)
.................................................................................................................................................................
GDP may be defined as the total value of all final goods and services produced within the boundaries of a
country during a certain period (usually a year).
.................................................................................................................................................................
This definition seems quite clear and simple at first; yet it contains a number of problems
and ambiguities peculiar to the measurement of any macroeconomic total. The first concept
in the definition which requires more detailed discussion is the word value.
What does the "value" of all goods and services mean? How is it possible to combine the
endless variety of goods and services into a unitary measure termed "value"? Is it possible
to add together products such as shoes, clothing, medical services, bread and meat to create
a meaningful whole?
The obvious solution to the above problem is to use prices as the link to combine goods
and services in a measure of total output or production. The justification for the use of
prices as "weights" to measure the relative importance of goods and services lies in
microeconomic principles. The price consumers are prepared to pay for a commodity or
service is a reflection of the value they attach to it. This principle logically leads to the
conclusion that a car, for example, will count for more than a loaf of bread in such a total
measure.
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To calculate the GDP, all the goods and services produced during the period concerned are
multiplied by their prices and then added together to yield the total value of the GDP. The
prices used for this purpose will be the market prices paid for the various goods and
services during the year.
6.2.2.1 Double counting and how to avoid it
The next concept in the definition of the GDP to be discussed is final goods and services.
Final goods and services can be distinguished from intermediate goods and services on the
basis that they are bought by consumers for final use. Any commodity or service purchased
for reselling or processing (by processing we mean use in another production process) is
regarded as an intermediate commodity or service and does not form part of the GDP. The
intention of the buyer when buying a good is therefore very important when a distinction
must be made between final and intermediate goods and services.
Examples of intermediate goods are wheat, which is bought by a miller from a farmer to
produce bread, or a battery bought by a motor manufacturer to fit into a new car. However,
when I buy a new battery to replace my old battery, it is regarded as a final product, because
I am the final consumer of the product. Also, when I as a motorist buy a car, the new battery
(included in the price of the car) will be regarded as part of the final product. In calculating
the GDP, we do not include the value of intermediate goods and services, since this leads to
double counting .
Let's use the production chain for the production of wooden tables to explain the difference
between final and intermediate goods:
i. Suppose a plantation sells 5 000 kg of pine logs to a sawmill at a total price of
R50 000.
ii. The sawmill debarks the logs and cuts it into even boards or lumber. The lumber is
sold to a carpenter who manufacturers furniture for R60 000.
iii. The carpenter uses the lumber to produce 80 tables, which are sold to the furniture
store at R1 000 a table, thus a total of R80 000.
iv. The furniture store subsequently sells the tables for R1 100 a table, thus R88 000.
These transactions may be summarised as follows:
Value of sales
Value added
Rand
Rand
Plantation
50 000
50 000
Sawmill
60 000
10 000
Carpenter
80 000
20 000
Furniture store
88 000
8 000
TOTAL
R278 000
R88 000
The total value of all the transactions (R278 000) cannot, as a whole, be regarded as part of
the GDP. Although the sawmill sold goods for R60 000, he did not produce goods to the
value of R60 000. The plantation had already contributed R50 000 to the production of the
lumber. This means that the amount of R278 000 includes double counting to a
considerable extent.
In order to avoid double counting, we only use the final value of the good when it is sold
to the final consumer. In our example it will be R88 000 – the total price at which the tables
were sold to consumers. Alternatively, we could have added the value that was added by
each of the participants in the production process – as you can see this also
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amounts to R88 000 if we add it together. In the next section, we discuss the different
ways in which GDP can be measured.
6.2.2.2 Three methods to calculate GDP
There are three methods for calculating the value of the GDP without double counting:
(1) Firstly, we can count only the value of those transactions where a commodity reaches
its final destination. As a result, only those transactions between the furniture store
and its customers, a total of R88 000, are taken into account, since only the tables
have actually been produced in this process. This method of accounting is also known
as the expenditure approach . If we go back to the economic circuit in learn- ing unit
1, we see that the value of the GDP could in principle be calculated according to the
expenditure method on the market for consumer goods. The mar- ket for consumer
goods is by implication the market where all final goods and services are sold. The
following equation shows how GDP is measured by adding the final consumption by
all the different sectors in the economy:
As you can see, it includes consumption expenditure by households (C) and the
government (G) plus investment spending (I) by firms. Investment spending by firms
refer to the capital equipment bought by firms plus the change in their inventories.
Since the firms are the final users of this equipment, we include expenditure on
investment to calculate total production in the economy. Changes in the firms’
inventories have to be added because these are goods which were produced during a
certain period; therefore, it should be added to GDP. However, it has not been sold
to consumers yet, so it will not be included in C; therefore, we add it to investment.
All goods that are produced in South Africa and exported to be sold to consumers in
foreign countries (X) also have to be added to calculate expenditure on final goods
and services. Finally, we have to subtract the amount spent on imported goods (Z) as
these are goods that are consumed in our country
(i. e. included in C, I and G) but were produced in other countries, and should
therefore not be included in our GDP.
(2) The second way in which we can calculate GDP while still avoiding double counting
is by adding, for each transaction, only the value added (i.e. the addition to the value
of the output). This is shown in the second column above and yields the same result
as in (1), namely R88 000. This method is known as the production method .
It is interesting to note that a very important equality of national income accounts
exists. From the above derivation, it is obvious that the total expenditure (or
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spending on final goods and services) is in principle equal to the total value of
production. From the example of the tables, it has, however, already become evident
that with the expenditure method (adding up the market values of all final goods), the
same result is achieved as with the value-added approach (the adding together of the
values added at each stage of the production process). And this should be so, because
the value of final goods must necessarily be made up of the successive values added
to the raw materials in the different stages of production.
(3) It is also true that the value of production (i.e. all final goods and services) is exactly
the same as the income which is paid to the owners of the factors of production. In
other words, the compensation paid to labour (wages and salaries), capital (interest),
natural resources (rent) and entrepreneurship (profit) is conceptually equal to the total value of production. By adding wages and salaries, interest, rent and profits we can
calculate the value of the GDP through the income method. Because the income
earned by the owners of factors of production is spent on goods that are produced, in
principle, total income must also equal total expenditure.
The following identity or equation therefore always holds true for national accounts:
PRODUCTION (P) = INCOME (Y) = EXPENDITURE (E)
This identity, which we also encountered in learning unit 1, ensures that the three methods
of calculating the GDP (i. e. the production, income and expenditure methods) will
conceptually lead to the same result.
One final remark on the definition of the GDP is that only the goods and services produced
in a particular year are included in the GDP. It therefore concerns primarily the production
of new products during a specific period. Remember, it does not concern sales over a
specific period. For example, the resale of any second-hand article (say a house or a car)
would not form part of the GDP; nor do activities on the stock market affect the GDP in
any way.
LEARNING ACTIVITY 6.3
Calculate the correct answers
(a) The following table shows the production process of bottled honey and the amount
received by each participant in the production and supply process:
Value of sales (R)
Farmer
5 000
Company that separates honey from
honey comb
6 000
Company that pasteurises and bottles
honey
9 000
Wholesaler
10 000
Retail shop
12 000
Provide the following answers:
i.
ii.
116
The total value added to GDP by the retail shop is R
.
The total value added to GDP by this production process is equal to
R
.
LEARNING UNIT 6:
Measuring Economic Performance
iii.
iv.
v.
The total value added to GDP by the company that pasteurises and bottles
the honey is R
.
The total value added to GDP by the wholesaler is R
.
The total value added to GDP by the farmer is R
.
(b) The following table provides information on economic activity in country XYZ for
2016:
Item
Amount (Q 000)
Consumption expenditure by households
150
Government expenditure
130
Gross capital formation
80
Exports
45
Imports
65
Expenditure on GDP of country XYZ for 2016 is equal to R
.
6.2.3 Real versus nominal values
In the above discussion, we often referred to the "value" of all final goods and services
produced in a particular year. However, we have not really explained which "market prices"
must be used to express the goods and services in money terms. In this respect, it is
important to distinguish between real and nominal values. Let us first have a look at the
meaning of nominal values.
The nominal value of the GDP in a particular year is measured in terms of the prices that
were applicable in that particular year. In this sense, “nomina” means “in monetary or rand
terms”. We can therefore say that 2016 prices were used to calculate the nominal GDP in
2016, whereas 2017 prices are applicable when measuring the nominal GDP in 2017. In
other words, the ruling market prices in a particular year will always be used to calculate the
nominal GDP in that year.
During a period of continuous price increases, it may be possible that the GDP will vary
from one year to the next as a result of (1) an increase in real production (more goods and
services) or (2) merely because of an increase in the prices of goods and services. There may
even be a decline in real production, but the nominal GDP will still increase as a result of
the higher prices. This situation often occurred in South Africa during the 1980s and early
1990s. It is therefore self-explanatory that a comparison of yearly nominal GDP values
cannot be used as an indication of economic progress or growth. There is no assurance that
an increase in nominal GDP portrays real growth instead of a mere increase in prices.
It is for this reason that estimates of the GDP in terms of real prices are also made. In other
words, an attempt is made at measuring the physical extent of the quantity of goods and
services every year. Because it is an indication of real production, this measurement is known
as the real GDP. The GDP of different years is therefore measured in terms of the prices
that prevailed in one specific year. Should we wish to calculate the growth in real GDP
between 2016 and 2017, the GDP in each of these years has to be valued in terms of fixed
prices. In this way, we eliminate the effect of price increases from our calculations. The
prices for the two years are therefore held constant in this way. By way of an example, table
6.1 depicts the South African GDP in terms of current (nominal) and constant (real) values.
Currently, Statistics South Africa, who are responsible for compiling these figures
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uses 2010 prices for calculating the real GDP. We call this the base year and you will notice
that the nominal and real GDP for 2010 in table 6.1 are equal, because that is the only year
for which the same prices were used to calculate nominal and real GDP. The base year is
adjusted from time to time.
TABLE 6.1
The GDP at current (nominal) and constant (real) prices and the implicit GDP deflator
2007–2017
Year
GDP at current prices (R million)
GDP at constant 2010
prices (R million)
Implicit GDP deflator
2010 = 100
(1)
(2)
(3)
2007
2 109 502
2 624 840
80 ,37
2008
2 369 063
2 708 600
87 ,46
2009
2 507 677
2 666 939
94 ,03
2010
2 748 008
2 748 008
100 ,00
2011
3 023 659
2 838 258
106 ,53
2012
3 253 851
2 901 076
112 ,16
2013
3 539 977
2 973 176
119 ,06
2014
3 805 350
3 028 090
125 ,67
2015
4 051 421
3 066 836
132 ,10
2016
4 350 314
3 084 174
141 ,05
2017
4 651 785
3 124 887
148 ,86
Source of GDP figures: https://www.resbank.co.za/Research/Statistics/Pages/Online
DownloadFacility.aspx
GDP deflator: calculated using downloaded figures.
i. In the first column , GDP is expressed in current prices (nominal values). The prices
prevailing in each year were used to calculate the value of GDP. The increase in GDP
from 2007 to 2017 was largely due to price increases over this period.
ii. In the second column , GDP is expressed in real (or constant) prices. From this column, we can clearly see that the increase in real production was much smaller than
the nominal (or current) increases in GDP. For example, compare the small increase
in real GDP between 2016 and 2017 (R40 713m) with the relatively large increase in
nominal terms (R301 471m).
iii. Prices from 2010 were used to calculate real GDP. You will notice that the value of
real and nominal GDP was the same in 2010. This must be so because the same prices were used in both calculations. The year 2010 was thus used as the base year for
the calculations.
iv. The last column gives an indication of price increases during the period. Column 3
can be calculated by dividing column 1 by column 2 and multiplying by 100. From
these figures, we can calculate the rate of inflation as the percentage change from one
year to the next. According to this example, the inflation rate for 2011 was 6,53% (the
GDP deflator increased from 100,0 to 106,53). We will give more atten- tion to the
calculation of the inflation rate in learning unit 7.
v. Obviously, real GDP (column 2) gives a much better indication of economic growth
than nominal GDP.
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6.2.4 Calculation of economic growth
How do we use column (2) to calculate South Africa’s economic growth? The economic
growth for 2017 can, for example, be calculated by showing the increase in real GDP
between 2016 and 2017 as a percentage of the real GDP in 2016.
The formula for calculating the growth rate is the following:
Growth rate in real GDP from 2016 to 2017
=
Growth rate in real GDP from 2016 to 2017
=
Change in GDP
GDP2016
x 100
GDP2017 – GDP2016
GDP2016
x 100
Thus, we can calculate the growth rate in GDP from 2016 to 2017 as follows:
R3 124 887m – R3 084 174m
Growth rate in real GDP from 2016 to 2017 =
R3 084 174m
R40 713m
=
R3 084 174m
x 100
x 100
= 1,32%
If current prices were used, the growth rate would have been 6,93%. The difference between
1,32% and 6,93% was entirely due to price increases that took place during 2017. We will
come back to the issue of economic growth in the next learning unit.
LEARNING ACTIVITY 6.4
Calculate the correct answers
The questions are based on the information in the following table:
Year
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GDP at current prices
GDP at constant prices
(X 000)
(X 000)
GDP
deflator
2010
135 000
a
92
2011
145 000
]151 515
95,7
2012
160 000
160 000
100
2013
162 000
b
2014
167 000
164 467
c
2015
171 000
2016
174 000
162 857
e
102
d
107,5
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(a) Please provide the following values:
i.
ii.
iii.
iv.
v.
(b)
(c)
(d)
(e)
(f)
a=X
b=
c=X
d=
e=X
The growth rate in the nominal GDP from 2013 to 2014 was
%.
The growth rate in the real GDP from 2013 to 2014 was
%.
The growth rate in the nominal GDP from 2015 to 2016 was
%.
The growth rate in the real GDP from 2015 to 2016 was
%.
In which years did real GDP decrease? Choose all possible correct answers:
i.
ii.
iii.
iv.
v.
vi.
2011
2012
2013
2014
2015
2016
6.2.5 The composition of the GDP
So far, we have just looked at the basic methods of calculating the GDP, and we have not
spoken about the type of products which comprise the GDP. There is more than one
method of calculating the GDP. There is also more than one method of identifying the
important subcomponents of the GDP. We will concentrate only on the origin of the
production and the total expenditure components.
6.2.5.1 The origin of the GDP
In the calculation of the GDP, one almost automatically takes into account the branches of
industry or economic sectors where it originates. In this way, the contribution of the
different sectors in the economy can be determined.
The extent to which a country is endowed with natural resources will largely determine the
types of products making up its GDP. Table 6.2 shows the relative importance of the main
sectors in terms of their contribution to the GDP since 1950. South Africa's considerable
mineral wealth is reflected, for example, in the large contribution made by the mining sector
to total production in South Africa. The contribution of this sector until the 1980s was more
or less consistently greater than 10%, and in 1980, as a result of the abnormally high gold
price, the relative contribution increased to as much as 21%. Since 1990, it has hovered just
below the 10% mark.
The primary sector (consisting of agriculture and mining) contributed 29% to the GDP in
1950 as opposed to 2015 when the contribution declined to only 10% in favour of the
tertiary and to a lesser extent to the secondary sector. These developments are in line with
what one would expect from any developing economy like South Africa. Initially, the
economy relies on the primary sector for growth, which is gradually overtaken by activities
in the secondary sector and finally spills over to a strong and vibrant tertiary sector as the
economy becomes more mature.
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TABLE 6.2
Origin of South Africa's gross domestic product (% contribution)
195- 196- 197- 198- 199- 200- 200- 201- 2010
0
0
0
0
0
5
0
5
Primary sector
29
24
16
27
14
11
10
12
10
Agriculture, forestry
and fishing
16
11
7
6
5
3
3
2
2
Mining
quarrying
13
12
9
21
9
8
8
10
8
Secondary sector
23
25
29
28
31
24
24
21
21
Manufacturing
18
20
23
22
24
19
18
15
13
Electricity, gas and
water
2
2
2
3
4
3
2
3
4
Construction
3
3
4
3
3
3
3
4
4
Tertiary sector
48
51
55
45
55
65
66
67
69
Wholesale and retail
trade, catering and
accommodation
Transport, storage
and communication
14
14
14
12
14
15
14
14
15
9
10
9
8
8
10
10
9
10
Finance, insurance,
real-estate and business services
9
11
14
11
14
19
21
21
20
General government
services
7
9
10
10
14
16
15
16
17
Other
8
8
7
4
5
6
6
6
6
Gross value added
at basic prices
100
100
100
100
100
100
100
100
100
and
Source: South African Reserve Bank Quarterly Bulletin, several issues
The manufacturing sector has decreased in importance and was only responsible for 13%
of total production in 2015. This is a worrying trend as this is a sector which can create
many employment opportunities.
The growing importance of the financial sector was particularly evident during the 1990s,
when its contribution increased from 14% in 1990 to 21% in 2010 and 20% in 2015.
The contribution of the government shows an increasing trend which can be a worrying
factor if it has to be sustained by increases in taxes, as it means that fewer private funds are
available for investment and growth.
6.2.5.2 The components of total expenditure
Besides determining the origin of GDP, we would also like to look at the division of the
GDP according to the type of expenditure. From the simple circular-flow diagram in
learning unit 1 and the discussion of the calculation of the GDP, it is clear that the
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expenditure on the GDP has to be equal to the value of the GDP. In section 6.2.2.2, we
explained that when we use the expenditure approach to calculate GDP, the equation we
use is:
GDP = C + 1 + G + X – Z
Because total expenditure is a reflection of the demand in an economy, important insights
into the components of total demand can be gained by looking at these expenditure
categories.
When the various components of expenditure are classified, it is sometimes useful to
distinguish between
(1) the nature or type of expenditure involved and
(2) the sector of the economy in which it occurs.
As regards (1), we distinguish between consumer expenditure and capital expenditure.
As regards (2), it is sometimes desirable to deal with the following groupings or sectors
individually: the private, the government and the external sector.
In the light of this dual distinction, the national accounts identify different components as
set out in table 6.3:
TABLE 6.3
Expenditure on gross domestic product in 2016 (R million)
Current prices
Constant 2010
prices
– Households (C)
2 410 401
1 846 622
– Government (G)
828 669
619 183
– Gross fixed capital formation
827 325
639 383
– Change in inventories
11 201
12 398
Residual item
16 161
– 38
Gross domestic expenditure (GDE)
4 093 757
3 117 549
Exports of goods and services (X)
1 229 935
911 366
Less: imports of goods and services (Z)
1 273 933
965 814
Expenditure on GDP
4 049 759
3 063 101
Final consumption expenditure by
Gross capital formation (I)
Source: South African Reserve Bank Quarterly Bulletin (2017)
Using the figures in table 6.3 above, we can see the following:
● Final consumption expenditure by households, representing the public's expenditure
on goods and services, is the largest single element of expenditure in the economy.
● Just more than 20% of the GDP is spent on capital formation (e.g. factories, buildings,
machinery and equipment), which has an influence on the production capacity of the
country. In Economics, this expenditure is identified as investment. Investment in capital goods is therefore expenditure on goods that are used to produce other goods and
services.
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● Since we are here concerned with the gross domestic product, no provision is made for
capital consumption (i. e. depreciation), so we have to take into account that the amount
spent on capital formation also includes replacement of capital assets.
● Also note that the government's capital expenditure is included in capital formation,
and not in government expenditure.
Together, these items (C, G and I) represent the gross domestic expenditure (GDE). The
residual item is ignored, since it is purely a balancing item. Therefore, we can say that
GDP = C + 1 + G + X – Z
The treatment of imports and exports in the above account requires further explanation.
Since the total of the expenditure components must add up to the GDP at market prices,
this means that all products produced in the country must be taken into account. Since the
domestic expenditure items (C, I and G) do not distinguish between goods and services
manufactured locally and those manufactured in other countries (such as French wine,
Italian shoes and German machinery and equipment), all imports (Z) have to be subtracted
from the GDE. For exactly the same reason, exports (X) such as coal, wool and fruit, which
do not form part of the GDE but which have definitely been produced in this country, must
be added to the GDE. The difference between exports and imports
(X – Z) is called net exports. The extent of exports and imports, which jointly constitute
about 62% of the GDP, is an indication of the importance of the foreign sector for the
South African economy. In economic parlance, we say that the South African economy is
particularly "open".
The above classification can be summarised in the following well-known equations:
From table 6.3, it is evident that imports (Z) exceeded exports (X). This meant that GDE
was greater than GDP. South Africans were spending more than what they were producing
domestically in 2015. As we will see in learning unit 10, this also implies that we were
running a deficit on our trade balance.
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LEARNING ACTIVITY 6.5
Find your own figures and do calculations
Visit the webpage of the South African Reserve Bank (https://www.resbank.co.za/Pages/
default. aspx). Find the South African Reserve Bank Quarterly Bulletin for September 2018 (click
on Publications and Notices, and choose Quarterly Bulletins from the dropdown menu). Click on
Quarterly Bulletin Publication on the left. Choose 2018 and find the Quarterly Bulletin for
September 2018. Go to the end of the page and choose the Statistical Table that contains
the National Accounts. Find the table that contains the Expenditure on Gross Domestic Product.
Use the information in this table to complete the following table and answer the questions
that follow
Note that you can also find the table that you should use under Additional Resources. Click
on Table for Learning Activity 6.5”.
(a) Complete the following table for 2016 and 2017 using the figures that you find in
the National Financial Accounts:
Current prices
(R million)
2017
2016
Constant 2010 prices
(R million)
2016
2017
Final consumption expenditure by
– Households (C)
– Government (G)
Gross capital formation (I)
– Gross fixed capital formation
– Change in inventories
Residual item
Gross domestic expenditure (GDE)
Exports of goods and services (X)
Less: imports of goods and services
(Z)
Expenditure on GDP
(b) Use the information in the table to calculate the following:
i.
ii.
Growth rate in nominal GDP from 2016 to 2017
Growth rate in real GDP from 2016 to 2017
6.2.6 Shortcomings of the GDP
.................................................................................................................................................................
True, the statistics are not as good as we want them to be, but what would we do without
them?
- Oscar Morgenstem, Fortune, October 1963 .................................................................................................................................................................
Much has been said about what the GDP is supposed to measure and how the GDP itself
can be measured and applied, and so the impression may have been created that this is an
extremely accurate and comprehensive measure of all possible economic activity. From the
residual item which occurred in the previous section, it could, however, have been
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deduced that the macro-economic totals, seen purely from an accounting point of view, are
not accurate. Such deviations are understandable if we look at the extent of the measuring
problems involved. This is, however, not regarded as a major problem. A far more serious
criticism that can be made of the GDP and other national accounts totals is related to these
estimates being used as a measure of economic welfare. The main objections are the
following:
Only goods and services appearing on a market, and therefore with a market price , are
included in the calculations. This principle has, for instance, resulted in the value of a meal
at a restaurant being fully included in the GDP, while a similar meal prepared at home (apart
from the purchased ingredients) is excluded. This applies to all work done by stay- at-home
parents. When a car is serviced at a garage, the GDP is increased because of the service
rendered, but if it is serviced at home, the GDP is not affected.
Closely related to the above problem is the large number of transactions which do go
through the market but are never recorded anywhere, and thus cannot be included in the
measurement of the GDP. Examples are the wages of many gardeners, maintenance done
at home, lift clubs, as well as all illegal activities such as smuggling. These activities are
known as the informal sector or the unrecorded economy.
This sector has gained importance in recent years and, for this reason, the government has
given official recognition to the possibilities of the informal sector, and is at present
encouraging a number of different actions to develop healthy activities in this sector.
The inclusion of goods and services for which a market price can be determined has also
resulted in the possibility of certain negative elements leading to an increase in the GDP. A
deterioration of the security situation in a country will lead to increased defence and police
expenditure (and a consequent increase in the GDP), which can hardly be regarded as an
increase in welfare. Increased production is often accompanied by increased pollution, but
no correction is made in the GDP for this decline in welfare. Finally, it should also be noted
that the availability of leisure time (i. e. a shorter working day or week) is not reflected in
the GDP measure.
Economists who were concerned about the possible misrepresentations which could result
from the above defects attempted to find a more acceptable measure of economic welfare.
They tried to determine the impact of factors such as leisure time, pollution and the
inconvenience of overpopulated cities in terms of money, and to add or subtract it from the
GDP. Unfortunately, the problems involved in establishing such a measure are so complex
and extensive that their efforts were largely a failure. The GDP and other similar
macroeconomic totals remain, in spite of their defects, the best indication of the level of
economic activity maintained during a specific period.
LEARNING ACTIVITY 6.6
Choose the correct answer
(a) Which one of the following statements describes a shortcoming of using GDP as a
measure of economic growth and welfare?
i.
ii.
iii.
iv.
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Production of goods that do not have a market price is not included in the
GDP.
Activity in the informal sector is included when the GDP is calculated.
An increase in expenditure to limit pollution will not be included in the
GDP.
An increase in the leisure time of workers will reflect as an increase in the
GDP.
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(b) Which of the following is/are [a] limitation [s] of GDP? Choose ALL correct
options.
i.
ii.
iii.
iv.
v.
GDP does not include unpaid labour.
GDP does not value leisure time.
GDP does not consider environmental degradation.
GDP does not account for resource depletion.
GDP includes imports.
LEARNING ACTIVITY 6.7
Discussion forum
Please read the following article that appeared on The Conversation on 1 December 2014:
Ida Kubiszewski
Senior Lecturer at Crawford School of Public Policy, Australian National University
“AT PRESENT, WE ARE STEALING THE FUTURE, SELLING IT IN THE
PRESENT, AND CALLING IT GDP.” — Paul Hawken
Imagine if a corporation used Gross Domestic Product (GDP) accounting to do its
books: it would be adding all its income and expenses together to get a final number.
Nobody would think that’s a very good indication of how well that business was doing.
Herman Daly, a former senior economist at the World Bank, said that, “the current
national accounting system treats the earth as a business in liquidation.” He also noted
that we are now in a period of “uneconomic growth”; where GDP is grow- ing but
societal welfare is not.
The good news is that there are several alternatives to GDP being actively developed,
discussed, and used. One of these is the Genuine Progress Indicator (GPI).
GPI starts with personal consumption expenditures — a major component of GDP —
and adjusts it using 25 components. These adjustments include incorporating the negative effects of income inequality on welfare; adding positive elements not considered
in GDP, such as the benefits of household work, volunteer work, and higher education;
and subtracting environmental costs and social costs like the costs of crime,
unemployment, and pollution. In doing so, it paints a more accurate picture of how far
we’ve come over the last three decades.
Regional level
In the United States, the states of Maryland and Vermont officially report their GPI
annually. In 2010, Maryland was the first state to officially adopt the GPI as an alternative to GDP. The state’s goal was “to measure whether or not economic progress
results in sustainable prosperity”.
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Since its beginning, Maryland governor Martin O'Malley has actively implemented
policies to encourage the increase of GPI. The media has also taken up the challenge
of shedding light on the true picture of societal welfare, with media coverage now
regularly reporting on changes in GPI.
In 2012, the state of Vermont passed legislation mandating the calculation of GPI.
Since then, GPI has been estimated for other states including Colorado, Hawaii, Massachusetts, Michigan, Ohio, Oregon, and Utah, while ten others have expressed
interest in developing their own studies.
This movement towards GPI is part of an international trend, and GPI has been calculated in around 20 countries worldwide. The international research community has
begun to develop what is being called “GPI 2.0”. GPI 2.0 seeks to improve standardization and robustness of the current GPI.
National level
GPI is not the only new measure of societal welfare being adopted around the world.
The Kingdom of Bhutan began using Gross National Happiness (GNH) as an alternative to GDP in 1972 after fourth King, Jigme Singye Wangchuck, stated that “Gross
National Happiness is more important than Gross National Product.”
GNH is estimated using a survey that takes approximately seven hours per person. In
2013, it was taken by more than 10% of the Bhutanese population. The Bhutanese
government also established the GNH Commission to assess all new policies for their
impact on the “happiness” or well-being of the population.
The Australian Bureau of Statistics also began moving in this direction with the
Measures of Australia’s Progress (MAP) initiative. MAP was established to address
the question, “Is life in Australia getting better?” MAP provides Australians with 26
indicators related to society, economy, environment, and governance. Unlike the GPI,
it does not aggregate the indicators into one overall measure, but allows viewers to
make their own assessment regarding the well-being of the Australian population
based on the individual indicators. However, funding was discontinued for MAP in
early 2014.
Global effort
Currently, no global consensus exists regarding alternatives to GDP. However, there
is growing agreement that the continued use of GDP as a proxy for overall well-being
is not appropriate. A range of national indicators exist and are being used around the
world
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LEARNING UNIT 6:
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The Millennium Development Goals, which are ending in 2015, look primarily at health, poverty, and education. To replace them, a UN-led
initiative has developed a set of 17 Sustainable Development Goals (SDGs).
These new goals have a broader agenda that includes the environ- ment,
inequality, and sustainable and equitable economic growth, amongst other
aspects.
Although metrics are being developed for each of the 17 goals and their subgoals, as of yet, no overall indicator has been developed to assess the overall
success of the SDGs.
Robert F. Kennedy once said that a country’s GDP measures “everything
except that which makes life worthwhile”. The only way to dethrone GDP
from its current role, is to start measuring all those things that do “make life
worthwhile”.
THIS ARTICLE IS PART OF AN ONGOING SERIES, Beyond GDP,
WHICH LOOKS AT THE DOMINANCE OF GDP IN ECONOMIC
THINKING AND HOW THAT MIGHT CHANGE. Read more here
Source: The Conversation: https://theconversation.com/beyond-gdp-are-there-better-ways-to-measure-well-being-33414
After having read the article, visit the discussion forum for learning activity 6.7 on
myUnisa and provide your opinion on the following:
GDP is the best measure of economic wellbeing that is available to economists.
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LEARNING ACTIVITY 6.8
Quiz on learning unit 6
Note that you can also do this quiz on myUnisa to get immediate feedback. The answers to
the quiz will also become available on myUnisa under Additional Resources at the end of
the week allocated to studying learning unit 6.
Indicate whether each of the following statements is TRUE or FALSE:
STATEMENT
TRUE
FALSE
1. Macroeconomics deals with phenomena such as total
production, total employment and inflation.
2. Microeconomics focuses on specific parts of the economy, while Macroeconomics is concerned with the
economy as a whole.
3. The study of the total output of the motorcar industry
is an example of Macroeconomics.
4. An increase in the price of tomatoes is a macroeconomic issue.
5. The compilers of the national accounts can avoid double counting by recording only every second
transaction in the economy.
6. According to the income method, GDP is estimated by
adding up the income earned by the various factors of
production.
7. Market prices are used to calculate the value of all final goods and services.
8. The GDP includes goods and services that are produced outside the borders of the country.
9. Nominal GDP could increase, while real GDP
decreases.
10. Nominal values should always be used to calculate
economic growth.
LEARNING ACTIVITY 6.9
Short questions on learning unit 6
Note that you can also do these short questions on myUnisa to get immediate feedback. The
answers to the questions will also become available on myUnisa under Additional
Resources at the end of the week allocated to studying learning unit 6.
1. What is the focus area of macroeconomic analysis?
2. What is the focus area of microeconomic analysis?
3. Indicate whether the following will be studied under Microeconomics or
Macroeconomics:
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LEARNING UNIT 6:
3.1
3.2
3.3
3.4
3.5
Measuring Economic Performance
Government purchases of goods and/or services
The purchase of a new designer T-shirt
The price of data bundles charged by Cell C and Telkom
The impact of a repo rate increase by the South African Reserve Bank on the
decision to buy a house
The impact of an increase in the petrol price on total spending by consumers
4. To calculate GDP, we must add the value of all
goods and services.
5. The GDP can be calculated by adding the value added. This is known as the
method.
6. GDP can be measured according to three different approaches. What are these
approaches?
ADDITIONAL RESOURCES THAT CAN BE CONSULTED
If you are interested to find out more about the topics covered in this learning unit, you
can consult the following sources:
Janse van Rensburg, J, McConnell, CR & Brue, SL. 2011. Economics: Southern African Edition.
Berkshire: McGraw-Hill: Chapter 15.
Mohr, P & Associates. 2015 (or other editions). Economics for South African students. Pretoria:
Van Schaik Chapter 13, pages 233–244.
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LEARNING UNIT 7
Selected Economic Indicators
CONTENTS
7.1
INTRODUCTION
134
7.2
INFLATION
134
7.2.1
Consumer price index (CPI)
135
7.2.2
Producer price index (PPI)
138
7.3
UNEMPLOYMENT
140
7.4
INCOME DISTRIBUTION
144
7.4.1
The Lorenz curve
144
7.4.2
The Gini coefficient
146
7.5
BUSINESS CYCLES
151
7.6
ECONOMIC GROWTH
153
7.6.1
153
132
Calculating economic growth
LEARNING UNIT 7:
Selected Economic Indicators
Mind map of selected economic indicators
Econosavvity
To pass this module, you will be expected to understand the following concepts and
apply them to economic situations:
●
●
●
●
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consumer price index (CPI)
producer price index (PPI)
unemployment rate
Lorenz curve
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LEARNING UNIT 7:
●
●
●
●
●
7.1
SELECTED ECONOMIC INDICATORS
Gini coefficient
business cycles
peak
trough
per capita
INTRODUCTION
A number of very important economic indicators, used by economic analysts, are discussed
throughout this learning material. Some of these are mentioned or discussed in other learning
units – examples are the gross domestic product (GDP) (unit 6), the budget of the South
African government (unit 8), various measures of the money supply (unit 9), the balance of
payments (BoP) (unit 10) and international trade statistics (unit 10). In this unit, we discuss
some additional economic indicators in order to broaden your vision of the South African
economy.
Economic indicators are used to measure the performance of the economy. The indicators
that we are discussing in this learning unit are all macro-economic indicators, and can
therefore be linked to macro-economic policy objectives.
The inflation rate provides an indication of the degree to which the objective of price stability
has been reached. This is discussed in section 7.2. The unemployment rate provides
information about the full employment objective. This is discussed in section 7.3.
Measurements of income distribution are discussed in section 7.4 and provides an indication
of how the income is distributed in a country. Business cycles provide an indication of
economic activity in the country, and are therefore related to the objective of economic
growth, but also to price stability and employment creation, as economic activity will affect
all these economic objectives. Business cycles are briefly explained in section 7.5. Section 7.6
discusses measurements of economic growth, and is therefore related to this objective.
7.2
INFLATION
Please see the following definition of inflation:
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When prices of goods increase, the value of money declines as you can now buy less with
the same amount of money, for example, with R100.
Inflation is regarded as a serious economic problem that should be addressed by economic
policy. The reasons why inflation is regarded as a problem include the following:
● Inflation has redistribution effects between debtors and creditors. Due to the decline in the purchasing power of money, the value of the debt that debtors pay back to creditors decline.
The only way to ensure that creditors are not disadvantaged is to keep the in- terest rate
levels at a higher rate than the inflation rate.
● Inflation can cause a redistribution of wealth from the private sector to the government. A person’s nominal income may increase moving him or her into a tax bracket where a larger
percentage of income has to be paid to taxes. However, if the inflation rate is high it is
possible that this person’s real income has not increased. We call this phenomenon
bracket creep.
● Poor people are more severely affected by rising prices during inflation periods. During inflationary periods, interest rates will usually increase. Wealthier persons who have invested part
of their wealth in interest bearing assets will benefit from the higher interest rates. Poorer
people who spend all their income cannot benefit from the higher interest rates. It is
even possible that they have debt that they have to pay back at higher interest rates,
disadvantaging them even more.
● Inflation may result in investment in non-productive assets such as rare art, postage stamps,
jewellery, etcetera. In a developing country, it is important that as much as possible is
invested in projects that create infrastructure and increase production and employment
opportunities. During inflation periods, persons may avoid such productive investment
due to the uncertainty attached to the returns.
● Domestic inflation also increases the prices of export goods, resulting in less competitive prices and thus a decrease in exports. This may result in balance of payments problems and
a depreciation of our currency.
● Inflation also has socio-economic effects. When individuals experience a decline in the purchasing power of their wages and salaries, they become unhappy. This may result in
protest action. Inflation will usually also result in increases in administered prices, for
example bus and train fares and electricity charges, that also create unhappiness and may
lead to protests.
A high inflation rate has severe destabilising effects in an economy. Therefore, it is
important that the inflation rate will be measured regularly to ensure that policy can be used
to address this problem immediately before the problem gets out of hand. The consumer
price index and the producer price index are two important measures that are used to
measure the inflation rate. These will now be discussed. In learning unit 9, we shall briefly
explain how monetary policy may be used to address the problem of inflation.
7.2.1
Consumer price index (CPI)
The consumer price index (CPI) is a series of numbers (an index) showing how the average
price level of goods and services (basket of goods and services) bought by a typical
consumer or household changes over time. The inflation rate is calculated as the annual
percentage change in the CPI.
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Table 7.1 indicates annual changes in average rates for all service categories according to
the classification of different types of goods and services, as well as the weight allocated to
each type of good and service.
TABLE 7.1
Consumer prices for services according to classification of different types of services
Weights
2012
2013
2014
2015
2016
2017
Housing and utilities
20,30
78,7
82,9
87,4
92,1
97,2
102,4
Household contents and
services
2,45
79
83,4
88
92,6
97,5
102,5
Health
0,83
78,1
83
88,1
93,8
99,5
105,9
Transport
3,10
79,9
87
92,3
95,8
98,7
101,6
Communication
2,43
98,3
100,2
100
99,7
100
99,6
Recreation and culture
3,27
83,4
87,6
89,5
91,4
98,4
100,7
Education
2,53
72,8
79,3
86,2
94,2
99,3
105,8
Restaurants and hotels
3,09
74,4
79,3
86
91,1
96,8
101,2
Miscellaneous services
13,25
74,3
80,3
85,9
92,2
99,1
106,8
Total services
51,30
77,9
82,8
87,7
92,8
98,1
103,5
Total CPI
100,00
78,4
82,9
88
92
97,8
103,0
* Seasonally adjusted, indices: 2016/12 = 100
Source: South African Reserve Bank Quarterly Bulletin (2018)
The CPI is a fixed-weight index, which implies that the weight for each item stays the same
throughout the five-year period. This means that it is assumed that the total percentage of
the budget spent on this item stayed the same throughout the period that is shown, for
example, an average consumer spent 17,24% of his or her basket on food and non-alcoholic
beverages (see table 7.2) and 24,68% (20,30%+4,38% – see table 7.1 and 7.2) of their total
budget on housing and
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Utilities. The CPI is then compiled by collecting retail prices for all the items included in
the basket on a monthly basis (between the first and the seventh day of each month) and
weighing each item according to its relative importance in the basket of goods and services.
The indices thus compiled for a number of the more important product/ service groups are
shown in tables 7.1 and 7.2.
The tables show clearly how divergent price movements in the different categories were. It
is important to note that the base year of the indices is 2016. Over the period from 2012 to
2017, the food and non-alcoholic beverages prices index rose from 73,1 to 103,3. This
means that a food basket costing R73,10 at the end of 2012 cost R103,30 at the end of 2017.
TABLE 7.2
Consumer prices for goods according to the COICOP classification*
Weights
2012
2013
2014
2015
2016
2017
Food and non-alcoholic
beverages
17,24
73,1
77,2
83,1
87,4
96,6
103,3
Alcoholic
beverages
and tobacco
5,82
76
81,2
86,3
93,6
99,0
102,8
Clothing and footwear
3,83
81,6
84,1
88,5
93,2
97,8
101,0
Housing and utilities
4,38
72,7
78,9
84,3
90,8
97,2
101,2
Household contents and
services
1,90
95
97,3
98
97,6
99,4
98,8
Health
0,53
81,5
84,4
88,2
93,1
97,7
103,9
Transport
11,18
85,5
91
96,8
93,5
97,7
103,3
Communication
0,20
71,1
152,9
134,5
117,3
104,5
92,4
Recreation and culture
1,88
85,6
92
93,7
94,5
98,3
100,2
Miscellaneous goods
1,79
81,7
84,4
88,7
93,2
98,0
102,1
Total goods
48,70
79
83
88,2
91,2
97,5
102,4
Total CPI
100,00
78,4
82,9
88
92
97,8
103,0
* Seasonally adjusted, indices: 2016/12 = 100
Source: South African Reserve Bank (2018)
Let's see how we calculate the change in the prices of food and non-alcoholic beverages
from 2012 to 2016. The index rose from 73,1 in 2012 to 103,3 in 2017, and therefore we
can calculate the change as follows:
Change in CPI index from 2012 to 2017 = 103,3 – 73,1 = 30,2
To calculate the percentage change in the CPI index, we divide this change by the CPI at
the beginning of the period, that is in 2012, and multiply by 100. The percentage change in
the index from 2012 to 2017 can now be calculated as follows:
% change in CPI index from 2012 to 2017 =
ECS1500/1
30,2
73,1
x 100 = 41,31%
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This means that the average price of food and non-alcoholic beverages increased by 41,31%
from 2012 to 2017. The inflation rate for food and non-alcoholic beverages over this period
is therefore 41,31%.
The CPI can thus be used to calculate the inflation rate as a percentage change in the CPI
over a specific period. This rate is then used by numerous institutions and organisations
such as trade unions to adjust prices and/or to negotiate for higher wages and salaries.
LEARNING ACTIVITY 7.1
Calculate the correct answer and interpret the answer
(a) Calculate the inflation rate for the total CPI from 2012 to 2017.
(b) Compare the inflation rate for food and non-alcoholic beverages from 2012 to 2017
to the inflation rate for the total CPI over the same period. Did the prices of food and
non-alcoholic beverages increase by more, or by less, than the increase in the total
CPI?
7.2.2
Producer price index (PPI)
The second important price index that we have to know about is the producer price index
(PPI). Before 1980, this was known as the wholesale price index. From this, we can deduce
that the prices of this index are measured at the level of the first significant commercial
transaction. Prices of imported goods are measured at the point when they enter the
country, and locally manufactured goods are priced when they leave the factory. In contrast
to the CPI, the PPI also includes capital and intermediate goods, but excludes services.
Furthermore, CPI is used when analysing changes in the price level of final goods and
services generally consumed by consumers, while PPI is used for goods generally consumed
by producers in the production process.
The basic method of calculating PPI is similar to that of the CPI, and is also published every
month by Statistics SA. From tables 7.3 and 7.4 below, it is clear that the basket of products
differs radically from the CPI basket of goods and services. For instance, the weight of food,
beverages and tobacco is 33,72% in the case of the PPI, and only 23,06% (17,24% + 5,82%)
in the case of the CPI.
Since not all items are shown in the table, the weights do not add up to 100.
An important advantage of the PPI is the fact that it provides some indication of what can
be expected from the CPI in the future. Since the prices are measured at the level of the
first transaction, the PPI is often used to predict what will happen with consumer prices in
a few months’ time.
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TABLE 7.3
Producer prices of selected products*
2012
2013
2014
2015
2016
2017
Agriculture, forestry and fishing
74,7
76,6
80,6
84,4
98,4
97,5
Mining
85
89,6
93,3
89,5
98,3
105,1
Electricity and water
72,2
79,8
87,6
97,4
98,3
113,7
Intermediate manufactured goods
78,3
84,4
91,3
92
98,3
102,2
Total final manufactured goods**
77,4
82,1
88,1
91,3
72,4
102,5
* Seasonally adjusted, indices: 2016 = 100
** Non-metallic mineral products, furniture and other manufacturing are omitted
from total final manufactured goods
Source: South African Reserve Bank Quarterly Bulletin (2017)
TABLE 7.4
Producer prices of final manufactured goods
Weights
2012
2013
2014
2015
2016
2017
33,72
72,5
76,8
82,6
87,7
96,4
100,8
Textiles, clothing and
footwear
4,07
76,6
80,5
86,2
90,9
97,9
103,1
Wood and paper products
9,18
75,7
80,9
85,7
92
97,3
103,5
Coke, petroleum, chemical, rubber and plastic
products
21,66
87,9
93,9
100,2
94,8
98,4
106,5
Metals, machinery,
equipment and computing equipment
14,82
77,4
80,9
87,9
92,9
99
101,2
Electrical machinery and
apparatus and subcomponents
1,91
81,9
86,1
91,5
93,4
98,5
102,5
Transport equipment
8,16
79
84,8
91,8
94,4
101,4 101,1
77,4
82,1
88,1
91,3
97,8
Food products, beverages
and tobacco
Total final manufactured
goods**
100
102,5
* Seasonally adjusted, indices: 2016 = 100
** The weights of final manufactured goods do not add up, as non-metallic mineral
products (4,20) and furniture and other manufacturing (2,28) are omitted.
ECS1500/1
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LEARNING ACTIVITY 7.2
Calculate the correct answers and interpret the answers
(a) Calculate the inflation rate for food products, beverages and tobacco from 2012 to
2017 based on the PPI.
(b) Calculate the inflation rate based on the total PPI from 2012 to 2017.
(c) Compare the inflation rate for food and non-alcoholic beverages from 2012 to 2017
based on the CPI, to the inflation rate for food products, beverages and tobacco over
the same period based on the PPI. Can you provide possible explanations for the
difference?
7.3
UNEMPLOYMENT
Unemployment is perhaps the greatest challenge facing economic policy makers in South
Africa. The unemployment rate is thus a very important economic indicator. In its simplest
form, the unemployment rate is the number of unemployed persons expressed as a
percentage of the total workforce. This figure is, however, not so easy to calculate, mainly
because of difficulties in finding precise definitions for terms such as “unemployed” and
“total workforce”.
In 1998, Statistics South Africa revised its definition of the official unemployment rate in
line with the International Labour Organisation’s (ILO) definition.
In terms of this definition, the unemployed are those people between the ages of 15 and
64 years within the economically active population who:
i. did not work during the seven days prior to the interview;
ii. want to work and are available to start work within a week of the interview; and
iii. have taken active steps to look for work or to start some form of self-employment in
the four weeks prior to the interview.
The economically active population consists of persons between the ages of 15 and 64
years who are employed and those who are unemployed. Its size therefore varies according
to the definition of unemployment used.
The official unemployment rate is calculated as the percentage of the economically active
population which is unemployed, according to the above definition.
This revised definition corresponds to what Statistics South Africa previously called the
strict unemployment rate. By contrast, the expanded unemployment rate does not
require criterion (iii) above to hold. Only criteria (i) and (ii) must be met in order for a
person to be classified as unemployed. This means that if we use the explanded definition
of unemployment, people who have been discouraged because they have not been able to
find a job and are no longer looking for a job, but would actually like to work, are counted
as part of the unemployed and thus also as part of the labour force.
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Table 7.5 shows the labour market statistics of South Africa, according to the Quarterly
Labour Force Survey (QLFS). The year-on-year increase in the labour force from the end of
2015 to the end of 2016 was 638 000. This can be ascribed to the increase in both
employment and unemployment by 51 000 and 588 000 respectively (due to rounding the
figures do not add up exactly). The total number of persons not economically active
decreased by 6 000 year on year. The official unemployment rate increased by 2 percentage
point to 26,5% over the same period.
Let's use the numbers in the table to calculate the unemployment rates according to the
strict definition of unemployment and the expanded definition of unemployment that we
explained above.
For the strict definition, you have to exclude persons who are no longer seeking work from
both the number of unemployed persons and from the number of persons in the labour
market. Thus, the unemployed persons will be only those who are unemployed and who
have been actively seeking work in the past four weeks, while the total labour market will
include those persons who are working plus those who are unemployed but have been
actively seeking work in the past four weeks.
TABLE 7.5
Labour market statistics of South Africa (’000)
Q3*
Q4**
Q3
Q4
Q3
Q4
Q3
Q4
2014
2014
2015
2015
2016
2016
2017
2017
Total employment
15 117
15 320
15 828
16 018
15 833
16 069
16 192
16 171
Total unemployment (official definition)
5 151
4 909
5 418
5 193
5 873
5 781
6 210
5 880
Total economically active
(= a+b)
20 268
20 228
21 246
21 211
21 706
21 849
22 402
22 051
Total not economically
active
15 221
15 415
14 867
15 061
15 044
15 055
14 971
15 474
Included in (d): discouraged work-seekers
2 514
2 403
2 226
2 279
2 291
2 292
2 436
2 538
* Quarter 3 (Q3) = July to September
** Quarter 4 (Q4) = October to December
Source: Statistics South Africa Quarterly Labour Force Survey (2015 to 2017)
ECS1500/1
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For the expanded definition, those persons who have given up and who have not actively
looked for a job in the past four weeks are included in both the number of unemployed
persons and the number of persons in the labour market. Thus, the number of unemployed
persons will include those have been actively looking for a job plus those who have not,
while the labour market will include those who are employed plus the unemployed who have
been actively looking for a job plus the unemployed who have not been actively looking for
a job.
Let's calculated the respective rates for the fourth quarter of 2017:
The formula for calculating the unemployment rate:
Unemployment rate
=
Number of unemployed persons
x 100
Labour force
The labour force includes both the unemployed persons and the number of employed
persons.
Let's see how we calculate this using the two definitions of unemployment:
Calculating the unemployment ratio using the
strict definition of unemployment
Number of unemployed persons = 5 880 000
Calculating the unemployment ratio using the expanded
definition of unemployment
Number of unemployed persons = 5 880 000 + 2 538 000
= 8 418 000
Labour force
=
5 880 000 + 16 171 000
=
22 051 000
Unemployment rate
5 880 000
=
22 051 000
x 100 = 26,7%
Labour force
=
8 418 000 + 16 171 000
=
24 589 000
Unemployment rate =
8 418 000
24 589 000
x 100 = 34,2%
As expected, the unemployment figure is quite a lot higher if we also take the discouraged
workers who are no longer actively seeking employment into account.
Normally, six types of unemployment may be distinguished:
i. Voluntary unemployment occurs when an individual chooses to be unemployed because of low wages.
ii. Involuntary unemployment occurs when an unemployed person wants to work, but
is unable to find work. (In general, all unemployment is classified as involuntary
unemployment.)
iii. Frictional unemployment (also known as search unemployment) arises during the
time it takes to find a new job or to move from one job to another. This kind of unemployment is temporary and unavoidable. It is not really considered as serious.
iv. Seasonal unemployment occurs when workers are laid off because of the seasonal
nature of the work. Examples include workers employed during farm harvest times
and festive seasons or to do summer jobs such as life-guarding at outdoor pools or
the beach.
v. Cyclical unemployment arises as a result of fluctuations in the demand for goods and
services. When there is a depression, workers normally lose their jobs. This type of
unemployment varies with the business cycles (boom and recession periods).
vi. Structural unemployment has to do with structural changes in the economy causing a
mismatch between the skills of workers and the requirements of jobs. Structural
unemployment can arise because certain products have become obsolete or unpopular. For instance, the fact that fewer people smoke nowadays has resulted in job losses
in the tobacco industry; and with the advent of modern word processing, typ- ing
pools were no longer required.
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LEARNING ACTIVITY 7.3
Choose the correct answers and do calculations
(a) The following persons are all unemployed:
● Zodwa has not had work for quite a while, and occasionally flips through job ads
to see what kinds of jobs are available.
● Caiphus does not have work, but is actively sending out his resume to employers.
● Sanele has just graduated from college and is starting his job search.
● Samuel used to work as a miner near Richards Bay, but the mine he worked for
has now closed down, and no other mining jobs is available.
● Lydia has left her job to care for her new-born child.
● The mine that Barney works for has closed down due to the low aluminium price,
but may open again if the aluminium price improves, and then he may be employed again.
● Mpho works in the restaurant on the beach front during holiday seasons, from
March to April and from November to January.
Use this information to indicate the types of unemployment each of the following
persons are experiencing, by writing the appropriate letters next to each person's
name:
Name
Letters (type
of unemployment)
Letter
Type of unemployment
Zodwa
a
Voluntary unemployment
Caiphus
b
Involuntary unemployment
Sanele
c
Frictional unemployment
Samuel
d
Seasonal unemployment
Lydia
e
Cyclical unemployment
Barney
f
Structural unemployment
Mpho
g
Not part of labour force
(b) The following information on the labour market in country X is provided for 2017:
Description
Number of persons
Employed persons
15 000
Unemployed persons
5 000
Discouraged work-seekers
3 500
Population
35 000
i.
ii.
ECS1500/1
Calculate the unemployment rate for country X in 2017 based on the strict
definition of unemployment.
Calculate the unemployment rate for country X in 2017 based on the expanded definition of unemployment.
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SELECTED ECONOMIC INDICATORS
INCOME DISTRIBUTION
Estimates show that the proportion of people living in poverty in South Africa did not
change between 1996 and 2001 (Schwabe 2004). There is also evidence that those
households living in poverty have sunk deeper into poverty, and that the gap between rich
and poor has widened. According to Leibbrandt et al (2010), the distribution of income in
South Africa became more unequal between 1993 and 2008. This is true not only of the
population as a whole, but also if ethnic groups are analysed separately. Despite rapid rises
in black per capita incomes, the gap between rich and poor in the black population has been
rising steadily since 1993 (Van der Berg & Louw 2003:16). Leibbrandt et al (2010) detected
that there was a decline in the importance of between-race inequality, but inequality within
the different race groups (e.g. within the black race group) rose sharply between 1993 and
2008. There is no doubt that income inequality is a serious socio- economic problem in
South Africa. But how do we measure this inequality?
7.4.1
The Lorenz curve
The Lorenz curve and the associated Gini coefficient are the most commonly used
indicators of income inequality in a country. Because the Gini coefficient is derived from
the Lorenz curve, we will start with how the latter is constructed.
The Lorenz curve is a graphical device used to illustrate the degree of inequality of income
distribution in a country. The curve was developed by an American statistician, Max O.
Lawrence in 1905. The Lorenz curve can best be explained by using a simple hypothetical
example. Let’s assume the size of the population of country A is 100 and the total income
of the population is R100. The total income of the poorest 20 people is only R2. The next
poorest 20 people earn a total income of R8. The income of consecutive groups of 20 people
steadily increases, until the richest 20 people in country A earn the remaining R65. This
information in the form of percentages and cumulative percentages is shown in table 7.6.
TABLE 7.6
Income distribution of country A
Percentage
Cumulative percentage
Point on
Lorenz curve
Population
Income
Population
Income
poorest 20
2
20
2
D
next 20
8
40
10
E
next 20
10
60
20
F
next 20
15
80
35
H
richest 20
65
100
100
C
By plotting the data for the cumulative percentage population and cumulative income in
table 7.6 on a graph, we obtain the Lorenz curve for country A, which you can see in figure
7.1.
The cumulative percentage income is measured on the vertical axis, and the cumulative
percentage of the population on the horizontal axis. The diagonal line from point A to point
C on the graph is the line of perfect equality. It shows what the Lorenz curve would have
looked like if each person earned exactly the same amount (i.e. if there was a perfectly equal
distribution of income). In our example of country A, it means that each person would have
earned exactly R1. The deviation of the actual Lorenz curve (see figure 7.1)
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LEARNING UNIT 7:
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from this perfect equality indicates the area of inequality or the skewness in the income
distribution. This is exactly how the Lorenz curve for a country is constructed if the
statistical data is available.
FIGURE 7.1
The Lorenz curve for country A
What would the Lorenz curve for country A look like if one person earned R100 and the
rest of the population earned nothing? This would be depicted by a right triangle running
from A to B to C (ABC) in figure 7.1. The income earned by the first 99 people is zero
(shown by AB in figure) and the 100th person earns R100 (the BC line). The further the
actual Lorenz curve moves away from the line of perfect equality (or towards ABC), the
greater the degree of inequality in the country.
Figure 7.2 shows the distribution of income in a few selected countries for 2016 or the latest
available year before 2016. As you can see South Africa's income distribution is by far the
most unequal (furthest away from the line of perfect equality, while income distribution in
the UK is the most equal (closest to the line of perfect equality). It is interesting that the
income distribution in Russia and the US was almost identical, despite the fact that Russia
was a communist country for a long period, while the US would most likely regard
themselves to be the most capitalist country in the world.
ECS1500/1
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FIGURE 7.2
Income distribution in selected countries
Source: OECD Income Distribution Database (IDD), http://stats.oecd.org/Index.aspx?DataSetCode=
IDD
7.4.2
The Gini coefficient
The Gini coefficient was developed by an Italian demographer, Corodo Gini, in 1912. The
information contained in the Lorenz curve is used to calculate the Gini coefficient, which
then provides us with a number that allows for clear-cut comparisons over time and
between countries. The Gini coefficient is obtained by dividing the area of inequality (the
area between the line of perfect equality and the Lorenz curve) by the area of the triangle
ABC (when perfect inequality prevails). The value of the Gini coefficient can thus vary
between 0 and 1 (0 signifies perfect equality and 1 perfect inequality). In table 7.7, the Gini
coefficient for South Africa by population group is given for selected years.
By international standards, South Africa's Gini coefficient has always been very high, and
from the table the situation appeared to be worsening from 1991 to 2001, but has been
improving slightly from 2006. From the information in the table, we can also see that
inequality in the African race groups is higher than for other groups, and although the
inequality in the white population group is the lowest, it has increased rather dramatically
from 2011 to 2015. Table 7.8 shows the Gini coefficient for the same countries for which
the Lorenz curve information in shown in figure 7.1. It is also clear that the overall Gini
coefficient for South Africa in very high compared to other countries. In practice, Gini
coefficients range from 0.30 (highly equal) to over 0.70 (highly unequal).
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TABLE 7.7
Gini coefficient for South Africa by population group for 1991, 1996 and 2001
Population
group
1991
1996
2001
2006
2009
2011
2015
African
0.62
0.66
0.72
0.64
0.66
0.65
0.65
White
0.46
0.50
0.60
0.56
0.47
0.45
0.51
Coloured
0.52
0.56
0.64
0.60
0.57
0.59
0.58
Asian
0.49
0.52
0.60
0.56
0.53
0.50
0.56
Total
0.68
0.69
0.77
0.72
0.70
0.69
0.68
Source: Figures for 1991, 1996 and 2001 were obtained from Schwabe (2004). Figures for 2006 to
2015 were obtained from Statistics South Africa (2017b).
TABLE 7.8
Gini coefficient for selected countries – 2016 or most recent figure available
Country
Gini coefficient
South Africa
0.623
China
0.514
Brazil
0.470
US
0.391
UK
0.351
Russia
0.376
Source: OECD Income Distribution Database (IDD) http://stats.oecd.org/Index.aspx?DataSetCode=
IDD
LEARNING ACTIVITY 7.4
Choose the correct answers
(a) Which of the following will contribute to a rightward shift of the whole or part of
the Lorenz curve?
a. The share of income of the top 20% of income earners increases by 5%.
b. The share of total income going to the bottom 40% of income earners increases
by 5%.
c. The share of income going to the bottom 20% of income earners decreases by
5%.
[1]
[2]
[3]
[4]
[5]
abc
ab
ac
bc
b
(b) Which of the following will contribute to an increase in the Gini coefficient?
a. The share of income of the top 20% of income earners increases by 5%.
ECS1500/1
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b. The share of total income going to the bottom 40% of income earners increases
by 5%.
c. The share of income going to the bottom 20% of income earners decreases by
5%.
[1] a b c
[2] a b
[3] a c
[4] b c
[5] b
Question (c) and (d) are based on the following diagram:
(c) Curves (a) to (d) in the above figure are
[1]
[2]
[3]
[4]
[5]
income curves.
Gini curves.
Lorenz curves.
population curves.
level curves.
(d) Based on the above figure, indicate which of the following statements is correct:
[1] If curve (d) represents the year 2010 and curve (a) represents the year 2016, income distribution for the relevant country has become more unequal from 2010
to 2016.
[2] If curve (b) represents country X and curve (c) represents country Y, income
distribution in country X is more equal than it is in country Y.
[3] The Gini coefficient for curve (a) will be larger than the Gini coefficient for
curve (c).
[4] If curve (b) represents country A and curve (d) represents country B, the Gini
coefficient for country A will be larger than the Gini coefficient for country B.
LEARNING ACTIVITY 7.5
Discussion forum
Please read the following article written by Anna Orthofer on The Conversation webpage on
6 October 2016 and visit the discussion forum for learning activity 7.5 on myUnisa to
discuss the issues mentioned below:
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LEARNING UNIT 7:
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Anna Orthofer
Economics PhD Candidate, Stellenbosch University
South Africa is known for its extreme income inequality, which is one of the highest in
the world. Ten percent of the population earn around 55%–60% of all income, compared to only 20–35% in the advanced economies.
But while the top income share is high in its own right, it pales in comparison to those
for wealth; such as real estate, pension funds and shares of listed companies. New tax
and survey data suggest that 10% of the South African population owns at least 90–95%
of all assets. This share is much higher than in the advanced economies, where the richest 10% own “only” around 50–75% of all assets.
Why does wealth matter? First, the level and distribution of wealth in a country are important indicators of its citizens’ long-term welfare. Whereas income and consumption
tell us something about a household’s current living standards, information on wealth is
important in assessing whether the household can sustain these living standards during
spells of unemployment or throughout retirement.
But wealth is also of particular concern for long-term inequality. This is because wealth
can generate its own income (such as interest, dividends, rents, and capital gains), and
can be passed on between generations. Over time, small differences in assets can therefore grow larger and larger. As Thomas Piketty argues in his influential book on wealth
and inequality (Capital in the 21st Century), this tendency has been one of the biggest
drivers of growing inequality in both advanced and developing countries.
A growing number of studies have suggested that high inequality can have unfavourable
political and economic consequences, which is why South African policymakers are increasingly concerned about it. Currently, most initiatives focus on inequality of income
and consumption, since these variables are closely linked to poverty and exclusion.
But based on my own research I argue that narrowing the wealth gap also deserves close
attention.
Why wealth is difficult to measure
We know that South Africa’s wealth distribution is highly unequal. It is, however, very
hard to measure precisely how unequal it is. This is because our usual tools are well
suited to measuring income and consumption, but not very good at measuring wealth.
The most widely used data on living standards come from household surveys. Their
main limitation when it comes to measuring wealth is that participation is voluntary and
that richer households tend to be less likely than others to participate. In addition, many
people are not aware of the current value of their assets or feel uncomfortable talking
about wealth.
Because of these limitations, researchers have started to use data from tax records. Since
tax filings are mandatory, tax data do not run the risk of under-representing individuals
at the top of the distribution.
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Nevertheless, tax data have their own limitations. First, they tell us nothing about the
population whose income is too low to require income tax filing. In South Africa this
group comprises more than 80% of the population. Secondly, they do not allow us to
measure wealth directly since only investment incomes are taxed in South Africa.
While this approximation introduces an element of uncertainty, it is currently the only
way to get data on the top of the wealth distribution.
Extreme wealth inequality
In my research I combine tax and survey data. Three main findings stand out:
The wealthiest 10% of the population own at least 90–95% of all wealth, whereas the
highest-earning 10% receive “only” 55–60% of income.
The next 40% of the population – the group that is often considered to be the middle
class – earn about 30–35% of all income, but only own 5–10% of all wealth.
The poorest 50% of the population, who still earn about 10% of all income, own no
measurable wealth at all.
The fact that the bottom half has very little wealth is not unique to South Africa. What
is striking, however, is the small wealth share of the middle of the distribution. Incomeor consumption-based studies find that around 20% to 30% of South Africans belong
to the middle class.
But my analysis suggests that a “propertied middle class” is largely non-existent. This
differentiates South Africa from the advanced economies, where a much larger share of
the population owns significant financial and non-financial wealth.
The data also show that race plays a role in inequality, as average wealth still differs
strongly between groups. Nevertheless, they suggest that wealth inequality within the
majority black population far exceeds overall inequality. This is consistent with the findings of a study on income inequality, which shows that the income distribution is
increasingly shaped by growing inequality within race groups rather than inequality between race groups.
Implications for policymakers
In theory, the extreme concentration of wealth in the hands of a few can be addressed
from two sides: redistributing wealth held at the top or building wealth at the bottom.
In reality, however, these two approaches should be balanced by combining taxation of
top wealth holders with policies to encourage middle-class wealth formation. This is because South Africa has a relatively low level of private wealth and should not risk
reducing overall private saving and investment.
The most common tools for redistributing wealth are taxes on investment incomes and
inheritances. Currently these taxes constitute only a tiny share of total tax revenue. Taxes
on investment income makes up about 1% of total tax revenue while inheritance tax
makes up 0.1%. The current proposals of the Davis Tax Committee aim to increase
these shares by closing loopholes in the estate duty.
More effective inheritance taxes can be very effective to counter the tendency of growing wealth concentration. But there are practical challenges when it comes to taxing the
wealthy effectively. Wealth can easily be shifted between asset classes, ownership structures and tax jurisdictions to avoid being subject to taxation.
The Panama Papers showed the extent to which the efficacy of wealth taxes is limited by
the fact that large fortunes are moved out of the reach of national tax authorities.
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Helping lower- and middle-class households build wealth may therefore be a more effective way to promote a more equitable wealth structure. Since pension assets are the
single most important form of wealth in South Africa, a more comprehensive pension
system would be particularly effective in reducing wealth inequality. The current proposals by the National Treasury, which aim to increase the coverage of occupational
pension systems and reduce pre-retirement withdrawals, are promising.
The new figures on the extreme extent of wealth inequality should provide some tailwind to these proposals, which could jointly lead to a more equitable wealth structure in
South Africa.
Source: The Conversation: https://theconversation.com/south-africa-needs-to-fix-its-dangerouslywide-wealth-gap-66355
Visit the discussion forum for learning activity 7.5 on myUnisa and provide your opinion
on the best manners to address income and wealth inequality in South Africa.
7.5
BUSINESS CYCLES
The next indicator we have to consider is the phenomenon of business cycles. Economic
growth does not occur smoothly and at the same pace. All economies are subject to periodic
booms or upswings, which are often followed by recessions or even depressions. This
pattern of expansion and contraction in economic activity is called the business cycle.
A typical business cycle consists of four elements: a trough (lowest point), an upswing
(also called the boom or expansionary phase), a peak (the upper turning point) and a
downswing (also called a recession or the contractionary phase).
In figure 7.2, the various phases of the business cycle are illustrated. A complete business
cycle is shown from the trough to the next trough. The upswing is when the economy is
expanding, thus production is increasing. At some stage a peak will be reached. It is never,
however, certain when the peak has been reached, and a downswing will begin. A
downswing takes place when the economy is shrinking, or production is decreasing. Similar
to the upswing, the length and severity of the downswing is also uncertain, but at some stage
a trough will be reached, and the economy will start expanding again. The theory of business
cycles explains all the possible causes of the cycles but falls beyond the scope of this module.
In table 7.8, the phases of the South African business cycle since the 1960s are shown. As
you can imagine, it is not easy to determine the dates of the turning points which determine
the lengths of the upswings and the downswings. In South Africa, the Reserve Bank is
responsible for establishing these turning points. The Reserve Bank uses a composite index
of leading, coincident and lagging economic indicators to predict and to confirm the
downturns and upturns of the business cycle. Leading indicators are variables that will lead
a change in production, for example, when more building plans are approved, the economy
can be expected to start expanding due to an increase in production. Coincident business
cycle indicators are variables of which the turning points (i. e. when they start to increase or
decrease) will coincide with the business cycle. Employment in the private non-agricultural
sectors is such a coincident indicator. Lagging indicators are variables that will follow a
change in production. An example of a lagging indicator is the value of new residential
building completed.
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In the next unit, we will discuss the government's policy with regard to business cycles.
As you can see in table 7.8, the lengths (in terms of number of months) of both the upswing
and downswing phases are not consistent at all. You will appreciate that it is therefore very
difficult to predict when an upswing or downswing will start to take place, or to put it
differently, when a peak or a trough were reached.
TABLE 7.9
Business cycle phases of South Africa since 1960
Upward phase
Start
End
Downward phase
Duration in
months
Start
End
Duration in
months
May 1960
Aug 1961
16
Sep 1961
Apr 1965
44
May 1965
Dec 1965
8
Jan 1966
May 1967
17
Jun 1967
Dec 1967
7
Jan 1968
Dec 1970
36
Jan 1971
Aug 1972
20
Sep 1972
Aug 1974
24
Sep 1974
Dec 1977
40
Jan 1978
Aug 1981
44
Sep 1981
Mar 1983
19
Apr 1983
Jun 1984
15
Jul 1984
Mar 1986
21
Apr 1986
Feb 1989
35
Mar 1989
May 1993
51
Jun 1993
Nov 1996
42
Dec 1996
Aug 1999
33
Sep 1999
Nov 2007
99
Dec 2007
Aug 2009
21
Sep 2009
Nov 2013
51
Dec 2013
Source: South African Reserve Bank Quarterly Bulletin (2018)
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LEARNING ACTIVITY 7.6
Choose the correct answers
(a) The
[1]
[2]
[3]
[4]
marks the beginning of the contraction of the business cycle.
upswing
peak
downswing
through
(b) The term "business cycles" can be defined as
[1]
[2]
[3]
[4]
[5]
periods for which aggregates such as GDP and GDE are calculated.
periods for which business accounts such as income statements are compiled.
fluctuating profits of businesses.
fluctuations in income of businesses.
alternating periods of recessions and expansions.
7.6
ECONOMIC GROWTH
7.6.1
Calculating economic growth
When we discussed the difference between nominal and real values of the GDP in learning
unit 6, the calculation of economic growth was briefly introduced. We explained why GDP
at constant prices (real values) should be used when calculating economic growth. We
showed you that GDP at current prices (nominal values) does not eliminate the effect of
inflation (rising prices) and should therefore not be used to calculate real economic growth.
Economic growth may be defined as "the annual rate of increase in total production or
income in the economy" (Mohr et al. 2008:576), and so the GDP is ideally suited for
measuring economic growth if real values are used.
Growth in GDP alone, however, does not take into consideration that the population of
the country also increases. Real economic growth can occur only when the actual
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production of goods and services (expressed in real values) grows at a faster rate than the
increase in population. If this is not the case people are actually getting poorer, and there is
really no improvement in their standard of living.
To solve this problem, the GDP should be expressed on a per capita basis. Per capita
means “per person”, which implies that the value of GDP should be divided by the
population in order to arrive at the GDP per capita. When the growth rate in the population
exceeds the growth rate in GDP, the growth rate in per capita GDP will be lower than
growth in GDP. Clearly, the objective of economic policy should be to increase the GDP
per capita and also the growth rate in the GDP per capita. If this objective is combined with
a more equal distribution of income, this will result in a higher living standard for the
population as a whole.
The gross national income (GNI) per capita are used because we are also interested in the
growth of the income earned by the citizens of South Africa over time. It gives a better
indication of the improvement in the standard of living of South Africans than the GDP.
The GDP is an estimate of the total production within the borders of the country,
irrespective of the owners of the factors of production used in the production process. The
value of the GNI can be derived from the GDP as follows:
.................................................................................................................................................................
GNI = GDP plus Primary income from the rest of the world
minus Primary income to the rest of the world
.................................................................................................................................................................
Subtract from GDP:
All wages, salaries, profits, interest and other income earned by residents of other
countries in South Africa. For example, profits earned by BMW and the wages paid
to residents from Lesotho who work on South African mines.
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Add to GDP:
All wages, salaries, profits, interest and other income earned by permanent South
African residents outside South Africa. For example, profits earned by South African
construction companies in Botswana and salaries earned by South Africans in Britain.
Table 7.10 shows the growth rates in GDP, GDP per capita and GNI per capita. All these
figures can be used to indicate the rate of economic growth in the economy.
TABLE 7.10
Growth rates of GDP, GDP per capita and GNI per capita at constant 2010 prices
Annual percentage change
(at constant 2010 prices)
Year
Gross domestic
product
Gross domestic
product per capita
Gross national
income per capita
2002
3,7
1,6
2,8
2003
2,9
1,1
1,3
2004
4,6
2,8
4,0
2005
5,3
3,6
4,0
2006
5,6
4,0
5,2
2007
5,4
3,9
3,3
2008
3,2
1,9
2,7
2009
–1,5
–2,7
–0,3
2010
3,0
1,9
3,4
2011
3,3
2,1
3,5
2012
2,2
1,0
–0,3
2013
2,5
1,2
1,0
2014
1,8
0,6
0,1
2015
1,3
–0,1
0,8
2016
0,6
–0,8
–0,7
2017
1,3
–0,1
0,9
Source:
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LEARNING ACTIVITY 7.7
Choose the correct answers
(a) Complete the last two columns of the following table to answer the question that
follows:
Year
GDP at current prices
(X 000)
GDP at constant prices
(X 000)
2010
135 000
146 739
2011
145 000
151 515
2012
160 000
160 000
2013
1 62 000
164 467
2014
167 000
163 725
2015
171 000
162 857
2016
174 000
161 860
Growth in
GDP at current prices
Growth in
GDP at constant prices
Based on the information in the table above, indicate which of the following
statements is correct:
[1] In 2011, GDP at constant prices grew by 7,41%.
[2] In 2013, the growth in GDP at current prices was higher than the growth in
GDP at constant prices.
[3] In 2015, the economy grew.
[4] From 2014 onwards, real GDP declined every year.
[5] From 2015 onwards, nominal GDP declined every year.
(b) Use the information in the following table to calculate the values of x and y for 2016
and 2017:
2016
2017
(R million)
(R million)
4 350 314
(y)
Primary income from the rest of the world
87 773
81 637
Primary income to the rest of the world
208 243
221 201
(x)
4 512 221
GDP @ market prices
GNI @ market prices
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LEARNING ACTIVITY 7.8
Quiz on learning unit 7
Note that you can also do this quiz on myUnisa to get immediate feedback. The answers to
the quiz will also become available on myUnisa under Additional Resources at the end of
the week allocated to studying learning unit 7.
Indicate whether each of the following statements is TRUE or FALSE:
STATEMENT
1.
TRUE
FALSE
The unemployed include those people who are not willing to work.
2. There will always be some frictional unemployment, and
this type of unemployment is not regarded as a serious
problem
3. Cyclical unemployment occurs when there is a recession
resulting from a temporary lack of sufficient aggregate
demand in the economy.
4. Structural unemployment is a serious problem, since it
cannot be remedied by simply increasing the aggregate
demand for goods and services.
5.
When measuring economic growth, changes in prices
and in the population should be taken into account.
6. One of the problems associated with GDP as a measure of
economic activity is that not all goods and services are
sold in markets, which makes it difficult to value them in
monetary terms.
7.
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The expansion phase of the business cycle ends at the
peak of the cycle.
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8. The expansion phase of the business cycle (upswing) always lasts exactly as long as the recession phase
(downswing).
9.
Sustained economic growth requires a sustained expansion of both aggregate supply and aggregate demand.
10. An increase in the quantity and/or quality of the factors of
production is a necessary condition for economic growth,
but not sufficient to ensure economic growth.
11. The wages earned by a citizen of Lesotho working at a
South African gold mine form part of the South African
GDP.
12. To measure real economic growth, GDP at current prices
has to be transformed into GDP at constant prices.
13. During inflationary periods, the growth in real GDP is always higher than the growth in nominal GDP.
14. A once-off increase in prices cannot be classified as inflation; inflation is a continuous process of increasing
prices.
15. The prices used to calculate the core inflation rate exclude value-added tax (VAT).
16. The consumer price index measures the cost of living, while
the producer price index measures the cost of production.
17. The PPI includes the prices of capital goods.
18. Consumers are generally more interested in the rate of
change in the implicit GDP deflator than in the rate of
change in the CPI.
19. The objective of price stability means that the inflation
rate should be kept as low as possible.
20. The consumer price index (CPI) and the inflation rate are
the same thing.
LEARNING ACTIVITY 7.9
Short questions on learning unit 7
1. Economic growth in South Africa must lead to (an increase/a decrease) in employment opportunities.
2. (Classical/Cyclical) unemployment exists during recessionary phases in the economy.
3. A person is classified as unemployed if the person is between the ages of
and
, is without paid work, is
to work and is actively searching for
.
4. The (consumer price index/producer price index) is an index of the prices of a representative basket of consumer goods and services.
5. Inflation is a
and
increase in the
price level.
6. Consider the population of Utopia. In 2017, the country had a total population of
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30 million, of whom 10 million were older than 64 or younger than 16 (the minimum
working age), while 9 million, mostly housewives and students, did not want to work.
A total of 8 million of the remainder of the population between the ages of 16 and 64
who wanted to work were employed, while the rest remained unemployed. Based on
this information, answer the following questions:
6.1
6.2
6.3
6.4
What is the size of the labour force or economically active population?
What is the labour force participation rate?
How many people are unemployed?
What is the unemployment rate?
ADDITIONAL RESOURCES THAT CAN BE CONSULTED
If you are interested to find out more about the topics covered in this learning unit, you
can consult the following sources:
Janse van Rensburg, J, McConnell, CR & Brue, SL. 2011. Economics: Southern African Edition.Berkshire: McGraw-Hill: Chapter 11, page 236–240 & Chapter 19.
Mohr, P & Associates. 2015 (or other editions). Economics for South African students.Pretoria:
Van Schaik: Chapter 13, pages 244–249 and 252–254.
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LEARNING UNIT 8
The Public Sector
CONTENTS
8.1
8.2
8.3
8.4
160
INTRODUCTION
162
8.1.1
The role of the the government
162
8.1.2
Market failures and government measures
8.1.2.1 Imperfect competition
8.1.2.2 Public goods
8.1.2.3 Externalities
8.1.2.4 Income inequalities
8.1.2.5 Economic instability
163
163
164
164
165
165
8.1.3
The functions of the government
165
8.1.4
Radical economic transformation
165
THE BUDGET OF THE SOUTH AFRICAN GOVERNMENT
170
8.2.1
Government expenditure
171
8.2.2
Government revenue
173
8.2.3
Personal income tax
175
8.2.4
Company taxation
176
TAX CRITERIA
177
8.3.1
Neutrality
177
8.3.2
Equity
178
8.3.3
Administrative simplicity
179
FISCAL POLICY
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Mind map of the public sector
Econosavvity
To pass this module, you will be expected to understand the following concepts and
apply them to economic situations:
●
●
●
●
●
●
●
●
●
●
●
●
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market failures
functions of the government
government expenditure and revenue
tax criteria
ability-to-pay principle
public goods
benefit principle
fiscal policy
policy lags
progressive tax
regressive tax
externalities
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THE PUBLIC SECTOR
INTRODUCTION
The government is one of the important participants in the economy of a country.
Everyone's life is influenced daily by laws and regulations made by the government to
promote an orderly community – for example, we drive on the left-hand side of the road
and stop at red traffic lights. Most people receive services from the government – these
include education, health services and sanitation. We are protected by the police and the
defence force. We must pay for these services by paying taxes – for example, we pay income
tax from our salaries and we pay value-added tax (VAT) when we purchase something. From
this short list, it is clear that the government has a substantial influence on our lives.
The public sector in South Africa consists of
● the central government, which concentrates on national issues such as defence and
foreign affairs (South Africa’s relationship with the rest of the world);
● the provincial and regional government, which concentrates on regional issues such
as education and health services;
● the local governments , which are involved with local issues such as street lighting
and local roads; and
● public corporations and public enterprises , such as the SABC and Eskom.
The central government, regional and local authorities together are called the general
government.
8.1.1
The role of the the government
It is clear that the government's expenditure and tax policies could have a significant impact
on the economy. To explain how the government fits into the economy, we will again look
at the economic circular-flow model, which you encountered in learning unit 1.
Figure 8.1 now also includes the government. This model, therefore, consists of the
household, business and government sectors. From this model, it is clear that the
government receives its revenue from taxes levied on households and business enterprises.
Both these sectors in turn receive transfers from the public sector. For example, pensions
will go to households, while the business sector could receive subsidies such as export
promotion benefits. In turn, the government purchases production factors, for example
labour, from households, and goods and services, for example stationery and internet
services, from the business sector.
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FIGURE 8.1
Circular-flow diagram with the government included
Source: Mohr et al (2008:49)
8.1.2
Market failures and government measures
In learning unit 1, you learnt that most present-day economies can be classified as mixed
economies, which implies that there is a role for the public and the private sector in the
economy. In his classical book, The wealth of nations, Adam Smith, viewed by many as the
father of the market economy, allocated certain functions to the government. Two of the
functions identified by Smith are the protection of the community against foreign aggressors
(i. e. an active defence force) and the protection of the lives and property of citizens against
criminals (i.e. an effective police force). Other reasons for the government to become
involved in the economy are found in market failures . Market failures refer to those
instances when markets fail to ensure the best solution to the economic problem. Because
of imperfections in the system, the signals from the market lead to harmful distortions in
the economy, and the government is then obliged to intervene. Let us consider these market
failures in greater detail.
8.1.2.1 Imperfect competition
In any market economy, monopolistic tendencies may develop, which have to be dealt with.
For example, it is possible that there may be only one firm in the economy that supplies a
certain good or service. Such a firm is called a monopoly . In the case of a monopoly, the
discipline of competition is lacking and the monopolist can greatly influence the quantity
supplied and the price of a good. A natural monopoly refers to a situation where one firm
can satisfy the total demand for a good in a certain area. A power station serves as an
example. After the original capital outlay has been recouped, the cost of providing this
service to additional people decreases, and therefore it would not make sense for other firms
to enter this field, as they will find it very difficult to compete with the existing firm. This
situation enables one firm to exert such a strong influence that it could lead to inefficiencies.
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How should the government deal with this situation? One possible solution is to do nothing
and trust that the big profits made by the monopolist will convince competitors to enter
this market. However, a monopolist who has the necessary resources can prevent this
through a price war. A second possibility for the government is to introduce price control
to prevent unrealistic prices. A third possibility is to tax away the excess profits of a
monopolist. In the case of a natural monopoly, it will make no sense for other firms to enter
the market. Private production combined with government regulation could be a solution,
or the government may even decide to produce the good itself. If the government decides
to let a private firm handle such production, the government will have to subsidise the firm's
losses.
8.1.2.2 Public goods
The concept "public goods" refers to goods that have specific characteristics that differ
from private goods. One of the characteristics of public goods is that you cannot exclude
anyone from the benefits of the good. A streetlight is an example of such a good, since
houses in its vicinity cannot easily be excluded from the benefits that it offers. In contrast
to this, private goods can easily exclude others from their benefits. If somebody purchases
a jacket, other consumers are excluded from the benefits of that jacket.
The non-excludability characteristic of a public good can lead to free riding . Free riding
means that people expect other people to pay for benefits, which they then enjoy without
paying. For example, people can hide their need for street lighting because they know they
will in the end also enjoy the benefits without having to pay for it. The government can
limit free riding by levying taxes (which everyone has to pay) to fund the provision of public
goods.
It is important to note that the existence of public goods does not imply that the government
must produce these goods. The government can leave the production of goods in the hands
of the private sector and just take responsibility for its financing. During the past decade or
more, the privatisation of government services has received much attention, which implies
that certain goods and services supplied by the government should rather be supplied by the
private sector. Supporters of privatisation are of the opinion that it would improve efficiency
in the economy, since they are convinced that the private sector is more efficient than the
public sector.
8.1.2.3 Externalities
It often happens that the actions of some market participants spill over to other parties in
the form of costs or benefits, which are not reflected in market prices. In Economics, these
are referred to as externalities. A classic example is pollution. The polluter (e. g. oil refinery)
does not take the cost of pollution into account during production. This is called a negative
externality. The government will, in most cases, have to intervene in the market to promote
efficiency. This can be done through regulation, which implies that the government can
prescribe the levels of production and pollution that are permissible, or alternatively, the
government can use taxes to compel firms to consider these costs.
On the other hand, production activities of firms can also bring about benefits to other
individuals for which they need not pay. These are called positive externalities. Inoculation
against measles is an example of a positive externality. The benefits of inoculation are not
limited to the person receiving the inoculation, since other people also receive a benefit: they
cannot be infected by the person who has been inoculated, because this person will now not
contract measles.
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8.1.2.4 Income inequalities
A market system may lead to an unequal distribution of income because individuals do not
all have the same opportunities, talents and abilities. It can therefore happen that some
people receive a very high income, while others hardly survive on their meagre incomes.
From an equity perspective, a skew distribution of income is unacceptable (also see learning
unit 7 in this regard). The government therefore tries to reduce inequality, because most
people will not be prepared to redistribute income voluntarily. The government can do this
through its tax and expenditure policies. A progressive income tax system (the higher a
person's income, the greater the proportion of tax he or she pays) ensures that more taxes
are collected from the rich, and this revenue can be used to finance housing, education and
other social services for the lower-income groups.
8.1.2.5 Economic instability
The economy usually moves through a phase of high economic growth (an upswing),
followed by zero or negative economic growth (a downswing), also called a recession or a
depression in severe circumstances. This phenomenon was discussed in the previous
learning unit and is called the business cycle. The government can use its macroeconomic
policy, monetary and fiscal, in an effort to smooth this wave, and in this way tries to ensure
that business cycles disturb the economy as little as possible. Monetary policy refers to the
money supply and interest rate policy of the central bank – this is something we will discuss
briefly in the next unit. Fiscal policy refers to changes in government expenditure and/or
taxes in order to promote economic stability. We will look at fiscal policy later in this unit.
8.1.3
The functions of the government
In short, the functions of the government can be classified as follows:
● Allocation – this refers to the role of the government in ensuring the efficient allocation of resources (we considered this topic in our discussion of public goods and
externalities).
● Regulation – this refers to the function of the government to promote efficiency by
implementing legislation to ensure certain minimum standards (this was something we
explored in our discussion of imperfect competition and externalities).
● Distribution – this refers to the function of the the government to promote a more
equitable distribution of income.
● Stabilisation – this refers to the monetary and fiscal policy measures of the government to promote macroeconomic stability (i. e. full employment, price stability and
balance of payment stability).
8.1.4
Radical economic transformation
We often hear politicians talk about radical economic transformation that is required in the
economy. Since there are many problems in the South African economy, of which high
unemployment, unequal distribution of income and low economic growth are probably the
most important, most people will agree that radical changes are necessary to ensure a better
living for the whole population of the country. However, it is not always clear exactly what
we mean when we say that radical economic transformation is necessary, and how it can be
brought about successfully.
The World Bank is of the opinion that rapid and sustained poverty reduction requires
inclusive growth that allows people to contribute to and benefit from economic growth
(Ianchovichina et al [s.a]:1). This means that economic growth will only decrease poverty
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and result in a more equal income distribution if it incorporates a large part of the country's
labour force, and especially those that are currently unemployed.
In a mixed economy such as that of South Africa, such a transformation of the economy has
to be driven by a mix of market participants (i.e. the business sector and labour) and the
government. According to the Bureau for Market Research at Unisa (Van Aardt 2017), the
following will contribute to reaching the macroeconomic objectives in South Africa:
● ensuring high quality primary, secondary and tertiary education focused on human capability formation
● ensuring unfettered access to education, combined with good management of resources spent on education
● ensuring the implementation of economic policies
● ensuring good governance at all levels and eradicating corruption
● strengthening macro-micro economic linkages
● continuous democratisation
● creating a caring society
The government's role in this process is to encourage private and government projects that
will ensure the achievement of the above objectives, while also ensuring that the private
sector and the international community are in the position to contribute to the objectives.
Good regulation without unnecessary bureaucratic red tape, and measures to ensure that
corruption is eradicated, will contribute in encouraging the private sector and the
international sector to become actively involved in contributing to economic growth and
employment creation, and in in this way also ensuring more equal distribution of income
and wealth.
LEARNING ACTIVITY 8.1
Choose correct answers
(a) A free market can still be efficient when negative or positive externalities are present.
[1] True
[2] False
(b) Which one of the following describes a role of the government in the economy
correctly?
1. Regulation should ensure that monopolies can continue to make monopoly
profit.
2. The government should ensure that no "free riding" takes place in the
economy.
3. The government should ensure that no positive externalities exist in the
economy.
4. The government should redistribute income and wealth from the rich to the
poor.
LEARNING ACTIVITY 8.2
Discussion forum
Please read the following article that appeared on ANC Today and visit the discussion forum
to discuss the questions that follow:
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Posted on 26th June 2017
Cyril Ramaphosa
The ANC’s programme of radical economic transformation has its roots in the Freedom
Charter, which was adopted at the Congress of the People in Kliptown 62 years ago this
week.
The Freedom Charter captures perfectly the intent and, to some extent, the content of
radical economic transformation. It was at the Congress of the People that representatives of the people of this country gathered to declare that: “The People Shall Share in
the Country’s Wealth.”
Given the extent of dispossession, discrimination, exploitation and exclusion, this call in
the Freedom Charter was a call for radical and fundamental economic transformation.
Over the intervening six decades, the principles of redress, redistribution, social justice
and equality have been at the centre of ANC economic policy. These principles have
underpinned the ANC’s policies in government, notably in the Reconstruction and Development Programme (RDP) and the National Development Plan (NDP).
At the ANC’s Mangaung Conference in 2012, the organisation adopted the NDP as an
overarching framework for the second phase of our democratic transition – the pursuit
of socio-economic freedom. The Mangaung Conference recognised that in the nearly
two decades since the advent of democracy, political freedom had largely been achieved.
The priority now was to pursue economic freedom.
The term ‘radical economic transformation’ was first used in the Medium-Term Strategic
Framework, which was adopted by government in 2014 to guide the work of this current
administration. The MTSF 2014–2019, which is derived from the NDP, introduced the
term to signal an intensification and acceleration of the economic transformation
process.
Radical economic transformation is therefore not a break with existing policy. It does
not represent a new, uncertain path. Radical economic transformation indicates a new
phase of accelerated implementation of the long-standing economic policy positions of
the ANC and government.
Among the most profound statements to come out of the Congress of the People was
that South Africa belongs to all who live in it, black and white. That statement was far
more than an assertion of the right of residence in this country.
It was a declaration that all South Africans, regardless of race, have a right to an equal
share of the country’s natural resources. They must share in ownership of, and access to,
the means of production.
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The ‘economic clause’ of the Freedom Charter expands on this sentiment: “The national
wealth of our country, the heritage of South Africans, shall be restored to the people;
the mineral wealth beneath the soil, the Banks and monopoly industry shall be transferred to the ownership of the people as a whole; all other industry and trade shall be
controlled to assist the wellbeing of the people; all people shall have equal rights to trade
where they choose, to manufacture and to enter all trades, crafts and professions.”
The Freedom Charter envisages a mixed economy with both public and private ownership. It envisages a developmental state that plays a leading role in ensuring economic
access to those previously denied economic opportunity. It envisages a state with sufficient legal authority and economic means to ensure decent working conditions and to
take steps to improve the lives of the poor and marginalised.
If we are to realise the vision of the Freedom Charter, we need an unrelenting focus on
the economy. It must be placed at the centre of all our efforts.
Radical economic transformation is, in essence, about building a more equal society
through sustained inclusive growth. We need to fundamentally alter the racial and gender
composition of the ownership, control and management of our economy. We need a
South African economy that truly reflects the composition, diversity and interests of the
South African people.
This necessarily requires that we address the concentration of ownership in the economy.
Many significant economic sectors are dominated by just a few companies. Not only
does this make transformation more difficult by limiting the scope for new entrants, but
it also stifles competition, keeps prices high and encourages inefficiency. If we are to
truly unleash our country’s potential, we need to tackle this concentration of ownership,
control and market dominance.
We also need to diversify our economy, specifically through the development of our industrial capacity. South Africa has abundant mineral and agricultural resources, but is
not extracting the true economic value of these resources before exporting them. In
reality, South Africa’s natural resources are creating millions of jobs in other countries.
By beneficiating our minerals, by processing our agricultural produce, we will be able to
realise their full potential value.
Radical economic transformation will not be achieved without a massive increase in the
number of South Africans who are employed. Job creation remains the most effective
driver of inclusive growth, the most direct route out of poverty, and the best way to address inequality. That is why government, business, labour and other social partners
have identified job creation as the most important and pressing economic task of the
moment. Everything we do must be aimed towards job creation.
But jobs will not be created in any significant quantity unless the economy grows at a
much faster rate. And the economy will not grow unless there is significant investment
in productive activity. It must therefore be a matter of great concern that the country is
in recession, that business confidence has declined and that our sovereign credit rating
has been downgraded. These developments severely undermine our efforts to fundamentally transform our economy.
Yet, although we find ourselves in difficult economic circumstances, we cannot afford to
be despondent. Now, more than ever, we need to work together on practical measures
to turn around the South African economy.
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Among the areas where progress has been made, and where work is ongoing, is in the
promotion of investment in industry. This includes through the work of the Inter-Ministerial Committee on Investment, the expansion of industrial incentives, the
establishment of special economic zones and streamlining investment approval
processes.
Another important area is to leverage public infrastructure investment far more effectively and deliberately. Even under the current fiscal constraints, government continues
to dedicate significant resources to its infrastructure build and maintenance programme.
We need to use this investment to develop our own manufacturing capabilities and local
suppliers. We need also to bear in mind that investment in infrastructure on the African
continent as a whole will only grow in the coming decades. As South Africa, we need to
ready ourselves to be among the leading suppliers for Africa’s infrastructure revolution.
For radical economic transformation to be successful, the process of black economic
empowerment needs to be integral to our efforts to grow the economy. Empowerment
and growth should be mutually reinforcing. By bringing more black South Africans into
the economy – as owners, managers, financiers, industrialists and employees – we are expanding the capacity of our economy. We are improving the potential for growth and
development.
We need to use the levers of state procurement more effectively to affirm black-owned
companies. We have been successful to some extent, but we need to do more to ensure
that government’s substantial procurement budget opens up opportunities for emerging
black businesses. We need to challenge the view that preferential procurement measures
encourage fraud and corruption. Where there is corruption, nepotism or fronting, it
must be dealt with decisively and those responsible must face the full might of the law.
Government’s black industrialists programme is part of a broader development in the
evolution of black economic empowerment. Until now, much of the empowerment activity has been around the acquisition of black partners of minority stakes in established
businesses. While this has enabled many to build up a capital base and acquire skills and
capabilities, it has not brought about the broad-based empowerment that the country
needs.
There is now a growing determination for black business people to establish their own
companies or to become majority shareholders in existing businesses. There is a greater
push, using mechanisms like the black industrialists programme and the revised BEE codes, for black people to establish, own, finance and control businesses in their own right.
Central to the success of radical economic transformation – central to the growth of our
economy and the prosperity of our people – is the development of our people’s skills. If
we can succeed in undoing the damage that apartheid education did, we will have succeeded in changing our country’s economy and our society beyond recognition.
If we can provide all our children with quality basic education, if we can make higher education accessible to all, and if we can equip our young people with skills appropriate to
the workplace of tomorrow, then we will have laid the firmest foundation for economic
growth and inclusion.
If these efforts are to succeed – if we are to transform our economy – we need to have
certain fundamentals in place. We need a capable developmental state that is able to effectively direct resources towards where they have the greatest economic and social
benefit. That means it needs to have an advanced planning and monitoring capability.
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It needs to ensure that the country’s resources – from its minerals to its oceans to its
broadband spectrum – are used to advance the interests of the people, particularly the
poor. We need to have state owned enterprises that fulfil a clear developmental function,
that are governed effectively, that manage their finances responsibly and that are led by
capable, honest and accountable people. We need to root out corruption both in the
public and private sectors. We need to eliminate mismanagement and wastage.
Fundamentally, radical economic transformation requires a supportive macroeconomic
policy. We need to preserve our economic sovereignty so that we, the people of South
Africa, may determine for ourselves the economic model, policies and programmes that
best serve our national interest. That means we need to avoid a debt trap, which would
scupper our transformation efforts and leave future generations saddled with the burden
of our irresponsibility.
We must adhere to the current fiscal framework. We need to be spending our public resources on infrastructure, education, health and the needs of the poor – not servicing
debt.
Above all, for radical economic transformation to succeed, we need to build a new national consensus on a programme for inclusive growth. We need to mobilise all sections
of society in support of that programme.
The Freedom Charter provides a vision of an economy that is fundamentally different
from what we inherited. It calls for radical economic transformation. It is our responsibility to effect this change.
CYRIL RAMAPHOSA IS THE DEPUTY PRESIDENT OF THE AFRICAN
NATIONAL CONGRESS.
Source: Ramaphosa (2017)
Based on the following, indicate if the following is true or false:
(i) Radical economic transformation implies changing from a capitalist to a socialist
economy.
(ii) Radical economic transformation implies supporting small business ventures as opposed to large business ventures.
(iii) Radical economic transformation implies ensuring that land is distributed away from
big farmers to small farmers.
(iv) Radical economic transformation implies reducing regulation related to business,
thus decreasing bureaucracy.
(v) Radical economic transformation implies encouraging job creation and a more equitable income distribution.
8.2
THE BUDGET OF THE SOUTH AFRICAN GOVERNMENT
As mentioned earlier, the government can use its expenditure and tax policy to influence
specific sectors in the economy and redistribute available resources. In this section, we will
look at the sources of government revenue and how the government spends these funds.
Table 8.1 provides a broad overview of South Africa's main budget framework. The table
gives an indication of the relative importance of parliament's involvement in the economy.
Roughly one-quarter of the gross domestic product seen from either the revenue or
expenditure side in South Africa is associated with decisions made by parliament. In the top
part of the table, we can see that taxes are the dominant source of income and that a
significant portion of these tax collections is paid over to other members of the Southern
African Customs Union (SACU), namely Namibia, Botswana, Swaziland and Lesotho.
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TABLE 8.1
Main budget framework, 2011/12 to 2016/17 (R billion)
Budget category
R billion
2014/15
2015/16
2016/17
Outcome Outcome Outcome
2017/18
Revised
estimate
Revenue
Gross tax revenue after proposals
986,3
1 070,0
1 144,1
1 217,3
Non-tax revenue
18,3
42,9
19,0
17,5
SACU1
–51,7
–51,0
–39,4
–56,0
National Revenue Fund receipts
12,6
14,4
14,2
15,7
Main budget revenue
965,5
1 076,2
1 137,9
1 194,6
Percentage of GDP
25,0%
26,1%
25,8%
25,4%
National departments
490,0
546,1
555,7
599,9
Provinces
439,5
471,4
500,4
538,2
Local government
87,6
98,3
102,9
110,7
1 017,1
1 115,8
1 159
1 248,8
Debt-service costs
114,8
128,8
145,6
163,2
Main budget expenditure
1 131,9
1 244,6
1 305,5
1 411,9
Percentage of GDP
29,3%
30,2%
29,6%
30,0%
Main budget balance
-166,4
-168,4
-167,6
-217,3
Percentage of GDP
–4,3%
–4,1%
–3,8%
–4,6%
Expenditure
Non-interest expenditure
Source: National Treasury Budget Review (2018)
1 SACU payments and other adjustments
In all four years, shown government spending exceeds the amount earned in taxation,
resulting in a budget deficit. In 2016/17, government expenditure was R1 305,5 billion and
revenue was R1 137,9 billion. The budget deficit was therefore R167,6 billion, or
approximately 3,8% of GDP. The government has to finance this deficit, and for this it can
employ two methods:
● funds can be borrowed locally and overseas by issuing government bonds to the public
and commercial banks; and
● the government can create new money.
A direct result of borrowing is that interest must be paid on these loans. Furthermore,
continuous deficits increase the public debt. Money creation may be inflationary which may
have serious detrimental effects on the economy as explained in section 7.2.
8.2.1
Government expenditure
In table 8.2, you can see how government's expenditure priorities in South Africa are
structured for the financial years ending in 2017/18 and 2018/19. From this table, we can
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see that learning and culture and social development dominate government expenditure.
Consolidated government expenditure is projected to increase from R1 558,0 billion in
2017/18 to R1 671,2 billion, thus by 7,6%.
TABLE 8.2
Consolidated government expenditure by function (R billion)
2017/18
2018/19
2018/19
R billion
Revised
estimate
Budget
estimate
% of consolidated
expenditure
Learning and culture
323,1
351,1
21,0
Health
191,7
205,4
12,3
Social development
234,9
259,4
15,5
Community development
183,5
196,3
11,7
Economic development
183,5
200,1
12,0
Peace and security
195,7
200,8
12,0
General public services
62,1
64,0
3,8
Payments for financial assets
20,4
6,0
0,4
Allocated expenditure
1 394,8
1 483,1
88,7
Debt-service costs
163,2
180,1
10,8
8,0
0,5
1 671,2
100,0
Contingency reserves
Consolidated expenditure1
1 558,0
Source: National Treasury Budget Review (2018)
1 Consisting of national, provincial, social security funds and selected entities
LEARNING ACTIVITY 8.3
Choose correct answers
(a) Indicate if the following statements are true or false:
(i) When the budget deficit increases, debt-service costs can also be expected to
increase.
(ii) From the 2014/15 financial year to the 2017/18 financial year, government
expenditure formed a larger percentage of total GDP than government
revenue.
(iii) South Africa spends less than 10% of the total government expenditure on
education and culture.
(b) Which of the following occurs when government expenditures exceed all taxes and
other revenues received by government in a year?
a. budget surplus
b. budget deficit
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c. balanced budget
d. an increase in government debt
[1]
[2]
[3]
[4]
[5]
8.2.2
a
b
c
d
b and d
Government revenue
.................................................................................................................................................................
In this world nothing can be said to be certain except death and taxes.
- Benjamin Franklin 1789 .................................................................................................................................................................
Thus far, we have established that the government has certain functions in the economy. We
also know that the government pursues a number of economic and political objectives
through its expenditure policy. In order to spend, the government needs revenue. The
revenue of the government consists of non-tax revenue, tax revenue and loans . In table
8.3, the 2013/14 and 2014/15 budget revenue outcomes and estimates (excluding loans) are
shown.
The non-tax revenue stems from departmental income and the various business enterprises
(e.g. the SABC and Eskom) owned by the government. The government also sells
agricultural, forestry and fishing products and receives rent from gold mining leases. In this
respect, the government is not really different from ordinary businesses. In 2014/ 15, the
non-tax revenue of the government was expected to amount to approximately
R27 006 million, an 11,8% decrease from 2013/14 (towards the bottom of table 8.3). A
large number of services such as protection, the judiciary, primary health care, education
and roads are rendered free of charge by the government. These expenditures are mainly
financed from taxation.
Taxes are compulsory payments, and in this respect, the government differs from ordinary
business enterprises regarding finances. The government can obtain revenue through
coercion. In 2014/15,
taxes were expected to amount to approximately R979 billion. We distinguish between direct
and indirect taxes. Direct taxes are levied on people and include personal income tax,
company tax and wealth taxes such as estate duty. Indirect taxes are levied on goods and
services, and people therefore pay these taxes indirectly when they pay for such goods and
services.
As can be seen from table 8.3, the most important indirect tax sources are VAT, fuel levies,
excise duty and customs duty. Excise duty is a selective tax – it is levied on specific goods.
The traditional excisable products include fuel, perfume, cigarettes and alcohol. The excise
duty on these goods is often jokingly referred to as “sin taxes”.
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TABLE 8.3
Budget estimates and revenue outcome, 2013/14 and 2014/15
2016/17–
2017/18
2016/17
2017/18
R million
Outcome
Revised
Taxes on income and profits
664 526
712 853
7,3%
Personal income tax
424 545
460 968
8,6%
Corporate income tax
204 432
218 109
6,7%
Dividend withholding tax
31 130
29 037
–6,7%
Other taxes on income and profits
4 420
4 739
7,2%
Skills development levy
15 315
15 771
3,0%
Taxes on property
15 661
16 047
2,5%
Domestic taxes on goods and services
402 464
423 616
5,3%
Value-added tax
289 167
299 058
3,4%
Specific excise duties
35 774
37 275
4,2%
Ad valorem excise duties
3 396
3 796
11,8%
Fuel levy
62 779
340
13,6%
Other domestic taxes on goods and services
11 348
12 146
7,0%
Taxes on
transactions
46 102
50 193
8,9%
45 579
49 011
7,5%
Diamond export levy
117
95
–18,9%
Miscellaneous customs and excise receipts
406
1 087
167,9%
Total tax revenue
1 144 081
1 217 307
6,4%
Non-tax revenue
33 264
33 229
–0,1%
5 802
7 522
29,6%
–39 448
–951
41,8%
194
5,0%
159 044
7,6%
international
trade
and
Customs duties
% change
of which:
Mining and petroleum royalties
Less: SACU payments
Main budget revenue
Provinces, social security funds and selected
public entities
Consolidated budget revenue
Source: National Treasury Budget Review (2018)
174
1
896
137
147 793
1 285 690
1
585
1
629
353
5,3%
LEARNING UNIT 8:
8.2.3
The Public Sector
Personal income tax
The most important direct tax in South Africa is personal income tax. This is the tax we all
have to pay if we earn more than a minimum income. To understand this tax, we need to
distinguish between the average and the marginal rate of taxation. The average tax rate is
the ratio of tax to income. The marginal rate is the fraction of each additional rand (income)
surrendered as tax. An important characteristic of personal income taxation in South Africa
is that the average tax rate is progressive.
● The tax is progressive if the average rate increases as income increases.
● The tax is proportional if the average rate is constant as income increases – that is,
the tax part (percentage) the individual pays is the same at all income levels.
● The tax is regressive if the average rate decreases as income increases.
Table 8.4 will help you understand the difference between the average and marginal rate of
taxation.
TABLE 8.4
Personal income tax rates and bracket adjustments, 2017/18–2018/19
2017/18
Taxable income (R)
R0 – R189 880
2018/19
Rates of tax
Taxable income (R)
Rates of tax
18% of each R1
R0 – R195 850
18% of each R1
R189 881 – R296 540
R34 178 + 26% of the
amount above R189 880
R195 851 – R305 850
R35 253 + 26% of
taxable income above
R195 850
R295 541 – R410 460
R61 910 + 31% of the
amount above R296 540
R305 851 – R423 300
R63 853 + 31% of
taxable income above
R305 850
R410 461 – R555 600
R97 225 + 36% of the
amount above R410 460
R423 301 – R555 600
R100 263 + 36% of
taxable income above
R423 300
R555 601 – R708 310
R149 475 + 39% of the
amount above R555 600
R555 601 – R708 310
R147 891 + 39% of
taxable income above
R555 600
R708 311 – R1 500 000
R209 032 + 41% of the
amount above R708 310
R708 311 – R1 500 000
R207 448 + 41% of
taxable income above
R708 310
R 500 001 and above
R533 625 + 45% of the
above R1 500 000
R1 500 001 and above
R532 041 + 45% of
the amount above
R1 500 000
Rebates
Rebates
Primary R13 635
Primary R14 067
Secondary R7 479
Secondary R7 713
Tertiary R2 493
Tertiary R2 574
Tax threshold
Tax threshold
Below age 65 R75 750
Below age 65 R78 150
Age 65 and over R117 300
Age 65 and over R121 000
Age 75 and over R131 150
Age 75 and over R135 300
Source: National Treasury Budget Review (2018)
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Take an example of a person with a taxable income of R250 000 in 2017/18:
This person will pay R34 178 tax on the amount of R189 880. The marginal tax rate that
applies to this person is 26% – that is the percentage of tax he or she has to pay of the
income higher than R189 880 (thus on R250 000 – R189 880):
Tax payable
= R34 178 + (26% of R60 120)2)
= R34 178 + R15 631
= R49 809
Average tax rate
= (R49 809 ÷ R250 000) x 100
= 19,9%
The average tax rate is therefore the total amount of taxes paid by a person divided by
the total income.
An example of a person with a taxable income of R475 000 in 2018/19:
Tax payable
= R100 263 + (36% of R51 7003)
= R100 263 + R18 612
= R118 875
Average tax rate
= (R118 875 ÷ R475 000) x 100
= 25,03%
It should be clear from these examples that the average rate increases as income increases
– the personal income tax is therefore progressive. Taxable income is the difference
between income earned and any rebates allowed by the Receiver of Revenue.
8.2.4
Company taxation
Company taxation is also regarded as a direct tax, since companies are legal persons. The
company tax rate in South Africa is currently 28%. Company tax is payable not on income
but on profit – in other words, expenditures such as salaries and wages, interest, and rent
are first deducted from income. A company can distribute its after-tax profit to shareholders
in the form of dividends, or the after-tax profit can be retained by the company. If the aftertax profit is distributed, it is subject to a 20% dividends tax rate which is levied on the net
amount of any dividends declared. The purpose of the dividends tax is to encourage
companies to reinvest their profits, and in this manner promote economic growth and
development.
2.
3.
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R475 000 – R423 300
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8.3
The Public Sector
TAX CRITERIA
.................................................................................................................................................................
The best tax is that which is least in amount.
- JB Say .................................................................................................................................................................
We are probably all in agreement with Say's remark. The government, however, has
expenditures which must be financed, and taxes are the most important sources of revenue.
Taxes affect almost every economic activity, and the impact on economic growth and
development may be either positive, negative or neutral. In the design and reform of tax
systems, the implications of taxes on the economy must be considered, and often there is a
trade-off between objectives. The question is: What is a good tax or tax system? There are
basically three characteristics of a good tax system:
● Neutrality: the tax system should not distort relative prices
● Equity: the tax system should treat individuals fairly
● Administrative simplicity: taxes should be easy and cheap to collect
8.3.1
Neutrality
In a market economy, prices determine how much, what and for whom should be produced.
The premise is that the market, via the price mechanism, will satisfy the aspirations and
desires of all market participants (producers, workers, employers and consumers) best – the
economic problem of scarcity and multiple needs is solved efficiently. Taxes, however,
affect relative prices and market participants react to these price changes. Consider the
following example:
Assume that excise duty on cigarettes is increased drastically. Smokers can react in
two ways: they can either reduce their consumption, or leave it unchanged. If they reduce their consumption, this could affect their state of mind (they become edgy) and
everyone around them suffers. Consequently, office morale is affected adversely and
productivity declines. If smokers do not change their consumption and if, in addition,
they are also poor, they might spend less on food. Consequently, work performance
and production are affected.
Take another example. The personal income tax rates of blondes are increased by
10%. How do you think they will react? Well, some will probably change their hair colour to red, and some may reduce their work effort.
Relative price changes affect choices and behaviour. If economic actors or participants are
made unhappy, their utility will decline and their welfare will be lowered. The economy is
furthermore worse off since work effort is reduced. The difference between the tax amount
paid to the Receiver of Revenue and the costs the tax causes the taxpayer and the economy
is called the excess burden of the tax. Whereas the government can compensate the
taxpayer for the taxes he or she pays in the form of public goods and services, the taxpayer
cannot be compensated for the excess burden.
A good tax is therefore a tax which has the smallest possible excess burden. Which taxes
are good taxes from this perspective? Since people always attempt to avoid taxes by
changing their behaviour (this is legal), a good tax is one which does not cause people to
change their behaviour. Taxes should therefore be neutral, that is, relative prices should be
disturbed as little as possible. However, sometimes taxes can be used to try to influence
behaviour. Think, for example, of a tax on a negative externality such as carbon emissions
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from motor vehicles. In this example, the carbon taxes not only generate revenue for the
government, but may also result in a decrease in fuel consumption which benefits society
due to lower carbon emissions. In this case, we want the tax not to be neutral but to affect
behaviour in a positive manner.
8.3.2
Equity
Although taxpayers are not always familiar with the excess burden of a tax, they are very
aware of the sacrifice tax payments cause. No one wants to pay more tax than is necessary,
and taxpayers are therefore very interested in how the tax burden is distributed among them.
It is important that the burden should be perceived as being distributed equitably, since this
ultimately affects people's willingness to pay taxes. Even high taxes will be tolerated, as long
as there is the perception that everyone is treated fairly. But what is fair?
There are two equity principles according to which the tax burden can be distributed in the
economy: the benefit principle and the ability-to-pay principle. But before we can
determine whether a tax is fair, we must first know who really bears the burden. In other
words, we must know what the tax incidence (i.e. how the tax burden will eventually be
distributed) is going to be. A tax such as an excise duty on locally produced perfume must
be paid by the producer to the Receiver of Revenue. But who bears the tax burden? You
would be right if you had said it is the consumer. The seller shifts the tax burden to the
consumer by increasing the price of the product by the amount of the tax. This is known as
tax shifting. You are, however, only partly correct.
Consumers are sensitive to price increases, particularly when the taxed good is a nonessential. If the tax causes a substantial increase in the price, consumption may decline. The
manufacturer is aware of this, and to temper the impact of the tax on the consumer, may
sometimes not increase his or her price by the full tax amount. In other words, the seller
absorbs part of the tax. The tax incidence is therefore on both the seller and the buyer. This
is important to know, since if it was the government's aim to tax rich consumers and to lower
the consumption of perfume, but part of the increase in tax is absorbed by the manufacturer,
the government was only partially successful. The incidence of taxation cannot always be
determined easily, and economists differ in this regard, but the probable incidence of taxes
is as follows:
Personal income tax
–
the individual on whom the tax is levied
Company tax
–
the firm and consumers
VAT
–
consumers
Excise duty
–
consumers and distributors
Property tax
–
the owners in cases where they occupy the property
themselves; tenants in the case of rented land or property; consumers in the case of commercial property
Now that we know the incidence of a tax, we can return to the question: What is a fair tax?
i. Ability-to-pay principle
The ability-to-pay principle states that people should pay taxes according to their abilities. In
the case of income taxation, a person's income is considered to be indicative of ability; in
the case of property tax, the value of the owner's property is considered to represent ability.
Furthermore, according to the ability-to-pay principle, a distinction is made between
horizontal and vertical equity. The horizontal equity rule states that people who
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are in the same position should be taxed equally (i.e. high-income groups should be taxed
similarly, and the low-income group similarly). The vertical equity rule states that people in
different positions should be taxed differently. According to this rule, rich people should
therefore pay more tax than poor ones.
On the surface, the ability-to-pay principle and rules appear obvious, but they in fact cause
many practical problems. For example, take income as a measure of ability:
Ruben earns R20 per hour and works 8 hours a day; in total he earns R160 per day.
Lorraine also earns R20 an hour, but works 10 hours as day; in total she earns R200
per day. According to the vertical equity rule, Lorraine should pay more tax. Is this
fair?
ii. Benefit principle
The benefit principle states that the person receiving the benefit of a particular public
expenditure should pay for it. Taxation is therefore viewed as a fee which is paid for goods
and services rendered by the government. Consequently, it is considered to be fair that the
more a person uses a service, the more he or she should contribute. Benefit taxes (also
known as user charges) are levied when mixed public goods and services have the
characteristic of exclusion – examples are toll roads, parks, libraries, electricity and water
provision, hospitalisation and university training. An earmarked fuel levy used for the
maintenance of roads can also be viewed as a mechanism to link benefits and taxes. The
different school fees paid at different schools can also be considered as a user charge.
8.3.3
Administrative simplicity
Taxes are a cost to taxpayers. In addition to the normal tax payments, taxpayers also incur
expenditures such as the cost of time to complete tax returns, record keeping or paying an
accountant for tax advice. These costs are called compliance costs. The Receiver of
Revenue also has to employ people to write tax laws, design tax forms, collect tax and assess
tax returns. A good tax system is one that tries to keep the administration and compliance
costs as low as possible. This implies that taxes must be simple. Complicated taxes not only
cause high administration and compliance costs, but also often present taxpayers with all
kinds of tax loopholes. The tax revenue of the government is lowered in this manner. If
people exploit tax loopholes, we refer to this practice as tax avoidance . This is perfectly
legal. However, if you, for example, make pottery items and sell these at a flea market and
don't declare the profit as income, you are evading tax. That is illegal.
LEARNING ACTIVITY 8.4
Choose correct answers
(a) The following table contains information that has been obtained from the South
African Reserve Bank’s Quarterly Bulletin for March 2017:
2011
2016
R million
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Income tax
359 817
579 257
Value-added tax
183 571
281 111
Total tax received
656 022
1 018 762
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The contribution of income tax to total tax increased from 2011 to 2016, and the
contribution of value-added tax to total tax decreased from 2011 to 2016.
[1] True
[2] False
(b) A tax system in which the marginal tax rate is higher than the average tax will ensure
that the following tax criteria are met:
a. neutrality
b. equity
c. administrative simplicity
[1]
[2]
[3]
[4]
[5]
abc
ab
ac
bc
b
(c) In South Africa, indirect taxes paid by households are progressive while direct taxes
paid by households are regressive.
[1] True
[2] False
(d) The average income tax rate paid by someone who earned R400 000 for the
2017/18 tax year will be higher than the average income tax rate paid by someone
who earned R400 000 for the 2018/19 tax year.
[1] True
[2] False
8.4
FISCAL POLICY
You already know that the economy is characterised by changes in the structure of the
economy and cyclical movements in economic activity (see learning unit 7). The economy
experiences times of high and low economic activity (the phases of the business cycle), and
conditions of inflation and unemployment occur. Governments aim at stabilising their
economies and it is their task to try to achieve the macroeconomic objectives of full
employment, price stability, balance of payments equilibrium, and so on. In order to realise
these objectives, the government has monetary and fiscal measures available. These
measures manifest in economic policy. Fiscal policy has to do with the manipulation of the
budget of the government (changes in government spending and taxation) to influence
macroeconomic objectives, while monetary policy mainly has to do with decisions regarding
the level of interest rates in the economy. Monetary policy will be discussed in the next
learning unit.
There are a number of barriers which restrict the effectiveness of policy. One of these is
the influence of policy lags . Let us briefly consider the problems associated with lags.
Stabilisation policy is hampered by three types of policy lags, namely the recognition,
administrative and impact lag. The recognition lag refers to the length of time it takes policy
makers to realise that macroeconomic conditions have changed sufficiently to warrant
attention. Remember that data must be compiled, processed and interpreted before macro
trends can be observed. Then one must determine whether the trend is temporary or
permanent, and whether action should be taken. The administrative lag refers to the length
of time it takes policy makers to make a decision and implement it. In the case of fiscal
policy, the implementation phase often coincides with long delays. Certain taxes, such as
income tax, can be changed only once a year. Usually such changes
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are made known in the Budget during February and come into effect after three months or
even later. When the structure of the tax system is affected, laws must be amended and it
takes time to write laws, get them passed by Parliament and eventually implement them.
Spending decisions are also subject to similar administrative lags. Firstly, expenditure must
be budgeted for. Secondly, in the case of projects of a capital nature such as roads and
bridges, it may take months or even years before funds are actually spent. The impact lag
refers to the length of time it takes new measures to have an effect on the economy. In the
case of fiscal policy measures, the impact lag is relatively short. People immediately
experience the effect of an increase in VAT. The commercial sector similarly quickly feels
the effect of an increase or decrease in government expenditure.
Because of the long administrative lag, fiscal policy measures are regarded as more
appropriate for corrections aimed at economic growth rather than for anti-cyclical purposes
– in other words, it is a long-term policy instrument. It is even possible that because of lags,
fiscal policy can cause instability if it is used for anti-cyclical purposes. Fiscal policy can
furthermore be manipulated by politicians who want to be re-elected, resulting in a political
business cycle. For example, politicians would prefer popular expenditure and tax measures
to be introduced just before an election, but these measures could wreck the stabilisation
policy.
LEARNING ACTIVITY 8.5
Choose correct answers
(a) The fact that the first (provisional) estimates of gross domestic product (GDP) become available only after a lag of about six weeks, forms part of the
[1]
[2]
[3]
[4]
recognition lag.
implementation lag.
impact lag.
decision lag.
(b) The time between the implementation of a new fiscal policy and the time at which it
starts to affect the economy is called the
[1]
[2]
[3]
[4]
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recognition lag.
administrative lag.
impact lag.
political business cycle.
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LEARNING ACTIVITY 8.6
Quiz on learning unit 8
Note that you can also do this quiz on myUnisa to get immediate feedback. The answers to
the quiz will also become available on myUnisa under Additional Resources at the end of
the week allocated to studying learning unit 8.
Indicate whether each of the following statements is TRUE or FALSE:
STATEMENT
TRUE
FALSE
1. The existence of externalities prevents the attainment of a
socially efficient allocation of resources in the economy.
2. The government could use the budget to try to influence
variables such as total production, income and employment and to redistribute income in the economy.
3. The government should implement restrictive fiscal policy measures during a recession.
4. The budget deficit is usually financed through taxation.
5. Direct taxes are levied directly on goods and services.
6. A tax is progressive if lower income groups pay a smaller percentage of their taxable income in the form of tax
than higher-income groups pay.
7. Value-added tax (VAT) is a regressive tax.
8. The government can always specify precisely who will
ultimately bear the burden of a tax.
9. An increase in the excise tax on beer will affect only the
consumers and producers of beer.
10. An increase in the excise tax on wine could affect workers in the wine industry.
LEARNING ACTIVITY 8.7
Short questions on learning unit 8
1. If you are a merchant selling medical equipment, you will definitely prefer (to be/not
to be) exempt for VAT.
2. If individuals are taxed at a fixed rate of 25% and all taxpayers are eligible for a tax
rebate of R7 200, personal income taxation is (proportional/progressive) to income.
3. An efficient tax does not affect
prices at all.
4. Explain each of the following:
4.1 Progressive tax
4.2 Proportional tax
4.3 Regressive tax
5. Government functions can be classified according to the following categories:
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5.1
5.2
5.3
5.4
The Public Sector
Allocation
Regulation
Distribution
Stabilisation
Describe each category briefly.
ADDITIONAL RESOURCES THAT CAN BE CONSULTED
If you are interested to find out more about the topics covered in this learning unit, you
can consult the following sources:
Janse van Rensburg, J, McConnell, CR & Brue, SL. 2011. Economics: Southern African Edition.
Berkshire: McGraw-Hill: Chapters 20 and 22.
Mohr, P & Associates. 2015 (or other editions). Economics for South African students. Pretoria:
Van Schaik: Chapter 15.
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CONTENTS
9.1
INTRODUCTION
186
9.1.1
The functions of money
9.1.1.1 Money as a medium of exchange
9.1.1.2 Money as a store of value
186
186
187
9.1.2
The evolution of money
187
9.1.3
The money supply in South Africa
9.1.3.1 The conventional measure (M1)
9.1.3.2 A broader definition of money (M2)
9.1.3.3 The most comprehensive measure of money (M3)
9.1.3.4 Medium of exchange as against store of value
9.1.3.5 Money and other related concepts, and the equation of exchange
188
188
190
190
191
191
9.2
THE FINANCIAL SYSTEM
193
9.3
FINANCIAL INTERMEDIARIES
194
9.3.1
The South African Reserve Bank (SARB)
9.3.1.1 Controller of note issues
9.3.1.2 Bankers' bank
9.3.1.3 Banker for the government
9.3.1.4 Custodian of gold and other foreign exchange reserves
9.3.1.5 Formulation and implementation of monetary policy
195
195
195
195
196
196
9.3.2
Financial institutions of the private sector
196
9.4
FINANCIAL SECURITIES AND MARKETS
200
9.5
DIFFERENT INTEREST RATES
201
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Mind map of the financial sector
Econosavvity
To pass this module, you will be expected to understand the following concepts and
apply them to economic situations:
●
●
●
●
●
●
●
●
●
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medium of exchange
store of value
financial instruments
financial intermediaries
monetary policy
measure of value
M1, M2 and M3 definitions of money
financial markets
interest rates
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THE FINANCIAL SECTOR
INTRODUCTION
The two most important ways in which the government can influence the economy of a
country are through its fiscal and monetary policies. In learning unit 8, you were introduced
to the role of the government and how it influences the economy via fiscal policy. In this
unit, we are going to look at the role of the financial sector in South Africa. Exactly how
changes in the quantity of money affect the real or actual welfare of a country remains a
matter of controversy among economists. It is surprising that no certainty (or even any
generally accepted theory) exists, even today, regarding exactly how money influences the
economy. One could well ask whether it would not be obvious that an increase in the money
supply would lead to increased expenditure and hence greater demand, which in turn would
lead to an increase in production and/or prices.
The important point to remember, however, is that money is not real income. There is no
mechanical or technical connection between an increase in the quantity of money and a
higher production of goods and services. If this were the case, the world's poverty and
development problems would be solved overnight.
Although no simple relation exists between money and real economic growth, economists
do accept that changes in the money supply affect the economy in some way or another.
Therefore, the role of money remains an extremely topical issue.
Let us now look at some of the basic characteristics of money.
9.1.1
The functions of money
9.1.1.1 Money as a medium of exchange
Money is such an integral part of our daily lives that we don’t always appreciate its
significance. Just how important money is can perhaps be understood by imagining an
economy that functions without it. In a barter economy , goods can only be exchanged for
other goods. For example, a wheat farmer requiring clothing for his family, first has to find
a tailor who needs wheat. Then the exchange can take place. If he cannot find a tailor who
happens to want wheat, the farmer will have to exchange his wheat for something else that
the tailor does require. The barter economy is therefore characterised by numerous
exchange transactions, which are cumbersome and inefficient.
This obvious inefficiency of the barter economy led, even in early primitive communities, to
the use of some form of money. The advantages of a monetary economy , where exchange
takes place through the medium of money, are just as obvious as the disadvantages of a
barter economy. The farmer no longer has to look for a tailor who needs wheat – as long as
a buyer can be found for his product, he can use the money yielded by such a transaction
to buy clothes. Money therefore serves as a lubricant or intermediary to facilitate the
process of exchange and to make it more efficient. This function as a medium of exchange
is the first and most important function of money.
.................................................................................................................................................................
Money is anything that is generally accepted as payment for goods and services or which is
accepted in settlement of debt.
.................................................................................................................................................................
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9.1.1.2 Money as a store of value
A further function of money is to serve as a store of value. In any society, a need exists to
conserve wealth (or surplus production) in some form or other. The most common form in
which wealth can be conserved is money, since money can be used in exchange for other
goods and services. Wealth can, however, also be conserved in more specific forms, such as
fixed property, real assets, stocks and shares. The advantage of using money as a store of
value lies in the fact that it is usually more convenient and can be used immediately in
exchange for other assets or to buy goods and services. We therefore say that money is the
most liquid form in which wealth can be conserved.
However, it is not always advantageous to use money as a store of value. In times of high
inflation, when money loses its purchasing power, it cannot be successfully utilised as a store
of value. A person who keeps all his or her wealth in the form of money will soon realise
that his or her wealth is not retaining its value. If the price level is unstable, as in our present
inflationary climate, there will be a tendency to use other objects as stores of value, for
example, fixed property, shares, works of art and postage stamps. The store of value
function, unlike the medium of exchange function, is therefore not unique to money.
9.1.2
The evolution of money
Through the ages, various goods have from time to time served as money. For example,
beads, tea, cattle, silver and cigarettes (in prisons, for example) have served as money at one
time or another. The evolutionary process whereby various forms of money were developed
runs from commodity money right through to the modern cheque account with a bank.
The earliest form of money was commodities; the intrinsic value (the inherent value of the
product itself) of the commodity was equal to the exchange value assigned to it. Naturally,
certain commodities were more suitable to be used as money than others. Not all
commodities had properties such as uniformity, durability, divisibility and the ability to
be carried (which is determined by size and weight). For example, cattle are not divisible
into "change", nor can they easily be carried about.
In due course, this type of commodity money made way for coins made of various kinds of
metal, which were more efficient. Initially, iron and copper coins were very popular as
money, but soon lost their value because of their abundance. They were replaced by scarcer,
more durable metals such as silver and gold.
In time, however, the exclusive use of coins as a medium of exchange also became
inconvenient as a result of increasing specialisation of production and the resultant greater
dependence on trade. In large transactions, in particular, the coins became unwieldy and
difficult to handle. This, in turn, led to the use of paper money, which made its first
appearance in England in the 16th century. What happened was that the owners of gold (or
silver) deposited it with certain institutions, for instance, the goldsmiths of that time. In
exchange for these deposits they received certificates of deposit, and these certificates
could be transferred to another person to pay for a transaction. The certificate of deposit
was the first form of paper money which was fully covered by the coins it was supposed to
represent.
The next step in the evolutionary process was the replacement of this entirely representative
paper money (i. e. 100% coverage) by notes which were only partially covered by a
commodity (e.g. gold). The gold standard, which applied in most countries up to the 1930s,
functioned under such a partial coverage of gold. This form of money therefore had an
exchange value which was much higher than its commodity value. Money of this kind is
called fiduciary or credit money. The modern bank note which is in use
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today bears no relationship to any commodity, and its value is based solely on confidence
in the government or monetary authorities to control the supply of notes in such a way that
their purchasing power will not disappear completely. As long as one is assured that goods
and services can be obtained in exchange for bank notes, the confidence in and acceptability
of, such paper money will not be affected.
This confidence is further supported by the fact that the notes and coins issued by the
central bank have been declared by law to be legal tender. (In South Africa, these notes and
coins are issued by the South African Reserve Bank.) This means that such notes or coins
cannot be refused if they are tendered in payment of a debt.
The next important development in the evolution of money was the use of cheque books
by banks. Clients could deposit their money with a bank, and write a cheque to instruct the
bank to transfer a specific amount from their account to someone else's account (see figure
9.1). Money in such a deposit account is called a demand deposit, because it can be
withdrawn without any prior notice to the bank. Nowadays, we do not really use cheques
any longer. Transfers from one demand deposit account to another account takes place by
means of electronic transactions. In any developed country, demand deposits constitute the
greater part of the money stock. In the next section, we discuss how money is defined in
South Africa.
FIGURE 9.1
Example of a cheque
9.1.3
The money supply in South Africa
When we talk about the money supply (or quantity of money) in a modern economy such
as that of South Africa today, we may be referring to any one of several measures. The
different measures relate to the general descriptive definition of money we supplied earlier.
9.1.3.1 The conventional measure (M1)
According to this measure, M1 is defined solely on the basis of the function of money as a
medium of exchange. The money supply is therefore measured on the basis of those articles
which are regarded as general means of exchange.
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.................................................................................................................................................................
M1 includes coins and notes (in circulation outside the monetary sector), as well as all
demand deposits (including cheque and transmission deposits) of the domestic private
sector with monetary institutions.
.................................................................................................................................................................
This definition of M1 is very important for our purposes, and you need to understand what
it means. The concept of demand deposits refers to deposits (money which has been
deposited) that can be withdrawn immediately in the form of cash, for example, at an
automated teller machine, or it can be transferred to someone else’s bank account. It is
therefore simply a more scientific term for the money which may be withdrawn in the form
of cash or transferred to another account, even out of the country. The value of these
accounts forms part of the money supply since it is immediately available and is also
generally accepted as payment in South African society.
Since only demand deposits of the domestic private sector are taken into account, deposits
of the government and the foreign sector are not included in the money supply. Only coins
and notes in circulation outside the monetary sector constitute a part of the money supply.
The reason is that only cash in the hands of the public can be used as a means of payment.
The cash in the bank vaults and in the hands of other financial institutions obviously cannot
be used in the money-goods flow, and is consequently excluded. A practical implication of
this is that the cash in an automatic teller machine becomes part of the money supply only
after it has physically been drawn by a cardholder. When you withdraw money from an ATM
machine, the amount in your demand deposit decreases, and the amount of notes and coins
in circulation increases by the same amount. Therefore, such a withdrawal does not affect
the amount of MI money in the economy.
To summarise, we can see that everything that serves and is available to the domestic private
sector as a means of payment in the normal course of events is included in the definition of
M1.
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Contrary to what may have been expected, demand deposits (D) form by far the largest part
of the M1 measure of money. In South Africa, the composition of M1 at the end of 2017
was as follows:
C = R114 430 million
D = R1 586 535 million
Total (M1) = R1 700 965 million
About 93,3% of M1 therefore consisted of demand deposits.
9.1.3.2 A broader definition of money (M2)
.................................................................................................................................................................
M2 = M1 + all short-term and medium-term deposits of the domestic private sector with
monetary institutions
.................................................................................................................................................................
As the name indicates, these short-term and medium-term deposits (savings accounts) are
not immediately available as a medium of exchange. They are deposits invested for a certain
period (less than 30 days in the case of short-term deposits and less than six months in the
case of medium-term deposits) and the bank has to be notified if you want to withdraw it
before the term expires (the notification period can vary from 24 hours to a few days). Since
the maturity of these deposits is not very long, it is very similar to M1 money, and is known
in South Africa as quasi money. Together with M1, this quasi money forms the M2
measure of money.
9.1.3.3 The most comprehensive measure of money (M3)
For many years, M1 and M2 were the only measures used to measure the money supply, but
today great significance is attached to the M3 measure, which gives money an even broader
definition than M2.
.................................................................................................................................................................
M3 = M2 + all long-term deposits of the domestic private sector with monetary
institutions
.................................................................................................................................................................
Over and above the short-term and medium-term deposits included in M2, long-term
deposits (with a currency of longer than six months) are added to form the M3 measure. The
monetary authorities today use this broad measure of the money supply to evaluate the
success of monetary policy, since they are of the opinion that this is the most reliable
indicator of developments in the monetary (or financial) sector of the economy.
At the end of 2017, the extent of the different measures of the money supply was as follows:
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TABLE 9.1
R million
Coins and bank notes
114 430
Demand deposits
1 586 535
M1
1 700 965
Short and
deposits
medium-term
M2
Long-term deposits
M3
1 105 067
2 806 032
553 098
3 359 130
Source: South African Reserve Bank Quarterly Bulletin (June 2018)
9.1.3.4 Medium of exchange as against store of value
Looking at the above three measures, it is clear that M1 is the only one that takes purely the
medium of exchange function as its point of departure. As financial assets (other than C
and D) are added to this measure, the emphasis placed on the medium of exchange function
becomes less distinct. As we move from M1 to M2 to M3, the emphasis on the store of
value function grows. It is evident that a deposit with a banking institution having a currency
of more than six months can hardly be regarded as an available means of payment today.
This type of deposit is much closer in kind to the store of value function.
9.1.3.5 Money and other related concepts, and the equation of exchange
Money is such a commonplace phenomenon that it is often confused with other concepts.
It should not, for example, be confused with concepts such as income or wealth. A person
in possession of great wealth does not necessarily possess a great deal of money, nor is a
person's income equivalent to the money he or she possesses. This wealth can take many
other forms, such as shares or fixed assets like land and buildings. This confusion between
the three concepts money, wealth and income arises from the fact that all three can be
expressed in terms of a particular monetary unit (e.g. rands, dollars or pounds).
Money supply and wealth are both stock concepts which can be measured at a particular
point in time. Wealth, however, is a far more comprehensive measure and includes other
assets in addition to money. In contrast, income is a flow concept which can be measured
over a period of time, say, R1 000 per month or R12 000 per annum.
From a macroeconomic point of view, the difference between income and money can best
be illustrated when we consider that the GDP (current value), which is a measure of income,
amounted to R4 651 785 million in 2017, while the money in circulation during the same
year came to only R1 700 965 million (M1). M1 as a percentage of the GDP therefore
amounted to around 36,6%.
This apparent contradiction can easily be resolved if we understand the concept of velocity
of circulation (V), which is the number of times the money supply is circulated in a given
period. We may also interpret it as the number of times an average rand changes hands –
that is, the number of times it has been used to execute transactions. Here is a practical
example to show you what we mean:
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Suppose we have a simple economic system in country Z with three participants —
John, Sue and Pete. The "system" kicks off by paying John R50 for being the president. John now pays Sue the amount of R50 to prepare a banquet for him. Sue then
pays Pete R50 to service her car. From this, it is clear that the money supply in country Z is only R50, but that the total income generated is equal to R150. The total
income earned is calculated by multiplying the money supply by the number of times
it has been circulated, that is M x V = R50 x 3 = R150. This R150 now also represents the value of all goods and services sold (or value of transactions) in country Z
for the relevant period. From learning unit 5, you should know that the total value of
goods and services (transactions) is a good approximation for the (nominal) GDP of a
country (in this case, country Z). You also learnt that the nominal GDP consists of a
price component (P) and a quantity component (Y). You should be able to see that M
x V is equal to the nominal GDP (P x Y).
If we consider South Africa's GDP and the value of M1 for 2017 that we looked at above,
we can calculate the velocity of the M1 money supply in South Africa for 2017 as follows:
GDP
V =
M1
=
R4 651 785 million
R1 700 965 million
= 2,7
This means that the M1 money supply was used 2,7 times during 2017 to facilitate all the
transactions that formed part of the GDP for 2017.
LEARNING ACTIVITY 9.1
Choose correct answers
(a) From the equation MV = PY, the velocity of the circulation of money refers to
[1]
[2]
[3]
[4]
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the number of times money changes hands during a specified period.
the change in the money supply during a specified period.
the change in the price level during a specified period.
the change in real production during a specified period.
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(b) Money is
a.
b.
c.
d.
wealth.
a medium of exchange.
a store of value.
income.
[1]
[2]
[3]
[4]
[5]
abcd
abc
bce
bc
ad
(c) This question is based on the information in the following table:
Aggregate
Amount (R 000)
M1
214 987
M2
321 365
M3
564 456
(d) Long-term deposits are equal to
[1] R106 378 000.
[2] R243 091 000.
[3] R536 352 000.
[4] R885 821 000.
[5] R1 100 808 000.
9.2
THE FINANCIAL SYSTEM
Now that we know what money is, we can take a closer look at the other elements of the
financial system. For a better understanding of the "mechanics" of this system in South
Africa, we express the flow of activities with the aid of figure 9.2.
FIGURE 9.2
The flow of funds through the financial system
Source: Mohr et al (2008)
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The financial system contains the following elements:
Market participants, which are made up of:
● Non-financial market participants , consisting of surplus units and deficit units, that
is, those wishing to borrow money (deficit units) and those wishing to lend money (surplus units)
● Financial intermediaries , which facilitate the lending and borrowing process
● Financial instruments , which are available to set the lending and borrowing process
in motion
● Financial markets , on which the instruments are traded
The non-financial market participants need no introduction, since they consist of the
government, the firms and all the private individuals (households) in the country. The role
of each of these participants should already be well known to you. However, we need to
pay more attention to the financial elements of the system.
LEARNING ACTIVITY 9.2
Choose correct answers
(a) Financial instruments are sold by surplus units to deficit units.
[1] True
[2] False
(b) The government can be a surplus or a deficit unit.
[1] True
[2] False
(c) The flow of money in the financial markets is in the opposite direction to that of the
flow of financial securities.
[1] True
[2] False
9.3
FINANCIAL INTERMEDIARIES
The first of the financial elements are the intermediaries. In any money economy, we find a
number of institutions specialising in financial transactions. There are, however, many
different types of institutions within the financial sector, each specialising in a specific kind
of service or market segment. Regardless of this specialisation, we find that the common
purpose of each of these institutions is to act as an intermediary between the surplus
units and the deficit units of the economy.
At any particular stage, there are surplus units (usually households which have saved money)
that have excess funds that can be invested, and deficit units (e. g. entrepreneurs wishing to
start new business enterprises) who are in search of funds. Although it is possible, and does
in fact happen, that such parties can contact each other directly, it has been shown in
practice that the vast majority of business transactions take place through the intervention
of financial intermediaries. These institutions therefore specialise in the acceptance of the
surplus funds of surplus units and granting of credit to deficit units.
The government is definitely also part of this process. On the one hand, it periodically places
surplus funds, for example, received from taxes, with financial institutions; while on the
other hand, it acts as a deficit unit seeking funds to finance government projects.
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Credit is granted when a person or institution lends funds to another person or institution.
In exchange for the funds, a piece of paper (a security or credit instrument, often also called
a bond) is issued that stipulates at what interest rate the funds are borrowed, and when and
how the amount is to be repaid.
The financial intermediaries in South Africa can be divided into two main categories. On
the one hand, we have the monetary authorities, with the South African Reserve Bank
(SARB) as the most important, and on the other, the institutions of the private sector.
9.3.1
The South African Reserve Bank (SARB)
The South African Reserve Bank (SARB), established in 1921, is the central bank of South
Africa. Together with the Treasury, the Reserve Bank forms the monetary authority in South
Africa. The main functions of the SARB are to act as the:
●
●
●
●
●
controller of note issues
banker for the government
banker for other banks
custodian of the country's gold and other foreign exchange reserves
institution responsible for the formulation and implementation of monetary policy in
South Africa
In the execution of these functions, the SARB uses its powers to exercise control over
interest rate level and credit creation.
9.3.1.1 Controller of note issues
Since its inception, the Reserve Bank has had the sole right to the issue of bank notes and
coins. This cash comes into general circulation through the granting of overnight loans
(against the security of financial assets) by the Reserve Bank. The Reserve Bank is largely
guided by the public's cash requirements in its issues of notes and coins.
9.3.1.2 Bankers' bank
In its capacity as bankers' bank, the SARB is the holder of the minimum (compulsory) cash
reserves required of banks. Banks have to hold 2,5% of all deposits that they hold in the
form of cash in a non-interest-bearing account with the SARB. On a daily basis, a bank may
experience a cash deficit due to the fact that funds are transferred between banks, and also
to the SARB. They may borrow funds from the SARB to finance such deficit. They will pay
a predetermined interest rate called the repo rate, which is determined by the Monetary
Policy Committee (more about this in section 9.5). As bankers' bank, the Reserve Bank also
acts as lender of last resort. This means that the SARB will assist a bank that is experiencing
a serious lack of cash in order to preserve the stability of the financial sector as a whole.
Such a loan will, however, be subject to strict conditions and the reason for the lack of cash
will be thoroughly investigated. It is not a regular occurrence that the SARB lends funds to
a bank in its capacity as lender of last resort; it only happens when a bank is experiencing a
serious crisis.
9.3.1.3 Banker for the government
As government banker, the Reserve Bank handles some financial receipts and payments of
the state. The bank-client relationship, in this case, also includes the granting of credit. The
Reserve Bank also advises the government about monetary and financial matters and is
responsible for the administration of all exchange control regulations.
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9.3.1.4 Custodian of gold and other foreign exchange reserves
With the exception of smaller necessary balances held by banks and the Treasury, the
Reserve Bank keeps all the country's gold and foreign exchange reserves. Gold coins and
gold bullion are added to the reserves at a market-related price. The level of South Africa's
gold and other foreign exchange reserves is one of the main barometers of the state of the
economy and of prospects for future economic growth.
9.3.1.5 Formulation and implementation of monetary policy
The SARB, in cooperation with the Department of Finance, is responsible for formulating
and implementing monetary policy. The way in which the bankʼs other functions is fulfilled
will be determined mainly by the goals of monetary policy at that juncture. In this
regard, it should be mentioned that the Reserve Bank has accepted the protection of the
domestic and external value of the rand as its most important goal. The main objective of
monetary policy is to keep the domestic inflation rate as low as possible, and the main
instrument used to attain this objective is the repo rate, which as previously explained, is
the rate at which banks borrow from the SARB to finance their daily cash shortage.
9.3.2
Financial institutions of the private sector
South Africa has a plethora of different institutions operating in the financial markets. Some
of you may have, at some stage in your life, invested some money with or borrowed money
from a bank, taken out a policy through an insurance company or opened a savings
account at Postbank .
The following list gives some indication of the variety of financial intermediaries in the
South African economy.
Classification of South African financial intermediaries
Deposit intermediaries
private banks
mutual banks
Postbank
Non-deposit intermediaries
Contractual intermediaries
long-term insurers
short-term insurers
pension and provident funds
Collective investment schemes
unit trusts
property unit trusts
participation mortgage bond schemes
Development finance intermediaries
Development Bank of South Africa (DBSA)
Industrial Development Corporation (IDC)
National Housing Finance Corporation (NHFC)
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Microfinance institutions
stokvels
village banks
friendly societies
micro lenders
Microfinance institutions are “organisations that provide savings, loans, money-transfer
services, insurance and other financial services to poor and low-income clients – clients who
are generally poorer and more vulnerable than traditional banking clients” (Goodspeed in
Van Zyl et al (2009)). It is estimated that more than 50% of adult South Africans currently
do not have a bank account.
LEARNING ACTIVITY 9.3
Choose correct answers
(a) The main function of financial intermediaries in the South African economy is to
[1]
[2]
[3]
[4]
assist with the transfer of funds from surplus units to deficit units.
assist the central bank in determining the repo rate.
maintain and implement monetary policy.
regulate the quantity of money in an economy.
(b) Which one of the following is not a function of the South African Reserve Bank?
[1]
[2]
[3]
[4]
[5]
issues notes and coins
lender of last resort to banks experiencing liquidity problems
administers exchange control regulation on behalf of the government
administers the payment of taxes by individuals and companies
sets the repo rate in accordance with the objectives of monetary policy
LEARNING ACTIVITY 9.4
Discussion forum
Please read the following extracts from an article written by Vishnu Padayachee and
Bradley Bordiss that appeared on The Conversation webpage on 11 July 2017:
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July 11, 2017 8.47pm SAST
Debates on monetary policy in South Africa over the last couple of decades seem to
have come from a madhouse. First, in the 1990s the country had old discredited Washington Consensus policies rammed down its throat. This was done with little regard for
alternative progressive ideas and little or no democratic debate or public participation.
And then recently the country’s Public Protector, Busisiwe Mkhwebane, released a report that made sweeping populist recommendations about the South African Reserve
Bank. The report favoured revising the country’s constitution and a binding recommendation for a monetary policy regime that excludes any reference to price stability. A
mandate like this simply doesn’t exist in any comparable country with a well-developed
private banking system.
To put the report in context, we want to focus on basic monetary policy principles that
have been debated for centuries by serious thinkers and scholars. We also explore how
South Africa can move the debate forward constructively and responsibly.
Broadly, thinkers on monetary policy can be considered on a scale with “sound money”
advocates on the one side, and those concerned that money and banking must serve the
productive economy – let’s call them “serve-society” advocates – on the other.
We locate ourselves unambiguously on the “serve-society” side of the debate. We agree
with William Lowndes who served in the British Treasury in 1695, who said that money
supply must serve society. Thomas Attwood in the 19th Century, John Maynard Keynes,
the trade union leader Ernest Bevin and Hyman P Minsky in 20th Century, concurred.
Unlike Mkhwebane’s report, these economists, particularly Keynes and Minsky, understood that currency and money markets under capitalism have a nasty tendency to be
unstable. That’s why the regulatory and lender of last resort function of the Reserve
Bank is so vital. (When the operations of the inter-banking lending market cease to operate, the lender of last resort is the entity – usually a central bank – that has sufficient
liquidity to lend to banks short of funds.)
The South African Reserve Bank has performed these roles moderately well for almost
a century. The country hasn’t had a systemic banking crisis since the formation of the
Reserve Bank in 1921. Experts in the field (Calomiris & Haber, 2004) find that South
Africa is among the most stable top 13 banking systems in the world. The Reserve Bank
should take credit for much of that.
That doesn’t mean that it’s beyond criticism, which is why a serious debate is needed.
The debate doesn’t need to rely on the ideas of fringe adventurers and crackpots. The
country has a wealth of intellectual talent on monetary and central banking policy inside
and outside its universities that straddle the ideological spectrum. The country’s public
intellectuals in the unions and in civil society organisations have excellent ideas on central banking and monetary policy. Ordinary citizens should be drawn in too.
One thing is clear: things cannot remain as they are because so much is changing in the
world of central banking and in economic life.
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The two camps
Sound money thinkers tend to view banking as just another business, best left to the free
market. Historically, sound money economists have preferred deregulation of the banking system. But since the spectacular collapse of thousands of banks in many parts of
the world in the 1930s, and the banking and financial crises after 2008, very few now
propose abolishing the lender of last resort function of central banks.
Sound money economists now want central bankers bound by rules, rather than allowing
for discretion. But they still focus on the virtues of trade and private finance.
For their part, “serve-society” advocates worry about production, employment and
growth.
Keynes – by no measure a crank or a crackpot – was very much in favour of adjusting
monetary and fiscal policy where necessary. He was a passionate advocate of sound
banking and financial regulation because he understood the inherent instability of capitalism. He warned that getting it wrong could massively increase poverty and
unemployment.
In 1933, he proposed three safeguards when shifting economic policy priorities: Firstly,
don’t be doctrinaire. Secondly, he maintained that “the economic transition of a society
is a thing to be accomplished slowly”. And thirdly, don’t allow “intolerance and the stifling of instructed criticism”. For those not in public office he offered this final piece of
advice:
Words ought to be a little wild – for they are the assault of thought on the unthinking.
A changing world
Conventional notions of what central banks are, and of what they should do, face a number of challenges. For example, the processes of technological innovation, including the
growth of crypto currencies like Bitcoin, are rapidly reshaping some of the core functions of central banks.
And over the last three decades a number of economic factors have forced central banks
to review their roles. They’ve had to do so to align their functions with other states in
the wake of greater economic regionalisation, the creation of monetary unions and the
establishment of regional central banks.
The events of 2008 also shook confidence in the ability of central banks to use their reputedly vast capacity and skills to predict and head off the crisis. This has been
particularly true as far as their regulatory responsibilities to promote financial stability
are concerned.
As pointed out by Princeton Professor and former deputy-governor of the Banque du
France, Jean Pierre Landau, a return to the status quo ante in respect of central bank policy is neither desirable nor indeed feasible.
Despite this warning the status quo ante is being defended all over the world as if nothing has changed, and as if all is well in our economies.
Let the debate begin
After the release of the Public Protector’s report, the Governor of the South African Reserve Bank, Lesetja Kganyago, offered the potential space to begin a serious debate
about South African monetary policy aimed at creating a more inclusive and prosperous
society and economy.
But, he warned, such a discussion would have to be based on “evidence and sound
analysis”.
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In our view, ideas must come from across the ideological spectrum. And they must be
debated in legitimate and properly structured forums. One place to begin the discussion
would be Parliament’s Portfolio Committee on Finance.
Other structures – such as the Reserve Bank’s Monetary Policy Forums (as proposed by
the governor) and forums led by business, labour and civil society organisations as well
as universities – need to keep up the momentum.
Source: https://theconversation.com/south-africa-needs-a-sensible-debate-about-its-reserve-bankheres-a-start-80552
Visit the discussion forum for learning activity 9.4 and air your opinion on the following
issues:
(a) Do you think it is important to fight inflation?
(b) Currently, the SARB states that its main objective is to protect the value of the currency, that is, to bring down the inflation rate. Do you think this is the correct objective
for the SARB? If not, what do you think should the objective of the SARB be?
9.4
FINANCIAL SECURITIES AND MARKETS
Refer again to the flow diagram in figure 9.2. The second financial element of the system is
the securities (or instruments) which flow between the non-financial market
participants (surplus and deficit units) and the financial intermediaries. Once again, a
great number of different instruments are to be found in the South African system. Some
of you may have encountered either shares, bills, bonds, debentures or other credit
instruments at some stage of your life.
A share represents ownership in the company that issued the shares. The owner of the
shares can attend the annual shareholder's meeting and has a say in the decisions taken at
such a meeting, for example, decisions regarding the management of the company. The
owner of shares in a company may also receive part of the profit of the company. When
shareholders receive a part of the profit of a company, we call this dividends. However, the
company is not obliged to declare a dividend; thus, the return on a share is uncertain. The
shareholder may also profit from holding the share when the value of the share increases,
but if the company is not performing well and not making a profit, the value of the shares
may also decrease. Shares are perpetual instruments; that means they do not expire. If a
shareholder wants to sell his or her shares, a buyer for the shares has to be found.
A bond represents debt. It is proof that the owner of the bond lent money to the issuer of
the bond. In return, the issuer will pay a predetermined interest rate on the bond, and the
capital amount of the bond will be repaid on a certain date, called the maturity date.
Both shares and bonds are capital market instruments ; that means they are issued for a
period of one year or longer. Shares do not have expiry dates, while the maturity date of
bonds will be predetermined, but will usually be rather far into the future, for example, five
years, ten years, or even 25 years.
The money market, by contrast, is associated with short-term securities, namely
instruments with tenure of less than one year. Negotiable certificates of deposit (issued by
banks) and Treasury bills (issued by government) are good examples of money-market
instruments. However, the distinction between the money market and the bond market is
not always exact. Bonds with tenure of less than three years are often regarded as liquid or
money-market instruments.
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In the sophisticated financial world we live in today, there are also derivative instruments
(options, swaps, warrants, futures and forwards). The name of these instruments arises from
the fact that they are derived from the value of an underlying asset, reference rate or index.
Therefore, they cannot exist on their own. In this module, no further attention will be
devoted to these and the other more conventional financial instruments.
The place where lenders and borrowers meet in order to trade financial instruments with
the aid of intermediaries is called the financial market. Activities on these markets are not
restricted to a particular building, as is the case with the market for fresh produce, but can
be represented by a broker or banker or any post office. The buying and selling of securities
discussed in the previous section occur in either the primary market or the secondary
market. The primary market is identified with the issuing of new securities that are being
traded on the market for the first time. The secondary market, by contrast, is identified with
the trading of existing securities, namely securities that have already been issued. The prices
of shares and bonds and money market instruments traded on the JSE which are published
in the daily papers apply mainly to secondary market instruments.
The financial markets in South Africa are well-developed markets offering sound credit and
investment facilities to both the private sector and the government. They are active and
respond quickly to any market impulse (e.g. when rumours of an interest rate change
develop), and also improve the efficiency of the Reserve Bank's monetary policy actions.
LEARNING ACTIVITY 9.5
Choose correct answers
(a) Which of the following statements is/are correct?
a. Financial instruments are issued in secondary markets.
b. Short-term financial instruments are issued in the money market.
c. Trading on the financial markets only takes place in the JSE building in
Johannesburg.
[1]
[2]
[3]
[4]
[5]
abc
ab
bc
ac
b
(b) Which one of the following is an example of a secondary market transaction?
[1] The government issues new government bonds to finance the budget deficit.
[2] A bank issues securities to obtain funds to lend out to deficit units.
[3] A person who wants to buy a house obtains a bond from a financial
institution.
[4] Standard Bank buys government bonds from First National Bank.
9.5
DIFFERENT INTEREST RATES
It is important to remember that there is not only one rate of interest. In reality, there are
many interest rates tied to different financial assets. One of the most influential interest rates
is the SARB’s repurchase (or repo) rate. This is the rate at which banks obtain funds from
the Reserve Bank when they experience a shortage of reserves. Other interest rates, such as
the prime lending rate of banks and the mortgage rate on residential houses, all tend to move
in harmony with one another and follow the direction of the repo rate. Therefore, when we
refer to the interest rate in Macroeconomics, we should see it as one
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that represents all the individual rates that exist in practice. In this respect, the general
interest rate level corresponds to the general price level, which is also an important variable
in Macroeconomics.
Why are interest rates important? The newspapers discuss interest rates daily – and with
good reason. Interest rates influence practically all our economic decisions. Should we spend
more, or should we rather save to buy a house? If we have a house, how will an increase in
the mortgage rate influence our financial position? Interest rates also influence decisions
taken by business people. Should they invest in new production plants or equipment, or
should they buy treasury bills? If the interest rate on bank deposits is, for example, in the
region of 10% while the inflation rate is 15%, the general public who have surplus funds will
find this negative real interest rate unacceptable. They might decide instead to buy
alternative securities with a higher expected rate of return. It can also happen that individuals
prefer not to save or buy any financial instruments, but to spend their money instead. From
this, it is clear that investment decisions are quite complicated, as all the numerous alternative
opportunities have to be weighed up against one another.
As we have said, the most important interest rate in the economy is the repo rate . This is
the rate at which the SARB lends money to the banks to finance their daily liquidity deficit.
This rate also determines the interest rate at which the banks are willing to provide loans to
the private sector, and therefore the banks’ prime overdraft rates and other lending rates
will change in harmony with the repo rate. The repo rate thus plays a key role in the interest
rate structure of the country. Table 9.2 gives an indication of how often the SARB has
changed the repo rate during the past few years.
TABLE 9.2
Changes in the repo rate since 2009
202
Date changed
Repurchase rate (%)
06/02/2009
10,50
25/03/2009
9,50
04/05/2009
8,50
28/05/2009
7,50
13/08/2009
7,00
25/03/2010
6,50
09/09/2010
6,00
19/11/2010
5,50
20/07/2012
5,00
30/01/2014
5,50
18/07/2014
5,75
24/07/2015
6,00
20/11/2015
6,25
29/01/2016
6,75
18/03/2016
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Date changed
Repurchase rate (%)
21/07/2017
6,75
29/03/2018
6,50
Source: South African Reserve Bank Quarterly Bulletin (June 2018)
The SARB takes many factors into account when it decides on the level of the repo rate. We
previously explained that the objective of monetary policy in South Africa is to protect the
value of our currency, the rand. Protecting the value of a currency means to protect the
buying power of the currency. Therefore, protection of the value of the currency implies
keeping the inflation rate as low as possible. Generally, it is accepted that higher interest rates
will result in lower levels of spending (because it is more expensive to borrow money), and
this may result in prices increasing at a slower rate and thus a lower inflation rate. Therefore,
when the inflation rate is expected to increase, the SARB may increase the repo rate. This
can then be expected to result in an increase in the general level of interest rates in the
country.
We also have to distinguish between short-term interest rates and long-term interest
rates. Short-term interest rates are determined in the money market, and long-term interest
rates in the bond market. The level of long-term interest rates is one of the most important
determinants of investment. The monetary authorities work mainly in the money market and
therefore mainly influence the short-term interest rates through the repo rate. Long- term
interest rate will usually also move in harmony with the short-term rates. There are two
important reasons why there will be differences between short-term and long-term interest
rates:
● Due to uncertainty with regard to what can be expected to happen in the future, there
is more risk attached to longer-term instruments. Therefore, we can usually expect that
long-term interest rates will be higher than short-term interest rates to compensate
holders of long-term instruments for the risk that they carry.
● Expectations with regard to what will happen to short-term interest rates also influence
long-term interest rates. If short-term interest rates are expected to decrease in the future, it may happen that long-term rates are lower than short-term rates despite the risk
profile. This will usually happen when the inflation rate is expected to decrease.
The rate of interest (via changes in the repo rate) is the most important operational variable
used by the monetary authorities (mainly the SARB) in the execution of monetary policy.
LEARNING ACTIVITY 9.6
Choose correct answers
(a) Which of the following statements are correct?
a. When the inflation rate is high, we can expect the repo rate to be decreased.
b. When interest rates increase, we can expect that borrowing activity in the economy will increase.
c. When interest rates increase, we can expect that spending activity in the economy will decrease.
d. When spending activity in the economy decreases, we can expect prices to increase at a slower rate or to stop increasing at all.
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[1]
[2]
[3]
[4]
[5]
abcd
abc
ac
bd
cd
LEARNING ACTIVITY 9.7
Discussion forum
Please read the following article written by Sunita Menon that appeared in Business Day
on 24 May 2018:
24 MAY 2018 – 05:33 SUNITA MENON
Never mind Thursday’s interest-rates decision, economists say the South African Reserve Bank will not be cutting the repo rate again in 2018.
That is because the inflation rate is edging up after surprising on the downside in recent
months.
In the first set of data that reflected the value-added tax (VAT) increase announced earlier in 2018, Statistics SA said on Wednesday the annual headline inflation rate had
increased to 4.5% in April, up from a seven-year low of 3.8% in March.
Since the last monetary policy committee (MPC) meeting — when the Bank cut the
main rate by 25 basis points and governor Lesetja Kganyago said the rand was overvalued — the currency has slid about 5% against the dollar.
Oil prices have also jumped, putting upward pressure on prices of imported goods.
"The Reserve Bank will flag heightened near-term pressure that didn’t exist at the last
MPC," said economist Thabi Leoka. "It makes sense to pause," she said.
The rand lost further ground against the dollar on Wednesday, erasing gains from earlier
in the week. In late trade it was at R12.6418/$ from R12.5703.
"The Bank takes a longer-term view and will especially be on the lookout for any second-round inflationary pressures that could be building up," said Sasfin Wealth analyst
Alvin Chawasema.
Kganyago said at the last MPC meeting that the VAT increase in April — the first in a
quarter of a century — would push the inflation rate up by about 0.6 percentage points
in coming months.
While SA had a reprieve from ratings agency Moody’s in March and is expected to escape unscathed after S & P Global Ratings announces its latest review of the country on
Friday, threats of downgrades had not completely disappeared, said Momentum economist Sanisha Packirisamy.
That is because the country’s efforts to restore the financial health of state-owned companies are still at an early stage.
"The Bank will play it on the safe side given the risks," she said.
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Economists also pointed to an improving economy as another reason for the Bank to
refrain from easing policy, with Nedbank saying that the MPC would probably start
tightening it in 2019.
The 2018 domestic growth outlook is more favourable, although it remains challenging,
with the bank expecting growth of 1.7% in 2018, 1.5% in 2019 and 2% in 2020.
That is still below the 3% growth rate that President Cyril Ramaphosa is seeking to
achieve as the country battles an unemployment rate close to 27%.
"The MPC will probably leave policy rates unchanged for the rest of the year before embarking on a mild tightening cycle from around September 2019," said Nedbank
economist Johannes Khosa.
Source: https://www.businesslive.co.za/bd/economy/2018-05-24-why-economists-expect-a-steadyrepo-rate-for-2018/
Visit the discussion forum for learning activity 9.7 on myUnisa and air your opinion on the
following issue:
(a) Identify the factors that affect the decision regarding changes in the repo rate.
LEARNING ACTIVITY 9.8
Quiz on learning unit 9
Note that you can also do this quiz on myUnisa to get immediate feedback. The answers to
the quiz will also become available on myUnisa under Additional Resources at the end of
the week allocated to studying learning unit 9.
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THE FINANCIAL SECTOR
Indicate whether each of the following statements is TRUE or FALSE:
STATEMENT
TRUE
FALSE
1. The use of money eliminates the need for a double coincidence of wants associated with a barter economy.
2. When inflation is experienced, money loses some of its
usefulness as a store of value.
3. Individuals can hold their wealth in the form of money only – in other words, money is the only possible store of
value.
4. In South Africa, there are at least three different measures
of the quantity of money: M1, M2 and M3.
5. M1 is the narrowest measure of money and consists of
coins, notes and demand deposits.
6. The cash reserve requirement of any South African bank
is held in a non-interest-bearing account with the SARB.
7. The money creation process is based on the ability of banks
to lend part of the deposits they receive to other customers.
8. Banks can create demand deposits by granting credit to
their clients in the form of overdraft facilities.
9. In South Africa, monetary policy is formulated and implemented by the SARB, which is the country’s monetary
authority.
10. The rate at which the SARB grants loans to the banks is
called the repo rate.
LEARNING ACTIVITY 9.9
Short questions on learning unit 9
1. The M3 money supply includes both the
function of money and the
function of money.
2. A
concept is measured at a particular point in time, while a
concept
is measured over a period.
3. Monetary policy in South Africa is applied within a(n)
framework.
4. The interest rate that banks have to pay when they borrow money from the Reserve
Bank is called the
rate.
5. The following values for M1, M2 and M3 are taken from the Quarterly Bulletin:
5.1
5.2
206
Year
M1
M2
M3
2013
1 132 039
2 049 694
2 512 251
2014
1 243 571
2 228 790
2 696 145
Calculate the value of short-term and medium-term deposits for 2013 and
2014.
Calculate the value of long-term deposits for 2013 and 2014.
LEARNING UNIT 9:
The Financial Sector
6. Discuss the functions of money.
ADDITIONAL RESOURCES THAT CAN BE CONSULTED
If you are interested to find out more about the topics covered in this learning unit, you
can consult the following sources:
Janse van Rensburg, J, McConnell, CR & Brue, SL. 2011. Economics: Southern African Edition.
Berkshire: McGraw-Hill: Chapters 12 and 13.
Mohr, P & Associates. 2015 (or other editions). Economics for South African students. Pretoria:
Van Schaik: Chapter 14.
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LEARNING UNIT 10
The Foreign Sector
CONTENTS
10.1 INTRODUCTION
10.2 THE BASIS FOR TRADE
210
210
10.3 SOUTH AFRICA'S FOREIGN TRADE
214
10.3.1 South Africa's exports
216
10.3.2 South Africa's imports
217
10.4 EXCHANGE RATES
10.4.1 Definition, methods of quotation and methods of calculation of exchange
rates
218
10.4.2 Direct and indirect quoting of exchange rates
218
10.4.3 The market for foreign exchange
220
10.5 THE BALANCE OF PAYMENTS
208
218
224
10.5.1 What is the balance of payments?
224
10.5.2 The items that make up South Africa's balance of payments
224
10.5.3 The link between exchange rates, the balance of payments and economic growth
in South Africa
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LEARNING UNIT 10: The Foreign Sector
Mind map of the foreign sector
Econosavvity
To pass this module, you will also be expected to understand the following concepts
and apply them to economic situations:
●
●
●
●
●
●
●
●
●
●
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absolute advantage
comparative (relative) advantage
exports and imports
exchange rates
market for foreign exchange
balance of payments (BoP)
current account of balance of payments
financial account of balance of payments
foreign reserves
direct and indirect quotation
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LEARNING UNIT 10: THE FOREIGN SECTOR
10.1
INTRODUCTION
The South African economy is regarded as a very open economy because of the importance
of international trade as a share of total economic activity. Internationally, the USA may be
regarded as less open because international trade makes a relatively small contribution to
overall economic activity. In contrast to this, Japan (which relies heavily on both imports of
raw materials and exports of manufactured products) may be considered as one of the more
“open” economies in the world. This unit will focus more closely on our trading relations
with the rest of the world.
The only way international trade differs from “domestic” trade is that one of the parties to
the transaction concerned is from another country. Naturally there are difficulties, in the
sense that different languages may be spoken and different currencies may be encountered,
but the fact remains that all the economic principles you have learnt up to this point are
wholly applicable to the study of International Economics.
Some of the questions raised in International Economics are: Why do we sometimes choose
to do business with foreigners rather than with our fellow South Africans? What is the
extent and composition of this cross-border economic activity? How are different monetary
units exchanged for one another?
10.2
THE BASIS FOR TRADE
Why does international trade take place? The answer to this question lies in the endowment
of different countries with natural resources (including climate), human resources and
the resources of capital equipment and technology which are built up over the years.
This can be illustrated by means of various examples. A country such as Japan has a large
and reasonably well-educated labour force – skilled labour is abundant and therefore quite
cheap. Japan can thus produce (efficiently and at low cost) a variety of goods for which
skilled labour is required: cameras, computers, TVs and DVD players are examples of such
labour-intensive and skill-intensive commodities. In contrast, a country like Australia has
vast tracts of land in comparison with its human and capital resources, and so can produce
land-intensive commodities such as wool and meat. Brazil, on the other hand, possesses
the soil, tropical climate, rainfall and ample supplies of unskilled labour needed for the
efficient, low-cost production of coffee. Industrially advanced nations (such as Germany)
are in a strategic position to produce a variety of capital- intensive goods such as cars,
heavy machinery and chemicals.
The fact that these cases would lead to trade is easy enough to understand, because in the
examples we mentioned each of the countries has an absolute advantage over other
countries in the production of a specific commodity.
.................................................................................................................................................................
Anabsolute advantage is the ability of one country to produce more of a particular commodity within
a certain period of time compared with another country using the same amount of resources.
.................................................................................................................................................................
However, international trade is not confined to cases where countries have an absolute
advantage over others in terms of the production of certain goods. International trade may
even be advantageous to a country that is extremely efficient in producing all goods. One
would think that such a country could produce anything it needed. This is indeed true, but
the advantage of trade would then lie in the fact that the country in question could
specialise in those goods where its comparative (or relative) advantage was greatest. If
a country specialises in the production of a particular good, it can result in an increase
in
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LEARNING UNIT 10: The Foreign Sector
productivity resulting in lower production costs. Workers become specialised and thus
better at doing that particular job.
.................................................................................................................................................................
A comparative advantage is the ability of one country to produce a particular commodity at a lower
cost within a certain period of time compared with another country.
.................................................................................................................................................................
The following example (although based on very simplified assumptions) illustrates the
nature of comparative advantage.
Suppose we have two countries, A and B, which can both produce only two possible
products, rice and wine. If A devotes all its resources to the production of rice, it will be
able to produce 40 bags of rice per person-hour. If it devotes all its resources to the
production of wine, it can produce 8 bottles of wine per person-hour. Country B, on the
other hand, can produce either 8 bags of rice or 4 bottles of wine per person-hour.
This situation is illustrated in the following table:
Rice
Wine
Country A
40
8
Country B
8
4
We can make the following deductions from this:
● Country A has an absolute advantage in the production of both rice and wine. This means
that given its resources, it can produce more rice and more wine than country B.
However, it has a greater absolute advantage in the production of rice. It is five times
(40:8 or 5:1) more efficient than country B in the production of rice, and only twice as
efficient (8:4 or 2:1) as country B in the production of wine.
● Therefore, country A will specialise in the production of rice, and export rice to country B.
● On the other hand, country B is less efficient in both products than A, but is relatively
more efficient in the production of wine than the production of rice.
● Therefore, country B will specialise in the production of wine and export wine to country A, while it imports rice from country A.
● The cost ratio of producing the two products is 5:1 (40:8) in country A and 2:1 (8:4) in
country B.
● Any trade ratio that falls between these two cost ratios can benefit both countries if
they traded.
● Let us take as an example a trade ratio of 4:1 (e.g. the two countries decide to trade 4
bags of rice for 1 bottle of wine).
● Country A will benefit because by switching a person-hour from wine production to
rice production it loses 8 bottles of wine, but gains 40 bags of rice. The 40 bags of rice
can now be traded for 10 bottles of wine. In the process, A has gained 2 bottles of wine.
● Country B will also benefit because by switching a person-hour from rice production
to wine production it loses 8 bags of rice, but gains 4 bottles of wine. The 4 bottles of
wine can earn 16 bags of rice through trade. In the process, country B has gained 8 bags
of rice.
● It is quite clear that both countries can gain by specialising in the products in which
they have a comparative advantage or comparatively the least disadvantage.
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LEARNING UNIT 10: THE FOREIGN SECTOR
According to the general principle of comparative advantage, the greatest benefit for all is
obtained when there is specialisation according to endowments and talents between people,
between regions within a country and also between countries. This type of specialisation
should arise naturally provided there is no interference with market forces. If there is no
economic policy that affects specialisation and trade between countries, we call this free
trade or free international trade.
International trade, however, by definition involves at least two independent countries, and
for this reason it is very difficult to put this principle of free trade into practice. Particularly
in the case of countries endeavouring to catch up economically with other countries with a
higher level of industrial development, it is often argued that local industries cannot get off
the ground without a certain measure of protection (the so-called “infant industries”
argument), and even that free trade could ruin existing industries. This is the opposite of the
principle of free trade and is known as protectionism. Protectionism involves policies such
as imposing tariffs on imports and the subsidising of exports. These measures tend to distort
prices and lead to retaliation by the trading partners, eventually leading to a reduction in
trade. There is no country in the world today which does not have some form of protection
for its local industries, agriculture and mining sector. Box
10.1 explains how tariff and subsidies may affect imports and exports.
BOX 10.1
The effect of tariffs and subsidies on imports and exports
The effect of tariffs on imports
Suppose that South Africa levies a tariff of 25% on completed garments that are imported from China.
If a jacket with a price in terms of rand of R200 is imported from China, 25% of this
price, thus R50 has to be paid to the government in the form of an import tariff. This increases the price to R250.
If the jacket could be produced in South Africa at a price of R230, the jacket will rather
be produced locally and will not be imported.
However, the jacket can be produced at a lower cost in China. Producing it in South
Africa means that the jacket is not produced in the country where it can be produced
most effectively. The tariff therefore distorts prices and the jacket is not produced by the
country that can produce it most effectively. The import of jackets from China to South
Africa will therefore decrease.
The reason for the introduction of the tariff can be to protect the industry and the jobs
of workers who produces jackets in South Africa.
The effect of subsidies on exports
Suppose that the government subsidises 25% of the salaries of workers in the renewable
energy sector. If the cost of a solar panel produced in South Africa is R3 000, and half
of this (i.e. R1 500) is labour cost, it means that the government will pay R375 (25% of
R1 500) of the cost. Effectively the cost of producing the solar panel is therefore
R3 000 – R375 = R2 625.
Suppose that it costs R2 800 to produce the same solar panel in Zambia. Without the
subsidy, the solar panel produced in Zambia is cheaper and companies who want to use
solar panels would import the solar panels from Zambia. However, due to the subsidy
the solar panels produced in South Africa are now cheaper to purchase. Therefore, exports of solar panels from South Africa can be expected to increase.
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LEARNING UNIT 10: The Foreign Sector
This number of solar panels exported from South Africa can therefore be expected to
increase, due to the subsidy. The subsidy therefore means that the solar panels will not
be produced in Zambia, which is actually the country where it can be produced most
effectively.
Similarly, South Africans will prefer to purchase locally produced solar panels, since the
subsidy results in these seeming to be cheaper than the solar panels that can be imported
from Zambia. Therefore, imports of solar panels can be expected to decrease.
Once again, the reason for the introduction of the tariff can be to protect the solar panel
industry in South Africa, and create or protect job positions in this industry. However,
this comes at a cost to the taxpayer, as the government is subsidising part of the cost of
the solar panels. Therefore, the introduction of the subsidy means that solar panels are
not produced in the country which can produce it most effectively.
Subsidies and tariffs therefore distort prices, and may result in goods and services not
being produced in the country which has comparative advantage in the production of
such goods and services. It also affects the level of imports and exports in a country.
LEARNING ACTIVITY 10.1
Discussion forum
Please watch the following video clip:
https://www.scmp.com/video/business/2152082/origins-and-impact-us-china-trade-war
Visit the discussion forum for learning activity 10.1 on myUnisa and provide your opinion
on the following issues:
(a) How will the proposed tariffs affect trade between China and the US?
(b) How will the proposed tariffs affect consumers in China and the US?
(c) Do you think the proposed tariffs will have a positive effect? Explain your answer.
LEARNING ACTIVITY 10.2
Choose correct answers
(a) Use the following information to answer the question:
Suppose:
● China produces 4 tables or 12 chairs
● South Africa produces 2 tables and 8 chairs
China has both absolute and comparative advantage over South Africa in the
production of tables.
[1] True
[2] False
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LEARNING UNIT 10: THE FOREIGN SECTOR
(b) According to the law of comparative advantage, if two nations specialise in the goods
in which each has a comparative advantage, then trade between the nations will result
in
[1]
[2]
[3]
[4]
both nations being better off.
one nation benefitting at the expense of the other nation.
a decrease in total world production.
nations decreasing their level of consumption.
(c) The question is based on the following information:
Suppose countries A and B both produce boats and cars. They can produce the
following number of boats and cars in a week if they utilise all their resources:
Boats
Cars
A
100
120
B
150
130
Which of the following options is/are correct?
a.
b.
c.
d.
Country A has a comparative advantage in producing cars.
Country B has a comparative advantage in producing boats.
Country A has an absolute advantage in producing boats.
Country B has an absolute advantage in producing cars.
[1]
[2]
[3]
[4]
[5]
abcd
abc
abd
ab
cd
(d) Which of the following is correct?
According to the theory of comparative advantage, countries gain from trade
because
[1] firms behave more competitively when they trade, and this reduces their market power.
[2] all firms can take advantage of cheap labour.
[3] output per worker in each firm increases.
[4] total global production can increase when each country specialises in what it
does relatively best.
[5] every country has an absolute advantage in producing something.
10.3
SOUTH AFRICA'S FOREIGN TRADE
In table 10.1, the total exports to some of South Africa's main trading partners are shown
from 2012 to 2017. The countries are ranked according to the value of total exports during
2017. Table 10.2 shows the total imports from some of South Africa’s main trading partners,
also from 2012 to 2017. The countries in table 10.2 are ranked according to the value of
total imports during 2017.
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LEARNING UNIT 10: The Foreign Sector
TABLE 10.1
South Africa's exports – top 10 trading partners (R'm)
Exports (R millions)
Ranking
% of
total
Country
2013
2014
2015
2016
2017
2017
2017
CHINA
116 381
95 219
94 402
101 174
115 485
1
9,7
UNITED STATES
66 881
70 439
78 578
80 411
88 661
2
7,5
GERMANY
41 327
49 436
67 727
82 028
83 869
3
7,1
JAPAN
53 827
53 039
50 826
50 760
55 468
4
4,7
INDIA
29 008
40 770
40 549
48 124
55 467
5
4,7
BOTSWANA
44 451
51 714
52 507
54 596
51 175
6
4,3
NAMIBIA
40 943
49 217
52 835
51 911
47 548
7
4,0
UNITED
KINGDOM
31 875
37 613
41 831
46 480
46 365
8
3,9
MOZAMBIQUE
27 316
32 529
29 532
33 273
38 523
9
3,3
NETHERLANDS
17 966
29 493
33 119
25 281
37 003
10
3,1
TOTAL
928 977
1 000 738
1 035 944
1 117 076
1 184 538
Ranking
% of
total
Source: Department of Trade and Industry (2018)
TABLE 10.2
South Africa's imports – top 10 trading partners (R'm)
Imports (R millions)
Country
2013
2014
2015
2016
2017
2017
2017
CHINA
154 444
167 611
199 371
198 962
202 931
1
18,4
GERMANY
106 228
108 566
122 344
129 680
127 373
2
10,0
UNITED STATES
63 029
71 361
76 284
72 903
72 757
3
5,8
SAUDI ARABIA
77 440
77 327
33 607
41 692
51 217
4
5,5
NIGERIA
34 898
55 705
38 558
30 460
22 855
5
4,0
INDIA
51 894
49 365
53 702
45 642
52 183
6
4,0
UNITED
KINGDOM
32 283
35 491
35 002
31 800
33 248
7
3,7
THAILAND
26 536
25 773
26 306
31 752
33 115
8
3,2
JAPAN
39 393
40 960
39 887
37 529
37 684
9
3,1
ITALY
25 971
28 643
28 309
27 063
29 568
10
2,8
TOTAL
998 056
1 083 513
1 087 953
1 099 265
1 106 836
Source: Department of Trade and Industry (2018)
As explained previously, there are different reasons why countries trade, and differences in
factor endowment is one of the most important reasons. Factor endowment refers to the
availability of natural, human, technological and capital resourcesin a country. South Africa is rich
in natural resources and as you will see in the following section, products from the mining
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LEARNING UNIT 10: THE FOREIGN SECTOR
sector forms a large part of our exports while we import very little such products. It will also
be shown that we import a lot of manufactured goods, because our labour force is not that
well trained, and we are not as technologically advanced as countries such as Germany and
Japan. A country such as Germany will therefore import mining products from us, while we
will import manufactured products from them. China has a huge population and an
abundance of well-trained labour. Therefore, they import natural resources from us and we
import manufactured goods from them.
Trade between neighbouring countries can also be expected to be relatively higher, despite
the fact that the countries may have similar factor endowments. This is because transport
cost also affects trade between countries. For example, if Botswana and Namibia import
maize from South Africa, the transport costs will be much lower than if they import maize
from the United States. Therefore, neighbouring countries will often feature in the list of
countries that countries trade with most.
10.3.1 South Africa's exports
In the previous section, we said that the reason for foreign trade is to be found in the
differences between countries in respect of the availability of natural, human, technological and
capital resources. This statement is clearly illustrated by the composition of South Africa's
imports and exports. Table 10.3 contains South Africa’s exports according to the trade
structure for 2012 to 2017.
From table 10.3, it can be seen that South Africa’s exports in general show a growing trend,
although mining exports declined in 2014 and 2015. This decline can be attributed to sluggish
global growth, which affected commodity prices negatively, as well as low output in South
Africa due to labour unrest in this sector.
TABLE 10.3
Structure of South African trade: exports 2013–2017
Exports (Rand million)
Agriculture
Mining
Manufacturing
Other
manufacturing
Other
sectors
2013
51 513
358 228
496 017
1 792
2 264
2014
59 941
339 321
570 829
2 483
3 482
2015
64 775
338 552
601 799
2 731
6 477
2016
75 468
359 545
643 741
3 045
8 035
2017
78 513
428 214
642 292
2 988
8 685
Per cent growth
Agriculture
Mining
Manufacturing
Other
manufacturing
Other
sectors
2014
16,36
–5,28
15,08
38,56
53,80
2015
8,06
–0,23
5,43
9,99
86,01
2016
16,51
6,20
6,97
11,50
24,05
2017
4,03
19,10
–0,23
–1,87
8,09
Source: Department of Trade and Industry (2018)
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LEARNING UNIT 10: The Foreign Sector
10.3.2 South Africa's imports
Table 10.4 shows that the growth rate of agricultural imports declined considerably in 2015
and 2017, but increased in 2014 and 2016. This is due to the fact that the produce of
agricultural products vary substantially from year to year, locally and internationally. For
example, some years South Africa may have a large surplus of maize and may be able to
export it, and the next year a drought results in a shortage of local maize and it has to be
imported. Weather and other natural phenomena will also affect demand for our products
globally. If there is a drought in the US, they may need to import fruit and vegetables from
other countries, but some years they may experience a surplus of fruit and vegetables. Mining
imports started to increase again in 2016 after declining substantially in 2014 and a bit more
in 2015. From table 10.4, it can be seen that manufacturing imports represent the largest part
of South Africa’s imports.
TABLE 10.4
Structure of South African trade: imports 2012–2016
Imports (Rand million)
Agriculture
Mining
Manufacturing
Other
manufacturing
Other
sectors
2013
29 942
9 183
949 874
7 892
1 165
2014
32 181
7 790
1 032 835
9 167
1 539
2015
38 877
7 806
1 030 182
9 673
1 414
2016
49 062
8 208
1 030 404
10 095
1 496
2017
43 095
10 856
1 041 516
10 006
1 363
Per cent growth
Agriculture
Mining
Manufacturing
Other
manufacturing
Other
sectors
2014
7,48
–15,17
8,73
16,16
32,10
2015
20,81
0,21
–0,26
5,52
–8,12
2016
26,20
5,15
0,02
4,36
5,80
2017
–12,16
32,26
1,08
–0,88
–8,89
Source: Department of Trade and Industry (2018)
LEARNING ACTIVITY 10.3
Choose correct answers
(a) None of the countries that appear in the list of top export trading partners of South
Africa appears in the list of top import trading partners.
[1] True
[2] False
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(b) Manufacturing goods make up the largest part of both the imports and exports of
South Africa.
[1] True
[2] False
(c) South Africa imports much more agricultural products than it exports.
[1] True
[2] False
(d) South Africa imports much more mining products than it exports.
[1] True
[2] False
10.4
EXCHANGE RATES
10.4.1 Definition, methods of quotation and methods of calculation of
exchange rates
The need for rates of exchange arises because countries make use of different currencies:
South Africa uses the rand (abbreviated to R), and the USA uses the dollar (US$). Other
examples of national currencies are the euro (€) for the European Union, the British pound
sterling (£), the Japanese yen (¥) and the Botswana pula (BWP). Once trade is carried on
between two nations, the parties conducting these international transactions would normally
prefer to pay, or to receive payment, in their own currencies. For this to be possible, there
must be a going rate at which one currency can be exchanged for another. This is referred
to as an exchange rate.
.................................................................................................................................................................
An exchange rate is the rate at which one monetary unit can be exchanged for another
monetary unit.
.................................................................................................................................................................
10.4.2 Direct and indirect quoting of exchange rates
Exchange rates are normally expressed in terms of how much of the local monetary unit is
needed to purchase one unit of the foreign currency concerned. This is the direct method
of quoting exchange rates. Let us consider two examples.
For a South African, the direct method of expressing the exchange rate between the rand
and the US dollar involves writing the number of rand needed to buy one dollar at that time.
For instance, the price of one dollar may be equal to R11,50. Using the direct method of
quotation, we say that the rand/dollar (R/$) exchange rate is R11,50 = $1,00, or simply that
the R/$ rate is R11,50 to the dollar.
What about the rate of exchange between the rand and the British currency, the pound
sterling? If the price of one pound is equal to R19,50, then the rand/pound (R/£) exchange
rate, using the direct method, is R19,50 = £1,00, or R19,50 to the pound.
Imagine that a South African buyer wants to import English cutlery to the value of £500.
Not having any pounds available, the importer wants to pay in rand. The English exporter,
in turn, would prefer to be paid in pounds. Therefore, the South African may have to
exchange a certain number of rand for the required number of pounds. The number of rand
needed is calculated by multiplying the R/£ exchange rate by the quantity of pounds
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LEARNING UNIT 10: The Foreign Sector
needed, that is, R19,50 multiplied by £500, which is equal to R9 750. This number of rand
will be sufficient to purchase the £500 needed to pay the English exporter.
Instead of the R/$ rate, we can also refer to the $/R rate. The difference is that the $/R
rate is the price (in dollars) of one rand, whereas the R/$ rate, as you will recall, is the price
(in rand) of one dollar. In our example, the R/$ exchange rate is R11,50 = $1,00. Inverting
this to arrive at the $/R rate of exchange, we now have $1,00 = R11,50. This can also be
expressed as $1,00/R11,50, which is calculated as 1/11,50 = 0,087. In other words, the
$/R exchange rate is equal to $0,087 = R1,00, or $0,087 to the rand. This way of express
the exchange rate between the rand and the dollar is known as the indirect method of
quotation, from the South African point of view, since it prices the rand in terms of the
dollar. As far as the Americans are concerned, of course, the $/R rate would be the direct
method of quotation.
Regardless of whether the direct or indirect method of quotation is used, the exchange rate
is always expressed as a certain number of units of one of the currencies required to
purchase one unitof the other currency. The denominator (the currency named second) is
always reduced to 1. To recap: the R/$ rate is the number of rand needed to buy one dollar;
the $/R rate is the amount of dollars needed to buy one rand .
While it is common to use the direct method of quoting exchange rates, there are
exceptions. For example, the exchange rate between the dollar and the euro is quoted as
€/$, rather than $/€, even by the Americans. This is a matter of convention (a convention
is a practice that is continued because it has become customary for some reason). The
exchange rate between the Japanese yen and the US dollar is quoted as ¥/$, rather than
$/¥, because it is less cumbersome to speak of an exchange rate of 100 yen per dollar, than
one-hundredth of a dollar per yen! Note that although neither the ¥/$, nor €/$ rate of
exchange involves the rand, these two rates of exchange are important international
economic indicators that are quoted in South African news bulletins.
The importance of the dollar as the major international currency unit means that the
exchange rates of most other currency units are usually quoted against the dollar. In South
Africa, if we know the R/$ exchange rate and the dollar exchange rate with another foreign
currency, say the Japanese yen, then it is possible for us to calculate the exchange rate
between the yen and the rand. Because this calculation is done using dollar rates of
exchange, the resultant yen per rand (¥/R) exchange rate is referred to as a cross rate.
For example, if we know the R/$ (= R11,50) and the ¥/$ (= ¥100) exchange rates, it is
possible for us to work out the cross rate of exchange between the yen and the rand (¥/R).
Let's see how we can do this:
We know that R11,50 = $1 and that ¥100 = $1
Because both are equal to $1, we can say that
R11,50
= ¥100
If we now want to find out how much yen is needed to buy one rand:
R11,50 = ¥100
11,50
11,50
Thus, R1,00 = ¥ 8,70
We have now defined what is meant by an exchange rate, and we have seen that there are
different ways of quoting exchange rates. But how are exchange rates arrived at in the first
place? Well, because an exchange rate is simply a price, we can expect that exchange rates
are established by means of demand and supply interaction, just as other prices are
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LEARNING UNIT 10: THE FOREIGN SECTOR
determined (remember the analysis in learning unit 4). This is indeed the case, and the
mechanism by which this process takes place is the foreign exchange market.
10.4.3 The market for foreign exchange
The participants in the foreign exchange market are involved in buying and selling foreign
exchange (forex). A South African importer buys (demands) dollars in order to effect
payment for a consignment of American-made computers. By contrast, an American
importer of South African platinum needs rand to pay for it and would therefore sell
(supply) dollars in order to obtain rand.
In all likelihood, the two parties, the South African importer of computers and the American
importer of platinum, don't know about each other. If they did, the South African could buy
the dollars from the American importer and use them to pay for the computers. The
American would receive rand from the South African, which would be used to pay for the
platinum. What is more probable, however, is that both parties will go through a forex broker
(i.e. a foreign exchange dealer), or the forex department of a bank, in order to change their
money. So will thousands of other participants in international transactions, which means
that on any trading day, a substantial amount of various currencies is bought and sold on
behalf of exporters, importers, travellers, investors, borrowers, lenders, speculators and
others. A balance between the quantity of forex (in this case the US dollar) supplied and
demanded will be established at a market-clearing price. As you know by now, equilibrium
is reached at the price where quantity demanded and quantity supplied are equal, and so the
equilibrium R/$ exchange rate is established (see figure 10.1).
FIGURE 10.1
The market for foreign exchange
Note that the quantity of dollars is measured on the horizontal, or X axis. The price of
one US dollar is on the vertical axis, expressed in rand per dollar (R/$). The $ part of this
ratio is always equal to 1, as was mentioned earlier.
From figure 10.1, we can see that the equilibrium quantity of dollars traded ($300 million)
is supplied and demanded at the equilibrium exchange rate of R11,50 = $1,00. At a higher
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LEARNING UNIT 10: The Foreign Sector
dollar value (e.g. R13,00), an excess supply of dollars (AB) will exist, and at a lower dollar
value, excess demand (CF) for dollars will result.
Just as any other price is set by means of supply/demand interaction, the equilibrium
exchange rate is liable to change in response to a shift of either the supply or the demand
curve for foreign exchange (or both). An increase in South African exports to the USA would
lead to a greater supply of US$ on the local forex market, causing the supply curve for US $
to shift to the right. A fall in exports would shift the supply curve to the left. Conversely, a
rise in South African imports from the USA would mean that South African importers would
need to supply more rands in order to demand more dollars, causing the demand curve for
forex to shift to the right. A fall in imports (fewer dollars are required for imports) would
shift the demand curve for dollars to the left. See figure 10.2 for the effects of these changes
on the equilibrium R/$ exchange rate.
FIGURE 10.2
Changes in the demand and supply of foreign exchange
A rise in the R/$ exchange rate is referred to as a depreciation of the rand against the
dollar.
.................................................................................................................................................................
Depreciation of a currency is a decrease in the value of a currency in comparison with
other currencies. This means that the depreciated currency is worth fewer units of some
other currency.
.................................................................................................................................................................
If the price of the dollar in rand terms has risen, which means that the price of the rand in
terms of the dollar has fallen: fewer dollars are now needed to buy one rand; therefore, the
rand has depreciated. A depreciation of the rand is depicted in figure 10.2 (a), where the
value of the dollar has risen from R11,50 to R12,50.
It also means that more rand is now needed to buy one dollar. This implies that goods
imported from the US that have to be paid for in dollar will now be relatively more
expensive (than before the depreciation of the rand). At the same time, South African goods
that are exported to the US will now be relatively cheaper for US citizens, as a US citizen
will receive more rand for one dollar (then before the depreciation of the rand).
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LEARNING UNIT 10: THE FOREIGN SECTOR
In contrast, a fall in the R/$ exchange rate indicates an appreciation of the rand against
the dollar.
.................................................................................................................................................................
Appreciation of a currency is an increase in the value of a currency in comparison with
other currencies. This means that the appreciated currency is worth more units of some
other currency.
.................................................................................................................................................................
If the price of the dollar in rand has fallen, it also means the price of the rand in dollar terms
has risen. More dollars are now needed to buy one rand; therefore, the rand has appreciated
against the dollar. This is shown in figure 10.2(b), where the value of the dollar has fallen
from R12,75 to R11,75.
It also means that less rand is now needed to buy one dollar. This implies that goods
imported from the US that have to be paid for in dollar will now be relatively cheaper (than
before the appreciation of the rand). At the same time, South African goods that are
exported to the US will now be relatively more expensive for US citizens as a US citizen
will receive fewer rand for one dollar (then before the appreciation of the rand).
A depreciation of the rand can therefore be expected to increase exports and decrease
imports (ceteris paribus), while an appreciation of the rand can be expected to decrease exports
and increase imports (ceteris paribus). Table 10.5 summarises the impact of the rand/dollar
exchange rate on export prices and import prices, and also indicates the effect on domestic
prices. When the prices of imported goods increase, the general price level in the country
will also rise. When imported goods become relatively cheaper, the general price level in the
country can be expected to decrease. Therefore, we can expect a depreciation of the rand
to result in inflation, and an appreciation of the rand to contribute to a lower inflation rate.
TABLE 10.5
Impact of changes in rand/dollar exchange rate
Impact on
Change in R/$ exchange rate
Export prices
Import prices
(in dollars)
(in rands)
Domestic
prices
Rand
dollar
depreciates
against
Decrease
Increase
Rise
Rand
dollar
appreciates
against
Increase
Decrease
Fall
LEARNING ACTIVITY 10.4
Choose correct answers
(a) The exchange rate is R13 = $2. If a laptop is selling for $700, then the cost in rand
would be
[1] R53,85.
[2] R107,69.
[3] R4 550,00.
[4] R9 100,00.
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LEARNING UNIT 10: The Foreign Sector
Question (b) is based on the following figure:
(b) Based on the figure, which of the following statements is/are correct?
[1]
[2]
[3]
[4]
The shift of D to D' may be caused by an increase in exports to the USA.
The shift of D to D' may be caused by an increase in imports from the USA.
The diagram illustrates a depreciation of the dollar.
The diagram illustrates an appreciation of the rand.
(c) At a certain date, the exchange rate between the rand and the dollar is R13,50 =
$1,00 and the exchange rate between the rand and the pound is R17,65 = £1,00.
Based on the information, which of the following statements is/are correct?
a. If a South African company imports a machine from the USA at a price of
$15 000, it will have to pay R202 500 for the machine.
b. If a South African company exports meat to the value of R100 000 to the UK,
it will receive £1 765 000 as payment, which it then has to convert to rand.
c. If the price of a tool is $50,00 in the USA and £40 in the UK, it is cheaper to
buy it from the US company.
[1]
[2]
[3]
[4]
[5]
abc
ab
ac
bc
b
(d) Which of the following are correct?
When the rand/dollar exchange rate changes from R1 = $13,50 to R1 = $14,10
a.
b.
c.
d.
the rand appreciates.
the dollar appreciates.
imports from the USA will become more expensive for South Africans.
exports from South Africa to the USA will become more expensive for
Americans.
[1]
[2]
[3]
[4]
[5]
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abcd
acd
bc
ad
bd
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LEARNING UNIT 10: THE FOREIGN SECTOR
10.5
THE BALANCE OF PAYMENTS
10.5.1 What is the balance of payments?
All transactions with an international flavour are summarised in a set of accounts called the
balance of payments. The balance of payments is divided into a current account, a capital
transfer account and a financial account. Included in the current account of the balance of
payments are the total rand amounts of goods and services imported and exported during
a certain period of time. The Department of Customs and Excise of the South African
Reserve Bank publishes the figures that can be used to calculate the trade balance each
month.
.................................................................................................................................................................
The trade balance is the difference between total exports (gold and merchandise) and
total merchandise imports.
.................................................................................................................................................................
A positive balance is a surplus, while a negative balance is a deficit. Once data on service
receipts and payments, as well as current transfers, are included, the balance on the current
account can be calculated (see table 10.6 for the calculation). This indicates whether the
country is living within its current means.
Any balance on the current account is offset by an equal but opposite flow on the other
two accounts. The capital transfer account is normally very small and can be ignored for
our purposes. The financial account records all inter-national transactions in assets and
liabilities and is an indication of the compensating flows of investment and loans, coupled
with a depletion or accumulation of gold and foreign reserves.
10.5.2 The items that make up South Africa's balance of payments
Table 10.6 is a slightly simplified presentation of South Africa's balance of payments for
2017. It shows that South Africa’s merchandise exports for the period amounted to
R1 108,322 million, plus gold to the value of R66 411 million.
South Africa’s trade balance for 2017 is equal to the value of exported goods (including
gold exports) minus the rand value of imported goods for the given period.
Thus, R1 108 322m + R66 411m – R1 105 876m = R68 857m.
South Africans rendered services to foreigners (e. g. hotel accommodation for tourists)
worth R210 238 million and earned income to the value of R81 637 million from the foreign
sector in 2017. The income earned in this way consists of compensation of employees
(wages, salaries and benefits earned overseas) and investment income (dividends, interest
and profits from overseas investments).
Merchandise exports, gold exports and service and income receipts are all added up in the
balance of payments. They represent an inflow of foreign exchange in return for goods, gold
and services provided by South Africa. Many foreign currencies are involved in this payment,
and because these amounts are all converted into rand by South African exporters and
service providers, the total amounts are shown in rand terms.
Payments for merchandise imports and income and services rendered by foreigners to South
Africa (including large amounts to service South Africa's foreign debt) are listed as negative
amounts (thus subtracted) in the balance of payments. This is because they reflect the
outflow of foreign exchange needed to pay for imports and foreign services. In 2017, imports
amounted to R1 105 876 million, and payments for services were R214 544
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LEARNING UNIT 10: The Foreign Sector
million and for services, R221 201 million. The final item in the current account is the net
amount of current transfers, that is, remittances of funds with no corresponding flow of
goods in the other direction. In 2017, there was a net outflow of R38 303 million of
transfers. By adding all of the above items together, a deficit of R114 317 million on the
current account is arrived at.
As we have said, the capital transfer account is of minor importance, and may be disregarded
for our purposes.
The financial account is divided into four categories of investments:
Direct investment includes all transactions related to the acquisition of share capital in
foreign countries with the purpose of gaining control of or a meaningful say in the
management of the enterprise in which the investment is made. The figure of R80 472
million shows that there was a net outflow of direct investment during 2017.
Portfolio investment, on the other hand, refers to the purchase of assets such as shares or
bonds, where the investor is interested only in the financial return of the investment. The
purpose of the investment is not to gain any meaningful control of any business enterprise.
This type of investment may be regarded as more volatile and short-term in nature than the
direct investment referred to above. During 2017, a net amount of portfolio investment
equal to R220 371 million flowed into the country.
Net financial derivatives refer to the purchasing and selling of derivative instruments from
and to the foreign sector. During 2017, a net amount of R4 247 million flowed out of the
country due to derivative transactions.
Other investment is a residual category of investment which includes financial transactions
not covered under direct and portfolio investment. It consists mainly of trade credit
associated with imports and exports. This amounted to R9 002 million that flowed out of
the country in 2017.
If we add these four types of investment shown on the financial account together, we get
the net amount that was invested in the country, or if it is negative, the amount that flowed
out of the country for investment purposes.
If there is a deficit on the current account, it has to be financed by an inflow of the financial
account, that is, an inflow of investment funds. During 2017, this was the situation that was
experienced. The deficit on the current account was equal to R114 317 million (we discussed
this above) and investment funds to the value of R126 650 million flowed into the country.
There was therefore an increase in reserve assets equal to R25 525 million. Note that an
increase in reserve assets is indicated by a negative amount, while a decrease in reserve assets
is indicated by a positive amount.
Unrecorded transactions are basically a recording of all the errors and omissions that might
occur when compiling individual transactions of the balance of payment. Unrecorded
transactions will be equal to the difference between the balance on the current account and
the balance on the financial account (including the change in reserve assets).
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LEARNING UNIT 10: THE FOREIGN SECTOR
TABLE 10.6
South Africa's balance of payments, 2017
Current account
Merchandise exports
R million
1 108 322
Net gold exports
66 411
Service receipts
210 238
Income receipts
81 637
Less: Merchandise imports
1 105 876
Less: Payments for services
215 544
Less: Income payments
221 201
Current transfers
–38 303
–114 317
Balance on current account
Capital transfer account (net receipts +)
246
Net lending to (+) / borrowing from (1) the rest of the world
114 071
Financial account
101 125
Net direct investment (+inflow/–outflow)
–80 472
Net portfolio investment (+inflow/–outflow)
220 371
Net financial derivatives (+inflow/–outflow)
–4 247
Net other investment (+inflow/–outflow)
–9 002
Change in reserve assets (–increase/+decrease)
–25 525
Unrecorded transactions
12 946
Source: South African Reserve Bank Quarterly Bulletin (June 2018)
LEARNING ACTIVITY 10.5
Choose correct answers
Use the table below to answer questions (a) and (b):
Item
226
R million
Merchandise exports
800 000
Merchandise imports
950 000
Unrecorded transactions
7 500
Service receipts
61 000
Net gold exports
60 000
Net direct investments
70 000
Net portfolio investments: assets
25 000
LEARNING UNIT 10: The Foreign Sector
Item
R million
Other investment: trade credit
11 000
Investment income paid to foreigners
105 000
Investment income received from foreigners
200 000
Payment for services
55 000
Current transfers
–20 000
Income receipts
75 000
Income payments
120 000
(a) Based on the information above, the balance on the trade balance is
[1]
[2]
[3]
[4]
R150 000 million.
R181 000 million.
–R90 000 million.
–R84 000 million.
(b) Based on the information above, the balance on the current account is
[1]
[2]
[3]
[4]
R161 000 million.
–R90 000 million.
–R149 000 million.
–R161 000 million.
(c) When a South African resident pays R20 000 into a money market fund in the
United Kingdom, this forms part of
[1]
[2]
[3]
[4]
direct investment.
portfolio investment.
income payments.
other investment.
Question (d) is based on the following information on country X for the year 2017:
Item
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Amount (Z)
Merchandise exports
150 000
Merchandise imports
130 000
Net gold imports
45 000
Service receipts
120 000
Payments for services
100 000
Income receipts
75 000
Income payments
95 000
Current transfers
–43 000
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LEARNING UNIT 10: THE FOREIGN SECTOR
(d) Based on the information in the table above, the balance on the current account of
country X for the year 2017 is
[1] Z672 000.
[2] Z108 000.
[3] Z65 000.
[4] Z22 000.
[5] Z–68 000.
10.5.3 The link between exchange rates, the balance of payments and
economic growth in South Africa
A discussion of exchange rates must take into account their impact on the items in the
balance of payments and vice versa. After all, exchange rates are prices, and in order for
South Africans to import vehicles from, say, Japan, it is not only the yen price of the vehicles
that determines the quantity demanded, but also the rand price of the yen. We explained
above that a depreciation of the rand against foreign currencies leads to a decline in
imports. The opposite effect applies to exports: the Japanese demand for South African
platinum exports depends, among other things on the yen price of the rand . If the rand
price of yen is high, it implies that the yen price of the rand is low, and this will be favourable
for Japanese importers. The lower the yen price of the rand, the lower the price of South
African goods for Japanese importers, and thus the higher the demand South African goods.
Exports to Japan will therefore increase.
We can see from the above discussion that a depreciation of the rand curtails imports, but
stimulates exports, thereby improving the balance on the current account (by reducing a
deficit or by increasing a surplus). A similar result is observed in the financial account: a
depreciation of the rand makes investment opportunities in South Africa appear cheap to
foreigners, while the high price of forex deters South Africans from investing or lending
funds abroad.
The opposite effects will appear should the rand appreciate in value in terms of foreign
currencies. Imports will rise; exports will become less competitive on international markets,
and thus fall. The effect on the financial account would be to encourage South African
investment in foreign shares/companies/bonds, at the same time as diminishing foreign
interest in (expensive) South African investment opportunities. A rand appreciation would
thus tend to harm the balance of payments (by increasing a deficit or by reducing a surplus).
There are other economic variables that affect exchange rates and the balance of payments.
It is hoped that South Africa's present policy of an accelerated and shared growth initiative
to put the economy on a higher growth path will lead to the desired effect. Historically, high
levels of economic growth in South Africa have been associated with a subsequent increase
in expenditure, and therefore increased imports. This is because South Africa is an open
economy, reliant on imports of machinery and consumer goods. Increases in imports during
a period of economic upswing may not be accompanied by a corresponding increase in
exports from South Africa, since local industries may have their time cut out just supplying
the expanding local markets with their products.
The result is a deterioration in the balance of payments – a vanishing of the all-important
trade surplus – and upward pressure on the rand prices of the various foreign currencies
concerned: the yen, the euro, the pound sterling and the US dollar, and so on. This is
because the excess demand for imports causes the demand curves for the respective foreign
currency units to shift to the right. Once the rand depreciates in this way, it feeds into
consumer and producer price inflation: imported goods become more expensive
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LEARNING UNIT 10: The Foreign Sector
because of the depreciation of the rand. The expansionary momentum of the economy runs
into higher prices and may stop altogether before it has got going properly.
The processes described above have led South African economists to speak of a "balance
of payments constraint". By this they mean the inability of the South African economy to
grow fast without soon leading to a deficit on the balance of payments and a depreciation
of the rand. The subsequent monetary policy action of raising interest rates is aimed at
curtailing the demand for consumer credit and therefore consumption spending, part of
which is used to purchase imports. Unfortunately, investment spending is also hurt by the
exchange rate depreciation and by the rise in interest rates. The result is that just as the
South African economy gets up and running, balance of payment problems appear, and the
corrective policies to deal with them tend to stop the recovery of the economy in its tracks.
LEARNING ACTIVITY 10.6
Choose correct answers
(a) As a nation’s income increases, its demand for imports increases, creating an increase
in its demand for foreign currencies.
[1] True
[2] False
(b) The balance of payment constraint implies that:
[1] economic growth will result in an increase in domestic prices
[2] economic growth may not necessarily result in an increase in employment
opportunities
[3] economic growth will result in an increase in imports and deterioration of the
balance of payments
[4] economic growth may be hindered by government policies such as trade tariffs
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LEARNING UNIT 10: THE FOREIGN SECTOR
LEARNING ACTIVITY 10.7
Choose correct answers
Note that you can also do this quiz on myUnisa to get immediate feedback. The answers to
the quiz will also become available on myUnisa under Additional Resources at the end of
the week allocated to studying learning unit 10.
Indicate whether each of the following statements is TRUE or FALSE:
TRUE
STATEMENT
FALSE
1. South African citizens would be better off economically
if the country did not engage in international trade at all.
Anna can knit 4 jerseys or sew 8 dresses per week, while Joan can knit 3 jerseys
or sew 4 dresses per week. Use this information to answer questions 2, 3 and 4.
2. Anna has an absolute advantage in knitting jerseys.
3. Anna has a comparative advantage in knitting jerseys.
4. Joan should specialise in knitting jerseys, while Anna
should specialise in sewing dresses.
5. All economic activities taking place within the borders of
a country are recorded in the balance of payments.
6. The balance of payments is a summary record of a country’s transactions with the rest of the world during a
particular period.
7. The flow of goods between South Africa and the rest of the
world is recorded in the current account of the South
African balance of payments, while the flow of services is
recorded in the financial account.
8. Exports create a supply of foreign exchange, while imports constitute a demand for foreign exchange.
9. An increase in South African imports from the United
States will give rise to an appreciation of the rand against
the US dollar.
1- A fall in the value of the rand against the Japanese yen is
0. described as a depreciation of the rand against the yen.
LEARNING ACTIVITY 10.8
Short questions on learning unit 10
1. An increase in exports increases the
curve for foreign exchange shifts to the
2. An increase in imports increases the
curve for foreign exchange shifts to the
230
for foreign exchange and the
.
for foreign exchange and the
.
LEARNING UNIT 10: The Foreign Sector
3. An increase in the demand for foreign exchange leads to a (rise/fall) in the rand exchange rate and the rand (appreciates/depreciates).
4. An increase in the supply of foreign exchange leads to a (rise/fall) in the rand exchange rate and the rand (appreciates/depreciates).
5. Consider the rand/dollar exchange rate. Assume that the exchange rate is currently
quoted as R11,50 to the US dollar.
5.1 How many US cents would be required to buy R1,00?
5.2 If you bought an Economics textbook for $45 over the internet, how much
would you have to pay in rand terms? (Ignore shipping costs etc.)
5.3 If the exchange rate were to change to R11,80 to the dollar, which currency
has appreciated and which has depreciated?
5.4 How much will the textbook (still $45) cost you now in rand terms?
5.5 Explain how a change in the exchange rate results in “winners” and “losers”.
6. Consider the following information:
Merchandise exports
Net gold exports
80
Merchandise imports
350
Service receipts
150
Service payments
200
Income receipts
90
Income payments
120
(Net) current transfers
–30
Capital transfer account
0
Balance of financial account
Unrecorded transactions
6.1
6.2
6.3
6.4
300
150
0
Calculate the trade balance.
Calculate the balance on the current account.
Calculate the change in (net) reserves, given the information above.
Of which three sub-accounts does the financial account consist?
ADDITIONAL RESOURCES THAT CAN BE CONSULTED
If you are interested to find out more about the topics covered in this learning unit, you
can consult the following sources:
Janse van Rensburg, J, McConnell, CR & Brue, SL. 2011. Economics: Southern African Edition.
Berkshire: McGraw-Hill: Chapter 24 to 26.
Mohr, P & Associates. 2015 (or other editions). Economics for South African students. Pretoria:
Van Schaik: Chapter 13, pages 249–252 and Chapter 16.
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Van Aardt, C. 2017. How radical is inclusive economic transformation? Bureau for Market
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