MBA ECONOMICS EXAM WORKSHOP Prepared by: H.Matsongoni

1. MBA ECONOMICS EXAM WORKSHOP Prepared by: H.Matsongoni

2. ROAD MAP / AGENDA TIME :180 MINUTES Introduction to Economics (i) What economics is all about? (ii) The interdependence between the major sectors, markets and flows in the mixed economy. Demand, Supply, Consumer equilibrium and price elasticity. (i) The circular flow of income and spending (ii) Government intervention Imperfect Competition (i) Market Structures Key macroeconomic concepts (i) Inflation (ii) Economic growth and development International Economics (i) International Trade 6. Examination guide

3. 1. WHAT IS ECONOMICS ? • The word economics is derived from the Greek word oikos, meaning house and nemein, meaning manage. • Economics is the study of how societies use scarce resources to produce valuable commodities and distribute them among different people. –Paul Samuelson • Economics is the study of how society manages its scarce resources – Ngregory Mankiw • Economics is the study how scarce resources are allocated among different uses – Richard Eckhaus • Economics also seeks to describe, explain, analyse and predict a variety of phenomena such as economic growth, unemployment, inflation, trade between individuals and countries, the prices of different goods and services, poverty, wealth, money, interest rates, exchange rates and business cycles.

4. SCARCITY, CHOICE AND OPPORTUNITY COST • Economics is concerned with scarcity. The basic fact of economic life is that there are simply not enough goods and services to satisfy everyone wants. • Wants are unlimited but the means with which the wants can be satisfied are limited. • Distinguish between wants and needs. • Wants are human desires for goods and services. • Individuals have biological, spiritual, material, cultural and social wants while people as a group have collective wants for things such as law and order, justice and social security. • Needs are necessities, the things that are essential for survival, such as food, water, shelter and clothing. Needs unlike wants , are not absolutely unlimited.

5. FACTORS OF PRODUCTION • Resources are limited. • There are three types of resources • i. Natural e.g. agricultural land, minerals and fishing resources ii. human resources (such as labour). iii. Man made resources (such as machines). • These resources are the means with which goods and services can be produced. In economics we call these resources factors of production. • Since the resources are limited, it follows that the goods and services with which we can satisfy our wants are also limited. Therefore we have to make choices. • e.g. Herrison has R20 in his pocket. R20 is the resource. He therefore has to choose what to buy and what to sacrifice.

6. ECONOMIC DECISIONS AND OPPORTUNITY COST • Economic Decisions • In the above cases difficult choices have to be made. Some wants will be satisfied but many will be left unsatisfied. • In each case it has to be decided which of the available alternatives will have to be sacrificed. • Economic decisions are all difficulty.   • Opportunity Cost • Since resources are scarce, the use of resources can never be costless. The are always costs involved even if these costs are not always apparent to consumers of the goods or services in question. • Scarcity must not be confused with poverty. Scarcity affects everyone. The rich are also subject to scarcity.

7. ECONOMIC DECISIONS & OPPORTUNITY COST CNT’D • Even the richest person on earth will have unsatisfied wants and will make economic decisions. • For example, no matter how rich you are in terms of money or material wealth, you only have 24 hours a day in which to sleep, eat, work and relax. • Everyone has to deal with the fact that time is a limited resource. • Although scarcity is an essential element of the economic problem, the need for decision making only arises when the scarce resources have to be allocated between competing alternatives. • However, with only one goal you will not have an economic problem to solve, since you do not have a problem on how to allocate your limited resources.

8. OPPORTUNITY COST • This is not a realistic example since no-one has only one goal in life, but it does illustrate the importance of choosing between alternatives in making economic decisions. • When we are faced with such a choice we can measure the cost of the alternative we have chosen in terms of the alternative that we have to sacrifice. This is called opportunity cost. • For example , if Tony has to choose between studying and going to the movies, the opportunity cost of studying would be the visit to the movies that he has to forgo. • The opportunity cost of a choice is the value to the decision maker of the best alternative that could have been chosen but was not chosen. In other words, the opportunity cost of a choice is the value of the best forgone opportunity. • Every time a choice is made, opportunity costs are incurred and economists always measure costs in terms of opportunity costs.

9. PRODUCTION POSSIBILITY CURVE (PPC) • Scarcity, choice and opportunity cost can be illustrated with the aid of a production • possibilities curve, also called a production possibilities frontier. • Consider the example where a farmer has to make a choice between planting oranges or apples. • There are different possibilities with different levels of output per year for the different types of fruit, shown as follows:

10. PRODUCTION POSSIBILITY CURVE

11. PRODUCTION POSSIBILITY CURVE

12. PRODUCTION POSSIBILITY CURVE EXPLANATION • Each point on the production possibility curve represents an alternative mix of output. It shows the combination of oranges and apples that can be produced with the available resources. • As we move along the Production Possibility Curve, the production of apples increases whilst the production of oranges decreases. • To produce 10 tons of apples, the farmer had to give up 1 ton of oranges (the movement for possibility point A to B). • To produce a further 8 tons of apples (movement from B to C), the farmer had to give up 3.5 tons of oranges. • The opportunity cost to produce an additional ton of apples increases as we move along the production possibility curve. This is why the curve bulges outwards from the origin (concave).

13. PPC FURTHER EXPLANATION • The production possibilities curve is a very useful way of illustrating, scarcity, choice and opportunity cost. • Scarcity is illustrated by the fact that all points to the right of the curve (outside the curve) are unattainable. • The curve thus forms a frontier or boundary between what is possible and what is not possible. • Choice is illustrated by the need to choose among the available combinations along the curve. • Opportunity cost is illustrated by the negative slope of the curve, which means that more of one good can only be obtained by sacrificing the other good. • Opportunity cost therefore involves what we call a trade-off between the two goods.

14. PPC FURTHER EXPLANATION • The production possibility curve illustrates two important principles; • Scarce resources: There is a limit to the amount that we can produce in a given time period with the available resources and technology; • Opportunity costs: We can obtain additional quantities of any desired good only by reducing the potential production of another good. • The Production Possibility Curve shows potential output and does not necessarily reflect actual output. • At every point along the production possibility curve, we are getting the maximum output from available resources. • Thus we say that all points on the production possibility curve are efficient.

15. PRODUCTION POSSIBILITY CURVE AND EFFICIENCES

16. PPC AND EFFICIENCES CONTINUED • If the farmer is operating at less than the potential output, illustrated by a point inside or below the production possibility curve, some of the available resources are unemployed or not employed efficiently. • In such a case, it is possible to expand production simply by using the existing resources fully and more efficiently (given the state of technology). • The production possibilities curve indicates the combinations of any two goods or services that are attainable when the community’s resources are fully and efficiently employed.

17. MACROECONOMICS VERSUS MACROECONOMICS • The Study of Economics is usually divided into two parts: microeconomics and macroeconomics. • Microeconomics - the focus is on individual parts of the economy The prefix micro comes from the Greek mikros meaning small. • Individual consumers , households - what to do , what to buy • Individual firms – what goods to produce, how to produce them, what prices to charge . Other organizations are considered in isolation from the rest of the economy. • These individual elements of the economy are, figuratively speaking, each put under the microscope and examined in detail. • It also includes the study of the demand, supply and prices of the individual goods and services like petrol, maize, haircuts and medical services.

18. MICROECONOMICS VERSUS MACROECONOMICS • Macroeconomics is concerned with the economy as a whole. • The prefix macro comes from the Greek word macros meaning large. • We develop an overall view of the economic system and we study total or aggregate economic behaviour. • The emphasis is on topics such as; • total production • income and expenditure • economic growth • aggregate unemployment • the general price level • inflation and • the balance of payments. • Macroeconomics is therefore the world of totals.

19. MICROECONOMICS VERSUS MACROECONOMICS EXAMPLES

20. WHY ECONOMISTS DISAGREE? • They might make different value judgments • They might not agree on the facts • They might be biased • They might hold different views about how the economy operates • They might have different time perspectives

21. 2.THE CIRCULAR FLOW OF INCOME AND SPENDING

22. INTERACTIONS OF THE GOVT AND THE PARTICIPANTS • Consumers: government provide services to consumers while consumers provide labour. • Factor markets: government acquires resources in the factor markets and also offers factors of production to the factor markets. • Business firms: government provides services to business while business provide services to the government. Thus business firm supply goods and services to product markets ( point A) and purchase factors of production in the factor markets (B). • Product markets: governments acquires products from the product markets and also provides product to the product markets. • International participants: the international market provides products and factors of production that the government utilises. • Government participation is essential to improve the standard of living of people because government is the largest employer and provides a number of essential services.

23. OPEN VS CLOSED ECONOMIES • The participation of foreigners results in a distinction between open and closed economies. In a closed economy, foreigners do not participate in buying and selling of goods and services. • Thus a closed economy does not take into account international trade while an open economy takes into consideration imports and exports.

24. GOVERNMENT INTERVENTION • The changes in demand and supply can only occur if the market forces of supply and demand are free to establish the equilibrium prices and quantity of goods and services. • Quite frequently, however, consumers, trade unions, farmers, business people and politicians are not satisfied with the prices and quantities determined by market demand and supply. • Their dissatisfaction leads them to put pressure on government to intervene to influence prices and quantities in the market. This intervention can take different forms, including: • Setting maximum prices (price ceilings) • Setting minimum prices (price floors) • Subsidizing certain products or activities • Taxing certain products or activities

25. MAXIMUM PRICES (PRICE CEILINGS, PRICE CONTROL) • Governments often set maximum prices for certain goods and services. • Price controls were in South Africa during the 1970s. • During the 1980s, however, almost all the price controls were abolished and nowadays most prices are determined by market forces. • It is nonetheless important to analyse the impact of maximum price fixing. • Many consumers call for price control and there is always the possibility that the government may reintroduce it. • WHY GOVERNMENT SET MAXIMUM PRICES? • To keep the prices of basic foodstuffs low, as part of a policy to assist the poor. • To avoid the exploitation of consumers by producers, that is, to avoid ‘unfair’ prices. • To combat inflation. • To limit the production of certain goods and services in war time.

26. MAXIMUM PRICES • If maximum price is set above the equilibrium (or market clearing) price it will have no effect on the market price or the quantity exchanged. • Prices and quantities will still be determined by demand and supply. • However, when maximum price is set below the equilibrium price (as is usually the case) it will have significant effects. • MAXIMUM PRICES

27. EFFECTS OF MAXIMUM PRICES • If the government sets a maximum price of Pm below the equilibrium price of Po, this results in an excess demand of Q2-Q1 (or ab) • There is thus a market shortage (or excess demand) ab. • But when price control is introduced, different ways have to be found to solve the problem of excess demand. • The basic problem is how to allocate the available quantity supplied (Q1) between consumers who demand a total of Q2 of the goods concerned. • WAYS OF MANAGING EXCESS DEMAND • This can be done in various ways: • Consumers can be served on a first come first serve basis resulting in queues or waiting lists. b. Suppliers may set up informal rationing systems e.g. by limiting the quantity sold to each consumer or by selling to regular customers c. Government may introduce an official rationing system by issuing ration tickets or coupons which have to be submitted when purchasing the product.

28. WAYS OF MANAGING EXCESS DEMAND CNT’D d. One possibility is to import to solve the excess demand is to import the difference between Q2 and Q1, provided such imports are available at price PM or less. • This will eliminate the shortage, but is such imports are available, price control is unnecessary to start with . • Other effects; • Private cost • Corruption e.g. bribery of rationing officials • Development of black markets: stimulate black market activity by providing an incentive for people to obtain the good and resell it at a higher price to those household who are willing to pay higher prices to obtain it.

29. BLACK MARKETS • Not all black markets are illegal, but in the case of maximum price fixing by government, black market activity is outlawed. • A black market is therefore often defined as an illegal market in which goods are sold above the maximum price set by the government. • All price controls (including controls on interest rates, exchange rates and other less obvious forms of prices) stimulate black market activity as unsatisfied potential purchasers seek to obtain the good or service concerned. • Price controls are invariably implemented in the sincere belief that they are in the best interests of society – in many cases they are motivated by an honest concern for the well-being of poor consumers or low-income citizens. • Is it always the case ???

30. RENT CONTROLS • Provides one of the best examples of the problems created by imposing a maximum price below the equilibrium (or market-clearing) price. • In S. Africa, for example rent controls was introduced in the late 1940s to protect tenants from being exploited by the owners of rented accommodation during the postwar housing shortage. • This shortage arose because during the war, production had been geared to the war effort and construction of dwelling units had been curtailed. • The results were permanent shortages of rented accommodation. • EFFECTS OF RENT CONTROLS • When rent controls are imposed , owners of rented accommodation (e.g. flats) can react by; • selling the flats under sectional title • Converting the buildings into offices or other forms of accommodation which are not subject to rent control. • Lowering their operating costs by skimping on maintenance and repairs (i.e. by reducing the quality of their service)

31. EFFECTS OF RENT CONTROL • to erect new rented accommodation – the supply of new rented accommodation falls (while the population and demand increase) and the shortage becomes worse. • ADMINISTERED PRICES • Following the abolishment of price controls in South Africa, government departments or other public sector agencies still determine the price of a range of goods and services in S.Africa. • These prices are usually called administered prices, to indicate that they are the result of administrative processes rather than of market forces of supply and demand. e.g. NERSA- National Energy Regulator of South Africa. • Administered prices often feature strongly in the debate on the causes of inflation in S.Africa and appropriate anti-inflation policy. • 20% of the goods and services in the CPI basket in South Africa can be classified as administered prices. e.g. prices of medical services, petrol and diesel, communication services, electricity, and education. • Other prices administered by the public sector include those of public transport services, water and licences.

32. ADMINISTERED PRICES CONTINUED • The term administered prices was first coined in the USA in the 1930s to indicate private sector prices that were determined discretionally by suppliers of goods and services instead of by market forces. • In SA, however, the term is used exclusively to indicate government involvement in price determination. • The different prices are administered according to different conventions, rules and formulae. • For example, a specific formula is used to determine the monthly adjustments in fuel prices, while other administered prices are determined in other ways, often on a cost-plus basis.

33. MINIMUM PRICES • To stabilise farmers’ income, government often introduce minimum prices (or price floors) which serve as guaranteed prices to producers. • If the minimum price is below ruling equilibrium, the operation of market forces is not disturbed, but if the minimum price is above the ruling equilibrium price(as is often the case) there is a surplus (or excess supply). • This is shown in the diagram below;

34. MINIMUM PRICES • DD and SS represent the demand and supply of beef. • The equilibrium price is R15 per kg and the equilibrium quantity is 7 million kg. • The introduction of a minimum price of R20 per kg results in a market surplus of 5 million kg (represented by ab). • FURTHER GOVERNMENT INTERVENTION • When government fixes a minimum price above the equilibrium price, it creates a market surplus. This usually requires further government intervention. • The options are essentially the following; • Government purchases the surplus and exports it. • Government purchases the surplus and stores it (provided the product is non-perishable) • Government purchases and destroys the surplus • Producers destroy the surplus

35. FURTHER GOVERNMENT INTERVENTION CNT’D • The artificially high price is usually justified by arguments that it is in consumers’ interest that farmers receive a stable income (and keep producing the products) or that the surplus can be exported to earn foreign exchange. • Instead of merely fixing a minimum price, government can also fix a producer price and a lower consumer price and subsidize producers by the difference. • For example, the producers’ price of maize is set at USD285.00 per tonne and the consumer price is USD260.00. The difference between the two prices (i.e USD25.00) is paid by government to producers as a subsidy. • This reduces or eliminates the surplus but still involves a cost to tax payers. It represents a redistribution of income from taxpayers to users of maize. • What government cannot do is sell the surplus to domestic consumers at a lower price - this will defeat the whole purpose of setting a price floor. • Another alternative is to give the surplus to the poor. Surpluses of perishables products are often offered to charitable institutions, but the collection and distribution of the products entail significant costs and the products are seldom collected.

36. FURTHER GOVERNMENT INTERVENTION CNT’D • Setting minimum prices above equilibrium prices is a highly inefficient way of assisting small or poorer farmers, since; • All consumers, including poor households, have to pay artificially high prices. • The bulk of the benefit accrues to large farmers or farming concerns owned by big companies. • Inefficient producers are protected and manage to survive . • The disposal of the market surpluses usually entails further cost to taxpayers and welfare losses to society.

37. DEMAND • Demand is defined as the ability and willingness to buy specific quantities of a good at alternatives prices in a given time period, ceteris paribus (holding all things else constant). • Total market demand is the sum of individual demand. • Construction of a Demand Curve

38. DEMAND CURVE FOR A POCKET OF POTATOES

39. DEMAND AND FACTORS AFFECTING DEMAND • Demand • The demand curve illustrates how the quantity demanded changes in response to a change in the price of that good, if nothing else changes (ceteris paribus). • Demand curve slope downwards. • The law of demand states that the quantity of a good demanded in a given period increases as its price falls. • Factors affecting demand • Change in Income • Prices of Complementary /Substitute Products • Changes in the number of buyers • Changes in preferences and tastes • Expectations of future prices

40. MARKET DEMAND AND SUPPLY Market Demand • The market demand refers to the total quantities of a good or service that people are willing and able to buy at alternative prices in a given time period. i.e. the sum of individual demands • Supply • The law of supply states that the quantity of a good or service supplied in a given time period increases as its price increases, ceteris paribus. • The supply curve is upward sloping suggesting a positive relationship between price and quantity. • The quantity supplied is directly influenced by a change in the price, whilst the supply is influenced by factors in the market e.g. prices of inputs, technology , expectations, number of sellers.

41. EQUILIBRIUM POSITION • Equilibrium in the market occurs where quantities demanded exactly balance the quantities supplied for goods and services, Qd=Qs • This is where the demand and supply curves intersect to determine the equilibrium price and equilibrium quantities that are bought and sold in this particular market.

42. DISEQUILIBRIUM POSITION • Whenever the market price is set above or below the equilibrium price, the market will be in disequilibrium. • This disequilibrium will result in either a market surplus or a market shortage. • To overcome a surplus or shortage, buyers and sellers will change their behaviour and the market will tend towards equilibrium where no further adjustments will be required.

43. ELASTICITY • Elasticity is the measure of the responsiveness of demand to a change in price. • The price elasticity of demand is a measure of the sensitivity of quantity demanded to changes in price. • It measures the relationship as the ratio of percentage changes between quantity demanded of a good and changes in its price. • Price Elasticity (EP) = % change in quantity demanded • % change in price • In practise goods are categorised according to their relative elasticity – whether Ep is larger or smaller than 1. If Ep is larger than 1, demand is elastic. • If Ep is less than 1, demand is inelastic. When demand is inelastic, the percentage change in quantity demanded is less than the percentage in price, consumers are not responsive to price changes.

44. DETERMINANTS OF ELASTICITY • Why are consumers price sensitive (EP greater than 1) with some goods and not (Ep less than 1) with others? • It is important to note that the elasticity of demand is computed between points on a given demand curve. • Price elasticity of demand is influenced by all the determinants of demand. • The four factors particularly worth noting are; • Necessities (relatively inelastic) Vs Luxuries (relatively elastic • Availability of substitutes • iii. Relative price (to income) • iv. Time

45. PRICE ELASTICITY OF DEMAND AND TOTAL REVENUE • The price elasticity of demand can be used to determine by how much the total expenditure by consumers on a product (which is also the total revenue of the firms producing that product) changes when the price of the product changes. • This is probably the most important reason why economists, business people and policymakers are so interested in information concerning the price elasticity of demand. • The total revenue (TR) accruing to the suppliers of a good or service (or the total expenditure by the consumers ) is equal to the price (P) of the good or service multiplied by the quantity (Q) sold. • There is an inverse relationship between the quantity demanded (Q) and the price of a product (P). Any change in price leads to a change in the quantity demanded in the opposite direction to the change in price. • The effect of a price change on total revenue will thus depend on the relative sizes of the price change and the change in the quantity demanded.

46. PRICE ELASTICITY OF DEMAND AND TOTAL REVENUE • If the change in price P leads to a proportionately greater change in quantity demanded Q (i.e. if the price elasticity of demand is greater than one ), total revenue TR will change in the opposite direction to the price change. • If the change in price leads to an equi-proportional change in the quantity demanded (i.e if the price elasticity of demand is equal to one ), total revenue will remain unchanged. • If the change in price leads to a proportionally smaller change in the quantity demanded (i.e if the price elasticity of demand is smaller than one), total revenue will change in the same direction as the price change. • CHANGES IN TOTAL REVENUE VS PED • As long as the price elasticity of demand is greater that one, total revenue TR (or the total expenditure by consumers) increases as the quantity sold Q increases. • TR reaches a maximum when the price elasticity of demand is equal to one. • When the price elasticity of demand is less than one, TR falls as the quantity sold Q increases. • The relationship between the price elasticity of demand and total revenue can be explained further by distinguishing five different categories of price elasticity of demand (PED).

47. RELATIONSHIP BETWEEN PED AND TOTAL REVENUE

48. DETERMINANTS OF PRICE ELASTICITY OF DEMAND • Price elasticity of demand is influenced by all the determinants of demand. • The five factors particularly worth noting are; • Substitution possibilities • The degree of complementarity of the product • The type of want satisfied by the product. • The time period under consideration • The proportion of income spent on the • OTHER DETERMINANTS OF PRICE ELASTICITY OF DEMAND The following factors can also affect the price elasticity of demand. • The definition of the product • Advertising • Durability • Number of uses of the product • Addiction

49. OTHERS : INCOME AND CROSS ELASTICITIES • Income elasticity • The income elasticity of demand relates the percentage change in quantity demanded to the percentage change in income that is; Income elasticity of demand = % change in quantity demanded % change in income • As is the case with price elasticity, income elasticity is computed with average values for changes in quantity and income. • Cross elasticity • Cross elasticity is a different type of elasticity and involves two related products. • It is defined as the relative change in the quantity demanded of product A, in relation to the relative change in the price of product B, which caused the change in the quantity demanded of product A. • Cross-price elasticity of demand is given by % change in quantity demanded of good X % change in the price of good Y

50. OTHERS : INCOME AND CROSS ELASTICITIES CN’TD • the cross-price elasticity of demand makes it easy to distinguish substitute and complementary goods. If cross price elasticity is positive, the two goods are substitutes; if the cross-price elasticity is negative, the two goods are complements. • Coca-cola and hamburgers are complements because a fall (-) in the price of one leads to an increases (+) in the demand for the other, in other words, the cross-price elasticity is negative