martin kaonga-text book of economics(115 and 125)

8/7/2019 MARTIN KAONGA-TEXT BOOK OF ECONOMICS(115 AND 125)

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Kmartin martin kaonga

K>MARTEENTHE UNIVERSITY OFZAMBIA

EC=115MICRO-

ECONOMICS

2009


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CHAPTER 1

INTRODUCTION TO ECONOMICS __________________________________________________________________________________________ __

After studying this chapter, the students should be able to:

Appreciate the subject matter of Economics XE "Economics"Explain how Economists derive their theoriesIdentify the nature of factors of production XE "factors of production"Explain the law of diminishing ReturnsExplain the relationship that exists between Scarcity XE "Scarcity" , Opportunity Cost andChoiceUnderstand the basic Economic tables, graphs and modelsExplain the Economic systems, their merits and demerits___________________________________________________________________________ _

1.0 INTRODUCTION THE SUBJECT MATTER OF ECONOMICS

Economics XE "Economics" comes from the verb to economise, and this means makingends meet. This is a study of how society makes decisions, regarding the allocation of scarce

resources. Economics as a subject is divided into two parts;

Microeconomics XE "Microeconomics" , which deals with individual economic decisionmakers or

agents, namely households, firms etc. Households as resource owners supply XE"supply" factors of

production XE "factors of production" to firms, and earn an income. In returnhouseholds demand goods and

services produced by firms, and spend their income.

Firm in general demand and pay for factors of production XE "factors of production"

from households and inreturn, supply XE "supply" goods and services at a price, to households.

The interaction between the individual decision makers is known as the circular flowof income , it is dealt with in detail at a later chapter.

Economics XE "Economics" assumes that these individual economic units behave


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rationally:

Firms or producers always try to maximise their profits.Households or consumers always try to maximise the satisfaction or utility theyderive from their income.Governments always attempt to maximise the welfare XE "welfare" of society

Macroeconomics looks at the total (aggregate ) picture, the practical effects of decisions of the Economic units.

Economics XE "Economics" as a subject makes use of normative statements of

Economic and socialvalue judgments of what society thinks ought to happen in an ideal scenario, such asZambia winning the world cup!

Economics XE "Economics" is also concerned with positive statements and objective explanations of what

has happened in the past, and based on that, what is likely to happen in the future.Economics XE "Economics" is a social science subject; it deals with human behaviour, whichis diverse. Therefore, it is difficult to come up with blanket conclusions. The assumption,ceteris paribus all things remain equal, usually applies.

The subject matter of Economics XE "Economics" is concerned with human beings trying tomake ends meet with what they have, the basic Economic problem is that:-

Human wants are unlimited or insatiable. Maybe because goods wear out and have to bereplaced, or, new and improved products become available on the market, or people are justtired of what they own and want a change.

Economic resources, which are required for the production of goods and services to satisfyhuman wants, are limited.

The above are the two pillars on which the whole subject matter of Economics XE"Economics" rests is the scarcity of resources and the choices that have to be made to try tomake ends meet, since not all of our unlimited wants can be satisfied!

The scarce economic resources are commonly known, as factors of production XE "factorsof production" and these have to be examined in relation to how they limit production.

Factors of production

The factors of production XE "factors of production" are the resources that are necessary for production, and if these were in plentiful supply XE "supply" , there would be no need toeconomise, and society would have free goods! What affect the rate of Economic growth XE"growth" that an economy can manage is the quantity and the quality of the factors of productionthey have .


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The following are the four different groups into which factors of production XE "factors of production" are usually classified :

Land

This refers to all natural resources XE "natural resources" such as farmlands, mineral wealthXE "wealth" , fishing grounds provision of site where production can take place, and so on.

Land differs from other factors of production XE "factors of production" in three main waysas follows:

It is a gift of nature, man has done nothing to bring it about.It is limited in supply XE "supply" but man through schemes such as fertilizers, irrigation,better quality seeds etc can improve it.Since land XE "land" is in limited supply XE "supply" , Diminishing returns tend to set inearly.

The Law of Diminishing Returns.

Diminishing returns refers to a situation where a firm is trying to expand by using more of its

variable factors, but finds that the extra output they get each time they add one more variable

factor to a fixed factor of production such as land XE "land" , gets progressively less and less.This usually

arises because the capacity of land for example, is limited in the short-run and thecombination

of the fixed and variable factors becomes less than optimal.

The law, with reference to land XE "land" , states, after a certain point, successiveapplication of

equal amounts of resources to a given area of land produces less than proportionatereturn.

If, for example, a farmer has one hectare of land XE "land" (fixed factor) and produces the

following bags of maize by employing more workers (variable factor).

Number of workers Output per year Addition to Output

1 100 1002 210 1103 300 904 250 -50


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Fig: 1 The law of Diminishing Returns

Output 300

per

year 250

200

150

100

50

0 1 2 3 4

Number of workers

Note that diminishing returns start after the second worker is employed, when theadditions

to output start to decline from 110 to 90, and eventually being negative. It is no longer worthwhile to employ more workers on only one hectare of land XE "land" , it costsmore to employ than the additional revenue XE "revenue" from an additional worker.Additional workers can only be employed when more land is acquired, but this canonly be achieved in the long run XE "long run" .

Labour

This is a human resource, it is human effort employed in production.Labour is considered as the most important economic resource, it is indispensable to all formsof production . It is the end user of everything that is produced. It differs from other factors inthat ethical and moral consideration has to be taken into account when dealing with labour XE"labour" .The quantity and quality of labour XE "labour" has to be considered as they both relate toproduction and productivity. The supply XE "supply" of labour depends on:-


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Total population XE "population" of a countryProportion of the population XE "population" available for employmentNumber of hours worked per year

Quality, efficiency or productivity of labour XE "labour" varies, depending on a number of

issues, such as

The climateNutrition and health of the worker Peace of mindWorking conditionsEducation and training

Capital

This is composed of man-made aids to production, for example, factory, bridges, machinery,raw materials, means of transportation etc.

Quantity of capital XE "capital" depends on the wealth XE "wealth" accumulated fromprevious production by firms and governments. Wealthy or rich firms and governments havea lot of the latest sophisticated equipment, while poor countries have very little, depending onobsolete equipment and few handouts. The quality of capital is influenced by a nationsEconomic development and technological progress.

Enterprise XE "Enterprise"

This is another human resource, but entrepreneurial ability requires organising land XE "land" ,labour XE "labour" and capital XE "capital" for production. It is concerned with decision-making. Therefore, there are two distinct functions of the entrepreneur, uncertainty bearing bysupplying risk XE "risk" capital and organizing for production by making decisions on whatto produce, how to produce and for whom to produce etc.

Such decisions or choices are necessary because factors of production XE "factors of production" are not only scarce but they also have alternative, competing uses. Choices aremade, to satisfy some wants and to forgo other wants.

When a choice is made, an alternative has to be given up, this sacrifice is termed as theopportunity cost XE "opportunity cost" . Opportunity cost explains the fact that the cost of

something is what you have to give up in order to get what you want a trade off. It is the realcost of an action, which is considered as the next best alternative forgone. It usually has amonetary value, but it can also be a choice over the use of time, for example, choosing to watcha movie or to study Economics XE "Economics" !

1.2 PRODUCTION POSSIBILITY CURVE


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The relationship between scarcity, choice and the forgone alternative is exhibited by aproduction possibilities curve or frontier, also known as the transformation curve, opportunitycost XE "opportunity cost" curve. It helps to explain the important Economic concept of opportunity cost.

To simplify, assume that they are only two commodities, and if the society chooses more of one thing it must necessarily choose less or sacrifice something else, such as more of good Xmeans less of good Y. The production possibility curve for any country is a graph showing thecombination of two goods that can be produced using all of its scarce Economic resources inthe most efficient manner, given a countrys Economic development and technologicalprogress.

Fig: 2 Production Possibility Curve

A

Good Y B

E

C

D

Good X

Any point along the PPF is the maximum of all possible combinations of the two products Xand Y. Society can choose a specific combination of output, a single point along the PPF suchas point A, B, C, and D.

At point A the existing resources are all being used to produce commodity Y and no X is beingproduced. Alternatively, at point D the economy chooses to produce X without Y, or decide onlarge quantities of Y and small quantities of X (at point B), or vice versa, at point C.

Any point inside the PPF (e.g. point E) or an inward shift to the left, is an indication that theeconomy is producing beneath its full potential, and therefore operating inefficiently or someresources are lying idle. An inward shift normally occurs when a country is at war and or theeconomy is contracting. There is no Economic growth XE "growth" .

An outward shift to the right, as shown by the dotted lines, shows an increase in the productivecapacity of the economy, Economic growth XE "growth" . Economic growth can occur from


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either better use of existing resources, increased productivity , or effective use of newlyacquired inputs or resources, that is increased production. Increased output may also be due todivision of labour XE "labour" and specialization.

It is important to note that the curve is normally drawn as being concave to the origin, a sign

that some resources are well suited to the production of one good rather than another good andvice versa. Otherwise, the PPF would be a straight line slanting downwards from left to right,implying that if production of X reduces by one unit, then the production of Y would increaseby one unit, if it reduces by two units, then the production of the other good would increase bytwo units, and so on. However, that is not the case.

The existence of scarcity and choosing between competing ends creates decisions that must bemade regarding resource allocation.

What to produceHow to produce

For whom to produceWhere to produceHow to distribute etc.

Note that factors of production XE "factors of production" are not only scarce with competinguses, but they can also be specific, if they are of a specialized kind, and therefore cannot beeasily used for any other purpose other than that for which they are originally intended.Examples of specific factors are bridges, factories, accountants, and economists, combineharvesters blast furnaces, etc.Alternatively, factors can be non-specific, that is, if a factor can easily be transferred from oneuse to another. For example, land XE "land" used for animal grazing, growing maize,

unskilled labour XE "labour" , raw materials like cotton is used to make blankets, carpetsclothes or small tools like a knife used to cut meat, rope and so on.

1.3 ECONOMIC GROWTH AND ECONOMIC WELFARE

When a countrys PPF shifts outwards, to the right, then Economic growth XE "growth" isjudged to have taken place. It is measured by a real increase in the national income XE"national income" figure. The national income is the total value of goods and servicesproduced in a country in a year. When production is increasing then the economy is growing.Factors determining increases in output are both internal and external. Internal factors includethe quantity and quality of a countrys factors of production XE "factors of production" , theamount of scarce Economic resources available and their productivity. The external factorsresult from a countrys relationships with the rest of the world, including the terms of trade ..

Economic growth XE "growth" is an important subject in that it affects the measurement of Economic welfare XE "welfare" , an improvement in the overall standard of living XE"standard of living" of the people in any country, more goods and services are available. Thequality of life in terms of, for example, the life expectancy in Zambia improving to an average


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of eighty years or above instead of forty years or less!

The other advantages of economic growth XE "growth" are an improvement in the socialsector, better infrastructure, a lower doctor: patient, teacher: pupil ratio etc.

Economic growth XE "growth" maybe balanced or unbalanced , that is some sectors andsome areas grow faster than others. In Zambia, the mining, agriculture and tourism sectors aswell as the some urban areas are expanding faster than others.

Unfortunately, there are a number of disadvantages associated with economic growth XE"growth" . It is associated with a cost, the opportunity cost XE "opportunity cost" of diverting resources from present consumption XE "consumption" . It also implies that there isfaster use of natural resources XE "natural resources" , it gets depleted quickly. There is needto continuously discover new natural resources to sustain Economic growth. Unfortunately, thewealth XE "wealth" is not equally distributed; there is a marked difference between the richand the poor people in the society.

Economic growth XE "growth" also leads to less desirable attitudes, people leading carefreeand selfish lifestyles, moving away from extended families to nuclear families in this era of H.I.V/A.I.D.S orphans prevalent in poor countries like Zambia, extended families are needed toassist in looking after orphans.

Another problem is social costs XE "social costs" , the undesirable effects of modernisationand industrialization as the economy grows. There is increased noise, traffic congestion, andloss of natural beauty, crime, pollution etc. Social benefits may also arise. The social costs andbenefits are jointly known as externalities . Externalities are spillover effects, there are externalto the transaction. An externality occurs when a cost or benefit of an Economic action is borne

or received by society as a whole, and not just the cost to a firm or a benefit to the consumer, itis regarded as the difference between private and social costs, as well as private and socialbenefits.

An example of the private cost and the private benefit to a person drinking a bottle of beer or smoking cigarettes is the actual cost of the items and the enjoyment by the customer. However,this transaction affects society in general through the social cost of drinking and drunkenness,fumes and generally the increased health care provision by the government. The loud musicplayed in bars and enjoyed by the patrons is a private benefit, but, even passersby may enjoythe music. This is a social benefit.

1.4 ECONOMIC SYSTEMS

The decisions to the central Economic problems of what to produce, how to produce and for whom to produce depend on the Economic system prevailing in any particular country. To alarge extent, the Economic system depends on the political system and the manifesto of thepolitical party that has formed the government.


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Society gives its mandate as to which political/Economic system they prefer by voting for aparticular political party during the general elections.

There are three (3) main Economic systems:

a) MARKET ECONOMY

Also known as the capitalist system. This is the kind of Economic system generallycharacterized by advanced Western countries such as Germany, France, the United Kingdom in

the 19 th and 20 th centuries. During the 20 th century there has been rapid technologicalprogress in many countries, many of them becoming capitalists.The features of this system is emphasis on the freedom of the individual or firm, both as aconsumer and as the owner of productive resources, to make their own Economic choices onwhat, how and for whom to produce.

In its pure form, there is no government interference in Economic activity, resources areallocated on the basis of price. Price signals facilitate change and show shifts in consumer wants, the concept of consumer sovereignty. A consumer expresses his choice of goodsthrough the price he is willing to pay for the product. The system responds to consumer preferences. There is no or very little wastage of resources.

The system is efficient and self-adjusting, there is an invisible hand in the market which helpsin the resource allocation. There is technical and Economic efficiency, and most importantly, itis more practical than the socialist system since there is a clear incentive by producers, this isself-interest!

DISADVANTAGES

Marked inequalities in income and wealth XE "wealth" distribution.It suffers from market failure, that is failure to produce a satisfactory allocation of resourcesusing the market forces of demand and supply XE "supply" for some commodities such asdefence, street lights etc, known as public goods XE "public goods" .Lack of adequate provision of goods considered worth providing in great volumes,

such as education providing in great volumes, such as education and health knowns merit

goods .

There are monopolies instead of competition

There is no guarantee that demand will match supply XE "supply" , there is usually a time lag.


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b) PLANNED (COMMAND) ECONOMY

This is a socialist political system advocated by idealists, or anyone uncomfortable with the

marked inequalities in income, which is a common characteristic of capitalism. In the plannedEconomicsystem, the government makes production decisions on what how and for whom to produce onbehalf of the community, for the benefit of everyone. An attempt is made to create a new socialorder, where everyone is happy, and utopianism.

The disadvantages of the market economy correspond closely to the merits of the centrallyplanned economy.

The central planning authority can ensure that

Adequate resources are devoted to community goods and merit goods XE "merit goods" .An attempt is made to distribute resources equally.There is full utilization of resource, no unemployment of resources. Sometimes, workers areemployed simply to keep them occupied.Monopoly powers are used in the interest of the community, no self-interest.There is certainty into production and improving mobility by directing resources, includinglabour XE "labour" .Inefficiencies, which result from competition, are eliminatedWeaker members of the society are well taken care of; their basic needs such as food, clothingand shelter are met by the government.Adequate resources are devoted to community

DISADVANTAGES

Lack of sensitivity and initiative, and even if the resources are fully employed, they are usedinefficiently.


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There is too much bureaucracy.Errors are easy to make so there are either surpluses (wastage) or shortages, resulting in black markets. c) MIXED ECONOMIC SYSTEM

There are few countries that follow entirely the market or the planned Economic system.Examples of socialist countries are Cuba and North Korea. In practice, most economies in theworld make decisions and choices regarding resource allocation by adopting both free marketand planned Economic policies. They do not make a complete choice between the twoextremes, in order to enjoy the best of both worlds, thus following the middle of the road.

Economic wealth XE "wealth" is divided between the private and the public sectors. The major difference is the extent to which an economy is leaning towards a market or a plannedEconomic system. A good example is Zambia, just after independence from Britain, the countrywas following a mixed system although the proportion of centrally planned decision making

was more than that of the free market. Under the Movement for Multi party Democracy(MMD), the country is more towards capitalism than socialism. Yet it is still maintains a mixedEconomic system.

A government can have three-quarters of production carried out by private enterprises throughthe market, while the government is directly responsible for the other quarter. Governmentinvolvement is necessary because there is need for public provision of merit goods XE "meritgoods" such as education and health, which are deemed to be worthwhile for everyone. Themarket forces cannot provide for public goods XE "public goods" , such as defence, police,justice and national parks. Government involvement may also be in the form of publicdeterrence of commodities considered being harmful to society like beer and cigarettes.

1.5 CHAPTER SUMMARY

The subject matter of Economics XE "Economics" is on allocation of scarce resources, how tomake ends meet by:-

Explaining the number of theories, models that make up the principles of Economics XE"Economics" ;Emphasizing that human wants are unlimited, while resources required to satisfy these wants

are limited;Looking at the problem of scarcity of resources (factors of production XE "factors of production" ) which have competing uses and the related problem of making choices thatinvolve sacrificing alternatives, called opportunity costs;Identifying the relationship between resources and Economic growth XE "growth" andEconomic welfare XE "welfare" ;Allocating resources using the market system or the planned Economic system, the advantagesand the disadvantages of each system;


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Looking at the real world, most economies have a the mixed Economic system;

REVIEW QUESTIONS

What is the basic Economic problem facing all economies?How would you describe positive and normative Economics XE "Economics" ?What are the main production decisions that have to be made?What are the four factors of production XE "factors of production" ?What is opportunity cost XE "opportunity cost" ?What does a production possibilities curve show?How are the decisions and choices on the allocation of resources made in a planned Economicsystem?What is an externality?How is actual Economic growth XE "growth" measured?What is unbalanced Economic growth XE "growth" ?

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EXAM TYPE QUESTION 1.1

(a)Explain the term opportunity cost XE "opportunity cost" . (4 Marks)Illustrate with examples the practical importance of this concept with reference to the individual,the firm and the state (6 Marks)

(b)What is the opportunity cost XE "opportunity cost" of a non Economic (free) good? ( 2Marks)Which of the following are non-Economic goods and why?

beer

hedge trimmings

a worn out suit case

a second hand car

a NATech Certificate

sand in the Sahara

sand in a builders yard (8 Marks)(Total: 20 Marks )



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What is meant by the law of diminishing returns (6 Marks)

How might the concept of Diminishing Returns be applied in the following cases:

Motor car production (2 Marks)Wheat production (2 Marks)Listening to lectures? (2 Marks)

How does the market system answer the key Economic questions relating

to the problem of the allocation of resources?(8 Marks)

(Total: 20 Marks)

CHAPTER TWO

SUPPLY AND DEMAND__________________________________________________________________________________________ _____


Explain how decisions are made on what to produce, how to produce and for whom toproduce, how prices act to allocate resources within an economyExplain Consumer behaviour and demandDraw standard demand and supply XE "supply" curvesExplain Price determination


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Explain why prices change from time to time, the main influences of demand and supply XE"supply"Distinguish between a change in demand or supply XE "supply" , and a change in the quantitydemanded and suppliedExplain why and how the government intervenes

Explain the effects of government intervention___________________________________________________________________________ ____

1.0 INTRODUCTION This chapter deals with how the free market Economic systems deals with the allocation of scarce resources, making choices on what, how and for whom to produce. This emphasis is onthe market for goods and services. However, the factor market , which is the market for factors of production XE "factors of production" , land XE "land" , labour XE"labour" , capital XE "capital" and enterprise, with the corresponding rewards, rent, wages,

interest and profit respectively, works in almost a similar way.

A market is where buyers and sellers meet, it does not necessarily mean a geographicallocation. What determines what and how much of anything to produce is the price, and priceresults from the operation of demand by buyers and supply XE "supply" from sellers.

In a free market, prices, which are basically determined by demand and supply XE "supply" ,combine to solve the problem of resource allocation. Prices act as a signal of what people wantto buy, indicating to producers where their scarce factors will most profitably be utilized.

1.1 DEMAND

Individual demand must be differentiated from wants or desires. Demand refers to thewillingness by consumers to own goods, and it must be backed by money XE "money" , it istherefore, qualified as effective demand. This is the quantity of a product or service thatconsumers are willing and able to buy at a given price. Emphasis is not only willingness, butthis must be supported by the ability to pay. Market demand is the total quantity, which allcustomers are willing and able to buy at a particular price.

1.2 THE DEMAND SCHEDULE

There is an inverse relationship between the quantity demanded and price, the amounts that a

consumer is willing and able to purchase at various prices at any given time tends to be high atlow prices, and low at high prices.

Below is Mr Bandas demand schedule for mangoes in the month of November.

Price (K) Quantity demanded (units)

1 000 0


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800 3500 4300 6200 10

1.3 DEMAND CURVE

When the data above is plotted into a line graph, a demand curve is produced.

FIG 3: DEMAND CURVE

PriceD

D

Quantity

A normal demand curve slopes downwards from left to right, due to changes in price. Achange in price never shifts the demand curve for any good, it results in a movement along ademand curve. This is a change in the quantity demanded.

An increase in price from OP to OP1 causes a contraction in demand from OQ to OQ1.Alternatively, a reduction in price from OP1 to OP results in an extension in the quantitydemanded from OQ1 to OQ.

Contraction in demand Extension in demand


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1.4 UTILITY THEORY

The standard shape of a demand curve, downward sloping, explains consumer behaviour with

reference to utility theory. Utility is the satisfaction or the benefit derived from consuming agood or a service, and total utility is the total satisfaction. The utility theory assumes thatconsumers want to maximize the total utility they gain when they buy goods and services, asign that they are behaving rationally.

In general, when a consumer buys more of a product, the total utility rises, but the marginalutility , which is the satisfaction gained from consuming one additional unit of a product,reduces. For example, if a very thirsty person drinks a glass of water, she will derive a lot of satisfaction from that, but the second glass of water will be less satisfying, by the time shedrinks the third and fourth glasses of water, there is very little satisfaction derived from

drinking water. This signifies that successive increases in consumption XE "consumption"raise total utility but at a diminishing rate, known as diminishing marginal utility. A person isonly prepared to pay less for an extra unit bought, more demand is at a lower price! Thisexplains the shape of the demand curve, it slants downwards from left to right, signifying thatthe lower the price, the higher the quantity demanded and the higher the price the lower thequantity demanded.

The normal demand curve is also partly explained by the substitution effect XE "substitutioneffect" , which occurs due to relative price changes. Changes in the price of goods and servicescause consumers to adjust their demand schedules. If the price of a good falls, there is asubstitution effect, consumers buy more of that good and less of the other goods because of

relative price changes. However, there is also an income effect XE "income effect" , as the fallin price increases a consumers real income. The consumer is better off, and can buy more of aproduct, hence increasing demand as price falls.

A consumers spending of a good is in equilibrium where the marginal utility is equal to price.Therefore the equilibrium for a combination of goods is

Marginal utility of good A = MU B = MU CPrice of good A P B PC

Note that the utility theory has a number of limitations, the important one being that it issubjective , an individual who does not smoke cannot derive any satisfaction from cigarettesmoking. For some products such as beer, there is no diminishing marginal utility for somepeople! In addition, a poor person who is starving can pay dearly for basic foodstuffs, while arich person will find this negligible in terms of price and utility.


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1.5 A CHANGE IN DEMAND

Demand curves shift only if there is a change in the conditions of demand other than price.

The following are the main influences on demand:

Household incomeAn increase in income leads to an increase in the demand for goods and services,known as norma l goods. These are expensive, luxurious products. Demand fallswhen there is a reduction in income, indicating a positive relationship betweenhousehold income and most goods and services.

For some products, there is an inverse relationship between household income and demand.Demand is high only when household income is low. Goods, whose demand decreases whenincome is high, are known as inferior goods. Examples are black and white television sets,

cheap wine, some vegetables etc.

The price of other goods`This can either be substitute or competitive goods, those goods that areinterchangeable, are competing with each other. Examples are margarine is a substitutefor butter, and tea is a substitute for coffee. Different brands of tea, coffee and differentcellular phone serviceproviders like Celtel, Telecel and Zamtel are very close substitutes of each other!

For substitute goods XE "substitute goods" , a change in the price of one good causes a changein the demand for the other good. Suppose there is an increase in the price of butter, the

demand for margarine is likely to increase as consumers will switch to margarine, which willappear relatively cheaper.

The other goods can also be complementary goods or those goods that are jointly demandedsuch as cars and fuel, or cell phones and sim cards.

For complementary goods, a change in the price of one good also causes a change in thedemand for the other good, however, an increase in the price of motor vehicles causes areduction in the demand for fuel.

There is an increase in demand for herbal medicines because of the complexities of the H.I.VA.I.D.S. scourge.

PopulationAn increase in population XE "population" creates a larger market for goods and

services, demand increasesand vice versa.

Price expectations XE "expectations"


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Expectations of future price increases in a commodity results in an increase in demand,the

idea is to purchase a lot of goods at the current low price and beat future priceincreases.

A change in demand is a shift in the whole demand curve either to the right or to the left,indicating an increase or a decrease in demand respectively.

Price D 2 D1 D

Quantity

In the diagram above, a decrease in demand shifts the demand curve to the left from DD toD1D1 and an increase in demand would shift the demand curve to the right from DD to D 2D2

2.0 SUPPLY

Supply must be differentiated from production, which is the total value of goods in stock.

Supply is the amounts of a good producer are willing and able to sell at a given price.

2.1 THE SUPPLY SCHEDULE

There is a positive relationship between the quantity supplied and price. The amounts thatproducers or sellers are willing and able to sell at various prices at any given time tend to behigh at high prices, and low at low prices.

Below is Ms Chandas supply XE "supply" schedule in the month of November.

Price (K) Quantity supplied (units)1 000 0

800 3500 4300 6200 10

2.2 SUPPLY CURVE


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When the data above is plotted into a line graph, a supply XE "supply" curve is produced.

Price S

S

Quantity

A normal supply XE "supply" curve slopes upwards from left to right, an indication that athigh prices, supply is high, while at low prices, supply is also low. A change in price never shifts the supply curve for any good, it results in a movement along a supply curve. This is achange in the quantity supplied.

An increase in price from OP to OP1 results in an extension in supply XE "supply" from OQ toOQ1. Alternatively, a reduction in price from OP1 to OP results in a contraction in the quantitysupplied from OQ1 to OQ.

Price

P1 P

P P1

0Q Q1 Quantity

Q1 Q

2.3 A CHANGE IN SUPPLY

The supply XE "supply" curve shifts only if there is a change in the conditions of supplyeither than price. If supply conditions change, a different supply curve must be drawn, unlike achange in the quantity supplied due to price changes,

The following are the main influences on supply XE "supply" :


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Cost of productionA rise in costs generally decreases the amount of a commodity being supplied to themarket, since firms cannot continue in business for long if they are failing to cover thecosts of production. Low costs encourage production and therefore increases the supply

XE "supply" of goods and services.

Technological changesImprovements in technology lead to more efficient production a method that reduceproduction cost per unit and therefore increases supply XE "supply" . Obsoletetechnological has the opposite effect.

Weather conditionsFor agricultural goods, natural disasters like floods, droughts or favorable weather conditions can reduce or increase the supply XE "supply" respectively.

Prices of other goodsThe goods can be either substitute goods XE "substitute goods" or those that are

jointly supplied.

Suppose it is easy to shift resources into the production of other goods, then an increase in theproducer price of one maize would lead to an increase in the production and supply XE"supply" of maize, and a decrease in the production and supply of groundnuts.

An increase in the price of a good such as beef, would lead to an increase in its supply XE"supply" . In addition, the supply of leather would also increase.

Government policy, such as taxes and subsidies XE "subsidies"Taxes are treated as costs, subsidies XE "subsidies" are benefits to a firm. An increasein taxes reduces supply XE "supply" , while a reduction in taxes tends to increase thesupply.

A subsidy is when the government pays part of the costs in order to encourage theproduction of goods. Increased production increases supply XE "supply" .

Other factorsIndustrial and political unrest in the form of work stoppage, strikes, fire, wars, riots etc,can lead to a reduction in supply XE "supply" .

A change in supply XE "supply" is a shift in the whole supply curve either to the right or tothe left, an

indication of an increase or a decrease in supply respectively.In the diagram below, a decrease in supply XE "supply" shifts the supply curve to the leftfrom SS to S 1S1 and an increase in supply shifts the supply curve to the right from SS to

S2S2.


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Price S 1S

S2

S1 S

S2

Quantity

4.0 PRICE DETERMINATION

The equilibrium market price is the price at which consumers want to buy equals the price atwhich producers want to sell.

Consumers and producers both act rationally. Consumers want to maximize their utility andtherefore want to purchase goods as cheaply as possible, while producers also act rationallyand aim at profit maximization, they charge high prices. The equilibrium market price thereforeis determined by the interaction of the market forces of demand and supply XE "supply" . Thepoint where the demand and supply curves intersect is the compromise price, both consumersand producers are satisfied at this point.

Consumers are willing and able to purchase OQ quantities at price OP, while Producers arealso willing and able to supply XE "supply" OQ quantities at price OP, as shown in thediagram below.

Price D S

P

S D

OQ Quantity

At the equilibrium price, there are neither surpluses nor shortages. The price is stable unless


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there are changes in either supply XE "supply" or demand conditions listed above under changes in demand and supply.

Note that the marginal utility of consumers varies, with some consumers willing and able topay for a product than the prevailing market price, since they are paying less, there is a

consumer surplus .A producer surplus also arises when some suppliers are willing to sale at less than theprevailing market price, since they are selling at a higher price there is a producer surplus .

Price

S

Consumer surplus

Producer surplus

D

Quantity

4.1 PRICE CHANGES

Shifts in the supply XE "supply" or demand curves will change the equilibrium price andquantity traded.

If for example, there is a large increase in consumers income, the demand curve will shift tothe right from DD to D 1D1 signifying an increase in the demand for goods and services. The

new equilibrium price is OP 1 and the quantity traded also increases to OQ 1.

Price D 1S

D

P1

P

D1S


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O Q Q 1 Quantity

4.2 DISEQUILIBRIUM IN THE MARKET

The market system is considered to be the best way of allocating scarce Economic resources,because prices act as signals to producers. An increase in the price of product X, is a signal to

producers to transfer resources to the production of product X and vice versa.

The objective of maximizing profits provides the incentive for firms to respond to changes inprice.

The system is self-adjusting. If the price is above the equilibrium at OP 1, there is excess supply

XE "supply" , surpluses. At this high price, producers are encouraged to supply more, but thequantity demanded at this high price is less. This causes a downward pressure of cutting downproduction to eliminate the surplus and reducing the price to encourage demand.

At prices below the equilibrium at OP2

, there is excess demand, shortages. Producers supply

XE "supply" few quantities at low prices while more consumers are willing and able topurchase products at low prices. Excess demand causes an upward pressure on price resultingin a rise in price and output.

Price D SExcess supply XE "supply"

P1

P

P2Excess demand

S D

OQ Quantity

4.3 GOVERNMENT INTERVENTION

Price regulation and government policy of taxation XE "taxation" and subsidy interfere withthe working of the free market system.

MAXIMUM PRICE (PRICE CEILING)


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If the government thinks that the price determined by the market forces of supply XE "supply"and demand for a product or service is high, the government might decide to set a maximumprice, that is the price should not go beyond the amount stipulated by the government.

Maximum prices are normally set to encourage the consumption XE "consumption" of goods

and services, considered to be essential, and therefore should be affordable to everyone.

This has the same effect as the price being below the equilibrium, at OP 2 in the diagram above.

The result is excess demand, shortages. There is no self-adjustment as this is governmentpolicy; queues, black markets and tie in sales become common whenever there are shortages.

The government may attempt to ration the few commodities, or subsidize consumers.

Price D S

P

M

S D

O

Q1 Q Q2Quantity

Maximum price OM, at this price OQ, quantities are supplied while OQ 2 quantities are

demanded, the result is a shortage.

MINIMUM PRICE (PRICE FLOOR)

This is set in order to protect producers. If the government feels that the price set by the marketforces of supply XE "supply" and demand is too low for producers to earn a decent standard


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of living XE "standard of living" them a minimum price is set. This meaning that the goodsshould not be sold below the amount stipulated by the government.

This has the same effect as the price being above the equilibrium at OP.

Price D S

M

P

DO

Q1 Q Q2 Quantity

Minimum price is OM, quantity supplied is OQ 2 while the quantity demanded at this high

price is only OQ 1. The result is excess supply XE "supply" , surplus amounts that have to be

sold at low prices dumped in poor countries.The surplus can also be stored away, but this is at a cost. Government intervention in relation to taxation XE "taxation" and subsidy is explained indetail in the next chapter.

5.0 CHAPTER SUMMARY

In a free market economy prices act as a means for consumers to signal to the market what theywish to buy, and for producers where their scarce Economic would most profitably be utilized.The price for any good or service is determined by the demand for and the supply XE "supply"of that good or service.

Changes in demand or supply XE "supply" cause changes in the equilibrium price andquantityGovernment intervention, such as the setting of maximum and minimum prices, as well as


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taxation XE "taxation" and subsidy also disturbs the equilibrium price and quantity.

If maximum prices are imposed, there are shortages or excess demand, and if minimum pricesare imposed, there are surpluses or excess supply XE "supply" .

Indirect taxes lead to an increase in price, while subsidies XE "subsidies" cause prices toreduce.

REVIEW QUESTIONS

Describe the shape of a typical demand curveWhat is the difference between a shift in demand and an expansion of demand?If a cabinet minister urged people in Zambia to cut down on the high cost of livingby buying only cheap products, is that Economically sound?How does a consumer surplus arise?List some factors which can cause a change in supply XE "supply"What are substitute and complementary goods? Give two examples of each.What is the shape of a typical supply XE "supply" curve?When the price of a good is set above the equilibrium price, what is the result?

Illustrating graphically and specifying the assumptions upon which your reasoning is based,describe briefly

The effect on the price and output of fresh maize of adverse weather conditions.The effects on the price and output of oranges of an increase in consumers income.

---------------------------------------------------------------------------------------


Explain the difference between a change in supply XE "supply" and a change in the quantitysupplied

(12marks)

Zim Police warns dubious traders .

HARAREThe Zimbabwean police warned last Monday unscrupulous traders sellingcommodities at above the government stipulated prices that they risked being arrested if caught doing the unlawful act.

Police spokesperson Inspector, Cecilia Churu, said that police would not hesitate to arrest


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any retailer caught flouting the gazetted price.

The warning comes in the wake of unjustified price increases of Mealie Meal in the pasttwo weeks by millers without the approval of the government .

Zambia Daily Mail, 24 th July,2003.

You are required to:

Explain, with the aid of a diagram, the effect of this form of government intervention on theprice mechanism.

( 8Marks)

(Total: 20 marks)

CHAPTER 3

ELASTICITY __________________________________________________________________________________________ ____


Explain why demand or supply XE "supply" may not change in spite of price changesExplain and measure the price elasticity of demand and supply XE "supply" .Explain the determinants of price elasticity of demand and supply XE "supply" .Assess the relationship between price elasticity of demand and total revenue XE "revenue"Explain why demand may change when income changes.Explain why demand for one product changes when there is a change in the price of

another productAppreciate the use of elasticity in pricing of goods, taxation XE "taxation" and subsidy of certain goods___________________________________________________________________________ ____

1.0 INTRODUCTION

The law of demand states that an increase in price causes a decrease in the quantity demanded,while a decrease in price causes an increase in the quantity demanded.Elasticity XE "Elasticity" measures the degree of responsiveness or sensitivity of demand to achange in price.

If a small change in price causes a big change in the quantity demanded then demand is elastic.


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However, if a big change in price causes only a small change in the quantity demanded, then itis inelastic.

2.0 PRICE ELASTICITY OF DEMAND (PED)

It is measured by the formula: % change in quantity demanded% change in price

There is an inverse relationship between price and quantity, as such the sign is negative.Note that the sign is always ignored when interpreting the elasticity value.

2.1 CATEGORIES OF PRICE ELASTICITY OF DEMAND

There are five categories of PED, namely:-

Perfectly or completely inelastic demand

When a change in price has no effect at all on the quantity demanded, PED when measured isequal to zero. This is an extreme situation, the closest it can be liked to is medicines.Consumers purchase exactly the same quantities whatever the price is, whether it is high at OPor low at OP 1, the quantity remains OQ.

Price D

P

P1

OQ Quantity

Inelastic demand

This is when elastic is relatively or fairly inelastic, a big change in price results in only a small

change in the quantity demanded and the conclusion is that demand is inelastic. Price changesby a big margin, from OP to OP1, but the demand reduces by a very small amount, from OQto OQ1. PED when measured is greater than zero, but less than one.

Inelastic demand applies to necessities such as mealie meal, sugar, salt, and addictive productssuch as cigarettes, beer, drugs.

PriceD


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P1

P

DO Q 1 Q Quantity

Unitary elasticity XE "Unitary elasticity" of demand

This is a hypothetical scenario, based on the assumption that if price changes by a certainpercentage, then the quantity demanded should also change by exactly the same percentage.

When measured, elasticity is equal to one exactly.

Price D

P1

P

D

O Q1 Q Quantity

Perfectly or completely elastic demand

This is another theoretical structure, it is important because a perfectly competitive marketstructure model is based on it.

At the compromise price of OP, demand is infinite, but a small change in price would causedemand to reduce to zero.

PRICE

P D


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QUANTITY

Elastic demand

Demand is relatively or fairly elastic when a small change in price results in a big change in thequantity demanded, a sign that consumers are able to respond to changes in prices.

Therefore goods and services that can easily be substituted, those that are mere luxuries and areexpensive (normal) goods are the ones which have an elastic demand.

When measured, the value would be greater than one but less than infinity.

PriceD

P1P

D

O Q 1 Q Quantity

2.2 CALCULATING PRICE ELASTICITY OF DEMAND

The calculation is done in two ways

(a) Point Elasticity XE "Elasticity" of Demand

Under point elasticity, the elasticity is calculated at a certain point on the demand curve.

Example1

The price of a product was K4000 and the annual demand was 2000 units when the price wasreduced to k3000, the annual demand increased to 4000 units.

Calculate the price elasticity of demand for the price changes given.

PED Formula = % change in quantity demanded = Q2 - Q1 P2 P1% change in price Q1 P1

= Q2 - Q1 P1


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Q1 P2 P1

where Q 2 = 4000

Q1 = 2000 P

2= 3000

P1 = 4000

= 4000 2000 x 1002000

___________________ 3000 4000 x 1004000

= 2000 x 4000 = -4_ 2000 -1000 Demand is elastic

Example 2

The price of a commodity was initially K10, 000 and 150 units were bought per day. When theprice fell to K5, 000 the units being bought increased to 200 per day. What is the price elasticityof demand for the price changes given?

PED Formula = % change in quantity demanded = Q2 - Q1 P2 P1% change in price Q1 P1

= Q2 - Q1 P1Q1 P2 P1

where Q 2 = 200

Q1 = 150 P2 = 5000

P1 = 10000

200 - 150 x 100 50150 150

= _____ = 50 x 10 000 = 10150 -5 000

-15

5 000 10 000 x 100 -5000


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10,000 10000

= -2 = - 0.673

Demand is inelastic

Example 3

From the following data

Price quantity bought (K000) ( units)1.75 1252.0 100

Calculate PED

At price K1.75% Change in quantity 25 x 100 = 20%

125

% Change in Price -0.25 x 100 = -14.2857%1.75

PED Formula = % change in quantity demanded

% change in price

= 20% = -1.4 Demand is elastic-14.2857%

(b) Arc elasticity of demand XE "Arc elasticity of demand"

The elasticity is calculated over a range of values or an arc.

Example 1


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The annual demand for a product is 1,800,000 at K2, 600 per unit and demand reduces to1,500,000 when the price increases to K3, 000 per unit. What is the elasticity of demand over this price range?

PED Formula = Percentage change in quantity demandedPercentage change in price

Q2 - Q1 x 100 Where Q 2 = 1 800 00

Q1 + Q 2 Q1 = 150 0000

___ 2______________ P2 = 2600

___ __________________

_____ P

1= 300 0

P2 - P1 x 100

P1 + P 22

18 00000 15 00 000 x1001500000 + 18 00 000

2

2 600 3 000

3 000 +2 600 x 1002

300,0001650 000

= 300,000 x 2800 = -1.27-400 1650 000 -400 demand is elastic

2800

Example 2

From the following data

Price Quantity bought


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K000 000 units10 155 20

Calculate PED

Change in quantity -5 x 100 = -28.57%17.5

Change in price -5 x 100 = 66.67%7.5

PED = -28.57% = - 0.4366.67% demand is inelastic

2.3 PRICE ELASTICITY ALONG THE DEMAND CURVE

The five categories of price elasticity of demand can be shown on one demand curve. Demandcurves generally slope downwards from left to right, and elasticity varies along the length of ademand curve. The ranges of price elasticity of demand at different points along a demandcurve are illustrated below.

Price PED =

PED>1

PED = 1 (mid-point of the line)

PED


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below:

Price Quantity(K000) (kilograms)

10 09 10

8 207 306 405 504 603 702 801 900 100

If the price is lowered from 8 to 7, PED is 10/20

1/8 = 10/20 x 8/1 = 4.Demand is therefore, elastic.

If price is lowered from 4 to 3, PED is 10/60 = 10/60 x 4/1 = 2/3 = 0.66.Demand is therefore, inelastic

At higher price ranges, demand is elastic. At lower price ranges, demand is inelastic.

At the point where demand is changing from elastic to inelastic demand, demand is unitary. If price is lowered from 5 to 4, PED is 10/50 1/5 = 10/50 x 5/1 = 1.

Note that it is wrongly assumed that when calculating elasticity values, either an increase or adecrease in price calculations, given the same values, have the same elasticity coefficient. It isalso wrongly assumed that two demand curves with the same shape will have the sameelasticity coefficient, and yet the slope and position of the demand curve determine thenumerical value of elasticity. In general, a big change in price causes only a small change inthe quantity demanded , resulting in an inelastic demand curve if the demand curve is steep,further from the origin, and vice versa.

2.4 POSITIVE PRICE ELASTICITIES OF DEMAND OR EXCEPTIONALDEMANDCURVES

If the quantity demanded of certain goods falls as an individuals income reduces, then thegoods are said to be inferior goods XE "inferior goods" . It is assumed that a personsubstitutes better quality alternatives, for example substituting a black and white television for acolour, flat plasma television set, from buying mixed cut beef to a high quality expensive steak.

The quantity demanded for a good may also increase when the price increases if the product isa status maxi miser! Ostentatious goods such as gold and diamond jewels, private jets, etc.,


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are more desirable to some consumers when the price is high, when the price falls, the productsbecome common and are no longer desirable to those people.

If consumers anticipate future price increases whenever the price of a product increases, theyare likely to buy more to beat inflation in the short term.

2.5 FACTORS DETERMINING PRICE ELASTICITY OF DEMAND

Elasticity XE "Elasticity" of demand depends on the consumers ability to increase or reducethe quantities being purchased when there is a change in price. This depends on the following:

Availability of substitutesSubstitutes have a very big impact on elasticity, if there are close substitutes available,then an increase in the price of a good, will enable consumers to react, and demand willbe elastic. However, the demand for a unique product is likely to have an inelasticdemand.

IncomeThis is when a commodity constitutes a small proportion of an individuals income, acheap product such as a razor blade, a rubber and pencil or a box of matches, itemscosting K100 or so would still be affordable even if there is a 100% percent increase in price. In contrast, the demand for luxurious expensive products is likely to be elastic. A10% increase in the price of a product costing K2 million would make consumersresponsive to changes in demand.

NecessitiesThe demand for commodities such as mealie meal, salt, sugar, milk etc is likely to be

stable and inelastic.

Additive or habit forming productsConsumers who are addicted to products such as beer, cigarettes, drugs etc feel thatthey cannot function properly without them. To them, the products are necessities, andtherefore their demand is stable and inelastic.

Time periodIt takes time to adapt to changes in price. Consumers are likely to cling to a certainlifestyle until reality sets in and they are forced to adjust their spending habits. As suchdemand is more likely to be elastic in the long run XE "long run" rather than in the

short run XE "short run" .

3.0 PRICE ELASTICITY OF SUPPLY XE "PRICE ELASTICITY OFSUPPLY" (PES)

Price elasticity of supply XE "supply" is analogous to price elasticity of demand, it measuresthe responsiveness of supply to changes in price. That is the extent to which producers increase


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production and therefore the quantity which they take to the market as a result of a rise in price.

PES is measured by the formula: % change in quantity supplied% Change in price

There is a direct relationship between price and quantity supplied .

3.1 CATEGORIES OF PRICE ELASTICITY OF SUPPLY XE "PRICE ELASTICITYOF SUPPLY"

As with elasticity of demand, there are five categories of elasticity of supply XE "supply" .

Perfectly or completely inelastic supply XE "supply"

A change in price has no effect at all on the quantity supplied to the market. The same quantityis supplied regardless of a price change, from 0P to 0P 1 or vice versa.

Elasticity XE "Elasticity" is equal to zero.

Price S

P

P1

O Q Quantity

Inelastic supply XE "supply"

This is when elastic is relatively or fairly inelastic, a big change in price results in only a smallchange in the quantity supplied. A large increase in price results in only a small increase in thequantity produced and therefore supplied to the market. The conclusion is that supply XE"supply" is inelastic. Price changes by a big margin, from OP to OP1, but supply increases bya very small amount, from OQ to OQ 1. PES when measured is greater than zero, but less than

one.


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Price S

P1

P

S

O Q Q 1 Quantity

Unitary elasticity XE "Unitary elasticity" of supply XE "supply"

This is a hypothetical; it is based on the assumption that if price changes by a certainpercentage, then the quantity supplied should also change by exactly the same percentage.When measured, elasticity is equal to one exactly.

Price S

P1

P

S

O Q Q 1 Quantity

Perfectly or completely elastic supply

This is another theoretical structure. At price OP, supply XE "supply" is infinite, producer will supply any amount, but a small change (reduction) in price would cause supply to reduce to


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0 Q Q 1 Quantity

In the same general way, the effects of a shift in demand depend on the elasticities of the supply

XE "supply" involved. Where supply is inelastic , a shift in demand causes a large change inthe equilibrium price but only a small change in the equilibrium output, and vice versa .

a) INELASTIC SUPPLY b) ELASTIC SUPPLY

Price D1 Price D1

D DP1 P1

PP

0 Q Q 1 Quantity 0 Q Q 1 Quantity

In extreme cases, where demand or supply XE "supply" is perfectly inelastic or elastic, achange in supply or demand does not change the equilibrium position at all.

a) PERFECTLY INELASTIC DEMAND b) PERFECTLY ELASTIC SUPPLYPrice

S1 Price

D1D

P1 S

P

0 Q Quantity 0 Q Q 1 Quantity

Under a), a change in supply XE "supply" causes the equilibrium price to change but theequilibrium output does not change. Under b) a change in demand causes the equilibriumoutput to change but the price does not change.

Note that an understanding of this first section is very crucial as sections 2, 3 and 4below are more or less a repetition and an extension of this concept.

4.0.2. WHEN THERE IS A CHANGE IN TOTAL REVENUE


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The calculation of PED is very useful to the business community, as well as the amount beingspent by consumers. If the demand for a good is elastic , then a reduction in price increasestotal revenue XE "revenue" , and the total amount being spent by consumers. A businessselling products that are very competitive on the market, those with close substitutes, luxuriesetc., can advertise small reductions in prices and discounts in order to woo customers andincrease the companys total revenue XE "revenue" .

Price

P D P1 D1

0 Q Q 1 Quantity

Total revenue XE "revenue" is price x quantity, the price reduction results in a more thanproportionate increase in the quantity demanded, this offsets the price reduction. Area 0PDQ isgiven up, while area 0P 1D1Q1 is what is gained when the price is reduced, total revenue

increases.

Alternatively, if total revenue XE "revenue" falls after a price rise then demand is elastic.

If the demand for a good is inelastic , then an increase in price increases total revenue XE"revenue" . A business selling products that are necessities and addictive products like beer andcigarettes, can afford to increase prices, and the reduction in the quantity demanded isnegligible, as shown below.Area 0P 1D1Q1 is given up, while area 0PDQ is what is gained when the price is increased,

therefore, total revenue XE "revenue" increases.

Price

P D

P1 D1


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0 Q Q 1 Quantity

Alternatively, if total revenue XE "revenue" falls after a price cut then demand is inelastic.

If total revenue XE "revenue" or total expenditure by households remains unchanged whether there is an increase or reduction in price, then the elasticity of demand is unitary . The areasare equal!

Price

P D

P1 D1

0 Q Q 1 Quantity

4.0. .3 WHEN AN INDIRECT TAX IS IMPOSED ON A PRODUCT

Imposing an indirect tax on a product is a form of government intervention, like the setting of maximum and minimum prices. An indirect tax is a tax on expenditure. Such taxes reduceoutput, maybe harmful to the domestic industry if it is in a competitive environment and someforeign firms are not subject to the same tax. Taxes however, can assist in the allocation of resources when there is a lot of pollution and only polluters are pay through heavy taxes.

The significance of elasticity is in determining how the burden of the tax is to be sharedbetween the producer and the consumer.

Suppose, a product has unitary elasticities of demand and supply XE "supply" , the marketforces determine the equilibrium price and output. Following the imposition of a tax, someproducers transfer their resources to another product, as this one would be deemed unattractive.Supply reduces, and the supply curve shifts to the left, to S 1. The price paid by consumers

increases to P 1, but the net amount received by the producer is lower than previously, since he

must pay to the government part of the earning and there is a reduction in output to Q 1, due to

the tax.

Price D S 1


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SP1

P

P2

0 Q 1 Q Quantity

In the diagram above, the burden of the tax is shared equally between the producer and theconsumer.

In practice, such an equal distribution of the tax burden is unlikely . The burden of the taxdepends on the elasticities of demand and supply XE "supply" involved! If the demand for agood is inelastic , a firm producing necessities and addictive products like beer and cigarettescan afford to pass the major burden of the tax on to consumers, price increases to P 1 from P.

Producers bear a small portion of the burden, return falls toP 2.

a) INELASTIC DEMAND

S

Price S1

P1

P

P2

0 Q Q 1 Quantity

b) ELASTIC DEMAND S

Price

S1

P1 P

P2


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0 Q Q 1 Quantity

If the demand for a good is elastic , then a firm dealing in products that are competitive on themarket by having close substitutes, luxuries etc., the burden of the tax is borne mainly byproducers. The price paid by consumers rises slightly to P 1, the return received by suppliers

falls by a big margin, to P 2.

INELASTIC SUPPLY

S 1 Price S

P1 P

P2

0 Q Q 1 Quantity

The conclusion as to how the burden is shared is self explanatory from the diagram, the pricepaid by consumers rises slightly to P 1, the return received by suppliers falls by a big margin, to

P2.

4.0.4 WHEN A SUBSIDY IS GIVEN

A subsidy is the exact opposite of an indirect tax. It is another form of governmentintervention, it is when the government makes a payment to producers, and it can bring aboutartificially low prices.

Suppose, a product has unitary elasticities of demand and supply XE "supply" , the marketforces determine the equilibrium price and output. When a subsidy is given, production isencouraged. Supply increases, and the supply curve shifts to the right, to S 1. The price paid by

consumers reduces to P 2, and this is a benefit to them. There is an increase in output to Q 1, and

the amount received by the producer increases.

Price D S


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S1P1

P

P2

0 Q Q 1 Quantity

The significance of elasticity is in determining how the benefit of the subsidy is to sharedbetween the producer and the consumer, the benefit will fall more on the consumers if theproduct has an inelastic demand and vice versa.

5.0 OTHER ELASTICITY MEASURES

5.1 INCOME ELASTICITY OF DEMAND XE "INCOME ELASTICITY OF

DEMAND" (YED)

The elasticity measures are alike, the definition of income elasticity of demand is similar to thatof price elasticity of demand, but price is replaced by income.

Income elasticity of demand measures the degree of responsiveness or sensitivity of demand tochanges in income.

The formula = percentage change in quantity demandedpercentage change in income

5.2 Categories of income elasticity of demand

Positive Income Elasticity XE "Elasticity"This is when an increase in income leads to an increase in demand, YED > 0. It applies tonormal goods such as colour television sets, motor vehicles etc. Most goods have a positiveincome elasticity of demand.

Quantity

Income

Negative Income Elasticity XE "Elasticity"For some goods, an increase in income causes a reduction in demand, YED < 0. Inferior goods, such as black and white television set, have a negative income elasticity of demand.


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Quantity

Income

Zero income Elasticity XE "Elasticity"A change in income may have no effect on the quantity demanded, demand remains the same,YED = 0. Consumers purchase only what they require, this applies to Giffen goods XE"Giffen goods" , necessities like mealie meal, potatoes etc. Note that with Giffen goods, lessis demanded when price falls because the negative income effect XE "income effect"overcomes the positive substitution effect XE "substitution effect" .

Quantity

Income

5.3 Factors affecting income elasticity of demand

The size of income elasticity of demand depends on the current standard of living XE "standardof living" . For example, the developed countries have a high standard of living, so that whenincome expands, sales of consumer durables such as washing machines and cars will rise; salesof basic commodities (Food, etc) are unlikely to respond significantly to the rise in income(zero income elasticity). In contrast, developing economies such as Zambia, when income rises,the income elasticity of demand for basic goods will be higher as a large percentage of thepopulation XE "population" is unable to afford basic commodities at its current level of income.

5. 4 Practical uses of income elasticity of demand Producers may wish to know the income elasticity of demand for their product, it has an effecton their businesses. The planned future production may depend on whether incomes are risingor falling. Income increases during Economic prosperity (Economic boom), businesses sellnormal goods XE "normal goods" . While during a recession, basic inferior goods XE "inferior goods" are more profitable.


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6.0 CROSS ELASTICITY OF DEMAND XE "CROSS ELASTICITY OFDEMAND"

Cross elasticity of demand measures the sensitivity of demand for one good to changes in theprice of another good. The formula for cross elasticity of demand (XED) is given below.

The formula for cross elasticity of demand

XED =percentage change in quantity demanded of Good Apercentage change in price of Good B

6.1 Categories of cross elasticity of demand

Positive cross elasticity of demand The XED between butter and margarine is positive, this is because butter and margarine aresubstitutes. When the price of butter goes up, demand for margarine rises and demand for butter falls. In other words, the price of margarine and demand for butter move in the samedirection, therefore XED is positive.

Negative cross elasticity of demand The XED between complements XE "complements" (goods that are jointly demanded) isnegative. Consider cars and fuel, if the price of cars increases, demand for fuel would fall. Carsand fuel are complementary goods, so demand for cars is also likely to fall. The price of carsand demand for fuel move in opposite directions, so the XED of complements is negative.


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Zero cross elasticity of demand

This applies to unrelated goods. A change in the price of one good has no effect on the quantitydemanded of the other good.

7.0 CHAPTER SUMMARY

Price elasticity of demand and supply XE "supply" measure how much the quantity demandedand supplied responds to changes in price.

PED/PES are calculated as the percentage change in quantity demanded/supplied divided by thepercentage change in price.

PED/PES are very important in determining the effects of changes in demand and supply XE"supply" , increases and reductions in total revenue XE "revenue" given changes in the pricesof goods and services. In addition, PED/PES are important in determining the effects of changes in government policy such as taxation XE "taxation" and subsidies XE "subsidies" .

If total revenue XE "revenue" i ncreases following a price cut , then demand is elastic . If totalrevenue falls after a price cut , then demand is inelastic , and vice versa. If total revenue remainsunchanged , then demand is unitary .

There are a number of factors, which determine the ability of consumers and producers torespond to changes in price, such as the availability of substitutes, whether a product is anecessity or it is addictive, as well as the income of consumers.

In most markets, supply XE "supply" is more elastic in the long run XE "long run" than in theshort run XE "short run" , it takes time to transfer resources following a price rise, it also

depends on the availability of factors of production XE "factors of production" especially rawmaterials and labour XE "labour" , as well as the ease of entry of new firms into the market.

Income elasticity of demand measures how much the quantity demanded responds to changesin income.

Cross-elasticity of demand measures how the quantity demanded of one good responds tochanges in the price of another good.


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REVIEW QUESTIONS

What is the price elasticity of demand?The price of a good falls by K10, 000, but the quantity demanded increases from 100 to 120units. Calculate the price elasticity of demand?List any four factors, which influence price elasticity of demand.What is an inferior good?Demand is said to be, when the price of a good rises, the quantity demanded falls and thetotal expenditure on the good decreases.How would you classify a good with a positive income elasticity of demand?How would you classify goods with a negative cross-elasticity of demand?List the commodities that has a positive price elasticity of demandDraw a perfectly or completely elastic supply XE "supply" curve.Show how the burden of a tax will be shared between the producer and the consumer whendemand for a product is perfectly elastic.

EXAMINATION TYPE QUESTIONS 3.1

The following table is a demand schedule for a particular commodity, between which pricerange is demand elastic? Explain your answer. Hint: At least three calculations, a reductionfrom K8, 000 to K7, 000, K5, 000 to K4, 000 and from K4, 000 to K3, 000.

Price (K000s) Quantity Demanded10 0

9 108 207 306 405 504 603 702 801 900 100

(10 Marks)

What do you understand by the term income elasticity of demand (6 Marks)Why should a firm pursuing long term growth XE "growth" be interested in the incomeelasticity of demand of its products? (4 Marks)

(Total: 20 Marks)


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CHAPTER 4

PRODUCTION AND COSTS

__________________________________________________________________________________________ ____


Differentiate legal forms of business units, the advantages and disadvantages of each

Name the three classes of productionExplain how production costs are determinedDiscuss Division of labour XE "labour" , its merits and demeritsExplain the differences between fixed, variable and marginal costs XE "marginal costs"Explain on the rewards of factors of production XE "factors of production"___________________________________________________________________________ ____

1.0 Introduction

Production takes place in firms. A firm is an independently administered business unit. Inpractice, there are different types of firms, known as sole traders XE "sole traders" ,partnerships XE "partnerships" etc.

1.1 Sole traders

Individuals who set up businesses of their own are sole traders XE "sole traders" . It can besomeone with a good business idea, an own invention or finding something to do after


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restructuring or simply being his or her own boss after several years as someone elsesemployee.An example of a sole trader is a corner shop, a fish trader, a marketeer etc.

Advantages

It requires little capital XE "capital" to set up.Self-interest acts as an incentive to work.Regular customers and suppliers are known.Owner can make quick business decisions.

Disadvantages

It does not have a separate legal personality, if a person mortgages the house to raise capital XE"capital" . If the business fails, then the house is lost.Thus, there is unlimited liability.Difficult to raise capital XE "capital" .Holidays or illnesses cause problems.Lack of continuity after the death of the owner.

1.2 Partnership

Business company owned by partners: a company set up by two or more people who putmoney XE "money" into the business and share the nancial risks and prots. An example of a partnership is a firm of doctors, lawyers etc. The activities of partnerships XE "partnerships"are regulated by a legal document, a partnership deed.

Most of the advantages and disadvantages of sole traders XE "sole traders" are transferred topartnerships XE "partnerships" , as it is only slightly better than a sole trader. Partnerscontribute the capital XE "capital" , and as owners, share the profits, they can specialize andthey have regular known customers.

However, partnerships XE "partnerships" also have unlimited liability, and one partnersmistake affects all partners. Lack of continuity if partners disagree, or if one partner dies.

1.3 Private limited Company

This is a company with limited stockholder liability, a registered company in which thestockholders' liability for any debts or losses is restricted, regulated by the Companies Act.Two or more shareholders own the company. An example is a small family firm. Shareholderscontribute capital XE "capital" of the company. Shares are not sold to the general public. Likesole traders XE "sole traders" and partnerships XE "partnerships" , there is limited capital for expansion, and therefore limited economies of scale.

The advantage of private limited companies XE "companies" is that if the company goes


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bankrupt, owners have limited liability for the companys debt. They only lose the capital XE"capital" they have invested in the company, nothing more.

1.4 Public limited Company

Public limited companies XE "companies" identify themselves by putting the word PLC after their name. These are companies whose share can be bought and sold on the stock market,unlike private limited companies, they are allowed to sell shares to the general public.Shareholders are subject to restricted liability for any debts or losses. An example is ChilangaCement PLC Large amounts of capital XE "capital" can be raised, as such they are usuallyvery large, enjoying economies of scale.

Professional managers normally run the companies XE "companies" , and the company can beremote from customers and there are potential diseconomies of scale.

1.5 Co-operatives These are formed when people join together to carry on an Economic activity for mutualbenefit. It is owned or managed jointly by those who use its facilities. An example is aconsumer cooperative, which is for the wholesale or retail distribution usually of agriculturalgoods. Membership is open, and goods are sold to the general public as well as to its members.

The major disadvantage of cooperatives is lack of business or management experience bymembers to carry out an Economic activity.

2.0 Industry- the three classes of production

Production is divided into three categories

Primary production XE "Primary production"The producers of natural goods such as farmers, oil drillers, copper miners etc, are allengaged in primary production.

Secondary production XE "Secondary production"The producers of sophisticated goods, manufactured goods such as carpenters, tailors, car manufacturers, are in secondary production.

TertiaryThese are providers of services like bankers, retailers, stockbrokers, accountants, teachers,doctors and entertainers.

3.0 Specialisation

Specialization happens when one individual, region or country concentrates in making onegood.


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Division of Labour

The division of labour XE "labour" is a particular type of specialization where the productionof a good is broken up into many separate tasks each performed by one person. An early

economist, Adam Smith, suggested that without any division of labour XE "division of labour"and specialization, one worker could produce only ten pins in one day. However, in a pinfactory where each worker performs only one task, ten workers using the division of labour principle, could produce a daily total of 48 000 pins. Output per person (productivity) can risefrom 10 to 4800 when the division of labour principle was used.

3.1 Advantages of the division of labour XE "labour"

The division of labour XE "labour" raises output, thereby reducing costs per unit, for thefollowing reasons:

Workers become more practiced at the task Workers can be trained more precisely for the task Specialization enables more efficient organization of production with a series of distinct

tasks

3.2 Disadvantages of the Division of Labour

Eventually the division of labour XE "labour" may reduce productivity and increase unit costsof the following reasons:

Continually repeating a task may become monotonous and boring

Workers begin to take less pride in their work If one machine breaks down then the entire factory stops.Some workers receive a very narrow training and may not be able to find alternative

jobs.Mass produced goods lack variety.

3.3 Limits to the Division of labour XE "labour"

Mass production requires mass demand.The transport system must be good enough to reach a large number of consumers

(mass market)Barter is the direct exchange of goods for other goods. Each worker creates only part of thefinished goods; -therefore the division of labour XE "labour" cannot be used in a barter society.

4.0 COSTS OF PRODUCTION


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It is important to first divide the costs of production into time period of short run XE "shortrun" and long run XE "long run" costs, depending on variable or fixed factors of productionXE "factors of production" .

The short run XE "short run" is defined as a period when at least one factor of production is

in fixed supply XE "supply" , a combination of both variable and fixed factors. The short runis the time period that is too brief for a firm to alter its plant capacity. The plant size is fixed inthe short run. Short run costs, then, are the wages, raw materials, etc., used for production in afixed plant.

A firm will undertake production in the short run XE "short run" , if the price at which their product is sold is at least equal to the average variable cost of production. Therefore, a firm willcontinue in business in the short run as long as it is able to cover the variable costs XE"variable costs" of production.

The long run XE "long run" is a period when all factors of production XE "factors of

production" can be varied. All the factors of production are considered to be variable. The long run is a time period long enough for a firm to change the quantities of all resources employed,including the plant size. Long run costs XE "Long run costs" are all costs, including the costof varying the size of the production plant.

4.1 Total Costs

The amount spent of producing a given amount of a good by a firm is called total cost, TC, andis found by adding together variable and fixed costs.

4.2 Variable Costs

Variable costs, VC, depend on how many (the output) goods are being made. If just one moreunit is made then total variable costs XE "variable costs" rise. Variables costs are costs thatvary with output. Examples include the following:-

Wages paid to casual workersThe cost of buying raw materials and components.The cost of electricity and charcoal.

4.3 Fixed Costs

Fixed costs XE "Fixed costs" , FC, are independent of output. Fixed costs have to be paid outeven if the factory stops production. Fixed costs are costs that do not vary with output.Examples include the following:

Monthly salaries paid to managersRent paid for the use of premisesRates paid to the council


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Any interest paid on loansDepreciation, that is money XE "money" put aside to replace worn-out machines and vehiclessometime in the future

The short run XE "short run" cost schedule of an individual firm shows the behaviour of costs

when output is varied. Table 1 below presents the cost structure of a hypothetical firm, toillustrate the general principles covered under 4.1, 4.2 and 4.3, total costs remain the same atdifferent levels of output. The total costs are made up of fixed and variable costs XE "variablecosts" . The output and the costs are in thousand units and thousands of kwacha respectively.

Output Total fixed Total variable Total Costsunits costs costs

0 50 0 501 50 50 100

2 50 90 1403 50 120 1704 50 160 2105 50 210 2606 50 270 3207 50 340 3908 50 420 4709 50 510 560

1

martin kaonga-text book of economics(115 and 125)

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