Foundation Course
Economics
OUfc008
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Open University of Mauritius - Foundation Course in Economics - Module 1
FOUNDATION COURSE
IN ECONOMICS
Module 1
OUfc 008
April 2013
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Open University of Mauritius - Foundation Course in Economics - Module 1
ACKNOWLEDGEMENTS
Course Author : Vinod Seegoolam
Course Reviewer : Dr Chong Wang Cheong Ah Tow
OPEN UNIVERSITY STAFF
Course Supervisor : Perienen Appavoo (Open School Division)
Project Coordinator: Premanand Koonjal (Open School Division)
Copyright : Open University of Mauritius, 2013
All rights reserved. No part of this course may be reproduced in any form
by any means without prior permission in writing from:
Open University of Mauritius
Réduit, Republic of Mauritius
Fax: (230) 464 8854
Tel: (230) 403 8200
Email : openuniversity@open.ac.mu
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Open University of Mauritius - Foundation Course in Economics - Module 1
Programme Overview
The growing complexity of economic condition in the work place requires a
basic undestanding of economic concepts. This Foundation course in Economics is divided into 2 modules and each awards four credits. Module 1
covers one semester( 3 months) and 80 hours of study time comprising 4
units. Students are advised to spend 20 hours on each unit. Duration of the
course is one year minimum and a maximum of two years. Assessment will
be based on written examination of 2 hours duration and Tutor marked assessment will carry 30% of the total marks and the final examination is 70%
of the total marks. Students will be supported by tutorials. Integrated video
programmes will also be provided to explain key concepts.
Module Overview
Module 1 covers 4 units and after completion of these units, students will be
able to undestand the basic economic problems of scarcity choice and opportunity cost, the production possibility curves and the different allocative
mechanism, the concept of Demand and Supply and Elasticity of Demand,
Government intervention in the Market and the Cost and Benefit Analysis
amd finally the theory of Firms and the Production Functions.
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Open University of Mauritius - Foundation Course in Economics - Module 1
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Table of Contents
Unit 1
- Basic Economic Ideas
Unit 2
- The Price System
19
Unit 3
- Government Intervention in the Prices System
39
Unit 4
- Firms and The Production Function
53
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1
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Open University of Mauritius - Foundation Course in Economics - Module 1
SELF STUDY GUIDE
COURSE TITLE
MODULE
COURSE DURATION
TOTAL STUDY TIME
: Foundation Course in Economics
:1
: One semester (3 months)
:80 hours (The course carries 8 credits for Modules I and II and students are advised to spend
20 hours of study on each unit).
COURSE OVERVIEW :The growing complexity of economic conditions in the works requires a basic understanding of economic concepts. The course gives an
overview of the main economic concepts both
at micro and macro levels.
COURSE OBJECTIVES:Upon completion of the course, learners will
be able to understand :
Basic Economic problems of scarcity,
choice and opportunity cost
The Production Possibility Curve and the
different allocative mechanism
The concepts of Demand and Supply and
Elasticity of Demand
Government intervention in the market
and Cost Benefit Analysis
Firm and the production functions
COURSE OUTLINE
: Module I covers 4 units
UNITS TITLES
1
2
3
4
STUDY TIME
Basic Economic Ideas
The Price System
Government Intervention in the Price System
Firms and the Production Function
20 hours
20 hours
20 hours
20 hours
COURSE DELIVERY : Written materials
Video programmes
Tutorials (optional)
ASSESSMENT MODE : Self-Marked Assessment
Tutor Marked Assessment
End of Course Examination
EVALUATION SCHEME:The Tutor- Marked Assessment will carry 30%
and the final examination 70% of the total
marks.
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Open University of Mauritius - Foundation Course in Economics - Module 1
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GLOSSARY
8
PPC
-
Production Possibility Curves
PED
-
Price Elasticity of Demand
YED
-
Income Elasticity of Demand
XED
-
Cross Elasticity of Demand
PES
-
Price Elasticity of Supply
AFC
-
Average Fixed Cost
TFC
-
Total Fixed Cost
TVC
-
Total Variable Cost
AVC
-
Average Variable Cost
TC
-
Total Cost
MC
-
Marginal Cost
AC
-
Average Cost
CBA
-
Cost Benefit Analysis
PC
-
Private Cost
ATC
-
Average Total Cost
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Open University of Mauritius - Foundation Course in Economics - Module 1
UNIT
1
BASIC ECONOMIC IDEAS
Introduction or unit overview
This unit provides an exposure to the basic concepts in economics and explains how scarce resources have to be allocated in order to maximize welfare.
It also describes the different economic systems and the role of specialisation.
Learning Objectives
On completion of this unit, students should be able to:
l Understand what is meant by the problem of scarcity and choice
l Describe what economists mean by the economic problem
l Understand the factors of production as economic resources
l Explain the concept of specialisation and the economic benefit it offers
l Explain the concept of opportunity cost and the nature of trade offs
l Explain the principles underlying the production possibility curves
Unit content
Scarcity, Choice and Resource Allocation
lThe nature of the basic economic problem and the production possibility
curve
lDifferent allocative mechanisms - market economies, planned economies,
mixed economies.
l Factors of production – Land, Labour, Capital and Enterprise
l Divison of labour and specialisation
l
Study Time: 20 hours each unit
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Open University of Mauritius - Foundation Course in Economics - Module 1
1.1 FORMULATING A DEFINITION FOR ECONOMICS
Economics is basically concerned with the use of scarce resources to satisfy
the maximum possible wants. We should in other words economise. It is the
study of the conflict between Man and Nature. This conflict arises because
man has unlimited wants while nature has provided very limited resources.
According to Lionell Robbins “Economics is a social science which
studies rational human behavior as a relationship between ends and
scarce means having alternative uses”. This implies that human wants
being unlimited while the resources being scarce, the human being has to decide rationally as to which want to satisfy and which one not to satisfy. Whenever a person chooses to satisfy one want, an alternative has to be forgone.
Economics is therefore considered as a social science which shows how rational human beings allocate their existing limited resources among their unlimited wants in order to derive the maximum possible satisfaction.
According to Alfred Marshall “Economics studies human behavior
in the everyday business of life”. Every individual is required to make
a number of choices everyday and the way we behave while making such
choice represents the core issue of economics. For example, when someone
is buying less tomatoes at a high price and more of it when it is very cheap is
a clear indication of how the individual behaves in his or her everyday life.
1.2 THE NATURE OF THE ECONOMIC PROBLEM
The basic economic problem is to satisfy human wants.
1.2.1. What is a want?
Wants are desires which people have. They are unlimited because human
beings are greedy by nature. Wants are not always backed by the ability to
pay. Examples of wants include the need for food, clothing, housing, entertainment and luxuries. It is however necessary to differentiate between wants
and needs. A want is just a desire to possess something whereas a need is a
commodity or service which is necessary for the survival of human being. For
example, food, shelter and clothing are needs while a want can comprise the
above needs as well as the desire to go on the moon.
Do we have sufficient resources to satisfy these wants?
Resources are provided by nature and are also created by human being over
time. They are used to produce goods and services which can satisfy human
wants. These resources which are known as the means which can satisfy our
daily wants are extremely limited. For example, the world does not have
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Open University of Mauritius - Foundation Course in Economics - Module 1
sufficient rice or wheat which can feed satisfactorily everyone in this world.
Resources are therefore scarce that is their supply is limited in relation to their
demand. Human wants are therefore insatiable thus making it necessary for
people to choose as to which want to satisfy and which not to. This necessitates choice.
1.2.2. What is choice?
Choice is a selection out of alternatives. Every choice therefore involves an
alternative forgone. The next best alternative forgone is known as the opportunity cost.
Choice has to be exercised at all levels for example
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A consumer has to choose so as to decide on which combination of
goods that will yield the maximum satisfaction or utility.
lA producer has to choose so as to minimize cost by using the best possible combination of factor inputs so as to maximize profits.
lThe government has to choose because national resources are insufficient to satisfy national wants. Government should therefore decide on
a. What to produce?
That is how to allocate the existing resources so as to maximize
welfare of the nation.
b. How to produce?
Given the scarcity of resources every country should use the best
possible techniques of production which can ensure maximum
utilisation of resources. For example, over populated countries can
use labour intensive techniques.
c. For whom to produce?
This concerns the problem of distribution. That is, once the goods
have been produced how do we distribute them among the population. Should government decide to distribute it equally among the
people or should we leave it to the market forces which normally
leads to an unequal distribution.
The above three questions represent the basic economic problem which all
societies face.
For more details about these concepts
view the video programme:
Unit 1 - Programme 1
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Open University of Mauritius - Foundation Course in Economics - Module 1
1.3. The production possibility curve (PPC)
Given the scarcity of resources, there is a limit to the amount of goods and
services which an economy can produce if it makes full use of all its existing
resources andoperates with a given state of technology. This limit is shown
by the production possibility curve.
What is a PPC ?
The PPC which is also known as the Production Possibility Frontier or the
Transformation curve of an economy shows the maximum possible combination of two goods which an economy is capable of producing if it makes full
use of all its existing resources and operates with a given state of technology.
The PPC is constructed on the basis of the following assumptions, namely:
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l
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The economy has a given stock of resources which will not change.
The resources will be fully utilised for producing two types of goods,
for example Good X and Good Y.
The level of technology remains constant.
roduction is subject to increasing opportunity cost because factor inputs
P
used in the production of goods X and Y are not homogeneous. Increasing
opportunity cost means that as we produce more of one good, the amount of
the other good which is given up will go on rising. This is so because resources are not homogeneous that is, they are not equally productive for all goods.
For example, some plots of land are better for cultivating tomatoes while others are better for rice. If we want to produce more tomatoes we will have to
divert land away from rice towards tomatoes. Since the land is not good for
rice, the opportunity cost of tomatoes in terms of rice will therefore rise.
Example to calculate opportunity cost
The opportunity cost is the next best alternative forgone. For example, if a
country is producing 100 tons of rice and 10 tons of tomatoes and now decides to produce 12 tons of tomatoes it will have to reduce the production of
rice. If now it produces only 95 tons of rice the opportunity cost of the 2 tons
of tomatoes is 5 tons of rice.
On the basis of the above assumptions we can construct a Production Possibility scheduled as follows.
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Open University of Mauritius - Foundation Course in Economics - Module 1
Production Possibility Schedule
COMBINATION
AMOUNT
OF GOOD A
OF GOODS
AMOUNT OF GOOD B
OPPORTUNITY
COST
A 0100
B
1
95
C
2
85
3
70
E
4
40
F
5
0
D
0
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EXERCISE 1
Complete the opportunity cost column in the above schedule
Plot the curve by showing good A on the X-axis and good B on Y-axis.
Y
Good B
X
Good A
Characteristics of the normal PPC
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It slopes downwards from left to right. This is so because of scarcity of
resources. That is, if we want to produce more of one good, we must
give up part of the other good. The PPC therefore has a negative slope.
It is concave to the origin. This is so because factors of production are
not homogeneous and so production takes place under increasing opportunity cost. In case of homogeneous factors, the opportunity cost
will become constant and the PPC will become a downward slopping
straight line. It will become convex if we have diminishing opportunity
cost.
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Open University of Mauritius - Foundation Course in Economics - Module 1
Good B
Good B
Good A
Good B
Good A
(I) Increasing
opportunity cost
Good A
(II) Constant
opportunity cost
(III) Diminishing
opportunity cost
The concave curve as shown at (I) above means that when more of A is produced, the country will have to sacrifice an increasing amount of the other
good. When it is a straight line as at (II) above it means that the same amount
of one good has to be given up when an additional unit of the other is produced. In case it is convex as at (III) above, it implies that as we produce more
than of one good, a decreasing amount of the other good has to be sacrificed
l
A
ny combination inside the PPC represents an inefficient output combination because resources will be unemployed. Efficiency occurs only
when we cannot produce more of one good without producing less of
the other good. For an economy to be efficient it must be using its resources fully and will therefore operate along the PPC. For example the
diagram below showing efficiency indicates that when more of good A is
produced, the amount of good Y will automatically fall. In contrast the
diagram on inefficiency below indicates that the country can produce
more of good A without reducing the production of good B. Combinations outside the PPC are unattainable unless there is a change in the
stock of resources or in the level of technology. This can be illustrated by
the following diagrams
Y
Y
A
P
O
A B
Q
B
Q1
Inefficiency
X
O
X
Efficiency
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Open University of Mauritius - Foundation Course in Economics - Module 1
l
hifts in the PPC. The PPC can shift outwards or inwards. An outS
ward shift represents an increase in the country’s productive potential
while an inward shift represents a fall in the productive potential.
The outward shift can be caused by:
a. An improvement in technology.
b. The discovery of new resources.
c. An increase in productivity.
d. An increase in economic growth.
Y
X
EXERCISE 2
As you have noted above the PPC can shift to the right or to the left. A leftward shift means that the country’s productive capacity is falling, in other
words, the country can now produce less goods.
List down 4 factors which can cause the PPC to shift to the left?
1.………………………………………………………………………
2.………………………………………………………………………
3.………………………………………………………………………
4.………………………………………………………………………
For more details about PPP curve
view the video programme :
Unit 1 - Programme 2
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Open University of Mauritius - Foundation Course in Economics - Module 1
1.4 THE DIFFERENT ALLOCATIVE MECHANISMS :
THE MARKET ECONOMIES, THE PLANNED ECONOMIES
AND THE MIXED ECONOMIES
All economies are basically similar because they face the same economic
problem. They all have to ensure the most efficient utilization of resources
in order to generate maximum welfare. The term welfare indicates the wellbeing of the people in a country and this is normally reflected in terms of
their income, living standard, entertainment, satisfaction of basic need, level
of luxuries and so on. However the way the economy goes about solving the
three basic economic problems can differ. This explains why we have four
different economic systems namely:
1. The market economy
2. The centrally planned economy
3. The mixed economy
4. The subsistence economy
1.0 The market economy
The market economy which is also known as the free market system,
laisser-faire economy or the capitalist economy is one where the government has no role to play and all economic decisions are taken solely on the basis of market forces. The main features of the market
economy include the following:
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Private ownership of all the means of production.
The existence of the profit motive, that is, producers undertake
production with the main objective of maximizing profits.
The operation of the free price mechanism, that is, prices are determined solely by the free market forces of demand and supply.
Consumers decide what goods and services will be produced and
producers have to produce according to the desires of consumers.
Absence of government intervention. Consumers express their desires through their purchasing power and producers will have to
respond to those desires. The government does not intervene to
indicate what should be produced.
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Open University of Mauritius - Foundation Course in Economics - Module 1
The main advantages of the market economy include:
Consumer sovereignty.
It is the consumer who decides what producers should produce
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Benefits of competition.
Since private firms are allowed to compete, the nation will benefit from
such competition for example better quality goods, lower prices, larger
variety of choice and so on.
l
Greater motivation for producers to produce and to expand.
Since producers know that they will enjoy all the benefits individually
they are motivated to put in more effort and to do better so that they
can get more rewards.
l
Greater efficiency among firms.
Competition ensures that only the best firms will survive. Thus everyone is forced to improve and become more efficient.
l
A higher level of output and a better standard of living.
Since a large number of firms are producing goods under such a system, the total amount of goods produce will rise and people in the
country will become better off.
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However the main disadvantages of such a system are:
The wastes of competition.
Firms are not able to operate on a large scale and many of them have
unutilized capacity.
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Huge advertising expenditure leading to higher price.
Firms advertise massively thus spending a large amount of money
which increases cost forcing people to pay higher prices.
l
Over production of luxuries and under production of basic
needs.
Given that producers are profit motivated, they lay more emphasis
on producing luxuries which are very profitable. The basic needs
which are less profitable are therefore produce in smaller quantities
thus affecting the poor.
l
l
N
on provision of public goods.
Public goods which will be consumed by everyone irrespective of
whether payment is made or not. For example street lighting will
not be produced by the private sector.
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Open University of Mauritius - Foundation Course in Economics - Module 1
Huge inequalities of income and wealth.
The market economy leads to unequal distribution of income and
wealth that is some people are very rich while the majority remain
poor.
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A very high degree of economic instability.
Since all decisions are taken by market forces which keep on changing
the economy becomes highly unstable economically.
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2.0. The centrally planned economy
The centrally planned economy also known as the command economy or the communist system is one where the government takes all
the decisions about what to produce, how to produce and for whom
to produce. A government planning office decides what will be produced. Detailed instructions are then given to households, firms and
workers.
The main features of the planned economy include the following:
l
Government ownership of all the means of production.
l
Absence of profit motive.
l
Decisions are based on the needs of the people.
l
Use of “shadow” pricing instead of the free price mechanism.
This means that the government artificial prices for goods instead
of prices which are determined by the market forces of demand
and supply. Thus these “shadow prices” do not really reflect the
true value of the good.
Directives are given by government.
The centrally planned economic system has, over the past two decades declined in importance as command economies have gradually moved towards the greater use of the market forces thus giving
rise to the Transition Economies like China. This change from
the planned to the transition economies is mainly explained by the
disadvantages of the centrally planned economies. These include:
l
2.1. The absence of economic freedom at all levels,
In a command economy neither consumers nor producers have any
freedom. It is the government which takes all the decisions. People
therefore do not have the freedom to own property or to decide on
what they are willing to do.
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Open University of Mauritius - Foundation Course in Economics - Module 1
2.2.Absence of incentive to work or expand because the profit
motive is absent
Since private enterprise is not allowed and the government does
not operate on a profit motive people managing these enterprises has no incentive to do better or to expand because they know
that such additional efforts will not be compensated.
2.3.Greater bureaucracy and red tape
Government procedures and regulations have to be followed
thus much time is lost while making decisions and this affects the
efficient operation of the enterprises.
2.4.Absence of consumer sovereignty
Consumers have no say in what is produced by government enterprises. In fact the government authority take the decision on
the basis of the needs of the population and these do not always
turn out to be the right mix.
2.5. The high risk of human error
Since decisions must be taken arbitrarily the risk that errors will
be made is very high. This explains why planned economies
often suffer from severe lack of some goods or excessive production of other goods.
3.0 The mixed economy
All economies today are mixed. This is mainly explained by the factthat both the free market economy and the centrally planned economy suffer from a number of disadvantages. The right approach will
therefore be to go for a mix between the two systems so that people
can take advantage of the benefits of both and yet minimize the disadvantages of both. The mixed economy therefore allows simultaneously the presence of both the public sector and the private sector. Resources are therefore owned by both the government and the private
sector. Economic decisions are taken partly by the market forces and
partly by government directives. The government will normally set
the national objectives and allow the private firms to operate according to those objectives. If government finds that the private firms are
not obeying those objectives it will take necessary measures in order to
control the private sector. The relative importance of the private and
public sector can differ between countries.
The mixed economy is considered to be the best economic system as it
allows the simultaneous advantages of both the market economy and
the planned economy while it minimizes the disadvantages of both the
systems. For example:
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Open University of Mauritius - Foundation Course in Economics - Module 1
l
l
l
l
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It ensures that the government sets the economic goals in the interest of the nation.
It allows government to guarantee the production of basic needs as
well as the public goods which the private sector will not be producing because they are not profitable.
It allows government to exercise necessary control over the private
sector so as to ensure that the interest of the public is safeguarded.
The mixed economy allows necessary freedom of consumption,
freedom to own property and freedom to operate where profits can
be maximized.
It helps government to reduce the economic instability associated
with the free market forces. For example, in a mixed economy the
government can ensure full employment of resources by proving
the necessary incentives. It can also encourage the private sector
to move into areas which are necessary for the benefit of the nation
and which can promote economic development.
4.0 The subsistence economy
This represents a traditional economic system where money is normally not in use and people exchange good and services directly. The
production in such an economy takes place mainly for consumption
purposes. For example, the nomadic life or the tribal living. Such
subsistence systems are nowadays phasing out as all economies are
becoming monetized and are moving towards the mixed economy system.
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EXERCISE 3
1. List five benefits of the market economy system.
a .............................................................................................................
b .............................................................................................................
c .............................................................................................................
d .............................................................................................................
e .............................................................................................................
2.Explain three reasons why centrally planned economies like China
have moved towards the market system.
a .............................................................................................................
b .............................................................................................................
c .............................................................................................................
In order to differentiate among the Different Allocative
mechanics watch the video programme :
Unit 1 - Programme 3
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Open University of Mauritius - Foundation Course in Economics - Module 1
1.4 Factors of production
A factor of production is a productive resource which helps in the production of other goods and services. We classify factors of production into four
categories, namely:
1.Land
Land refers to all the gifts of nature. A gift of nature represents an asset or
something which is available naturally and where no other factor is involved
in its production. It includes the soil, the rivers, the sea, the mineral resources
and other natural gifts. Land is the only factor which can be considered as
being a free good because no one has sacrificed for the production of these
natural gifts. The reward for land takes the form of rent.
2.Labour
Labour is defined as the mental and the physical effort made by a worker towards production of goods and services. Labour is therefore represented by the
worker and a country’s labour force represents its labour potential. The labour
force normally depends on the size and the age composition of the population, the age of retirement, the school leaving age and the number of hours for
which people are legally required to work. Labour as a factor is different from
the other factor of production because it is influenced by the human element.
For example the productivity of labour can be influenced by the attitude of the
worker and by trade union pressure which normally does not occur in the case
of other factors of production.
Given that labour is productive it has to be rewarded in the form of wages
and salaries. Some workers can be paid on a piece rate, on a time rate or on
a combined rate.
Labour is one of the most difficult factors to manage. This is mainly explained
by the fact that a human being has its sensitivity. For example the mood of
the worker influences his or her productivity. Similarly the worker gets tired
when he is exposed continuously to a work situation. His productivity is also
affected by the environment in which he is operating. The attitude of his supervisor or boss has a direct influence on his performance. This explains why
we have a whole management science known as Human Resources Management and Development in order to ensure maximum returns from labour.
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Open University of Mauritius - Foundation Course in Economics - Module 1
3.Capital
The term Capital as a factor of production is viewed differently in economics
and in accounting. To the economist Capital is a stock of productive wealth
which can be used to produce other goods and services.Capital refers to all
the man made assets. It includes machinery, tools and equipment, the infrastructure and the buildings. In contrast the accountant looks at Capital in
the form of money that is invested in order to undertake production of goods
and services. It can comprise, for example the operating capital of the firm
that is the amount of money that the firm has in order to finance day to day
operation. In accounting terms capital is therefore viewed in terms of liquid
capital while to the economist it is a basic man made productive asset.
Capital represents the productive potential of a firm or of a country. To
accumulate capital, we must save and invest. Our future productive capacity therefore depends on the existing stock of capital. When the total value
of the existing stock of capital is added up, it gives us the National Capital
of a country. Capital as a factor of production is therefore necessary for the
promotion of economic development. The production of capital involves the
use of all the other factors.
The reward for capital normally takes the form of interest.
4.Entrepreneurship
This represents one of the most important factors of production because it is
the entrepreneur is the one who is responsible to bring together all the other
factors and combine them in the right proportion in order to produce goods
and services. He also bears all the risk of the business. The entrepreneur
therefore fulfills two main roles namely:
a. The organiser of the means of production
This means that the entrepreneur is responsible to look after the day
to day functioning of the business. He has to manage the workers, to
buy all the raw materials and machinery, to organize the production
system and to provide all the facilities which will allow the smooth
production of goods and services. This will allow the firm to operate
smoothly. The firm is also known as the enterprise which the entrepreneur is responsible to look after. In fact an enterprise is an initiative by an individual to create the physical infrastructure including
the building and machinery and it also comprises of the workers and
all other factors and facilities which are used for producing a good or
a service. In modern times, however, this role of the entrepreneur is
increasingly being performed by paid managers.
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Open University of Mauritius - Foundation Course in Economics - Module 1
b.The risk bearer
Businesses have to face risk some of which are insurable and others
are non-insurable. It is the entrepreneur who bears these risks. That’s
why the entrepreneur is more of a risk bearer than that of a manager. This might not however always be the case, especially in small
enterprises where the owner is also the manager of the business. For
example, a small retail shop in a village. The reward for the entrepreneur takes the form of profits.
EXERCISE 4
List four examples of Capital in a textile factory.
a .............................................................................................................
b .............................................................................................................
c .............................................................................................................
d .............................................................................................................
2. What is the difference between Labour and Entrepreneurship?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
1.5. Division of labour and specialisation
Division of labour is also known as specialisation and such a specialisation
can occur at different levels. For example
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Specialisation at the level of the worker (Division of labour)
Specialisation at the level of a region (Regional Specialisation). This
can occur because of a common facility like climate, availability of
skilled labour or an airport/seaport in the region. For example the
central plateau region in Mauritius specializes in the tea industry because of the climatic factor.
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Open University of Mauritius - Foundation Course in Economics - Module 1
l
Specialisation at the national and international levels. Each country
normally specializes in the production of a good or service in which
it has a comparative advantage. For example in the 1960’s Mauritius
was specializing in sugar production.
Division of labour is defined as the process by which a job is broken down
into different stages and each stage is performed by a particular worker. For
example in a textile factory some workers work on the machines others are
involved in spinning, some work in packaging others in ironing and so on.
They all however work towards a common goal that is to produce the piece
of a t-shirt or a dress which will be sold to the consumer.
The concept of the division of labour was emphasised by Adam Smith who
showed how the division of labour in the pin manufacturing factory led to a
substantial increase in total output of pins.
Division of labour has various advantages namely:
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It leads to a substantial rise in total output.It is good to differentiate
between the term production and the productivity of the worker. Production refers to the total output produce by the firm while productivity refers to the output per unit of labour. The division of labour
leads to an increase in productivity, that is each worker is now able to
produce more of the good because he or she is a specializing in that
task only. This rise in productivity automatically leads to a rise in the
level of output.
It allows each worker to develop his/her potential fully in the area
where the person is best.
It minimizes the waste of time in production as workers do not have to
shift between tasks.
It increases the dexterity of the worker and encourages him/her to
come up with suggestions on the development of better tools and
equipment.
The main disadvantages of the division of labour however are:
l
l
It increases the degree of dependence among workers as the absence
of one worker can affect the whole production process.
The work becomes boring as the worker does the same thing everyday
and does not get the opportunity to develop new skills.
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Open University of Mauritius - Foundation Course in Economics - Module 1
l
l
It increases the risk of unemployment specially because workers cannot do alternative jobs.
It has led to the decline in craftsmanship because it has necessitated
the standardization of products.
EXERCISE 5
1. Give five examples of division of labour in a textile factory.
a .............................................................................................................
b .............................................................................................................
c .............................................................................................................
d .............................................................................................................
2.Consider the case of a car mechanic who concentrates in this job.
What are the benefits and dangers of such concentration.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
Watch the video programme Unit 1 – Programme 4
to have a better idea regarding Factors of Production,
Division of Labour and Specialisation
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Open University of Mauritius - Foundation Course in Economics - Module 1
UNIT
2
THE PRICE SYSTEM
Unit objective and learning outcomes
The objective of this unit is to introduce the students to the concept of the
market and to the forces of demand and supply which influence the price
level. It also aims at allowing students to understand how the equilibrium
price is determined as well as the concepts of elasticity.
Upon completion of this unit, students should be able to:
Understand what is meant by a market and the role of markets.
l
Understand the different objectives of consumers and producers in
the markets.
lUnderstand what is meant by individual demand and supply curves as
well as market demand and supply curves.
l Explain the factors influencing demand and supply.
lExplain what is meant by the concept of price elasticity, income elasticity and cross elasticity of demand as well as the elasticity of supply.
l Evaluate the business relevance of these elasticity concepts.
l
Unit content
l
l
l
l
l
l
l
l
2.1
The concept of the market and the different types of markets.
Individual demand curves and market demand curves.
Factors influencing demand.
Price, income and cross elasticity of demand.
Individual supply curves and market supply.
Factors determining supply.
Price elasticity of supply.
Determination of equilibrium price.
MARKETS
A market comprises all the buyers and the sellers of a good. To have a market the good must be scarce that is markets do not exist for free goods. In
everyday language, markets are associated to a specific place or building. In
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Open University of Mauritius - Foundation Course in Economics - Module 1
economics, however, the market is viewed differently. We can define a market
as any situation, either local, national or international, over which buyers and
sellers who have a common interest in an economic good or service, come
into contact with each other either directly or indirectly in order to transact
in that good or service. The market can be local for example the fish market
or the vegetable market. It can be national, for example, the labour market
and it can even be international, for example, the Foreign Exchange Market.
2.1.1. Types of markets
Markets can be of different types namely
Consumer good markets
These are markets which deal in final goods and services which can
directly satisfy consumer wants. For example, the vegetable market.
The public mostly deals in such markets because they have to buy
goods and services which can directly satisfy their daily wants.
l The Spot market
This is a market where the good being transacted is available at the
time of transaction. The buyer can therefore take delivery of the good
on the spot. For example the market for bread.
l
l
l
l
The future market.
This is a market where the good being transacted is not available at the
time of transaction. The buyer and the seller can meet and agree on
the terms but the good will be delivered at a future date on the terms
and conditions agreed at the time of transaction. For example, a textile firm which collects orders internationally before it starts planning
its production for the coming year.
Factor markets
These are markets which deal in the factors of production. For example, the labour market where workers looking for jobs can meet
employers who have job opportunities or a bank where investors willing to borrow liquid capital can get their loans.
Markets for securities
These markets are exemplified by the Stock Exchange where people
can buy or sell shares and other securities.
Markets can also be classified according to the degree of competition which
exist in these markets. For example:
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Open University of Mauritius - Foundation Course in Economics - Module 1
a.The monopoly market which is dominated by a single producer or seller. For example, the Central Electricity Board in Mauritius.
b.The monopsony market which is dominated by a single buyer
of a good or service. For example the government which is the
sole employer of labour in a planned economy. Such markets can
however also exist in a market economy or in a mixed economy.
c.A duopoly market which is dominated by two firms for example, the Beer market in Mauritius.
d.The oligopoly market which allows for a few large firms to
compete with each other. For example, the Petroleum market in
Mauritius which is dominated by four firms.
e.The monopolistic competition market which has a large
number of small firms dealing in differentiated products. For example the Retail shops in Mauritius.
f.The perfect market which has a very large number of small
firms dealing in a homogeneous product. This is considered to be
the best possible marker form but, it does not exist in practice.
EXERCISE 6
1. Give three examples of oligopoly markets in your country.
a .............................................................................................................
b .............................................................................................................
c .............................................................................................................
d .............................................................................................................
2.Give two reasons why some people would like to deal on a futures
market
a .............................................................................................................
b .............................................................................................................
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Open University of Mauritius - Foundation Course in Economics - Module 1
2.2. DEMAND
The concept of demand explains how consumers behave in a market. Demand can be defined as the quantity of a commodity that a consumer is willing to buy and is capable of paying for it, at a particular price, during a given
period of time, all other things remaining constant.
Demand must be effective, that is, we demand a commodity only when we
can pay for it.
The quantity demanded of a commodity depends on the price of the good.
The demand function is normally written as follows
Qdx = f(Px)
In the above equation Qdx represents the quantity demanded of the good
and Px represents the price of the good. The equation shows that the quantity demanded is function of the price.
The relationship between quantity demanded and price is an inverse one.
That is, when price increases, quantity demanded will fall. When price falls,
quantity demanded will rise, all other things remaining constant. This inverse
relationship is known as the Law of demand.
The relationship between price and quantity demanded can be illustrated by
a demand schedule as follows:
Demand Schedule
Price of the good (Rs) Quantity demanded (Units)
5
110
6
100
7
90
8
80
9
70
10
60
11
50
If we plot the schedule on a graph we get the demand curve
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Open University of Mauritius - Foundation Course in Economics - Module 1
Price
D
P
D
P₁
O
Q
Q₁
Quantity demanded
The normal demand curve will slope downwards showing that the consumer
buys more of a good at a lower price than at a higher price. For example,
when tomatoes become cheaper, we normally buy more of it and when price
goes up we buy less of it. A fall in price leads to an increase in quantity demanded which is also known as an expansion in demand. A rise in price
leads to a contraction in demand. The effects of a change in price is shown
by a movement along the same demand curve as shown below.
Price
Price
D
P₁
P
P
D
P₁
O
D
Q
Q₁
Expansion in demand
Quantity
D
O
Q₁
Q
Quantity
Contraction in demand
Other factors determining demand
Apart from price, the quantity demanded of a good will also depend on certain other factors which are known as the conditions of demand. These
include the following:
1.
Changes in income of the consumer.
A rise income will normally increase demand while a fall in income will reduce demand.
2.
Changes in the price of substitute goods.
A substitute is a good which can replace another good. For example tea and
coffee. They are in competitive demand. For example if price of tea rises
the consumer will demand more coffee.
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Open University of Mauritius - Foundation Course in Economics - Module 1
3.
Changes in the price of complements.
A complement is a good which must be jointly demanded with another
good. For example, car and petrol. A rise in the price of petrol will reduce
the demand for cars.
4.
Changes in taste and fashion.
If a good becomes fashionable or goes out of fashion, its demand will
change.
5.
Changes in climatic conditions.
Some goods have a seasonal demand. For example, the demand for ice
cream falls in winter while the demand for umbrellas rises in the rainy season.
6.
Changes in the size of the population
An increase in population will increase the demand for a good. Similarly an
ageing population will reduce the demand for sports cars.
7.
Advertising and marketing strategies by firms.
If firms advertise aggressively or provide easy credit facilities demand will
rise.
8.
Government policy.
A tax on a good will reduce demand because it makes the good more expensive while a subsidy will make the good cheaper and increase its demand.
The effects of a change in any of the above conditions of demand is shown
by a shift in the demand curve. A rightward shift represents an increase in
demand while a leftward shift represents a decrease in demand as shown
below:
Price
P₁
D
P₂
P
T₂
T₁
T
D₁
D₂
0
Q₂
D
Q
Q₁
Quantity demand
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Open University of Mauritius - Foundation Course in Economics - Module 1
EXERCISE 7
1.List five factors which determine the demand for holidays in Mauritius.
a .............................................................................................................
b .............................................................................................................
c .............................................................................................................
d .............................................................................................................
e .............................................................................................................
2. Why does a consumer normally buy more of a good when price falls.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
Individual demand curve and market demand curve
The individual demand curve shows how a specific consumer will behave
when price changes. The market demand curve shows how all consumers
taken together behave when price changes. In other words, it shows the
change in the total demand for a commodity resulting from a change in price.
The market demand curve is the horizontal summation of all the individual demand curve and will slope downwards just like the individual demand
curve.
To have a better understanding of Demand and Supply
and how to obtain the equilibrium between Demand and
Supply watch video programme:
Unit 2 – Programme 1
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Open University of Mauritius - Foundation Course in Economics - Module 1
2.3 ELASTICITY OF DEMAND
2.3.1 Price Elasticity of demand (PED)
Price Elasticity of demand measures the degree of responsiveness in the
quantity demanded of a commodity as a result of a given change in the price
of that commodity, all other things remaining constant. In other words, it
shows how quantity demanded changes when there is a change in price.
The Price elasticity of demand (PED) can be calculated as follows
PED =
% or proportionate change in quantity demanded
% or proportionate change in price
Proportionate change in change in quantity demanded Q
quantity demanded =
Original quantity Q
P
Proportionate
change in price = change in price
P
Original price
PED therefore =
Q X
P
Q
P
Example:
If price of a good increases from Rs 20 to Rs 22 per unit and the quantity
demanded falls from 1000 units to 800 units the PED will be
200
X
1000
20
2
= -2
EXERCISE 8
Calculate the PED if the price of good falls from Rs 10 to Rs 8 per unit
and quantity demanded rises from 50 units to 55 units.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
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Open University of Mauritius - Foundation Course in Economics - Module 1
Significance of the values of PED
The coefficient of the PED will vary between zero and infinity.
If PED is zero it means that a change in price does not lead to any
change in quantity demanded. Demand becomes perfectly inelastic
and the demand curve will be a vertical straight line.
l
If PED is less than one but greater than zero a change in price will lead
to a less than proportionate change in quantity demanded. Demand
becomes inelastic and the demand curve will be downwards slopping
but steep.
l
If PED is equal to one, a change in price will lead to a proportionate
change in quantity demanded. Demand becomes unit elastic and the
demand curve will be a rectangular hyperbola.
l
If PED is greater than one a change in price leads to a more than proportionate change in quantity demanded. Demand becomes elastic
and the demand curve will slope downwards but will be flatter.
l
If PED is infinity, then the good will be demanded only at given price.
A change in price will disrupt the whole quantity demanded. Demand
is perfectly elastic and the demand curve will be a horizontal straight
line.
l
Price
0
a
<1
>1
<1
0
Quantity demanded
Factors determining PED
As explained above the quantity demanded of different goods will respond
differently to a given change in price. For example an increase in the price of
electricity will reduce demand for electricity by very little making the demand
inelastic. On the other hand, a rise in the price of diamond can reduce the
demand by a large amount as consumers will shift to other form of metals
which can replace diamond. This will make the demand elastic.
The quantity demanded of different goods will therefore respond differently
to a given change in price. This is due to the following factors:
l
The nature of the good, that is, whether it is a basic necessity or a
luxury. Basic needs have an inelastic demand.
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Open University of Mauritius - Foundation Course in Economics - Module 1
l
l
l
l
l
The level of income of the consumer. High income earners have an
inelastic demand because they are less affected by a price increase than
low income earners.
The availability of substitutes. Goods having many substitutes have an
elastic demand.
The percentage of income spent on the good. If the consumer spends
a high percentage of his income on the good demand becomes elastic
because a rise in price will affect him directly.
The price of the goods. Normally cheap goods have an inelastic demand while expensive goods like luxuries have an elastic demand.
The degree of addiction to the commodity. Some goods are habit forming and they make demand inelastic.
EXERCISE 9
1. Give five examples of goods which have an inelastic demand.
a .............................................................................................................
b .............................................................................................................
c .............................................................................................................
d .............................................................................................................
e .............................................................................................................
2. Give five examples of good which have an elastic demand.
a .............................................................................................................
b .............................................................................................................
c .............................................................................................................
d .............................................................................................................
e .............................................................................................................
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Open University of Mauritius - Foundation Course in Economics - Module 1
2.3.2. Income elasticity of demand (YED)
Income elasticity measures the rate of responsiveness in quantity demanded
as a result of a given change in the income of the consumer. The YED can
be calculated as follows:
% or proportionate change in quantity demanded
YED =
% or proportionate change in income
Y
Q
YEDX
=
Y
Q
Example
If the income of a consumer increases from $1000 to $1500 as a result of
which the quantity demanded of a good increases from 50 units to 60 units
weekly the YED will be:
10 X
50
1000
500
= 0.4
The coefficient of the income elasticity will be positive in the case of normal
goods and negative in the case of inferior goods.
The value of the coefficient will vary between zero and infinity implying that
demand can be perfectly income inelastic, income inelastic, unit income elastic, income elastic or perfectly income elastic. Normally luxuries have an
income elastic demand while basic needs have an income inelastic demand.
EXERCISE 10
Give three examples of goods which you would consider as having an income inelastic demand and explain why.
a .............................................................................................................
b .............................................................................................................
c .............................................................................................................
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Open University of Mauritius - Foundation Course in Economics - Module 1
2.3.3. Cross Elasticity of demand (XED)
The cross elasticity of demand measures the rate of responsiveness in the
demand for a good as a result of a given change in the price of some other
related good like a substitute or compliment. For example, if the price of
petrol increases by how much will the demand for cars fall. XED can be calculated as follows:
% or proportionate change in quantity demanded of good X
XED =
% or proportionate change in price of good Y
Q x X
XED =
Q
x
Py
Py
Example
If bus fares rise by 10% and this leads to an increase in the demand for travel
by rail of 20%, the XED for rail travel in relation to the price of bus travel
will be
20%
=2
10%
The coefficient of the cross elasticity will be positive if the goods are substitutes and will be negative if the goods are compliments.
The value of the coefficient indicates the degree to which the goods are related. If it is zero, it means that the goods are not related and if it is infinity
it implies a perfect relationship.
2.3.4.Importance of elasticity concepts for
management and society at large.
Management relies heavily on elasticity notions for decision making. Elasticity of demand helps management to decide on the following:
l
Whether it can increase price of the good or not when cost of production is rising (this is possible only when demand is inelastic)
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Open University of Mauritius - Foundation Course in Economics - Module 1
l
l
l
l
l
Whether it can go for sales promotion by reducing the price of the
good (this is possible only when demand is elastic)
Whether it can shift the burden of a tax on the consumer (this is possible only when demand is inelastic)
Whether it can charge different prices for the same good from different customers or at different time periods (this is possible only when
the PED is different for different customers)
Whether a rise in price will increase the total revenue from sales (this
is possible only when demand is inelastic)
Which type of good should the firm produce. Normally when income
is rising firms benefit by producing goods which have an income elastic demand.
The three elasticity concepts are equally important for society at large. For
example government can equally used these elasticity concepts to decide on
which goods to tax so as to raise revenue and which goods to tax if it wants to
reduce consumptions. Firms and other organisations which want to compete
with each other can equally use elasticity concepts to decide on their strategies.
2.4SUPPLY
The theory of supply studies the behavior of the producer in a market.
Supply can be defined as the quantity of a commodity which a producer is
willing to offer for sale and is capable of doing so at a particular price, during
a given period of time all other things remaining constant.
The quantity supplied of a good is directly related to its price. The supply
function is written as follows :
Qxs = f(Px)
In the above equation Qxs represents the quantity supplied by the producer
or the seller and Px represents the price of the good. In fact producers who
are profit motivated will normally look at the price before deciding on the
quantity of the good that they will offer for sale.
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Open University of Mauritius - Foundation Course in Economics - Module 1
The direct relationship between price and quantity supplied represents the
law of supply. This law states, that all other things remaining constant, a
producer will be willing to sell more of good when price increases and less
of it when price falls. This is mainly due to the fact that producers are profit
motivated and higher prices therefore generate higher profits.
Other reasons which can explain such a behavior include the following:
l
l
Producers accumulate stocks when prices fall thus reducing the market
supply and they off load existing stocks on the market when price rises.
New firms join in when price is rising, thus increasing the market supply.
A supply schedule shows the relationship between price and quantity supplied as follows:
Supply Schedule
Price of the good
Quantity supplied
(Rs) (Units)
1
50
2
55
3
60
4
65
If we plot the supply schedule we will get the supply curve which is a normal
upward sloping one.
Price
S
S
0
Quantity supplied
Factors determining supply
The quantity supplied of a commodity depends on the price of the commodity as well as on the following factors:
32
Open University of Mauritius - Foundation Course in Economics - Module 1
1.
Changes in the cost of production.
An increase in cost will reduce supply.
2.
Government policy
A tax on the commodity will discourage production and reduce supply
while a subsidy will encourage the producer to expand output.
3.
Variation in climatic condition
For example bad weather conditions will reduce supply in agriculture
while a favorable climate will increase supply.
4.
Changes in technology
Technological improvements will increase the supply of a good as it
allows producers to produce more from the same resources.
5.
Speculation about future prices
If producers speculate that price will fall in future, they will increase
the present supply in order not to make a loss in future.
The effect of a change in price leads to an expansion or a contraction in
supply and it is normally shown by a movement along the same supply curve.
The effect of a change in the other factors determining supply leads to a shift
in the supply curve. A rightward shift represents an increase in supply and a
leftward shift represents a decrease in supply.
S
P₁
S₁
P
P
0
S₂ S
S₂
Q
Q₁
Effect of price charge
0
Q₂
S
S₁
Q
Q₁
Effect of change in other factors
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Open University of Mauritius - Foundation Course in Economics - Module 1
2.5 PRICE ELASTICITY OF SUPPLY (PES)
The PES measures the rate of responsiveness in quantity supplied resulting
from a change in the price of the good, all other things remaining constant.
Thus like PED, the PES is calculated by looking at the percentage or the
proportionate change:
PES =
% or proportionate change in quantity supplied
% or proportionate change in price
Q
PES therefore =
Q
X
P
P
EXERCISE 11
Calculate the PES if an increase in the price of a good from $10 to $12
increases the quantity supplied from 200 units to 225 units.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
The coefficient of the PES will just like that of the PED vary between zero
and infinity.
1. If PES is zero a change in price will not affect the quantity supplied
and the supply curve will become a vertical straight line.
S
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Open University of Mauritius - Foundation Course in Economics - Module 1
2. If PES is infinite a change in price will lead to a total change in
supply that is supply becomes perfectly elastic and the supply curve
becomes a horizontal straight line.
S
3. If PES is unit elastic a change in price will lead to a proportionate
change in quantity supplied. The supply curve will be an upward
sloping straight line passing through the point of origin.
S
4. If PES is less than one a change in price leads to a less than proportionate change in quantity supplied and supply becomes inelastic.
The supply curve will slope upwards steeply.
S
If PES is greater than one a change in price will lead to a more than
proportionate change in quantity supplied. Supply becomes elastic and
the supply curve will be upward sloping but flatter.
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Open University of Mauritius - Foundation Course in Economics - Module 1
Factors determining PES
The price elasticity of supply will normally depend on the following factors
1.
2.
3.
4.
The nature of the good (whether agricultural or manufactured good)
The time period (supply is inelastic in the short run)
The level of technology being utilized.
The existence of idle capacity (firms having huge idle capacity will
have a more elastic supply)
5. Type of market condition (barriers to entry will make supply inelastic )
2.5 DETERMINATION OF MARKET EQUILIBRIUM
The market is influenced by two opposing forces namely demand and supply. Consumers are willing to pay the lowest possible price while producers
are willing to charge the highest possible price. The equilibrium price in the
market is determined when producers are willing to sell the same amount
of good as consumers are willing to buy. In other words equilibrium occurs
when quantity demanded equates quantity supply. The equilibrium price
can be determined as follows:
Demand and Supply Schedule
Price of the good Quantity demanded Quantity Supplied
(Rs)
(Units)
(Units)
10
600
200
20
500
300
30
400
400
40
300
500
50
200
600
The equilibrium price will be Rs30 because demand equates supply at this
price. If price is less than Rs30 the excess demand will force up the price.
If price is above Rs 30 the excess supply will cause the price to fall.
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Open University of Mauritius - Foundation Course in Economics - Module 1
Diagrammatically the equilibrium price is given by the point where the demand curve cuts the supply curve as shown below.
Price
D
S
T
P
D
S
0
Equilibrium Price
Q
Quantity
The equilibrium is determined by assuming that demand and supply conditions do not change. Any change in either demand or supply will cause the
price to fluctuate.
EXERCISE 12
1.Give two examples of how changes in demand will affect equilibrium
price (use diagrams)
a .............................................................................................................
b .............................................................................................................
2.Give two examples of how changes in supply will affect equilibrium
price (use diagrams)
a .............................................................................................................
b .............................................................................................................
Since Elasticity of Demand is quite a complex sub-topic,
watch video programme: Unit 2 – Programme 2 to have
a better idea about PED, YED, XED
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Open University of Mauritius - Foundation Course in Economics - Module 1
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Open University of Mauritius - Foundation Course in Economics - Module 1
UNIT
3
GOVERNMENT INTERVENTION
IN THE PRICES SYSTEM
Unit objective and learning outcomes
The objective of this unit is to introduce students to the Cost Benefit Analysis (CBA) and its importance in decision making. It also aims at exposing
students to the different types of goods and to understand how and why the
presence of government is necessary in order to promote social welfare.
Upon completion of this unit students should be able to:
Describe what is meant by positive and negative externalities and explain
them in terms of divergences.
Differentiate between public goods, private goods, merit goods and demerit goods.
Explain why public goods may not be provided by the private sector.
Explain how a cost benefit analysis exercise is carried out.
Understand the concept of a maximum and a minimum price.
Unit content:
Private goods, public goods, merit goods and demerit goods.
Private, external and social costs and benefits.
Decision making using the cost benefit analysis.
The concept of maximum and minimum pricing.
Other forms of government intervention in the operation of the free market.
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Open University of Mauritius - Foundation Course in Economics - Module 1
3.1PUBLIC GOODS, PRIVATE GOODS, MERIT GOODS
AND DEMERIT GOODS
Goods consumed by people can be of different types. They are broadly classified into the public and the private goods.
3.1.1. PUBLIC GOODS AND PRIVATE GOODS
The distinction between a public good and a private good is made on the
basis of four basic principles namely:
a. The principle of exclusion.
If the consumption of the good can be restricted only to those who are
paying for it and the non payer is excluded, the commodity becomes a
private good. In contrast if the principle of exclusion does not apply and
the good can be consumed by anyone, irrespective of whether payment
is made or not, the commodity becomes a public good. Public goods are
also known as “free riders”. Examples of such goods include street lighting or the police force.
b. The principle of the diminishability.
If increased consumption by some people affects the amount left for others, the good is a private good. In contrast if increased consumption by
some does not affect the amount left for others, the good becomes a public good. For example, a fire cracker display or radio broadcast.
c. The principle of divisibility.
A public good is one which is indivisible. Thus, once it is provided everyone, will take advantage. It cannot be subdivided to restrict its consumption. For example defence. In contrast a private good is one which
is divisible so that its consumption can be restricted to some people. For
example electricity supply or water supply.
d. Principle of additional cost
If increased provision or consumption of the good leads to an increase
in the total cost of providing the good the commodity becomes a private
good. In contrast if the total cost does not rise even when more of the
good is consumed, the good becomes a public good. For example a public
road.
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Open University of Mauritius - Foundation Course in Economics - Module 1
3.1.2. Merit goods and demerit goods
A merit good is one whose consumption leads to an improvement in the quality of life of the people in a country. For such a good, government believes
that it will be underprovided if left solely to the private sector. For such goods
the social benefits exceed the private benefits. Examples of merit goods include health care, education, housing and transport.
A demerit good is one whose consumption leads to a deterioration in the
quality of life of the people in a country. These goods are normally overprovided by the private sector because they are very profitable. In the case of
such goods, the private benefit is far greater than the social benefit. Example
of demerit goods include alcoholic drinks, cigarettes and drugs.
3.1.3 Who should provide these goods?
Given the nature of the public, private, merit and demerit goods there is
much controversy over who should provide these goods.
As far as public goods are concerned, they cannot be provided by the private
sector because the profit motive will not encourage a private producer to allow the non payer to consume his good. This explains why all public goods
are provided by the government. In contrast private goods can be provided
by both the private sector and the public sector. For example a private commodity like electricity is provided by a state enterprise in Mauritius.
As far as merit goods are concerned, it is necessary that both the government and the private sector should provide them simultaneously. For example health care in Mauritius is provided both by government hospitals and
private clinics. It is necessary to have such co-provision in order to
l
l
l
Ensure competition between the private and the public sector. This
will help to improve the quality of the good for the public.
To ensure sufficient provision of the good. The private sector or the
public sector alone might not have enough resources to provide sufficient amounts of the good. The co-provision will therefore ensure
that people get the amount that they need.
Incomes are unequally distributed in a country. The poor people
might not be able to pay the high price charged by the private sector.
Thus government can ensure the provision of the good for the lower
income groups while the rich who can pay the higher price can buy
the good from the private sector.
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Open University of Mauritius - Foundation Course in Economics - Module 1
In contrast to merit goods the demerit goods are usually provided by
the private sector because they are highly profitable. These affect social welfare and governments normally try to discourage consumption
of such demerit goods.
EXERCISE 13
1. Give three examples of public goods not mentioned above.
a .............................................................................................................
b .............................................................................................................
c .............................................................................................................
2. Why are merit goods important for society.
......................................................................................................................
......................................................................................................................
......................................................................................................................
......................................................................................................................
3.Should government encourage or discourage consumption of demerit
goods.
......................................................................................................................
......................................................................................................................
......................................................................................................................
4.Give three examples of measures which the government in your country has adopted in order to discourage consumption of demerit goods
like cigarettes.
a .............................................................................................................
b .............................................................................................................
c .............................................................................................................
Before completing Exercise 13 in your booklet,
watch video programme:
Unit 3 – Programme 1
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Open University of Mauritius - Foundation Course in Economics - Module 1
3.2. Cost Benefit Analysis (Cba)
The CBA is a technique that is used by government for decision making.
The main objective of the government is to maximize social welfare. Thus,
whenever government has to decide on its projects, it will have to undertake
a cost benefit analysis.
3.2.1. Private cost, external cost and social cost.
Cost can be divided into private, external and social.
Private cost is the sacrifice which an individual or a firm undertaking an
activity has to make when that activity takes place. In other words, it is the
cost to the “doer”. For example the private cost to a smoker is the cost of the
cigarette or the private cost to the producer is the amount he spends while
producing the good.
External costs which are also known as negative externalities refer to the
sacrifice which the rest of society, apart from the doer, has to make when an
activity is taking place. In other words, it is the cost to the non “doers”. For
example if a firm producing a good pollutes the environment this represents a
negative externality. Other examples of external cost is soil erosion resulting
from deforestation.
Social cost is the sacrifice which society as a whole is called upon to make
when an activity is taking place. We calculate social cost by adding the private
cost to the external cost.
3.2.2. Private benefits, external benefits, and social benefits.
When an activity takes place, it generates certain benefits.
The private benefit is the advantage which the doer gets when performing an activity. For example the personal satisfaction that a smoker gets from
smoking or the profit which a private firm gets while producing a good.
The external benefit, which is also known as positive externalities refer
to the advantages which the rest of society enjoy when an activity is taking
place. For example the creation of jobs in a region where a factory is set up or
the improvement in the natural beauty which everyone enjoys when a person
cultivates a flower garden in a region.
The social benefit refers to the advantages which society as a whole enjoy
when an activity is taking place. Social benefit is the sum of the private benefit and the external benefit.
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Open University of Mauritius - Foundation Course in Economics - Module 1
EXERCISE 14
1.Consider the surrounding where you live and think of two types of
external cost and two types of external benefits which inhabitants
enjoy in that region.
a
.............................................................................................................
b
.............................................................................................................
2.How does traffic congestion affect society’s welfare.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
3.3.Decision making using
the cost benefit analysis
The CBA is normally undertaken by the government. However it can also be
carried out by the private sector.
In case the CBA is being carried out by the private sector, the producer will
consider only the private cost and the private benefit. At the level of the private sector all external costs and benefits are ignored. The private sector will
undertake an activity only when private benefit is greater than private cost.
In case the CBA is carried out by the government, the latter will have to
consider the social costs and the social benefits because it aims at maximizing
the social welfare. The choice of public sector projects is therefore done by
comparing the social benefits to the social cost. Government will undertake
the project only if social benefits exceed the social costs of the project.
The application of the CBA at the level of the government can be exemplified by a situation where government has to decide on whether to construct a
new primary school in a village or not. The main items of cost to the government will include:
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Open University of Mauritius - Foundation Course in Economics - Module 1
1.
Private cost
The cost of buying the plot of land, the cost of constructing the building, the furniture and equipment, the day to day running cost and so on.
2.
External cost
The relocation of people who were living on that plot of land, the loss
of use of that land to society, the noise pollution that will be created
by pupils, the increased road congestion that will affect society, the
increase cost of policing and so on.
3.
The private benefits
This includes the reduction in government expenditure on delinquents, the increased political support that people will provide to the
government, the fall in government expenditure on unemployment
benefit as some people will be employed and so on.
4.
The external benefits
These include the creation of jobs for the people in the region, the
amount of time and transport cost saved by parents who were formally travelling to the nearby village to leave their children at school,
the improvement in infrastructure and so on.
The CBA therefore necessitates consideration of the different types of
costs and benefits. Although it is relatively easy to estimate the private
cost and benefits, it is often very difficult to measure the external cost
and benefits. For example, it is difficult to give a money value for the
cost of pollution.
EXERCISE 15
Imagine you are the economist working at the Ministry of Health. You are
requested by your minister to carry out a cost benefit analysis and to advise
on whether it is viable to construct a new hospital in a given region from
where the minister has been elected.
a.Identify five items each of private cost, external cost, private benefits
and external benefits you would consider while conducting the CBA.
a
.............................................................................................................
b
.............................................................................................................
c
.............................................................................................................
d
.............................................................................................................
e
.............................................................................................................
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Open University of Mauritius - Foundation Course in Economics - Module 1
b.List down four difficulties which you would encounter in conducting
such a cost benefit analysis.
a .............................................................................................................
b .............................................................................................................
c .............................................................................................................
d .............................................................................................................
3.4 G
OVERNMENT INTERVENTION BY
PRICE FIXATION POLICIES.
Government’s normally intervene by fixing the price of goods. Such prices
can be of two types namely:
A maximum price and a minimum price
3.4.1. Maximum prices or price ceilings
A maximum price is one which is fixed by the government or any other authority and no one is allowed to sell the good at a price above that maximum.
For example; the price of bread in Mauritius.
Maximum prices are normally fixed in order to protect the consumer. The
main reasons for fixing maximum prices are :
l
l
l
To prevent producers or sellers from exploiting consumers by charging
high prices.
To control inflation (a maximum price will prevent the price from rising above that limit)
To encourage consumption of certain goods. For example a maximum price for potatoes will keep the price relatively low, thus encouraging people to buy more of it.
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Open University of Mauritius - Foundation Course in Economics - Module 1
A maximum price is not an equilibrium price. It is fixed below the equilibrium because a maximum price above equilibrium will have no effect on the
market price. A maximum pricewill therefore generate excess demand and
this can cause the consumer to suffer as illustrated in the diagram below
Price
D
a
P
S
0
S
b
Maximum Price
D
Qa
Qb
Quality
Excess Demand
As shown in the diagram the maximum price is below equilibrium and it
generates an excess demand of Q a Q b. Such excess demand can lead to
black marketing where producers can refuse to sell at the official price and
illegally charge a higher price. To prevent such exploitation, the government
will have to intervene further by rationing out the good in the short run or by
encouraging production in the long run.
EXERCISE 16
(i) Give five examples of maximum prices in your country.
a .............................................................................................................
b .............................................................................................................
c .............................................................................................................
d .............................................................................................................
e .............................................................................................................
(ii)Explain how a maximum price for potatoes can cause the consumer
to suffer. (use practical examples from your country)
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
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Open University of Mauritius - Foundation Course in Economics - Module 1
i. Minimum prices or Prices Floors
A minimum price which is also known as a price floor is one which is fixed
by the government or a producers association and no one is allowed to sell
the good below that price. For example minimum wages fixed by the government where no employer can pay less than that wage.
Minimum prices are fixed for the following reasons:
l
l
To prevent exploitation of factors like labour.
To encourage producers to expand production by guaranteeing them
a minimum price.
l
To prevent a deflation.
l
To prevent producers from deteriorating quality.
Minimum prices are usually fixed above the equilibrium price and so they
generate excess supply as shown in the diagram below.
Price
D
a
P
S
b
Minimum price
S
0
D
Q
a
Q
b
Quality
Excess Supply
As shown in the diagramw above, the minimum price is OP and it generates excess supply of Q a Q b. Whenever governments fix minimum prices, the excess supply will necessitate further government intervention. For
example,government will have to buy the excess supply and stock it so that
it can be sold later on. Alternately the government can subsidise the good
directly by paying the producer the difference between the maximum price
and the equilibrium price.
Government intervention trough maximum and minimum prices will therefore affect the market and government should intervene further in order to
minimize those effects.
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Open University of Mauritius - Foundation Course in Economics - Module 1
EXERCISE 17
(i)Give three examples of minimum prices fixed by the government in
your country.
a .............................................................................................................
b .............................................................................................................
c .............................................................................................................
(ii)Use the example of the Agricultural Marketing Board to show how
government guarantees minimum prices and how stock piling by the
board helps to minimize the effects (you can explain your answer by
taking the case of the price of potatoes)
......................................................................................................................
......................................................................................................................
......................................................................................................................
......................................................................................................................
a.
Other Forms of Government Intervention
Government can also intervene in various other ways in order to minimize
the negative effects of the free markets.
3.5.1.Government intervention to reduce divergences
between costs and benefits
Private cost and social cost can often diverge. For example a firm which produces a good and while doing so pollutes the environment represents a case
where social costs are greater than private costs. In other words, pollution
represents a negative externality.
In such cases, the government will have to intervene in order to remove these
divergences. For example it can:
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Open University of Mauritius - Foundation Course in Economics - Module 1
a. Impose a tax on the firm.
This will increase the private cost to the doer and make it equal to the
social cost. In practice however it is difficult to decide on the amount of
the tax because it is difficult to estimate the value of the external cost.
Furthermore taxes can generate inflation causing people to suffer. In
some cases, the producer can even shift the tax burden to the consumer
especially if demand for the good is inelastic.
b.
Use laws and regulations.
Government can pass laws in order to minimize the external cost. For
example, the law preventing smoking in public places or the sale of
cigarettes to young children. The law can equally prevent the setting
up of a polluting industry in a residential area.
c.
Forcing firms to invest in corrective actions.
Firms which create pollution might be forced to use better equipment
and machinery which can minimize the effects. For example textile
firms or hotels are today being forced to invest in retreatment plants
where they can use the waste water for other purposes.
d.
Preventing the firm from operating.
As an extreme measure the government can ask the firm to close down
in case it continues to create the negative externality.
In case social benefits are greater than private benefits the government can
intervene by directly subsidizing the good or even by providing the good freely to the people. For example, subsidized housing for the poor.
EXERCISE 19
1.Think of one example of an industry or firm which has been polluting the environment in your country and describe the actions which
government took or which you would like government to take in order to minimize the impact of the pollution.
......................................................................................................................
......................................................................................................................
......................................................................................................................
........................................................................................................................
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Open University of Mauritius - Foundation Course in Economics - Module 1
i. POLICIES TO MINIMIZE INCOME INEQUALITIES
AND TO REDUCE POVERTY
The free market system normally leads to huge inequalities in the distribution of income. It can even create extreme poverty.
Government can intervene in such cases in order to minimize the effects of
such inequalities. For example government can:
l
l
Tax the rich and subsidise the poor
Provide free education in order to improve the social mobility of the
poor
l
Provide free or subsidised housing for the poor
l
Provide free health facilities
l
Empower the unemployed and the poor to set up their own enterprises.
EXERCISE 20
List down some policy measures which are being adopted by the government in your country in order to meet the problem of poverty.
a .............................................................................................................
b .............................................................................................................
c .............................................................................................................
d .............................................................................................................
Don’t forget to watch video programme:
Unit 3 – Programme 2 in order to know why,
when and how Government intervene in the market.
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Open University of Mauritius - Foundation Course in Economics - Module 1
UNIT
4
FIRMS AND THE PRODUCTION
FUNCTION
Unit objective and learning outcome
The objective of this unit is to expose students to the concept of firms and
help them to understand why and how firms grow in size while some prefer
to remain small.
Upon completion of this unit, students should be able to:
l
l
l
l
l
l
Understand the difference between a firm, a plant and an industry.
Understand how we measure the size of firms.
Understand the concept of economies and diseconomies of scale.
Calculate the different types of costs of production.
Understand the concept of the production function.
Differentiate between the various concepts of time.
Unit content
l
l
l
l
l
l
l
Firms, plants and industry.
Measurement of the size of firms.
Reasons for growth in the size of firms.
How do firms grow in size.
Reasons for survival of small firms.
The Production Function and the Time Concepts.
Cost of production and its different types.
4.1.
COST OF PRODUCTION
4.1.1
The production function
Output is a function of inputs
P = f ( INPUTS)
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Inputs can be classified into two types namely fixed factors and variable factors.
A fixed factor input is one whose use does not vary with the level of output. Examples of such factors include land, building, machinery, indirect labour etc.
A variable factor is one whose use varies directly with the level of output. For
example raw materials, electricity, direct labour etc.
Firms make use of both fixed and variable factors in order to produce their
output.
EXERCISE 27
1.List the name of one factory operating in your area and give three examples of fixed factors used by that factory.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
2.List down three variable factors which are used in a university or
school.
a .............................................................................................................
b .............................................................................................................
c .............................................................................................................
4.1.2.
The short run and the long run
The short run in economics is defined as a time period which is too short to
allow the producer to vary the use of all his factors. In the short run at least
one factor will remain fixed. Thus in the short run firms use both fixed and
variable factors.
The long run is defined as a time period which is long enough to allow the
producer to vary the use of all his factor inputs. Thus in the long run all factors are variable and the firm has no fixed factor.
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4.1.3
Types of cost
Cost of production is defined as the expenses made by a producer on the different factor inputs while producing a good or service. Cost can be of different types and they include the following:
a. Fixed costs
Fixed costs which are also known as the overhead cost or the non avoidable
cost refer to those expenses which do not vary with the level of output. For
example the salary of the manager in a factory, depreciation of asset, rent on
building, interest on bank loans and so on.
The total fixed cost curve (TFC) is shown by a horizontal straight line.
TFC
TFC
Output
Average fixed cost (AFC) is the fixed cost per unit of output
AFC =
TFC
Output
The AFC falls continuously as output increases and the AFC curve will take
the shape of a rectangular hyperbola.
AFC
AFC
Output
Fixed costs are borne even when output is zero.
Output
0
Total Cost
10
The 10 represents the fixed cost.
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b.
Variable cost
The total variable cost (TVC) is the sum total of all expenses incurred on
the variable factors. As output increases the TVC will rise and the TVC
curve will slope upwards as follows.
TVC
TVC
TVC
TVC
Output
Output
The average variable cost (AVC) is the variable cost per unit of output.
AVC =
TVC
Output
As output increases the AVC will fall at first and then rise.
AVC
Output
Output
Total Cost Total Variable Cost
010 0
1
15
5
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Open University of Mauritius - Foundation Course in Economics - Module 1
a.
Total cost
The total cost (TC) is the sum total of all expenses incurred in the production
of a good.
TC = TFC + TVC
The TC will rise as output increases and the total cost curve will slope upwards.
TC
TC
TC
TVC
TC
TVC
TFC
TFC
Output
Output
In the short run the TC curve will start from above the point of origin because of the fixed cost. In the long run it will start at origin because there is
no fixed cost.
b.
Average total cost (ATC)
The average cost is the cost of producing one unit of the good on an average.
The ATC can be calculated as follows
TC
AC =
Output
AC= AFC + AVC
Since both the AFC and the AVC will be falling initially, the AC curve will
slope downwards at first. However when output expands the AVC will start
rising after a certain point while the AFC will continue to fall. Thus we will
expect the AC curve to rise subsequently but the minimum point of the AC
curve will lie to the right of the minimum point of the AVC curve.
Cost
AC
AC
AFC
0
Output
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c.
Marginal cost (MC)
The Marginal cost of production is the cost of producing one additional unit
of the good it is normally defined as the addition to total cost when one extra
unit of the good is produced. The marginal cost can be calculated as follows
MCn= TCn – TCn-1
For example if the TC of 100 units of output is Rs5000 and the TC of 101
Units is RS5200, the MC will be Rs 200.
Marginal cost is concerned with variable costs only because fixed costs do not
change. We can therefore also calculate MC by looking at the difference in
the TVC. The MC curve will fall at first and then rise.
Cost
MC
Output
d.
Implicit costs and Explicit costs
Explicit costs refer to the cost of those factors which do not belong to an entrepreneur and for which a payment should be made. They are also known
as the paid out costs or the accounting costs. For example the electricity bill
or the interest on bank loans.
Implicit costs which are also known as the imputed costs are the cost of those
factors which belong to the entrepreneur and for which no payment has to
be made. For example the rent which is not paid if the producer owns the
building or the interest which is not paid if the producer has invested his own
capital in business.
The difference between explicit and implicit cost is important because of the
way we calculate profits in accounting and in economics.
To the accountant, Profit = Total revenue – Explicit cost.
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To the economist, Profit = Total revenue – Total cost (Explicit cost + Implicit cost)
Cost can therefore be of different types. Diagrammatically the different cost
curves in the short run will be related as follows.
MC
AC
Cost
AVC
AFC
Output
EXERCISE 28
Fill in the following table
COST SCHEDULE
Ouput TC TFCTVC AFCAVC AC MC
050
180
2100
3110
4130
5160
6200
7
8400
270
After completion of Exercise 28, watch video programme:
Unit 4 – Prog 2 to really understand the terms TC, TFC, TVC,
AFL, AVC, AC and MC
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4.2. PLANT, FIRM AND INDUSTRY
A Plant is defined as a production unit which usually belongs to a firm. It
comprises the building and the machinery. It operates in the name of the
firm and it does not have its own legal identity. An example of a plant is the
branch which Aquarelle Textile Ltd has in Surinam.
A firm is a legal entity; distinguished from other firms by ownership. It is normally referred to as an economic unit which operates in its own name and
which undertakes all the activities related to the production of a good or service. Some firms can be local while others can be national or even international. An example of a firm in Mauritius is Floreal Knitwear Ltd or Winners.
An industry is a collection of firms producing the same or similar products.
The term can also be used sometimes to identify all the economic activity in
a certain geographical area. The industry does not exist in physical terms.
It is just a concept which is used to describe all the firms taken together. For
example, the sugar industry in Mauritius.
Plant
Industry
Firm
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Open University of Mauritius - Foundation Course in Economics - Module 1
EXERCISE 21
(i)Give five examples of Plants operating in Mauritius and find out
the name of the firms which own such Plants.
a .............................................................................................................
b .............................................................................................................
c .............................................................................................................
d .............................................................................................................
e .............................................................................................................
(ii) Give two examples of multi-national firms operating in Mauritius.
a.............................................................................................................
b.............................................................................................................
(ii)Explain why some firms prefer to become multi nationals
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
4.3. HOW DO WE MEASURE THE SIZE OF FIRMS
Firms can be large, medium size or small and they are normally classified on
the basis of the following criteria.
1.
Number of workers employed
The number of workers is a common indicator of the size of a firm. For
example in Mauritius, firms employing less than 10 workers are classified as
small. Firms employing up to around 500 workers may be viewed as medium sized while those employing more are large firms. For example, a firm
like Floreal Knitwear employs nearly 8000 workers. The use of the number
of workers employed can sometimes be misleading because the firm can be
capital intensive.
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2. The amount of capital invested in the firm.
The capital investment of a firm can be an indicator of its size. For example, firms which have an investment of up to 15 million rupees are normally
classified as a small and medium enterprise (SME). Capital investment can
sometime be misleading as firms can be highly labour intensive.
3.
The annual turnover of the firm
In many countries the annual turnover of a firm is used to classify firms into
small, medium or large. The use of turnover can sometimes be misleading as
turnover depends largely on the nature of the good being produced or sold.
For example a firm dealing in gold or diamond will have a very high turnover
despite being physically small. In contrast a firm dealing in coal or another
cheap commodity might have a very low turnover despite the fact that it is
very large.
4. The market concentration ratio
This refers to the percentage of the market of a good which is controlled by
a single firm. If the firm controls a big share of the market it is classified as
a large firm. The problem in using market size is that the size of the market
itself differs between regions or countries. For example, the single shop in a
small village will have a 100% market share despite the fact that it is a small
retail shop while a big supermarket in town will have a much smaller market
share.
Given the difficulty with each of the above measure, it is normally advisable
to use all the four criteria simultaneously in order to measure the size of the
firm.
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EXERCISE 22
(i)Consider a town in your country and give two examples, each of a
small firm, a medium size firm and a large firm.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
(ii)Describe the major difficulties that someone faces while measuring the
size of a firm.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
4.4. REASONS FOR GROWTH IN THE SIZE OF FIRMS
Firms usually grow in size in order to take advantage of large scale operation.
The main reasons why firms grow include the following:
4.4.1. Economies of scale
Economies of scale are the advantages which a firm enjoy when it expands
its size. Economies of scale lead to a fall in the average cost of production.
These include:
Managerial economies
Large firms can employ qualified professionals while small firms cannot do
so. They therefore become more efficient in their operation.
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Open University of Mauritius - Foundation Course in Economics - Module 1
Financial economies
Large firms can raise capital more easily and at a lower cost because banks
are more willing to lend to the large firms. They can also use undistributed
profits and can request shareholders to invest more.
Risk bearing economies
Large firms can more easily diversify and spread their risks over various goods
so that even if the demand for one good falls, the firm can still survive on the
other goods.
Technical economies
Large firms find it easier to use modern technology and machinery as a result
of which they can reduce their cost of production. Small firms can hardly
invest in such technology.
Commercial and Marketing economies
Large firms transact in bulk and they can get huge discounts which allow
them to sell at a lower cost. At the same time, they can advertise more aggressively and this makes them more competitive.
Research economies
Large firms find it easier to invest in research and development. Many of
them have their own research departments. Small firms cannot do so and
they become less competitive.
Welfare economies
Large firms can cater for the welfare of their workers, customers and shareholders in a much better way than small firms.
Economies of linked processes
These refer to the advantages of vertical integration. Large firms can invest
in the production of their own raw materials. For example, Floreal Knitwear
limited in Mauritius which is a large textile firm and which owns Ferney spinning Mills which produces its spinned cotton for knitting purposes.
4.4.2.Firms also grow in size in order to increase their economic security
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Open University of Mauritius - Foundation Course in Economics - Module 1
by developing a wide variety of product range this allows them to
compete in different markets and to have a big market share.
4.4.3.Many firms grow with the objectives of attaining status, power,
market dominance and the removal of actual and potential competitors. Growth in the size of firm allows them to achieve huge
power and status which give them a high bargaining power and
they can therefore easily force rival firms out of business.
EXERCISE 23
(i)List down the name of two large firms in your country and two small
firms.
a.......................................................................................................... b.......................................................................................................... c........................................................................................................... d.......................................................................................................... (ii)Compare the two types of firms and list down five benefits which
the large firms have over the smaller firms.
a.......................................................................................................... b.......................................................................................................... c........................................................................................................... d.......................................................................................................... 65
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4.5. HOW DO FIRMS GROW IN SIZE
It is a legitimate wish by all firms to grow in size. Growth in the size of
firms can take place in different ways. These include:
4.5.1. Organic growth
This is the natural process of growth by firms. They start small and reinvest
their profits in order to become larger gradually. In the long run, they end up
becoming very large firms. For example, Compagnie Mauricienne de Textile
in Mauritius which is today one of the largest textile firms operating in the
country. However its started its operation long time back in a garage with a
few machines. Another example is the Sik Yuen Supermarket in Curepipe
which, years ago started as a small retail shop.
4.5.2.
Integration and merges
Most firms grow as a result of merges and integration. Such mergers can be
of four main types namely:
a.
Horizontal mergers where two or more firms operating in the
same industry and at the same stage of production decide to come
together in order to carry out business on a larger scale. For example the integration of two retail shops in order to open a supermarket.
b.
Vertical mergers where two or more firms operating in the same
industry but at different stages of production decide to come together in order to carry out business collectively. For example, a
furniture manufacturer merging with a chain of retail furniture
shops. Such mergers can be forward or backward.
c.
Lateral mergers where two or more firms producing different
but related goods decide to merge in order to carry out business collectively. The goods can be related in the sense that they are using
the same raw material or they might be sold in the same market.
Such mergers will allow them to save in terms of transport cost for
distribution or to rationalize the use of raw materials.
d.
Conglomerate mergers where a number of different firms pro-
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Open University of Mauritius - Foundation Course in Economics - Module 1
ducing different types of goods are brought under the ownership
of a single large company for example the Rogers Group which
controls a variety of firms producing different goods. The main
advantage of such merges is market power, status and the benefits
of diversification.
4.5.3.Acquisition and Takeovers
Some firms grow through acquisition and takeovers. In such cases, a large
firm buys a smaller rival firm in order to expand. For example the recent
acquisition of the ESSO Petroleum chain in Mauritius by Total.
Growth in the size of firms can therefore occur because of internal factors
or external factors.
EXERCISE 24
(i)Give one example of a horizontal merger in your country and think
of two possible reasons why they might have merge.
.....................................................................................................................
.....................................................................................................................
(ii)Give an example of a conglomerate organization in Mauritius and
think of five advantages and five disadvantages which such a conglomerate is likely to face.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
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Open University of Mauritius - Foundation Course in Economics - Module 1
4.6.
REASON FOR SURVIVAL OF SMALL FIRMS
Although firms would prefer to grow in size because of the reasons mentioned in the previous sections, the majority of firms in operation today
have remained small. The predominance of small firms can be explained
by three main factors.
Diseconomies of scale
W
hen firms grow they are likely to face certain disadvantages. These include:
l They cannot provide personalized services.
l
T
hey face managerial diseconomies that is problems of coordination and
conflict.
l Strong trade union pressure and industrial actions.
l High tax rates which are normally progressive and which affect large
firms more.
l Large firms are rigid and cannot be easily converted in times of economic difficulties.
l Large firms have locational problems as they need a large market in order
to become efficient.
l Large firms face the problem of a divorce between ownership and management.
l Large firms have high overhead cost.
l
4.6.1. Factors limiting growth
In some cases firms find it difficult to grow because:
l
l
l
hey have limited capital
T
They have a limited market for the good
The nature of the good requires a personalized service for example
a hair cutter
4.6.2 The benefits of small firms and government policy
In many countries government encourages the creation of small and medium
sized firms instead of the large firms because small firms have the following
advantages:
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Open University of Mauritius - Foundation Course in Economics - Module 1
Easy location
l
High flexibility and can be easily converted
l
Require little capital to start up
l
Can be managed by people with average education
l
Survives period of economic changes more easily
l
Provision of personalized services
l
Can target niche markets
l
The above set of reasons explain why small firms continue to predominate.
In fact, as income increases there is a demand for more variety of goods.
Thus the production system must move away from mass production and standardized products towards more specific goods. Furthermore quality comes
more from small rather than large firms.
EXERCISE 26
Plan a visit to small firm in the region where you live and list down five
advantages and five disadvantages which the firm has when compared to
a large firm operating in the country.
a .............................................................................................................
b .............................................................................................................
c .............................................................................................................
d .............................................................................................................
e. .............................................................................................................
f. .............................................................................................................
In order to have clear understanding of plant,
firm and industry and why do firm grow in size
and the reason for the survival of small firm
watch video programme: Unit 4 – Programme 2
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Open University of Mauritius - Foundation Course in Economics - Module 1
SUGGESTED READING :
Author
Title
Publisher DateISBN
Anderton, AG
Economics A Level (5th Edition)
Causeway
2008 1405892358
Bamford, Colin et al Economics International AS and A Level * Cambridge
2002 052100781X
Begg, David et al Economics (9th edition)
McGraw Hill 2008 0077117875
Grant, Susan
Introductory Economics: A Study Guide
Longman
1997 0582302560
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Open University of Mauritius - Foundation Course in Economics - Module 1
ANSWERS TO EXERCISE
Production Possibility Schedule
COMBINATION AMOUNT OF AMOUNT OF OPPORTUNITY
GOODS
GOOD X
GOOD Y
COST
A
0100
B
1
95
5
C
2
85
10
3
70
15
E
4
40
30
F
5
0
40
D
EXERCISE 1
c. Fill in the opportunity cost column in the above schedule
d.Plot the curve by showing good X on the X-axis and good Y on yaxis.
Good X
Good Y
EXERCISE 2
As you have noted above the PPC can shift to the right or to the left. A leftward shift means that the country’s productive capacity is falling, in other
words, the country can now produce less goods.
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Open University of Mauritius - Foundation Course in Economics - Module 1
List down 4 factors which can cause the PPC to shift to the left?
5.
6.
7.
8.
Deterioration in technology.
Depletion of resources.
Fall in productivity.
Negative economic growth.
EXERCISE 3
5. List five benefits of the market economy system.
f.
It allows consumer sovereignty.
g. It generates the benefits of competition.
h.It motivates investors to invest and expand because of the profit
motive.
i.
It leads to a higher standard of living.
j.
It allows freedom at all levels.
6.Explain three reasons why centrally planned economies like China
have moved towards the market system.
d.
Government failure. For example high bureaucracy.
e.
Lack of motivation to invest or to do better.
f.
Delays in decision making and the lack of competition.
EXERCISE 4
5. List four examples of Capital in a textile factory.
e.
The building and premises.
f.
The knitting machines.
g.
The lorries used for transportation.
h.
The computers which are used in order to design products.
6. What is the difference between Labour and Entrepreneurship?
Labour is represented by the worker who accepts to work for a wage
or salary and who does not bear the risk of the business. The entrepreneur is the one who owns the business he has invested his capital
and he bears all the risks. It is the entrepreneur who is responsible for
management of the business and he/she recruits the labour.
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Open University of Mauritius - Foundation Course in Economics - Module 1
EXERCISE 5
5. Give five examples of division of labour in a textile factory.
f.
The machinist who works on the knitting machines.
g.
The merchandiser who looks after sales.
h.
The technician who maintains the machines.
i.
The driver.
j.
The person working in the packing or pressing section.
6.Consider the case of a car mechanic who concentrates in this job.
What are the benefits and dangers of such concentration.
The main benefits are that he acquires experience and becomes a better mechanic, he’s productivity will rise because he concentrates in one
job, the work is done quicker become he does not move between jobs
and he can developed better tools for car repairs.
The main disadvantages are that he has greater risk of losing his job
if people stop demanding cars, it is difficult to get another job because
he does not have other skills and his work becomes boring as he does
the same thing everyday.
EXERCISE 6
5. Give three examples of oligopoly markets in your country.
d. The large supermarkets like Jumbo, Shoprite etc.
e. The soap industry which has three main producers.
f.The mobile communication phone market which is dominated by
three firms.
6.Give two reasons why some people would like to deal on a futures market
c.
To protect themselves against risk of price changes in future.
d.
To plan production because they can collect orders in advance.
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Open University of Mauritius - Foundation Course in Economics - Module 1
EXERCISE 7
5.List five factors which determine the demand for holidays in Mauritius.
f.
The level of income.
g.
The price of hotels.
h.
Airfares and the cost of local transportation.
i.
Security measures in holiday resorts.
j.
Types of facilities offered by the holiday planners.
6.Why does a consumer normally buy more of a good when price falls.
This is explained by the fact that the consumer is rational and wants to
maximize satisfaction. It can also be explained by a rise in real income
when price falls. The consumer will also use the goods instead of
other substitutes when the price falls because the good is now relatively
cheaper that the other products.
EXERCISE 8
Calculate the PED if the price of good falls from Rs 10 to Rs 8 per unit and
quantity demanded rises from 50 units to 55 units.
PED=
Q x P
QP
=
5 x10
50
2
=0.5
EXERCISE 9
5. Give five examples of goods which have an inelastic demand.
f.Cigarettes
g.
Alcoholic Drinks
h.
Kitchen Salt
i.
Petroleum for cars
j.Electricity
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Open University of Mauritius - Foundation Course in Economics - Module 1
6. Give five examples of good which have an elastic demand.
f.
Colored television sets
g.Jewellery
h.
Top quality foods
i.
Luxury cars
j.Holidays
EXERCISE 10
Give three examples of goods which you would consider as having an income inelastic demand and explain why.
d.Rice
e.Vegetables
f.
Basic clothing
The demand is income inelastic for all the three products because whatever be the level of income the consumer is forced to consume these
goods.
EXERCISE 11
Calculate the PES if an increase in the price of a good from $10 to $12 increases the quantity supplied from 200 units to 225 units.
Q x P
PED
=
QP
25x10
=
200 2
5
=
8
EXERCISE 12
5.Give two examples of how changes in demand will affect equilibrium
price (use diagrams)
c.An increase in the demand for computers will increase the price of
computers because the demand curve will shift to the right.
d.A fall in income will lead to a fall in the demand for luxury goods
causing price to fall because the demand curve will shift to the left.
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Open University of Mauritius - Foundation Course in Economics - Module 1
6.Give two examples of how changes in supply will affect equilibrium
price (use diagrams)
c.A rise in the cost of production will increase price because the
supply curve will shift to the left.
d.A subsidy given by the government will reduce price because
the supply curve will shift to the right.
EXERCISE 13
9. Give three examples of public goods not mentioned above.
d.Defense.
e. Law courts.
f. A public botanical garden.
10.
Why are merit goods important for society.
The consumption of such leads to an improvement in the quality
of life of the people. It therefore makes society better off.
11.Should government encourage or discourage consumption of demerit goods.
Discourage because they affect the quality of life of the people
and the cause society to suffer.
12.Give three examples of measures which the government in your
country has adopted in order to discourage consumption of demerit goods like cigarettes.
d. Laws prohibiting sale of cigarettes to children.
e. Anti-smoking campaigns.
f. High tax on cigarettes.
EXERCISE 14
5.Consider the surrounding where you live and think of two types of external
costandtwotypesof externalbenefitswhichinhabitantsenjoyinthatregion.
Given an industrial environment the firms creates pollution which affect
the environment and there is a high level of traffic congestion because
large number of vehicles come and go everyday. The external benefits
include jobs provided to people who live in the region as well as the development of better roads and communication facilities which everyone
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Open University of Mauritius - Foundation Course in Economics - Module 1
can enjoy. People can also benefit from the services of a bank in the
region.
6.How does traffic congestion affect society’s welfare.
Traffic congestion pollutes the environment thus increasing the risk of
disease. It also leads to sound pollution because of the noise made by
road vehicles. A large amount of traffic also leads to loss of time by
passengers who can be late at work thus affecting productivity.
EXERCISE 15
Imagine you are the economist working at the Ministry of Health. You are
requested by your minister to carry out a cost benefit analysis and to advise
on whether it is viable to construct a new hospital in a given region from
where the minister has been elected.
e.Identify five items each of private cost, external cost, private benefits
and external benefits you would consider while conducting the CBA.
4.Private cost will include the cost of purchasing the land, the
cost of constructing the building, the purchase of equipment
and furniture for the hospital by the government, the payment
of salaries to those who will be employed and the purchase of
medicine for the patients.
5.External cost include the alternative use of the land, the pollution that the hospital will create, the traffic congestion that will
result, the risk of accident in the region and the rise in the cost
of land.
6.The external benefits will include a healthier pollution, higher
productivity at work, creation of jobs, better health care facilities and improvement in living standard of the population.
f.List down four difficulties which you would encounter in conducting
such a cost benefit analysis.
5.
6
7.
8.
Difficulties in calculating the external benefits.
Difficulties in estimating the external cost like pollution.
The lack of qualified people to conduct such a study.
The high cost of conducting such analysis.
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Open University of Mauritius - Foundation Course in Economics - Module 1
EXERCISE 16
c.
Give five examples of maximum prices in your country.
7.
8.
9.
10.
11.
Price of bread.
Bus fares.
The price of potatoes.
The price of electricity.
The price of soft drinks.
d.Explain how a maximum price for potatoes can cause the consumer
to suffer. (use practical examples from your country)
A maximum price for potatoes will discourage producers from producing
potatoes but will encourage consumers to buy more potatoes. This will lead
to an excess demand and black marketing activities where consumers can be
exploited. It will also force some consumers not to get the good because of
the limited supply.
EXERCISE 17
c.Give three examples of minimum prices fixed by the government in
your country.
4.
5.
6.
Price of potatoes guaranteed to farmers.
Price of onions for farmers.
Minimum wages for labour.
d.Use the example of the Agricultural Marketing Board to show how
government guarantees minimum prices and how stock piling by the
board helps to minimize the effects (you can explain your answer by
taking the case of the price of potatoes)
A minimum price will encourage farmers to produce more potatoes because
it is above the equilibrium price. However consumers will demand less potatoes because the price is too high. As a result the market will have excess
potatoes and government will have to buy this excess and keep it in stock in
order to prevent the price from falling. Later on it can use these stocks to
supply more potatoes in the market in order to prevent the price from rising.
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Open University of Mauritius - Foundation Course in Economics - Module 1
EXERCISE 18
3.Think of one example of an industry or firm which has been polluting the environment in your country and describe the actions which
government took or which you would like government to take in order to minimize the impact of the pollution.
An example is the case of the United Basalt Products in Trianon which was
polluting the environment consequently the government force the firm to
take precautionary measures and since the firm continued creating pollution
the government had to order the firm to close down and transfer its production to Bambous.
EXERCISE 19
List down some policy measures which are being adopted by the government in your country in order to meet the problem of poverty.
f.
g.
h.
i.
j.
Fixation of minimum wages.
Provision of cheap housing for the poor.
Creation of jobs in the poverty ridden regions.
Payment of social security benefits.
Encouraging the poor to start micro enterprises.
EXERCISE 20
5.List the name of one factory operating in your area and give three
examples of fixed factors used by that factory.
A Beer producing factory and the fixed factors are the building, the
management and the machinery.
6.List down three variable factors which are used in a university or
school.
Markers, stationary and books.
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Open University of Mauritius - Foundation Course in Economics - Module 1
EXERCISE 21
Fill in the following table
COST SCHEDULE
Output
TC
0
50
TFC
TVC
50
AFC
AVC
AC
MC
0
1 80 50 3050308030
2 10050 5025305020
3
110 50 6016.62536.610
4
130 50 8012.52032.520
5 1605011010223230
6
200 50 1508.3 2533.340
7
270
50
220
7.1
31.42
38.6
70
8
400
50
350
6.25
43.75
50
130
EXERCISE 22
4.Give five examples of Plants operating in Mauritius and find out
the name of the firms which own such Plants.
f. The branch which Aquarelle has in Surinam.
g. Winners at Rose-Belle.
h. The branch of the Comlonne restaurant in Port-Louis.
i.The Cash Office of Mauritius Telecom in the different villages.
j. Dream Price Supermarket in Rose-Belle.
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Open University of Mauritius - Foundation Course in Economics - Module 1
5. Give two examples of multi national firms operating in Mauritius.
c. Barclays Bank
d. Kentucky Fried Chicken
6.Explain why some firms prefer to become multi nationals
Becoming a multi-national allows firms to grow, they can enjoy
economies of scale, they better good will, they can avoid trade
barriers and they can take advantage of local facilities offered
by government.
EXERCISE 23
3.Consider a town in your country and give two examples, each of a
small firm, a medium size firm and a large firm.
In Curepipe we have a small firm like a pastry, a medium size firm like
Sik Yuen Supermarket and a large Floreal Knitwear.
4.Describe the major difficulties that someone faces while measuring the
size of a firm.
It is often conflicting to use the different measures for example a firm
might be very large because it employs a large number of workers but
it might be small if we look at the capital investment. We must therefore used all the measures together.
EXERCISE 24
3.List down the name of two large firms in your country and two
small firms.
Two large firms are the Rogers Group and Compagnie Mauricienne De Textile and two small firm are retail shop in a village and a pre-primary school.
4.Compare the two types of firms and list down five benefits
which the large firms have over the smaller firms.
f.
g.
h.
i.
j.
Average cost is lower in the large firm.
It can get loans more easily form banks.
It can use better technology and machinery.
It can employ more qualified people.
It can invest more in research and development.
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Open University of Mauritius - Foundation Course in Economics - Module 1
EXERCISE 25
3.Give one example of a horizontal merger in your country and
think of two possible reasons why they might have merge.
One example is the merger between Total and ESSO. The
main reason could have been to increase market share and to
enjoy economies of scale.
4.Give an example of a conglomerate organization in Mauritius
and think of five advantages and five disadvantages which such
a conglomerate is likely to face.
An example is the Rogers Group which controls a large number of firms in different areas.
The main advantages are the benefits of diversification, bigger
market share, greater bargaining power, variety of services to
customers and lower prices.
The main disadvantages are complexity of management, lack
of control, higher waste of resources, danger of monopoly and
greater trade union pressure.
EXERCISE 26
Plan a visit to small firm in the region where you live and list down five advantages and five disadvantages which the firm has when compared to a large
firm operating in the country.
The advantages and disadvantages will be noted in the course of the visit that
you will effect and you can counter check them with the list of advantages
and disadvantages mention in this unit.
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Open University of Mauritius - Foundation Course in Economics - Module 1