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MASTER OF BUSINESS ADMINISTRATION

MANAGERIAL ECONOMICS

STUDY GUIDE

Copyright © 2015

REGENT Business School All rights reserved; no part of this book may be reproduced in any form or by any means, including

photocopying machines, without the written permission of the publisher.

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1 MANAGERIAL ECONOMICS

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TABLE OF CONTENTS

Introduction to the Managerial Economics Study Guide 4

Managerial Economics Module

PART I: Introduction

SECTION 1: Managerial Economics: An Introduction and Overview 14

SECTION 2: Micro Economics, Macro Economics & the Circular Flow 28

PART 2: Economic Environment of Business

SECTION 3: Demand, Supply & Elasticity 49

SECTION 4: The Macro- Economic Environment of Business 85

PART 3: Market Structures

SECTION 5: Perfect Competition and Monopoly 103

SECTION 6: Monopolistic Competition and Oligopoly 123

PART 4: Economic Concepts for Global Managers

SECTION 7: International Trade 133

SECTION 8: Exchange Rates 147

BIBLIOGRAPHY 164

APPENDIX A

CASE STUDY 1:

Collusion behaviour during Building of SA World Cup Stadiums 166

APPENDIX B

CASE STUDY 2:

Wal-Mart in South Africa 170

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INTRODUCTION TO THE

MANAGERIAL ECONOMICS STUDY GUIDE

Introduction

1. Welcome

Welcome to the world of MBA Economics!

This module forms the core of the Master in Business Administration (MBA) programme

and lays the foundation for other subsequent courses or disciplines you will encounter

during the programme. On successful completion of this module, you will be able to

competently and strategically apply economic theory towards making more informed

business decisions.

Understanding the role of Economics in business management and decision making is

integral for the modern business leader. After all, Economics is about society and

society is about the people. How the people who make up society view firms is

important. Equally important is how we express our opinions. Through our

understanding of Economics, we can transform start-ups to prosperous sustainable

organisations and, as such, contribute to job creation and economic growth.

Module Overview

In today‘s globalised and highly competitive business world, it is of great importance for

business managers to thoroughly understand the direct and indirect impacts of the

environment in which they operate.

Managerial Economics is intended to provide skills in economic analysis that could be

applied in a business environment, enabling managers to understand, analyse and

resolve economic issues related to their industry. As such, this module aims to address

several aspects of economics relevant to business management, such as

microeconomics, macroeconomics and international economics.

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Your Business

Consumers: high, middle, low, traders,

hawkers, inside & outside SA

Suppliers:

Inside & outside SA,

goods, electricity,

labour

Government, Unions, Trade associations

Competitors

This module attempts to arm business managers with the necessary knowledge to

understand their environment (see Figure 1 below), as well as to make informed

decisions. As such, this module provides input into managerial economics in relation to

the micro and macro environment in which firms find themselves in. This module will

prepare the managers to be able to improve profit margins as well as improve

shareholder value, whilst maintaining long term sustainability. The module will also

equip managers with skills to effectively respond to various economic phenomena.

Figure 1 Business within the context of the environment

Source: Econometrix (2015)

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This module explores:

Microeconomic concepts relevant to business decision making;

Macroeconomic concepts and key economic indicators which impact on a

business‘s performance; and

The overall global environment, international trade and associated aspects

which business managers need to be aware of when competing globally.

According to McNair and Meriam (cited in Atmanand, 2005:4), Managerial economics is

the use of economic models of thought to analyse business situations”. Spencer and

Siegelman (2007) define it as ―The integration of economic theory with business

practice for the purpose of facilitating decision making and forward planning by

management.‖

2. How to use the Module

This module should be studied using the recommended textbook/s and the relevant

sections of this module. You must read about the topic that you intend to study in the

appropriate section before you start reading the textbook in detail. Ensure that you

make your own notes as you work through both the textbook and this module. In the

event that you do not have the prescribed textbook, you must make use of any other

source that deals with the sections in this module.

As part of your studies, you also need to keep abreast of current economic issues

covered in the media and, as such, it is highly advisable for you to read business

newspapers daily such as Business Report, Business Day and Finweek.

At the beginning of each section, you will find a list of objectives and outcomes. This

outlines the main points that you should understand when you have completed the

section/s. Do not attempt to read and study everything at once. Each study session

should be 90 minutes without a break.

In the course module, you will find the following symbols and instructions. These are

designed to help you study. It is imperative that you work through them as they also

provide guidelines for examination purposes.

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? THINK POINT

A Think point asks you to stop and think about an issue. Sometimes you are asked to

apply a concept to your own experience or to think of an example.

PRESCRIBED READING

Mohr, P. and Fourie, L. (2014) Economics for South African Students. 5th Ed.

Pretoria: Van Schaik Publishers.

SELF ASSESSMENT ACTIVITY

You may come across self – assessment questions that test your understanding of what

you have learned so far. Answers to these questions are given at the end of each

section. You should refer to the textbook or any other relevant source to help you.

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ADDITIONAL REFERENCES AND SUGGESTED

READING

At this point you must read the references given to you.

If you are unable to acquire the suggested readings, then you are welcome to

consult any current source that deals with the subject. This constitutes

research.

1. Schiller, B. (2014) Essentials of Economics. 7th Ed. China: McGraw-Hill.

2. Howard, D. and Pun-Lee, L. (2001) Managerial Economics: An Analysis Of

Business Issues (3rd Ed). Cape Town: Prentice Hall Financial Times.

3. Parkin, M. Powell, M. and Mathews, K. (2008) Economics. 7th Ed. London:

Pearson Education Limited.

CASE STUDY

1. Economics Network, http://www.economicsnetwork.ac.uk/teaching/casestudy

2. The Economic Times, http://economictimes.indiatimes.com/topic/case-studies

http://www.economicsnetwork.ac.uk/teaching/casestudy

http://economictimes.indiatimes.com/topic/case-studies

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2. Structure of this Study Guide

This Study Guide is structured as follows:

Introduction to Managerial Economics Study Guide

Provides an overview of the

Managerial Economics Study

Guide and how to use it.

1. Introduction

This part of the Study Guide details

what you are required to learn.

Each section details:

Specific learning outcomes;

Essential reading (textbooks

and journal articles);

An overview of relevant theory;

and

● Questions for reflection.

Overview of Managerial Economics

Microeconomics, Macroeconomics and the Circular

Flow

2. Economic Environment of the business

Demand, supply and elasticity

The macro environment of business

3. Market Structures

Perfect Competition and Monopoly

Monopolistic Competition and Oligopoly

4. Economic concepts for global managers

International Trade

Exchange Rates

Appendix A: Case Study 1 Appendices A & B provide two case

studies. You are required to

prepare and analyse these case

studies

.

Appendix B: Case Study 2

3. Structure of Each Section

Each section is structured as follows:

Specific Learning Outcomes;

Essential (Prescribed) Reading;

Brief Overview of Relevant Theory; and

Questions for Reflection.

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3.1 Specific Learning Outcomes

These are listed at the beginning of each section. These detail the specific outcomes

that you will be able to competently demonstrate on successful completion of the

learning that each particular section requires.

3.2 Essential (Prescribed) Reading

Your essential (prescribed) reading comprises the following:

International Textbook

Keating, B. and Wilson, J. 2009. Managerial Economics (2nd ed). Atomic Dog

Publishers. USA.

This textbook will provide you with a strategic understanding of managerial

economics and its application to the general business context.

South African Textbook

Mohr, P. and Fourie, L. (2014) Economics for South African Students. 5th Ed.

Pretoria: Van Schaik Publishers.

This textbook will provide you with an understanding of managerial economic

concepts within the South African context, by relating concepts covered to

examples from SA.

Journal Articles

Journal articles have been prescribed for each section. They are available from

the EBSCO, Emerald and Sabinet databases.

These journal articles will provide you with an understanding of Managerial Economics

within emerging markets. It is imperative that you acquire and read these journal

articles, as they form a key part of the curriculum.

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Useful Websites

Brunel open learning archive www.brunel.ac.uk

Bureau for Economic Research www.ber.ac.za

Khan Academy Micro economics www.khanacademy.org/economics-finance-

domain/microeconomics

Net MBA www.netmba.com

Reserve Bank www.reservebank.co.za

Statistics South Africa www.statssa.gov.za

The Economist www.economist.com/topics/south-africa

3.3 Brief Overview of Relevant Theory

Each section contains a very brief overview of theory relevant to the particular

Managerial Economics topic. The purpose of the overview is to introduce you to some

of the general and emerging market issues regarding each Managerial Economics topic.

Once you have read the overview, you need to explore the individual topic further by

reading the prescribed textbooks and journal articles listed under ―Essential Reading‖

for each section.

3.4 Questions for Reflection

At the end of every section there are questions for reflection. You need to attempt

these on completion of your study of the entire section. The questions are designed to

enable you to reflect on what you have learnt, and consider how what you have learnt

should be applied in practice.

3.5 Case Studies

Case studies form an integral part of developing competence in Managerial Economics.

Two case studies, are included in Appendix A and Appendix B of this study guide. You

are required to analyse these case studies as self-study.

http://www.ber.ac.za/

http://www.khanacademy.org/economics-finance-domain/microeconomics

http://www.khanacademy.org/economics-finance-domain/microeconomics

http://www.reservebank.co.za/

http://www.statssa.gov.za/

http://www.economist.com/topics/south-africa

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4. Assessments

The formal assessment of Managerial Economics takes the form of an assignment and

an exam.

5. Electronic Learning Resources

Additional electronic learning resources are available to supplement your learning.

These are detailed in the document “Electronic Learning Resources”. These resources

seek to build on, and expand, the learning that is facilitated through the Managerial

Economics Study Guide and the Managerial Economics workshops. They include video

podcasts, audio podcasts, individual activities, as well as additional recommended

reading on Managerial Economics within the African and South African context.

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SECTION 1:

Managerial Economics: An

Introduction and Overview

Specific Learning Outcomes

The overall outcome for this section is that, on its completion, the student should be

able to demonstrate a general understanding of the context of Managerial Economics.

The student must understand what managerial economics entails and its importance to

business decisions. As part of Managerial Economics, the student should be able to

discuss and understand the difference between micro and macroeconomics. The

student should also be able to discuss the circular flow model and its applicability to the

flow of goods, services and money in the economy. This overall outcome of part 1 will

be achieved through the student‘s mastery of the following specific outcomes, in that the

student will be able to:

1. Analyse and apply the circular flow model as a model which demonstrates the

coordination in the economy

2. Distinguish between households and firms and show how their decisions and

activities are interrelated.

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ESSENTIAL READING

Students are required to read ALL of the textbook chapters and

journal articles listed below.

Textbooks:

Keating, B, and Wilson, J. 2009. Managerial Economics (2nd ed). Atomic

Dog Publishers. USA. (Chapter 1 : Pages 1-13)

Mohr, P. 2012. Understanding Macroeconomics. Van Schaik. Cape Town.

(Chapter 1 : Pages 4-18)

Journal Articles & Reports

McKinsey Global Institute. 2014. South Africa‘s big five:

Bold priorities for Inclusive growth. Available At:

file:///C:/Users/yumnae/Downloads/South_Africas_big_five_bold_priorities_for_in

clusive_growth-Executive_summary.pdf. Date of Access 6 October 2015.

OECD. 2015. OECD Economic Surveys South Africa. Available at

http://www.treasury.gov.za/publications/other/OECD%20Economic%20Surveys%

20South%20Africa%202015.pdf. Date of Access 6 October 2015.

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1.1 Introduction

The study of Economics is primarily concerned with how we can allocate scarce

resources among alternative uses to satisfy society‘s wants as a whole.

The American Economic Association defines Economics as:

―The study of labour, land, and investments, of money, income, and production,

and of taxes and government expenditures. Economists seek to measure well-

being, to learn how well-being may increase over time, and to evaluate the well-

being of the rich and the poor”.

www.aeaweb.org (2015)

“Economics is the study of the production and consumption of goods and the

transfer of wealth to produce and obtain those goods. Economics explains how

people interact within markets to get what they want or accomplish certain goals.

Since economics is a driving force of human interaction, studying it often reveals

why people and governments behave in particular ways.”

www.whatiseconomics.org (2015).

Economic theory and methodology lay down rules for improving business and public

policy decisions (Hirschey and Bentzen, 2014: 3). Managerial economics helps

managers recognise how economic forces affect organisations and describes the

economic consequences of managerial behaviour. It also links economic concepts and

quantitative methods to develop vital tools for managerial decision making.

Decision making lies at the heart of most important business and government problems.

The range of business decisions is vast. Should a high-tech company undertake a

promising but expensive research and development programme? Should a

petrochemical manufacturer cut the price of its best-selling industrial chemical in

response to a new competitor‘s entry into the market? What bid should company

management submit to win a government telecommunications contract? Likewise,

government decisions range far and wide. Should the Department of Transport impose

http://www.aeaweb.org/

http://www.whatiseconomics.org/

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stricter rollover standards for sports utility vehicles? Should a city allocate funds for the

construction of a harbour tunnel to provide easy airport and commuter access?

These are all interesting, important and timely questions, with no easy answers. They

are also all economic decisions. In each case, a sensible analysis of what decision to

make requires a careful comparison of the advantages and disadvantages (often, but

not always measured according to a monetary value) of alternative courses of action.

Managerial Economics is the analysis of major management decisions using the tools of

economics. Most of these analyses have its origins in theoretical microeconomics.

Topics such as the theory of demand, the profit–maximising model of the firm, optimal

prices and advertising expenditures, and the impact of market structure on firms‘

behaviour, are all approached using the economist‘s standard intellectual tool-kit which

consists of building and testing models (Davies and Lam, 2001:1). In other words,

managerial economics offers a comprehensive application of economic theory and

methodology to management decision making.

The concept of scarcity in Economics implies that choices must be made. For every

decision we take, we incur opportunity costs, which refer to the opportunity forgone. It

simply means giving up something to gain something else. For example, as a business

manager, one is constantly faced with trade-offs of the problem of choosing among

alternative methods of production, pricing of products and maximising profits.

Understanding economics provides the tools necessary to solve the above trade-offs in

the most efficient manner.

An understanding of economics and the environment, in which a business operates, is

also an important element in the current business era. The primary difference between

Managerial Economics and other economics courses is that, in Managerial Economics,

the focus will lie slightly more toward micro economics concepts and the application

thereof with a view towards decision making. An understanding of Managerial

Economics is of importance, as one only needs to follow media headlines to realise the

value and importance of having a practical understanding of economics.

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1.2 Problem Solving Principles

A common factor that unites all economists is their use of the rational-actor paradigm to

predict behaviour. Simply put, it says that people act rationally, optimally and self-

interestedly (Froeb et al; 2014: 4). In other words, people respond to incentives.

Therefore, to change behaviour, one has to change self-interest. This is achieved by

changing incentives which are created by rewarding good performance, with for

example, a commission on sales, or a bonus based on profitability.

Under the rational actor paradigm, bad decisions happen for one of two reasons: either

decision makers do not have enough information to make good decisions, or they lack

the incentive to do so. Using this insight, one can isolate the source of almost any

problem by asking three simple questions:

1. Who is making the bad decision?

2. Does the decision maker have enough information to make a good decision?

3. Does the decision maker have the incentive to make a good decision?

Answers to the above questions not only point to the source of the problem, but will also

suggest ways to fix it by:

1. Letting someone else – someone with better information or better incentives –

make the decision;

2. Giving more information to the current decision maker, or;

3. Changing the current decision maker‘s incentives.

From the above, it can be inferred that developing problem-solving skills requires the

following practical approach:

1. Think about the problem from the organisation’s point of view – avoid the

temptation to think about the problem from the employee‘s point of view as the

fundamental problem of goal alignment will be missed.

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2. Think about the organisational design – Once a bad decision is identified,

avoid the temptation to solve the problem by simply reversing the decision.

Instead, think about why the bad decision was made, and how to make sure that

similar mistakes won‘t be made in the future.

3. What is the trade-off – Every solution has costs as well as benefits. Use the

three questions to spot problems with a proposed solution; in other words,

whatever solution is proposed, ensure decision makers have enough information

to make good decisions and the incentive to do so.

4. Do not define the problem as the lack of a solution – This kind of thinking

may cause one to miss the best solution, for example, if one defines a problem

as ―a lack of centralised purchasing,‖ then the solution would be ―centralised

purchasing‖ regardless of whether this is the best option or not. Instead, define

the problem more broadly and then examine the alternatives as potential

solutions to the problem.

1.3 Why Economics is Useful To Business

Froeb et al. (2014;18) state that economics can be used by business people to spot

money-making opportunities. This begins with the idea of efficiency – an economy is

efficient if all assets are employed in their highest-valued uses. A good policy facilitates

the movement of assets from lower-valued uses to higher-valued uses. If the movement

of assets to higher-valued uses creates wealth, then anything that impedes asset

movement destroys wealth.

Determining whether an economic policy is good or bad, requires analysing all of its

effects – the intended and the unintended. For example, if it is proposed that lenders be

prevented from foreclosing on houses – this proposal helps the delinquent homeowner,

but it also hurts the lender. If lenders cannot foreclose on bad loans, this raises the cost

of making loans, which hurts prospective home buyers. Therefore, the art of economics

consists of tracing the consequences of a policy not merely for one group, but for all

groups.

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1.4 Business Objectives and Basic Models of the Firm

At its simplest level, a business enterprise represents a series of contractual

relationships that specify the rights and responsibilities of various parties (see Figure 2).

People directly involved include customers, stakeholder management, employees and

suppliers. Society is also involved because businesses use scarce resources, pay

taxes, provide employment opportunities and produce much of society‘s material and

services output.

Figure 2: The Corporation is a Legal Device

Source: (Hirschey and Bentzen, 2014:7)

There are many different models of the firm, embodying many different assumptions.

One particular version forms the mainstream orthodox treatment of the firm, known as

the neoclassical model of the firm. This model centres around three basic sets of

assumptions of the firm, as follows:

FIRM

Society Investors Supplier

s

Customer

s

Employees Managemen

t

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1.4.1 The assumption of profit-maximisation

Profit is defined as the difference between the firm‘s revenues and its costs. The firm‘s

owner-manager is assumed to be working to maximise the firm‘s short-run profits. The

short-run is defined by economists as the period in which the firm is restricted to a given

set of plant and equipment, and has some fixed costs which cannot be avoided even by

ceasing production (Davies and Lam, 2001:11). Today, the emphasis on profits has

been broadened to encompass uncertainty and the time value of money. In this more

complete model, the primary goal of the firm is long-term expected value maximisation.

In other words, the objective of the firm is to maximise the wealth of its stakeholders,

which in turn is equal to the discounted value of the expected future net cash flows into

the firm.

In the above case, the firm can be seen as facing two interrelated kinds of decisions.

First, it has to take long-run or investment decisions on the level of capacity and the

type of plant it wishes to install. Second, it has to decide upon the most profitable use of

that set of plant and equipment. These short-run capacity utilisation decisions are

essentially the same as those facing the firm maximising profits in the short-run.

If the profits made in each period are independent of each other, the single period and

multi period models will be consistent with each other. However, there is a more difficult

decision to be made in the future. In this case it is possible that shareholders‘ wealth

could be maximised by sacrificing profits in the current period. For instance, if a firm has

a monopoly position, the maximum profit possible in the current period may be very

large.

However, if the firm uses its monopoly power to make that maximum profit, other firms

may be drawn into the industry or it might draw the attention of the anti-trust authorities.

In either case, it is possible that the maximisation of shareholders‘ wealth will be better

achieved by not taking the maximum profit available in the short-run. The simple neo-

classical model of the firm does not consider such complications and is best interpreted

as being concerned with the maximisation of short-run profits or single-period profits.

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1.4.2 Costs and output

The second component of the theory of the firm concerns the nature of the firm‘s

production and the behaviour of costs. The firm is assumed to produce a single,

perfectly divisible, standardised product for which the cost of production is known with

certainty. In the short-run when some costs are fixed, the average cost curve will be U-

shaped. Costs per unit falls over a range as fixed costs are spread over a larger number

of units, but begins to rise from beyond a certain range as the principle of diminishing

returns leads to increasing variable costs per unit.

1.4.3 Demand conditions

The third component of the orthodox model of the firm is the assumption that the firm

has certain knowledge of the volume of output that can be sold at each price. These

demand conditions are considered in more detail later on. For now it is sufficient to note

that demand depends upon two sets of factors. First, it depends upon the behaviour of

consumers, which determines the total demand for the product. Second, it depends

upon the structure of the industry in which the firm is operating, and the behaviour of

rival sellers.

1.5 Equilibrium in the Profit Maximising Monopoly Model

The profit-maximising equilibrium for the firm can be identified in the form of an

equation. This follows from the assumptions of the model. The mathematical formulation

of the model can be set out as follows:

Maximise R(q)

R(q) = r(q) – C(q) where

(q) = profit

r(q) = total revenue

C(q) = total costs

q = units of output produced and sold

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Translated into words this simply means ―maximise profit where profit is equal to

revenue minus costs, and where costs and revenue depend upon the amount of output

that is sold.‖ If profit is maximised, the following conditions must hold:

Condition 1 : dR/dq = dr/dq – dC/dq = 0

or dr/dq = dC/dq

Condition 2 : d2r/dq2 > d2C/dq2

Stated in words, profit will be a maximum if the firm produces the level of output such

that marginal revenue (dr/dq) equals marginal cost (dC/dq) and when the slope of the

marginal cost curve exceeds the slope of the marginal revenue curve.

This formal presentation of the model can be expanded upon with the aid of a diagram

as in Figure 3 below.

Figure 3 Profit-Maximising Equilibrium

Source: Mohr and Fourie (2015:191)

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D is the demand curve for the product of the firm (or average revenue AR), MR is

marginal revenue, MC is marginal cost and AC is average cost. The firm is in

equilibrium where MR = MC. The profit-maximising level of output is Qe and the profit

maximising price is Pe. The decision that the firm is facing concerns the level of output

that should be produced and sold using the set of plant and equipment that has been

installed. It will pay the firm to produce any unit of output for which the extra revenue

earned (marginal revenue) exceeds the extra cost (marginal cost). At level of output Qe

all such units are being produced. If output is increased further, the additional units

produced will add more to costs than to revenues, and the profit margins will fall. At the

output level of Qe and price of Pe, AR is tangent to AC, MR = MC and AR = AC. If cost

and demand conditions remain the same, the firm has no incentive to alter its price or

output, and the firm is said to be in equilibrium.

The model presented above may be used in a number of ways. Its purpose in

mainstream economic theory is essentially to predict how a firm will respond to changes

in its environment. If some aspect of the environment changes, the model indicates the

ways in which the firm will respond in order to move to a new equilibrium. For example,

if demand increases, both price and output will increase. If costs rise, price will rise, but

output will fall. Table 2 below shows the comparative static properties of the profit-

maximising model.

In addition to these positive uses of the model, it may be used for normative purposes,

providing prescriptions for managers in certain circumstances. For instance, a direct

implication of the model is that a firm seeking maximum profit should produce every unit

of output for which the marginal revenue exceeds marginal cost. If it is not doing so,

then it is not maximising profits.

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Table 2 The Comparative Static Properties of the Profit-Maximising Model

Change

Impact of the change on:

Price Output

Demand increase Increases Increases

Demand fall Falls Falls

Increase in variable cost Increases Falls

Lump sum tax or change in fixed costs No effect No effect

Source: Davies and Lam (2001:15)

1.6 Limitations of the Theory of the Firm

Many dilemmas in present day corporate practice cannot be answered by the model

presented above, for example:

- Do managers try to optimise (seek the best result), or merely seek satisfactory

rather than optimal results?

- Are generous salaries and stock options necessary to attract and retain

managers who can keep the firm ahead of the competition?

- When a risky venture is turned down, is this inefficient risk avoidance or does it

reflect an appropriate decision from the standpoint of value maximisation?

The result of the above is the development of alternative theories of firm behaviour.

Some of the more prominent alternatives are models in which size or growth

maximisation is the assumed primary objective of management, models that argue that

managers are most concerned with their own personal utility or welfare maximisation

and models that treat the firm as a collection of individuals with widely divergent goals,

rather than as a single, identifiable unit (Hirschey and Bentzen, 2014:8). These

alternative theories or models of managerial behaviour have added to our

understanding of the firm.

However, the basic value maximisation concept cannot be replaced as a firm foundation

for understanding and analysing managerial economics. Research shows that

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managers do seek value maximisation, for example, vigorous competition typically

forces managers to seek value maximisation in their operating decisions, competition in

the capital markets forces managers to seek value maximisation in their financing

decisions, and stockholders are interested in value maximisation because it affects their

rates of return on common stock investments.

Have You Completed the ‘Essential Reading’ for this Section?

Now that you have been introduced to this section on Economics and

Managerial Economics, source and work through the textbook chapters and

journal articles listed in the “Essential Reading” list at the beginning of this section. It is

essential that you read all of the textbook chapters and journal articles listed.

QUESTIONS FOR REFLECTION

After completing your study of this introductory section, reflect on the following

questions. (To adequately address these questions you will need to have

completed all the „essential reading‟ listed at the beginning of this section.)

1. Discuss the importance and benefits of having an understanding of Economics,

to the business manager.

2. Explain what the discipline of Managerial Economics entails and how it can assist

decision makers in a business.

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SECTION 2:

Microeconomics, Macroeconomics

& the Circular Flow



able to appreciate the difference between what microeconomics entails versus what

macroeconomics entails. The student should also understand that, while these two

branches appear to be independent of each other, they do ultimately overlap and are

inextricably linked. This overall outcome will be achieved through the student‘s mastery

of the following specific outcomes, in that the student will be able to:

1. Critically evaluate the differences between microeconomics and

macroeconomics, and their application to business;

2. Ascertain the importance to a business manager of having knowledge of the

macro economy and how it can help to improve business decisions; and

3. Analyse the circular flow of production and how the coordination between

households, firms and business occurs within an economy.

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2.1 Introduction

The study of Economics is usually divided into two main branches: microeconomics

and macroeconomics.

Microeconomics

Microeconomics is described as the study of decisions that people and businesses

make regarding the allocation of resources and prices of goods and services.

Microeconomics focuses on supply and demand and other forces that determine the

price levels seen in the economy. For example, in microeconomics, the focus would be

on how a specific company could maximise its production towards becoming more

competitive. This module shall also consider how the structure of the industry, in which

a firm operates, impacts on the firm‘s long-term profitability prospects.

Macroeconomics

Macroeconomics, on the other hand, is described as the field of economics that studies

the behaviour of the economy as a whole and not merely on specific companies, but

entire industries and economies. Macroeconomics is concerned with economy-wide

phenomena, such as Gross Domestic Product (GDP) and how it is affected by changes

in unemployment, national income, rate of growth, and price levels. For example,

•prefix micro means small

•bottoms up approach to economics

•focuses on individual parts of economy

•focuses on households and firms

•includes demand, supply and prices of individual goods and services

Microeconomics

•macro means large

•top down approach to analysing economy

•concerned with economy as a whole

•macroeconomics looks at economy at the aggregate (total) level or at level of government

Macroeconomics

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macroeconomics would look at how an increase/decrease in net exports would affect a

nation's balance of trade or how GDP would be affected by the unemployment rate.

John Maynard Keynes is often credited with founding macroeconomics.

Further examples of the distinction between microeconomics and macroeconomics are

provided in Box 1. However, It is important for the student to note that, while these two

branches of economics appear to be different, they are actually interdependent and

complement one another since there are knock-on effects between the two fields. For

example, increased inflation (macro effect) would cause the price of raw materials to

increase for companies and, in turn, affect the end product's price charged to the public.

Microeconomics tries to understand human choices and resource allocation, and

macroeconomics tries to answer such questions as "What are the reasons behind the

low economic growth in the SA economy?‖

Regardless, both microeconomics and macroeconomics provide fundamental tools for

any finance professional and should be studied together in order to fully understand

how companies operate and earn revenues and, thus, how an entire economy is

managed and sustained.

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Box 1 Microeconomics verses Macroeconomics – Some Examples

In Microeconomics we study:

The price of a single product

Changes in the price of a product, like

tomatoes

The production of maize

The decisions of individual consumers

The market for individual goods like

bananas

The demand for a product like maize

An individual‘s decision whether to work or

not

A firm‘s decision whether or not to expand

its production of for example, motorcars

A firm‘s decision to export its product

A firm‘s decision to import a product from

abroad

In Macroeconomics we study:

The consumer price index

Inflation (i.e. the increase in the general

level of prices in the country)

The total output of all goods and services

in the country

The combined outcome of the decisions of

all consumers in the country

The market for all goods and services in

the economy

The total demand for all goods and

services in the economy

The total supply of labour in the economy

Changes in the total supply of goods in the

economy

The total export of goods and services in

the economy

The total import of goods and services

from other countries

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Two important questions summarize the scope of economics, namely:

i. How do choices end up determining what, how, when, where and for whom

goods and services get produced? (See Box 2)

ii. When do choices made in the pursuit of self-interest also promote the social

interest?

2.2 The Fundamental Economic Challenge

2.2.1 Choices, Trade-offs and Opportunity Costs

The economic way of thinking places scarcity and its implication of choice, at centre

stage. Due to the fact that we face scarcity, we must make choices. When we make a

choice we select from the available alternatives. You can think about every choice as a

trade-off – giving up one thing to get something else.

In making choices, we have to make decisions about the best possible choices in terms

of allocating resources efficiently and effectively. This includes incurring opportunity

costs. Thus for every decision we take, we incur opportunity costs.

The highest-valued alternative that we give up to get something is the opportunity cost

of the activity chosen. The concept of opportunity costs refers to the best option

forgone. It is simply, giving up something to gain something else. For example, as a

business manager you are constantly faced with the problem of choosing among

BOX 2: Important

questions asked in

Microeconomics

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alternative methods of production, pricing of products, and maximising profits and

minimising losses. Other decisions may relate to aspects of budgeting, human

resources, and a range of other firm activities. Understanding economics and employing

economic tools can help one solve many business problems. The economic principals

of scarcity, choice and opportunity cost are captured in the production possibilities

curve.

2.2.2 The Production Possibility Frontier

The production possibility curve shows the maximum amount of production that can

be produced by an economy with a given amount of resources. If we want to

increase our production of one good, we must decrease our production of something

else – we face trade-offs. The production possibilities frontier (PPF) is the boundary

between those combinations of goods and services that can be produced and those that

cannot, that is, it is the limit to what we can produce.

To illustrate the PPF, we focus on two goods and hold the quantities of all other goods

constant.

In other words, we look at a model economy in which everything remains the same

(ceteris paribus) except the two goods we‗re considering. Consider an isolated rural

community along the Wild Coast whose main foods are potatoes and fish. The people

have found that by devoting all their available time and other resources to fishing, they

can produce 5 baskets of fish per working day. On the other hand, if they spend all their

production time gardening, they can produce 100 kilograms (kg) of potatoes per working

day. The only way that the inhabitants can enjoy a diet which includes both fish and

potatoes is by using some of their resources for fish production, and some for potato

production. Therefore, resources must be shifted from one production possibility to

produce the other.

The different alternatives can be illustrated graphically in a production possibilities

curve as in Figure 4. The curve shows the possible levels of output in an economy with

limited resources and fixed production techniques. As we move along the production

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possibilities curve from point A to point B through to point F, the production of fish

increases while the production of potatoes decreases. To produce the first basket of fish

the community has to sacrifice 5 kg of potatoes (from 100 to 95). To produce the

second basket of fish the sacrifice is an additional 10 kg of potatoes (the difference

between 95 and 85). To produce the third basket of fish an additional 15 kg of potatoes

have to be forgone (the difference between 85 and 70). The opportunity cost of each

additional basket of fish therefore increases as we move along the production

possibilities curve. This is why the curve bulges outwards from the origin.

Figure 4 The Production Possibility Frontier Illustrating Different Combinations of

the Production of Two Goods

Source: Mohr and Fourie (2013: 6)

All points to the right of the curve, such as G are unattainable. G is unattainable due to:

Scarcity – a lack of resources to achieve that level of production. Points within the

frontier are attainable but inefficient. All points along the frontier, (from A to F) are

attainable and efficient.

Choice is illustrated by the need to choose among the available combinations along the

curve. Opportunity cost is illustrated by what we refer to as the negative slope of the

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curve, which means that more of one good can be obtained only by sacrificing the other

good. Opportunity cost therefore involves a trade-off between the two goods.

2.2.3 Further applications of the production possibilities curve

We have seen that resources are limited and that choices have to be made. We

illustrated the problems of scarcity, choice and opportunity cost by using a production

possibilities curve, sometimes also called the production opportunity curve. Points A,

B, C, D, E and F on the production possibilities curve in Figure 4 illustrated attainable

and efficient combinations of potatoes and fish. Point G, beyond the curve, illustrated an

unattainable combination and point H, inside the curve, illustrated an attainable but

inefficient combination. The bulging shape of the curve also illustrated increasing

opportunity costs: as we move along the curve more of the one good has to be

sacrificed to obtain an extra unit of the other good. With a given level of resources and a

given state of technology, the community can produce different combinations of

potatoes and fish. But it cannot move beyond ABCDEF (or AF for short). That is why the

curve is sometimes also called the production possibility boundary or frontier. It

indicates the maximum attainable combinations of the two goods, also called the

potential output.

In any economic system, the first challenge is to produce one of the maximum

attainable combinations of goods and services. In other words, the scarce resources

should be used fully and as efficiently as possible. This occurs when it is impossible to

produce more of the one good without sacrificing some production of the other good. On

the production possibilities curve actual output is equal to potential output.

The community would, of course, have preferred a combination beyond the production

possibilities curve or frontier, such as G in Figure 4. Point G indicates a combination of

85 kg of potatoes and four baskets of fish. But any point beyond the curve is

unattainable.

Given the available resources and the current production techniques, a

combination such as that indicated by G is impossible. However, the quantity of

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available resources may increase and/or production techniques may improve over time.

If this happens, it can be illustrated by a production possibilities curve that shifts

outwards. Such an outward movement illustrates economic growth. To explain this, we

use a production possibilities curve which illustrates the production of consumer goods

and capital goods, the two broad types of goods produced in the economy. See Box 3,

which indicates the different types of goods and services in the economy. The potential

production of consumer goods and capital goods can be increased in a number of

possible ways.

If an improved technique for producing capital goods is developed, it will be possible to

produce more capital goods with the available factors of production. The original

production possibilities curve is illustrated in Figure 5 as AB.

Figure 5 Improved Technique for Producing Capital Goods

Source: Mohr and Fourie (2013: 9)

If we assume that the available factors of production and the technique for producing

consumer goods remain the same, the maximum potential production of consumer

goods remains at A. But the maximum potential output of capital goods (if all available

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resources are used to produce capital goods) increases from B to C. The new

production possibilities curve is thus indicated by AC. Except at point A, it is now

possible to produce more capital goods and more consumer goods than before. For

example, at point Y more of both types of goods are produced than at point X.

Similarly, if a new technique for producing consumer goods is developed, while the

available resources and the technique for producing capital goods remain the same, the

maximum potential output of consumer goods will increase. This is illustrated in Figure

6. The original production possibilities curve is again indicated as AB. But this time the

maximum potential output of consumer goods increases (from A to D), while the

maximum potential output of capital goods remains unchanged (at B). Again, the

production possibilities curve swivels, but this time on point B rather than on point A.

Except at point B, it is now possible to produce more consumer goods and capital

goods than before.

Figure 6 Improved Technique for Producing Consumer Goods

Source: Mohr and Fourie; 2013; 10

If the amount of available resources (e.g. the number of workers) and/or the productivity

of the available resources increase, it will be possible to produce more consumer goods

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and more capital goods than before. This can be illustrated by a shift of the original

production possibilities curve (AB) to the right (to EF) as in Figure 7.

Figure 7 Increase in the Quantity or Productivity of the Available Resources

Source: Mohr and Fourie (2013:10)

Figures 5, 6 and 7 all illustrate economic growth. The amount of resources or their

productivity (or efficiency) can, of course, also decrease, resulting in a decline in

potential output. This can be illustrated by inward shifts of the production possibilities

curve (i.e. a reversal of the shifts illustrated in Figures 5, 6 and 7).

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BOX 3: GOODS AND SERVICES

The purpose of economic activity is to satisfy human wants. Humans have different types of wants, including material wants and

spiritual wants. Most wants are satisfied by goods and services. Goods are tangible objects like food, clothing, houses, books and

motorcars. Services are intangible things like medical services, legal services, financial services, the services of an economics lecturer

and the services provided by public servants. Because much of economics is concerned with the production and distribution of goods

and services, it is often necessary to refer to the term ―goods and services‖. For the sake of convenience, however, we frequently refer

to ―goods‖ only when we really mean ―goods and services‖. We now look at different types of goods.

Consumer goods and capital goods

Consumer goods are goods that are used or consumed by individuals or households (i.e. consumers) to satisfy wants. Examples

include food, wine, clothing, shoes, furniture, household appliances and motorcars.

Capital goods are goods that are not consumed in this way but are used in the production of other goods. Examples include all types

of machinery, plant and equipment used in manufacturing and construction, school buildings, university residences, roads, dams and

bridges. Capital goods do not themselves yield direct consumer satisfaction, but they permit more production and satisfaction in future.

Choosing between producing consumer goods and producing capital goods therefore means making a choice between present and

future consumption. However, like all other goods, capital goods have a limited lifetime. They are subject to wear and tear and may

also become obsolete. Their value therefore depreciates over time. Capital goods are an important factor of production.

Different categories of consumer goods

Consumer goods can be classified into three groups: non-durable, semi-durable and durable.

• Non-durable goods are goods that are used once only. Examples are food, wine, tobacco, petrol and medicine.

• Semi-durable goods can be used more than once and usually last for a limited period. Examples are clothing, shoes, sheets and

blankets and motorcar tyres.

• Durable goods normally last for a number of years. Examples are furniture, refrigerators, washing machines, dishwashers and

motorcars.

Final goods and intermediate goods

Final goods are the goods that are used or consumed by individuals, households and firms. A loaf of bread consumed by a household,

for example, is a final good. Intermediate goods, on the other hand, are goods that are purchased to be used as inputs in producing

other goods. Intermediate goods are thus processed further before they are sold to end users. Flour used by a baker is an intermediate

good. The baker does not consume it. The flour is processed into bread, cake or something else. However, when a household

purchases flour it is a final good since the purpose is to consume it in some form or another. Private goods and public goods A

private good is a good that is consumed by individuals or households. All typical consumer goods (like food, clothes, furniture and

motorcars) are private goods. The distinguishing feature of private goods is that consumption by others can be excluded. A public

good, on the other hand, is a good that is used by the community or society at large. Consumption by individuals cannot be excluded.

A traffic light, for example, is a public good. Other examples of public goods are national defence and weather forecasts.

Economic goods and free goods An economic good is a good that is produced at a cost from scarce resources. Economic goods

are therefore also called scarce goods. As one would expect, most goods are economic goods. A free good is a good that is not

scarce and therefore has no price. Air, sunshine and sea water at the coast are usually regarded as free goods. Nowadays, however,

air and sea water are often polluted, with the result that clean air and sea water are not always freely available. Some people regard all

the gifts of nature as free goods, since they are not produced by humans. But in many instances it requires effort and cost to make

them useful to humans. Minerals have to be mined and even water has to be stored and piped, often at great expense.

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2.3 Circular Flow Model of the Economy

According to Mohr (2012:9), the Circular Flow diagram shows the flow of goods and

services between households and firms. Households sell their factors of production

such as land, labour and capital to the factor market. Firms transform these factors into

goods and services which are then sold to households in the goods markets.

The construct below provides a simplified diagram of the flows in an economy:

Figure 8.1 Circular flow of the economy


The circular flow model illustrates how an economy operates, identifies key economic

participants, and highlights the interrelationships between them. To understand the

circular flow model of income, output and spending the relevant economic sectors will

first be identified, as well as markets and flows in the economy, namely, production,

income and spending. The economic sectors are households, government, financial

and foreign sectors.

http://commons.wikimedia.org/wiki/File:Circular_flow_of_goods_income.png

https://www.boundless.com/economics/textbooks/boundless-economics-textbook/the-market-system-2/introducing-the-market-system-45/the-circular-flow-model-168-12266/images/circular-flow-of-goods-income/

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Figure 8.2 Interaction of firms and households

Source: Mohr (2012:9)

In the above diagram, households are buyers and firms are producers and sellers of

goods and services within the goods and services market. Furthermore, firms are

buyers of factors of production and households, in turn, sell factors of production (such

as land, labour and capital) in the factor market.

There are four main factors of production: natural resources (or land), labour, capital

and entrepreneurship. Natural resources and labour are sometimes called primary

factors of production, while capital and entrepreneurship are called secondary factors.

Another possible distinction is between human resources (labour and

entrepreneurship) and non-human resources (natural resources and capital).

Natural resources (land)

Natural resources (sometimes called land) consists of all the gifts of nature. They

include mineral deposits, water, arable land, vegetation, natural forests, marine

resources, other animal life, the atmosphere and even sunshine. Natural resources are

fixed in supply. Their availability cannot be increased if we want more of them. It is,

however, often possible to exploit more of the available resources. For example, new

mineral deposits are still being discovered and exploited every year. But once they are

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used, they cannot be replaced. We therefore refer to minerals as non-renewable or

exhaustible assets.

As with all other factors of production, both the quality and the quantity of natural

resources are important. Some countries cover a vast area but the land is of limited

value. A desert, for example, has little or no agricultural value. But it may contain

valuable mineral deposits. Some countries have a relatively small geographical area but

a plentiful supply of arable land and minerals. The situation can also vary within a

country. For example, in South Africa there are large areas with little or no agricultural

or mineral value. But there are also areas that are rich in minerals or arable land.

Because natural resources are in fixed supply, the rate at which they are exploited is

often a cause of concern. Nowadays environmentalists are extremely concerned about

pollution and the destruction of natural resources such as the rain forests.

Labour

Goods and services cannot be produced without human effort. Labour can be defined

as the exercise of human mental and physical effort in the production of goods and

services. It includes all human effort exerted with a view to obtaining reward in the form

of income. The efforts of gold miners, rubbish collectors, professional boxers, civil

servants, engineers and university lecturers are all classified as labour. In modern

societies there is a high degree of specialisation of labour.

The quantity of labour depends on the size of the population and the proportion of the

population that is able and willing to work. The latter, in turn, depends on factors such

as the age and gender distribution of the population. The proportion of children, women

and elderly people all affect the available quantity of labour, which is called the labour

force. The quality of labour is even more important than the quantity of labour. The

quality of labour is usually described by the term human capital, which refers to the

skill, knowledge and health of the workers. Education, training and experience are all

important determinants of human capital. Firms or the business sector of the economy

are composed of private sector organisations which produce goods and services for

individuals who are willing to pay a price for them. These businesses may be

corporations, partnerships or sole proprietorships.

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Capital

Capital comprises all manufactured resources, such as machines, tools and buildings,

which are used in the production of other goods and services. Capital goods are not

produced for their own sake but to produce other goods. Capital can be a confusing

concept, particularly because it is often used in a financial or monetary sense.

Business people, bankers and accountants all have their own definition of capital. Even

in economics the term sometimes has a financial connotation. It is important to

remember, however, that when we talk about capital as a factor of production, we are

referring to all those tangible things that are used to produce other things.

To produce capital goods, current (i.e. present) consumption has to be sacrificed in

favour of future consumption. The more capital goods that are produced in a particular

period, the fewer the number of consumer goods that will be produced in that period,

but the greater the production capacity will be in future. On the other hand, if all current

resources are used for producing consumer goods, the future means of production will

be fewer.

Like all other goods, capital goods do not have an unlimited life. Machinery, plant,

equipment, buildings, dams, bridges and roads are all subject to wear and tear.

Equipment can also become out-dated or obsolete because of technological progress.

For example, huge mainframe computers installed a decade or two ago have been

replaced by much smaller, cheaper and more efficient personal computers. Provision

therefore has to be made for the replacement of existing capital goods. This is called

the provision for depreciation (or depreciation allowance).

Entrepreneurship

The availability of natural resources, labour and capital is not sufficient to ensure

economic success. These factors of production have to be combined and organised by

people who see opportunities and are willing to take risks by producing goods in the

expectation that they will be sold. These people are called entrepreneurs. The

entrepreneur is the driving force behind production. Entrepreneurs are the initiators, the

people who take the initiative. They are also the innovators, the people who introduce

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new products and new techniques on a commercial basis. And they are the risk-

bearers, the people who take chances. They do this because they anticipate that they

will make profits. But they may also suffer losses and perhaps bankruptcy.

The entrepreneur is more than a manager. The entrepreneur is dynamic, a restless

spirit, an ideas person, a person of action who has the ability to inspire others.

Because entrepreneurship is such an important factor of production, a lot of research

has been done to identify the characteristics of successful entrepreneurs. What drives

an entrepreneur? What differentiates entrepreneurs from other human beings?

Unfortunately there are no simple answers. There is, for example, still a lively debate on

the question of whether entrepreneurial talent comes naturally or whether it can be

acquired (e.g. through appropriate training). All that can be stated with certainty is that

entrepreneurship is an important economic force. In countries where entrepreneurship

is lacking, the government is sometimes forced to act as entrepreneurs in an attempt to

stimulate economic development.

Technology

Technology is sometimes identified as a fifth factor of production. At any given time, a

society has a certain amount of knowledge about the ways in which goods can be

produced. When new knowledge is discovered and put into practice, more goods and

services can be produced with a given amount of natural resources, labour, capital and

entrepreneurship. If this happens we say that technology has improved. The discovery

of new knowledge is called invention, while the incorporation of this knowledge into

actual production techniques and products is called innovation. The wheel, the steam

engine and the modern computer are all examples of important inventions. For these

inventions to be used in actual production, new machines (i.e. capital goods) have to be

developed. In other words, the inventions have to be embodied in capital. The

application of inventions also requires entrepreneurs to identify the opportunities and

exploit them. Thus, while technology is important, it can be argued that it forms part of

capital and entrepreneurship. For the purposes of this module, we therefore do not deal

with it as a separate factor of production.

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Figure 9 The Circular Flow of Income


Another important participant is the government. The government is responsible for the

production of public goods and services, such as infrastructure like roads, ports, etc., for

use by firms and households.

Government taxes both households and firms to raise money for subsidies which it

provides to households, e.g., social grants as well as infrastructure required by

business.

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Figure 10 The Participation of Government



After completing your study of this section reflect on the following questions.

(To adequately address these questions you will need to have completed all

the „essential reading‟ listed at the beginning of this section.)

1. Illustrate and explain the circular flow diagram, by explaining the roles of each of

the participants (also known as economic actors) in the economy.

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2. Why do you think the ‗government‘ is placed at the centre of the circular flow

diagram?

3. Give an example of an economic problem involving opportunity cost that the

South African government is currently facing. Use the PPF to illustrate this

problem,

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SECTION 3:

Demand, Supply & Elasticity



able to demonstrate an understanding of demand and factors which influence demand.

This overall outcome will be achieved through the student‘s mastery of the following

specific outcomes, in that the student will be able to:

1. Evaluate the law of demand and its implication for business managers (on

pricing decisions);

2. Critically assess the determinants of demand;

3. Distinguish between demand and change in quantity demanded;

4. Be able to apply the concept of demand to pricing decisions in a firm; and

5. Analyse the concepts of price elasticity and income elasticity and their

applications by the business manager.

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ESSENTIAL READING



Textbooks:

Keating, B. and Wilson, J. 2009. Managerial Economics (2nd ed). Atomic Dog

Publishers. USA. (Chapter 2 and 5)

Mohr, P. and Fourie, L. 2008. Economics for South African Students (4th ed).

Pretoria. Van Schaik.

Mohr, P. 2012. Understanding Macroeconomics. Cape Town. Van Schaik.

Schiller, B.R., Hill, C.D. and Wall, S.L. (2013) The Economy Today 13th

Edition, Boston: McGraw Hill. Chapter 22: The Competitive Firm.

Schiller, B.R., Hill, C.D., Wall, S.L., (2013) The Economy Today 13th Edition,

Boston: McGraw Hill. Chapters 23 - 26.

Janse Van Rensburg, J.J., McConnell, C., Brue, S., (2011) Economics

Southern African Edition Boston: McGraw Hill.Chapter 7: Pure Competition

and Pure Monopoly


Southern African Edition Boston: McGraw Hill.Chapter 8: Monopolistic

Competition and Oligopoly).


World Economic Forum. 2014. The Global Competitiveness Report 2014–

2015.Available at:

www.weforum.org/reports/global-competitiveness-report-2014-2015

World Bank. 2015. Doing Business in South Africa, 2015. Available at

http://www.doingbusiness.org/~/media/GIAWB/Doing%20Business/Document Date of

Access: 6 October 2015.

South African Reserve Bank Quarterly Bulletin, (2012), South African Reserve Bank,

December, No 266outh African Reserve Bank Quarterly Bulletin, (2011), South African

Reserve Bank, December, No 262.

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3.1 Introduction

The economic environment in which business operates is becoming increasingly

complex and dynamic. Forces external to the firm impact on nearly every decision taken

by managers. Business decisions are taken within the context of governmental/political

influences, as well as labour unions (which play an important role particularly in the

South African context). This chapter will discuss the foundation of Economics by

discussing demand and supply, which will later be expanded upon.

3.2 The concept of demand: The core of business activity

The term demand in the economics context refers to the quantity of a good or service

that consumers are willing to purchase at various prices in a given time period. For

demand to be effective, a consumer must be willing to make the purchase. There are

many products that one can afford, (i.e. have the ability to buy them), but for which one

may not be willing to spend one‘s income. If the consumption of a good or service is not

expected to bring a consumer additional satisfaction, the consumer will not be willing to

purchase that good or service. Demand refers to purchases made during a given period

of time.

For example, a consumer may have a weekly demand for chocolates. However, a

consumer‘s demand for shoes may better be described on a yearly basis. In other

words, when we refer to a consumer‘s demand for a product, we usually mean the

demand over some appropriate time period.

More formally, the law of demand states that:

―Consumers are willing and able to purchase more units of a good or service at lower

prices than at higher prices (other things being equal). Therefore, the demand curve can

be said to be negatively sloping or downward sloping‖ (Keating and Wilson, 2009).

The question that arises is why is there an inverse relationship between price and

quantity demanded? Three possibilities explain this inverse relationship, namely:

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1. The law of demand is consistent with common sense or rational behaviour.

People do buy more of a product at a low price than at a high price. Price is an

obstacle that deters consumers from buying. The higher that obstacle, the less of

a product they will buy and vice versa. The fact that businesses have sales is

evidence of their belief in the law of demand (van Rensburg et al, 2011: 52)

2. In any specific time period, each buyer of a product will derive less satisfaction

(or benefit or utility), from each successive unit of the product consumed, for

example, a second burger will yield less satisfaction than the first and a third

burger will yield even lesser satisfaction than the second. In other words,

consumption is subject to diminishing marginal utility and as successive units of a

particular product yield less and less marginal utility, consumers will only

purchase additional units if the price of those units is progressively reduced.

3. The law of demand can also be explained in terms of the income and substitution

effects. The income effect indicates that a lower price increases the purchasing

power of a buyer‘s income, enabling the buyer to purchase more of the product

than before. A higher price has the opposite effect. The substitution effect

suggests that the lower price buyers have the incentive to substitute what is now

a less expensive product for similar products that are now relatively more

expensive. The price of the product that has fallen is now a better deal relative to

the other products, for example, a decline in the price of chicken will increase the

purchasing power of consumer incomes, enabling people to buy more chicken

(the income effect). At a lower price, chicken is relatively more attractive and

consumers tend to substitute it for lamb, beef or fish (the substitute effect). The

income and substitute effects combine to make consumers willing to buy more of

a product at a low price than at a high price.

Consider the information in 12 below:

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Table 3 Price of Coffee

Price of a cup of

coffee

Quantity

demanded

$0 24

$1 20

$2 16

$3 12

$4 8

$5 4

$6 0


Figure 11 Demand Curve


High price, low quantity demanded

Low price, high quantity demanded

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The above (Figure 11 Demand Curve) indicates the demand curve. It shows that as the

price of good (e.g. coffee) declines, the quantity demanded increases.

3.3 Determinants of demand

Numerous forces influence decisions regarding the choice of goods and services a

consumer purchases. It is important for managers to understand these factors in order

to assess their impact on a firm‘s long-term growth

3.3.1 Product price as a determinant of demand

As mentioned above, one of the major factors which influences demand for a product is

the price. In this regard, this is one of the first considerations of a business manager.

3.3.2 Income as a determinant of demand

A change in consumer income will lead to a change in demand. Graphically, this is

illustrated by a shift of the demand curve. An increase in income will normally lead to

an increase in demand, while a fall in income will result in a decrease in demand. The

demand curve will thus shift to the right when income increases and to the left

when income decreases. When this happens, the good is called a normal good.

In some exceptional cases, demand decreases when income increases. When this

happens, the goods in question are called inferior goods. Poor consumers may, for

example, reduce their consumption of bread when their income increases. This will

happen when the increase in income enables them to switch to other, more expensive,

foodstuffs such as meat. Note that the adjective ―inferior‖ does not refer to any physical

attribute of the good concerned. It merely indicates that demand increases as income

decreases, or decreases as income increases.

3.3.3 Tastes and preferences

When consumers‘ tastes or preferences change, demand changes. For example, if

doctors discovered that the acidity of tomatoes can cause serious health problems, the

demand for tomatoes would fall. In other words, the demand curve would shift to the

left, ceteris paribus. Similarly, if doctors discovered that tomatoes contain substances

that are good for one‘s health, demand would increase, that is, the demand curve would

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shift to the right, ceteris paribus. Advertising and fashion can also change consumers‘

tastes or preferences. Any change in taste or preference will be illustrated by a shift of

the demand curve.

3.3.4 Prices of other goods

The quantity of tomatoes that consumers or households plan to buy does not depend

only on the price of tomatoes. It also depends on the prices of related goods. As

mentioned earlier, these related goods fall into two categories: substitutes and

complements.

Substitutes

A substitute is a good that can be used in place of another good to satisfy a certain

want. Examples include butter and margarine, beef and mutton, tea and coffee, apples

and pears, bus trips and train trips, hamburgers and hot dogs. An increase in the price

of a substitute will cause an increase in the demand for the product in question, ceteris

paribus. To illustrate the point, we examine an example of two goods that are generally

accepted as being substitutes, namely butter and margarine. An increase in the price of

butter will increase the demand for margarine, ceteris paribus. If the price of butter

increases, a greater quantity of margarine will be demanded at each price of

margarine than before. If the price of butter increases, the demand curve for

margarine will therefore shift to the right. This is called an increase in demand.

This is shown in Figure 12, which depicts the market for margarine. The original

demand for margarine is illustrated by DmDm. If the price of butter increases, more

margarine will be demanded at each price of margarine than before. This is illustrated

by a rightward shift of the demand curve for margarine to D'mD'm. An increase in the

price of a substitute (butter), will thus lead to a rightward shift of the demand

curve for the product concerned (margarine). Similarly, a decrease in the price of a

substitute will lead to a decrease in the demand for the good concerned, illustrated

by a leftward shift of the demand curve. If the price of butter should fall, fewer

kilograms of margarine will be demanded than before at each price of margarine,

ceteris paribus. The demand for margarine will therefore decrease.

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Figure 12 Two substitutes: butter and margarine

Source: Mohr and Fourie, 2013: 67

Complements

Complements are goods that tend to be used jointly to satisfy a want. Examples include

fish and chips, ―pap en vleis‖, motorcars and petrol, coffee and milk, tea and sugar,

spaghetti and meatballs, golf clubs and golf balls, compact discs (CDs) and CD players,

tomatoes and onions, tomatoes and lettuce. If the price of the complement good

changes as a result of a change in supply, the demand for the good will also change.

For example, the fact that compact discs are used with CD players means that a

change in the price of CD players will affect the demand for CDs.

This is illustrated in Figure 13, which shows the market for CDs. The original demand

for CDs is illustrated by DcDc. If the price of CD players decreases, more CD players

will be demanded than before and more CDs will also be demanded than before (at

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each price of CDs). The increase in the demand for CDs is illustrated by a rightward

shift of the demand curve to D'cD'c. A decrease in the price of a complementary

product (CD players) increases the demand for the product concerned (CDs) and this is

illustrated by a rightward shift of the demand curve. Similarly, an increase in the price

of the complement (CD players) as a result of a change in supply, will lead to a

decrease in the demand for the product (CDs). In this case the demand curve for

CDs will shift to the left.

Figure 13 Two complements: CD players and CDs

Source: Mohr and Fourie, 2013: 67

3.3.5 A change in population

Demand also depends on the size of the population served by the market in question.

Other things being equal, the larger the population, the greater will be the demand for

the product, and the smaller the population, the smaller will be the demand for the

product. An increase in the population will thus shift the demand curve to the right,

ceteris paribus.

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3.3.6 Other influences on demand

A change in expected future prices

One important influence on economic decisions which we have not yet introduced, is

expectations. A change in consumers‘ expectations in respect to any of the

determinants of the quantity demanded can cause a change in demand. For example,

expected price changes can cause a change in current demand. If the price of a good is

expected to fall, ceteris paribus, consumers will tend to reduce their current demand,

preferring to wait and buy more at a later stage, at a lower price. Similarly, expected

price increases can cause an increase in demand, ceteris paribus. Sometimes price

increases are announced in advance, for example the monthly adjustment in petrol

prices. If a price increase is announced, the demand for petrol rises sharply before the

actual price increase. Likewise, if a price decrease is announced, consumers will tend to

delay their purchase until after the price decrease comes into effect.

The ceteris paribus condition is extremely important in this case. During inflation all

prices tend to increase. What we are dealing with here, however, is an expected

increase in the price of one good only. Put differently, we are dealing with a situation in

which the relative price of the good is expected to change, not only the absolute price.

The distribution of income

Demand may also change if a constant total income is redistributed among the different

households in the economy. For example, if income is redistributed from high-income

households to low-income households, the demand for goods bought mostly by low-

income households will increase, while the demand for goods purchased mostly by

high-income families will decrease, ceteris paribus. The distribution of income is an

important determinant of the composition or structure of demand in a market economy,

since only money votes count in the market.

From the above it can be generally stated that the quantity of a good demanded by an

individual (or household) in a particular period depends on (or is a function of) the price

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of the good, the prices of related goods, the income of the individual (or household),

taste, the number of people in the household and any other possible influence.

Expressed in symbols, the quantity of a good demanded can be represented as follows:

Let: Qd = quantity of tomatoes demanded in a particular period

Px = price of tomatoes

Pg = prices of related goods

Y = household‘s income during the period

T = taste of the consumer(s) concerned

N = number of people in household concerned

…= allowance for other possible influences

Given these symbols, we can express the individual‘s demand for a good or service as

follow:

Qd = f(Px, Pg, Y, T, N,).................................. (i)

In Equation (i) the dependent variable (Qd) is expressed as a function of five

independent variables. However, the most important determinant of the quantity

demanded of a particular good is probably its price. In terms of Equation (i), the focus is

on the relationship between Qd and Px.

3.3 7 Change in demand vs. a change in quantity demanded

The terms change in demand and change in quantity demanded refer to different

effects. The former refers to a movement along the demand curve, while the latter refers

to an actual shift in the demand curve. See Figure 14

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(a)

Figure 14 Movement along a demand curve and shift of a demand curve

Source: Mohr & Fourie (2008)

In the figure above, panel (a) refers to a change in demand or a movement along the

demand curve. Note the price can either increase or decrease and there will be an

associated change in quantity.

Movements along a demand curve are always associated with a change in price.

Panel (b) refers to a Shift in demand. In the diagram, one can see the demand curve

actually shifting to a new location from its original position.

Shifts in demand are caused by factors such as those mentioned in the section above,

e.g., tastes and preferences, prices of substitutes, etc.

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3.4 Elasticity: Measuring the sensitivity of quantity demanded

The term elasticity can be thought of as meaning ‗responsiveness‘, i.e., how responsive

is one variable to a change in another variable. For a business manager it is important

to understand how changes in the price of a good will affect the quantity demanded.

3.4.1 Price elasticity of demand

Elasticity is calculated as:

E = %change in Quantity demanded / % change in Price

There are five main categories of price elasticity of demand, as follows:

Perfectly inelastic demand (ep = 0)

Inelastic demand (ep lies between 0 and 1)

Unitarily elastic demand or unitary elasticity of demand (ep = 1)

Elastic demand (ep lies between 1 and ∞)

Perfectly elastic demand (ep = ∞)

These five categories are illustrated in Figure 15.

3.4.2 Perfectly inelastic demand

Perfectly inelastic demand refers to a situation where the price elasticity of demand is

zero. A perfectly inelastic demand curve is represented by a vertical line parallel to the

price axis, such as DD in Figure 15(a). This shows that consumers plan to purchase a

fixed amount of the product, irrespective of its price. If the demand for a product is

perfectly inelastic, the producers can raise their revenue by raising the price of the

product. Producers‘ total revenue TR is equal to the price of the product P times the

quantity sold Q (ie TR = P × Q). When P increases and Q remains constant, TR

increases.

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3.4.3 Inelastic demand

Demand is said to be inelastic when the quantity demanded changes in response to a

change in price, but the percentage change in the quantity is less than the percentage

change in the price of the product. The value of the price elasticity of demand, or the

elasticity coefficient, is thus greater than zero but smaller than one. In contrast to

the case of perfect inelasticity, we cannot draw a linear demand curve (i.e. a straight

line) which represents inelastic demand all along the curve. As explained earlier, the

elasticity coefficient varies from point to point along any downward-sloping linear

demand curve. Nevertheless, we use a steep curve, such as the one in Figure 15 (b), to

approximate an inelastic demand. If producers are faced with an inelastic demand for

their product, they will have an incentive to raise the price of the product, since the

percentage fall in the quantity demanded Q will be smaller than the percentage increase

in the price P of the product. In other words, if the price of the product increases, the

producers‘ total revenue TR (= P × Q) will increase. By the same token there will be no

incentive for the producers to drop the price of the product, since the increase in the

quantity demanded will be proportionally smaller than the percentage decrease in

the price, that is, their total revenue TR (= P × Q) will decrease.

3.4.4 Unitarily elastic demand (unitary elasticity)

Unitary elasticity occurs when the percentage change in the quantity demanded is

exactly equal to the percentage change in price. The elasticity coefficient is thus equal

to one. Unitary elasticity is the dividing line between inelastic and elastic demand. It

cannot be represented by a straight line demand curve, but those of you with a

mathematical background will realise that a unitarily elastic demand curve can be

represented by a rectangular hyperbola, as in Figure 15(c).

If producers are faced with a unitarily elastic demand curve, they cannot raise their total

revenue by decreasing or increasing the price of the product. In both cases, the

percentage change in the price will be exactly offset by a corresponding percentage

change in the quantity demanded (in the opposite direction to the change in price). TR

(= P × Q) will therefore remain unchanged.

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3.4.5 Elastic demand

Demand is said to be elastic when a price change leads to a proportionally greater

change in the quantity demanded, that is, when the elasticity coefficient is greater than

one. An elastic demand curve cannot be represented by a unique downward-sloping

linear demand curve, since the elasticity coefficient varies along such a curve.

Nevertheless we use a relatively flat demand curve, such as the one in Figure 15(d), to

represent an elastic demand curve (bearing in mind that it is not fully accurate).

If producers are faced with an elastic demand for their product, they can increase their

total revenue by lowering the price of the product. When the price of the product P

decreases there will be a proportionally greater increase in the quantity demanded Q.

Total revenue TR (= P × Q) will thus increase. An increase in total revenue should not,

however, be confused with an increase in total profit. The impact on profit will also

depend on the change in total cost. When faced with an elastic demand, producers will

have no incentive to raise their prices, since the resulting decrease in the quantity

demanded will be proportionally greater than the increase in the price of the product, so

total revenue will fall.

3.4.6 Perfectly elastic demand

A perfectly elastic demand curve has an elasticity coefficient of infinity and is depicted

by a horizontal line, as in Figure 15e. This curve shows that consumers are willing to

purchase any quantity at a certain price (P1), but if the price is raised only fractionally,

the quantity demanded falls to zero.

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Figure 15 The Different Cases of Price Elasticity of Demand

Source: Mohr and Fourie, 2013:111

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Price elasticity of demand is a useful tool because it can be used to show how much

total expenditure by consumers on a product will change should the price of the

product change. Furthermore, total expenditure by consumers is also the total revenue

of the firms who produce that product. Due to its usefulness in analyzing the responses

of both consumers and producers to situations in the market, price elasticity of demand

serves as a useful tool in decision making.

The focus of this section will be on the usefulness of price elasticity of demand with

respect to total revenue. The total revenue (TR) that suppliers obtain from the sales of a

good or service is calculated by multiplying the price of the product (P) by the quantity of

the product sold (Q). Total revenue (TR) is, therefore, P x Q or PQ. Should a producer

decide to change the price of the product, then the effect on total revenue will depend

on the relative sizes of the change in price and the change in quantity demanded, i.e.,

the size of the price change with respect to the size of the change in quantity supplied.

Remember, price and quantity demanded move in the opposite direction.

So, how exactly do changes in the relative sizes of price (P) and quantity supplied (Q)

affect total revenue (TR)?

In the case where a change in the price of a product leads to a proportionately larger

change in the quantity demanded (i.e., if we change the price of the product by 10% and

the result is that quantity demanded changes by 20%, in the opposite direction of

course), then the price elasticity of demand is greater than one or ep>1 and, as such,

the total revenue will change in the opposite direction to the price change (i.e., decrease

price = increase total revenue).

Remember, total revenue is calculated as TR = PQ. (total revenue = price x quantity) So

long as the price elasticity of demand is greater than 1 (ep>1), total revenue will

increase as the quantity sold (Q) increases.

In the case where the change in price leads to an equi-proportional change in the

quantity demanded (i.e., if we change the price of the product by 10% and the result is

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that quantity demanded changes by 10% as well, in the opposite direction, of course),

then the ep = 1 and total revenue will remain unchanged. In the case where the price

elasticity of demand is equal to one (ep = 1), the total revenue (TR) of the firm has

reached its maximum.

In the case where a change in the price of the product leads to a proportionately smaller

change in the quantity demanded (i.e., if we change the price of the product by 10% and

the result is that quantity demanded changes by 5%, in the opposite direction, of

course), then ep < 1 and total revenue will change in the same direction as the price

(i.e., raise the price = raise the total revenue). If the price elasticity of demand is less

than one (ep < 1), then total revenue (TR) will fall as the quantity sold (Q) increases

(Mohr and Fourie, 2008: 158-159).

3.4.7 Determinants of the price elasticity of demand

We have now defined the price elasticity of demand, shown how it is related to total

revenue and identified five different categories of price elasticity of demand. But what

are the determinants of the price elasticity of demand? Why are certain goods

characterised by an inelastic demand while other goods have an elastic demand? What

types of goods and services tend to have elastic demands and which tend to have

inelastic demands? We now discuss some of the determinants of price elasticity and

give some practical examples. In discussing each determinant we have to assume once

more that all other things remain unchanged (i.e. we have to make the ceteris paribus

assumption). In practice, however, all things can change. This means that the impact of

one determinant can be neutralised by another determinant which works in the opposite

direction. Moreover, different consumers or groups of consumers (e.g. poor and rich

consumers) may respond differently to price changes. Therefore, in deciding whether

the demand for a particular good or service will tend to be elastic or inelastic, all

relevant information must be considered (i.e. all the possible determinants have to be

taken into account).

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3.4.7.1 Substitution possibilities

The availability of substitutes is undoubtedly the most important determinant of

consumers‘ reactions to a price change. The larger the number of substitutes and the

closer (or better) the substitutes are, the greater is the price elasticity of demand, ceteris

paribus. Goods and services with good substitutes (shown here in brackets) include

beef (mutton), butter (margarine), taxi services (bus services, train services),

hamburgers (hot dogs) and apples (pears). These goods and services will therefore

tend to have an elastic demand. For example, if the price of a good with close

substitutes increases, consumers will tend to switch to the substitutes, which become

relatively cheaper. On the other hand, if a good has no close substitutes, like salt,

petrol, electricity or certain medicines, demand will tend to be inelastic.

3.4.7.2 The degree of complementarity of the product

In the case of highly complementary goods (i.e. goods which tend to be used jointly with

other goods rather than on their own) the price elasticity of demand tends to be low.

Examples of goods with complements (shown here in brackets) include sugar (tea,

coffee and many foodstuffs), motorcar tyres (motorcars), petrol (motorcars), salt (food)

and golf balls (golf clubs). In many cases it may be argued that it is the absence of good

substitutes, rather than the degree of complementarity, which is responsible for the

inelastic demand of highly complementary goods.

3.4.7.3 The type of want satisfied by the product

The price elasticity of the demand for necessities, like basic foodstuffs, electricity,

petrol and medical care, tends to be lower than the price elasticity of luxury goods and

services such as recreation, entertainment, swimming pools and luxury motor vehicles.

There are no hard and fast rules to determine whether a particular good or service is a

necessity or a luxury. All we can really say is that the demand for a product that is

considered a necessity tends to be relatively inelastic, whereas the demand for a

product that is considered a luxury tends to be relatively elastic.

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3.4.7.4 The time period under consideration

Demand tends to be more price elastic in the long run than in the short run. When the

price of a product changes, ceteris paribus, consumers usually need time to adjust to

the change in relative prices. In the 1970s, for example, the price of crude oil increased

more than twenty-fold. In the short run, consumers could do little about it and sales did

not fall significantly. In due course, however, consumers switched to smaller, more fuel-

efficient cars. Another example is the price elasticity of demand for airline tickets.

Someone who has to fly somewhere at short notice does not have the opportunity to

shop around for the best deal. In many cases he or she purchases the first available

ticket without paying too much attention to the price. However, if someone in Gauteng

plans to go on holiday to Cape Town in a few months‘ time, he or she has plenty of time

to compare the prices offered by different airline companies, as well as to compare the

cost of flying with the cost of alternative modes of transport (train, bus, motorcar). The

long-run demand for airline tickets will therefore be more price elastic than the short-run

demand.

The airline companies realise this and base their fare structure on the differences in

price elasticity. The practice of charging different prices to different sets of customers

according to differences in price elasticity is called price discrimination.

3.4.7.5 The proportion of income spent on the product

It is often argued that the greater the proportion of income spent on a product, the

greater the price elasticity of demand will be (or that the smaller the proportion, the

lower the price elasticity of demand will be). The expenditure on products such as

matches, salt and paper clips constitutes a small share of a consumer‘s budget, so it is

argued that a price change will have a negligible effect on the quantity demanded. In

many cases, however, the low price elasticity of demand can probably also be

explained by the lack of substitutes, the degree of complementarity or the type of want

that is satisfied.

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3.4.8 Other possible determinants of price elasticity of demand

The following factors can also affect the price elasticity of demand:

The definition of the product. The broader the definition of the product, the

smaller the measured price elasticity of demand will tend to be. This is again

related to the substitution possibilities. Broader definitions reduce the number of

possible substitutes. The price elasticity of the demand for food, for example, will

be less than the price elasticity of demand for any particular type of food. Meat

and beef is another example – the price elasticity of demand for beef is greater

than the price elasticity of demand for meat. Similarly, the price elasticity of the

demand for a particular motorcar will be greater than the price elasticity of the

demand for motorcars. In the United States, for example, it was at one time

estimated that the price elasticity of demand for Chevrolet motorcars was four

times as great as the price elasticity of demand for motorcars in general.

Advertising. The price elasticity of demand for a particular brand of a product

(e.g. OMO washing powder) will be greater than the price elasticity of demand for

the product (washing powder). The reason again is that one brand (e.g. OMO)

may be substituted by another (e.g. Surf). Producers spend large amounts of

money on advertising and other forms of non-price competition, such as

packaging, distribution and service, to develop a loyalty among consumers to

their particular brands. In other words, they try to convince consumers that their

particular products have no real substitutes. To the extent that they are

successful, they reduce the price elasticity of demand for their brands.

Durability. The more durable the good, the more elastic the demand will tend to

be, ceteris paribus. For example, if the price of washing machines or refrigerators

increases, consumers may decide to keep their existing machines for a longer

period than they had originally intended. Non-durable goods, like household

cleaning materials, cannot be used more than once and therefore tend to have a

more inelastic demand.

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Number of uses of the product. It is sometimes argued that the greater the

number of uses of a particular product, the greater the price elasticity of demand

will tend to be. The argument is that substitutes may be available for certain of

the uses. Electricity, for example, has a variety of uses. A rise in the price of

electricity may cause consumers to switch to other means of cooking. Less

important uses of electricity (such as heating) may be eliminated altogether.

Addiction. Products that are habit forming (e.g. cigarettes, alcohol, drugs) will

tend to have a relatively low price elasticity of demand. For consumers who are

totally addicted, the demand may even be perfectly price inelastic.

3.5 Other Demand Elasticities

3.5.1 Income elasticity of demand

The quantity demanded of a product depends on the income of the consumers. As

consumers‘ incomes rise, the quantity demanded usually increases, ceteris paribus.

The question is, by how much will the quantity demanded change, relative to the

change in income? The income elasticity of demand (ey) measures the

responsiveness of the quantity demanded to changes in income. Applying our general

definition of elasticity, it is defined as the ratio between the percentage change in the

quantity demanded (the dependent variable) and the percentage change in consumers‘

income (the independent variable), that is:

percentage change in the quantity demanded of the product

ey = –––––––––––––––––––––––––––––– percentage change in consumers‘ income

Income elasticity of demand may be positive or negative. A positive income elasticity of

demand means that an increase in income is accompanied by an increase in the

quantity demanded of the product concerned (or that a decrease in income is

accompanied by a decrease in the quantity demanded). Goods with a positive income

elasticity of demand are called normal goods. A negative income elasticity of demand

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means that an increase in income leads to a decrease in the quantity demanded of the

good concerned (or that a decrease in income leads to an increase in the quantity

demanded). Goods with a negative income elasticity of demand are called inferior

goods.

Normal goods are further classified as luxury goods or essential goods. When the

income elasticity of demand is greater than one, that is, when the percentage change

in the quantity demanded is greater than the percentage change in income, the good is

called a luxury good. When the income elasticity of demand is positive but less than

one, that is, when the percentage change in the quantity demanded is smaller than the

percentage change in income, the good is called an essential good.

Information about the income elasticity of demand is important to the suppliers of goods

and services. They want to know what will happen to the quantities demanded of the

goods and services they supply as the incomes of consumers increase for example, in

the 1960s, Japanese entrepreneurs assumed, quite correctly, that incomes in the

industrial countries would increase rapidly. They therefore identified a number of goods

with relatively high income elasticities of demand and were ready to supply them (e.g.

electronic equipment and motorcars) when the quantities demanded of these goods

subsequently increased faster than the incomes of consumers in the industrial

countries.

On the other hand, the low income elasticity of demand of basic foodstuffs is one of the

reasons why developing countries which export agricultural products fared relatively

badly during the post-World War II economic boom. Consumers‘ income increased, but

the quantities of basic foodstuffs demanded did not increase to the same extent. In

other words, the demand for these commodities did not keep pace with the growth in

income and the demand for manufactured goods.

3.5.2 Cross Price Elasticity of Demand

The quantity demanded of a particular good also depends on the prices of related

goods. The cross elasticity of demand measures the responsiveness of the quantity

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demanded of a particular good to changes in the price of a related good. Applying our

general definition of elasticity, we can define the cross elasticity of demand (ec) as the

ratio between the percentage change in the quantity demanded of a product (the

dependent variable) and the percentage change in the price of a related product (the

independent variable), that is:

percentage change in the quantity demanded of product A

ec = –––––––––––––––––––––––––––––– percentage change in the price of product B

When two goods are unrelated (eg motorcar tyres and margarine) the cross elasticity of

demand will be zero. In the case of substitutes (eg butter and margarine) the cross

elasticity of demand is positive. A change in the price of the one product (eg butter) will

lead to a change in the same direction in the quantity demanded of the

substitute product. For example, when the price of butter increases, more margarine will

be demanded, ceteris paribus, as consumers switch to the relatively cheaper margarine.

In the case of complements the cross elasticity of demand is negative. A change in

the price of the one product (e.g. motorcars) will lead to a change in the opposite

direction in the quantity demanded of the complementary product (e.g. motorcar tyres).

For example, if the price of motorcars falls, the quantity of motorcars demanded will

increase and as a result, more motorcar tyres will be demanded.

? THINK POINT

Why do you think knowledge of elasticity would be of use to a business manager?

Can you think of examples of normal goods and inferior goods?

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3.6 Supply

The focus is now on supply. When dealing with supply, it is useful to remember that

supply has to do with producers or manufacturers. So, try to relate to it as if you were

the business manager.

Supply can be explained as the quantities of a good or service that producers plan

to sell at each price during a period.

Just as demand refers to the plans of consumers who are willing and able to purchase,

supply refers to the plans of producers who are willing and able to supply the quantities

of the product concerned. See Figure 16 Supply Curve below.

Figure 16 Supply Curve


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Table 4 Price of coffee

Price of a cup of coffee

Quantity supplied

$0 0

$1 6

$2 9

$3 12

$4 15

$5 18

$6 21


The amount that an Individual firm supplies are determined by a few factors, which

include:

The price of the product:

The higher the price, the greater the quantity supplied to the market. Remember, prices

convey information to market participants. High prices indicate that demand in the

market is good and, therefore, there is profit to be made. (This is the reason why the

supply curve is upward sloping).

The state of technology:

Technology plays an important role in the production process as it impacts directly on

the cost of production. Should there be technological developments which allow

producers to produce at lower cost, then the quantity supplied will increase at every

price level.

As with the case of the demand curve mentioned above, there can also be shifts and

movements of the supply curve.

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Figure 17 Shifts in supply


The above chart demonstrates the concepts of shift in supply. A shift of the supply curve

from S to S2 indicates an increase in supply while that from S to S1 indicates a

decrease in supply.

The factors which cause the supply curve to shift are discussed below:

Prices of inputs – if the price of a key input declines, then it becomes cheaper for

the supplier to produce his/her product and the supply will increase (supply curve

shifts to the right and vice versa);

Technology – an improvement in technology could result in increased production

(supply curve shifts to the right and vice versa); and

Number of sellers or firms in the market.

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3.5 Demand and supply together – the concept of equilibrium

Remember, a market occurs where there is any contact or communication between

potential buyers and potential sellers of a good or service. It follows that markets,

therefore, bring the forces of demand and supply in contact with each other.

Market equilibrium occurs where the quantity of a good/service demanded is equal to

the quantity supplied of that good/service. Equilibrium between households

(demanders) and firms (suppliers) will occur at a certain price, known as the equilibrium

price. At the equilibrium price, the plans of households and the plans of firms will be one

and the same, in that households will plan to purchase X amount of a good/service and

firms will plan to sell the same amount of the good/service.

The result of this matching of plans is that the market will come to a state of rest. This

state occurs as the two opposing forces (demand and supply) are in a state of balance.

As such, there will be no tendency for the conditions to change.

However, should the underlying forces change, the balance in the market will be upset

and the market will adjust accordingly. This is the topic of discussion which will now be

embarked upon.

To understand how the market arrives at a state of equilibrium, we need to understand

disequilibrium.

Disequilibrium occurs when the price charged is at a level other than the equilibrium

price level, i.e., any price other than the equilibrium price will bring about disequilibrium

in the market.

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Figure 18 Excess Demand and Supply


As can be seen in Figure 18 above, should a price above or below R5/kg be charged for

tomatoes, then demand and supply will not be equal (disequilibrium). At a price above

R5/kg, the quantity supplied will be greater than the quantity demanded. There will,

therefore, be excess supply at prices above R5/kg.

This occurs as the higher price encourages producers to increase supply in the

hope of making greater profits However, at prices greater than R5/kg, consumers plan

to purchase less of the good than they would have at R5/kg. The result is that there

will be more of the good on the market than consumers are willing and able to

purchase, i.e., excess supply. Similarly, should the price fall below R5/kg, then the

quantity demanded will exceed the quantity supplied. This occurs because (as you

know) cheaper prices result in more of the good being demanded, ceteris paribus (the

law of demand).

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Whereas consumers are demanding more, producers are now producing less than they

would have if the good was R5/kg (low prices signal low demand and less profits).

There is now an excess demand in the market.

When the market is in disequilibrium, it goes through a process which leads it back to

equilibrium. In the case of excess demand, there are too few goods on the market.

Firms have, therefore, sold their total production but households have not obtained the

quantity of the good that they demanded at the particular price. As households wish to

obtain more of the good (at the going price), they offer more money for the product (i.e.

prices higher than the market price) in an effort to outbid other households. The result is

that the price of the product rises.

As the price starts to rise, firms realise that they can obtain a higher price for their

product and, therefore, increase their production of the good. However, as the price

rises, demand starts to slow down (law of demand), and with it the rising price.

Production will slow with demand and the process ends when equilibrium is obtained.

In the case of excess supply, there is not enough demand for the amount of goods

on the market. Firms are, therefore, unable to sell their products and, as such, are left

with a surplus of unsold goods (market surplus). These unsold stocks are also known as

inventories, and as the level of inventories rise, firms cut their production of the product

in an attempt to sell off the rising levels of stock and to compete with the other firms for

the limited demand. By reducing their level of production, firms lower their cost and, as

a result, can charge lower prices in order to compete. Graphically, this can be shown as

a movement down the supply curve towards the point of equilibrium. At the same time,

demand will increase as the price decreases and producers and consumers will move

toward the point where quantity demanded and quantity supplied are equal to each

other.

Market equilibrium, therefore, occurs at the intersection of the demand and supply

curves.

This point is characteristic of both buyers and sellers agreeing upon both the quantity of

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goods that will be exchanged on the market and the price for which these goods will be

exchanged. At equilibrium, there is no tendency for change.

The above analysis assumed a „free market „with no government intervention, where the

forces of supply and demand are left to determine what gets produced and at what

price.

The reality is that markets are not always free to determine what the equilibrium prices

and quantities will be.

Governments have various methods available with which to intervene in the market.

This intervention can take the form of:

setting maximum prices (also known as price ceilings); and

setting minimum prices (also known as price floors).

Source: http://mg.co.za/article/2006-06-22-zim-bakers-arrested-for-defying-price-ceiling

Governments can set maximum prices with the intention of:

keeping the prices of basic food items low (this may form part of policy to assist

the poor);

SELF ASSESSMENT ACTIVITY

The following headline from a newspaper provides an example of how a price ceiling

was implemented in Zimbabwe on bread….

―Zimbabwean police have arrested more than 280 bakers and shopkeepers for defying

a state-imposed ceiling on bread prices meant to combat inflation, a newspaper said on

Thursday.‖At least 282 bakers and shopkeepers have been arrested in Harare for

charging more than Z$85Â 000 (US83c) for a standard loaf of bread," the state-

controlled Herald reported.‖

What do you think happened to the supply of bread once a price ceiling (maximum price

was introduced?

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avoiding the exploitation of consumers by producers (producers may be charging

―unfair‖ prices);

combating inflation and

limiting the amount produced of certain goods and services in times of war.

(Mohr and Fourie, 2008: 144)

Should the maximum price be set above the market clearing price (equilibrium price),

then the intervention will not have any effect on the outcome of the market. The market

will, therefore, arrive at the equilibrium price and equilibrium quantity. However, when

the maximum price is set below the market clearing (equilibrium price), the intervention

disrupts the market mechanism (price mechanism) and, therefore, causes instability in

the market. In Figure 19, we can see that if the market were left alone the forces of

demand and supply (remember, excess demand and excess supply) will result in the

market achieving equilibrium with a price P0 and a quantity supplied of Q0.

Figure 19 Price per unit


In the figure above, the government has set a maximum price of Pm which is below the

equilibrium price of P0. At the price Pm, producers are willing to sell Q1 units whilst

consumers are demanding a quantity of Q2. This can be seen if we follow the line Pm

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across to the supply curve (point a) and then across to the demand curve (point b). The

quantity demanded by consumers at a price of Pm is clearly greater than the quantity

which producers are willing to produce (Q1). As such, there is now excess demand in

the market (market shortage) and this excess demand is equal to the difference

between Q2 and Q1, i.e., Q2 – Q1.

If the market were left alone, then the market mechanism would raise the price until this

excess demand was eliminated (remember the example of excess demand earlier).

However, as the price has been pegged artificially, this process cannot occur.

We are, therefore, left with the problem of how to allocate Q1 worth of product amongst

people who demand Q2?

To summarise, should the government set a maximum price below the equilibrium price

of a product it would:

1) cause excess demand in the market;

2) prevent the market from allocating the quantity of product available among

consumers; and

3) result in black market activity occurring in the market. A black market is an illegal

market which occurs when goods are sold at prices which are above the maximum price

set by government.

If we refer to the figure, we can see that at a quantity of Q1 (the quantity which will be

supplied), the price which a consumer is willing and able to pay for the product is P1 and

this price is clearly greater than Pm. Therefore, those who have the product can charge

prices in excess of Pm to those who are looking to purchase.

We now turn our attention to the case of minimum prices (price floors). In the case

where a minimum price is set by government, the minimum price will not impact on the

outcome of the market if the price is set below the market equilibrium price. However,

should the minimum price be set above the equilibrium price, then there will be excess

supply of products in the market. To illustrate the case of a minimum price set above the

equilibrium price, your attention should now be on Figure 20.

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Figure 20 Price of beef


In the figure above, the market is at equilibrium at a price of R15 per kilogram and at

this price a quantity of 7 million kilograms is being sold. The government sets a

minimum price (price floor) of R20 per kilogram on the product. At a price of R20 per

kilogram, consumers demand a quantity of 4 million kilograms. However, producers are

producing 9 million kilograms of beef. Therefore, there is a surplus of 5 million kilograms

of beef in the market (the difference between point a and point b). By setting a minimum

price above the equilibrium market price (market clearing price), the government

creates an excess supply in the market.

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questions. (To adequately address these questions, you will need to have


1. Discuss why the demand curve is downward sloping and what the implication of

this is for business managers.

2. Explain the concept of elasticity and its applicability by providing a suitable

example.

3. Differentiate between price elasticity and income elasticity

4. Discuss why the supply curve is downward sloping and what the implication of

this is for business managers.

5. Explain the concepts of price ceiling and price floors and how these create

distortions in a market.

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MBA Year 1



SECTION 4:

The Macro- Economic

Environment of Business


The overall outcome for this section is that, on completion, the student should be able to

demonstrate a broad understanding of the environment in which a business operates by

demonstrating knowledge of the common economic indicators used to assess the

macroeconomic performance of a country. You must also be able to explain the

macroeconomic variables and, at least, have a reading knowledge of the latest

macroeconomic changes in your domestic country/region. This information will be used

in your assignments and/or examinations. This overall outcome will be achieved through

the student‘s mastery of the following specific outcomes in that the student will be able

to:

1. Critically assess the key economic indicators used to assess economic

performance; and

2. Provide direction on macroeconomic data sources and where to find suitable

information.

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4.1 Introduction to the Business Environment

Knowledge on the health of an economy is important to business managers and needs

to be taken account of, in the process of business decision making. The figure below is

extracted from the Global Competitiveness Report 2014-15. It shows that, according to

the Global Competitiveness Report 2014/15, SA ranks 56th out of 144 economies

surveyed globally, and indicates that the most problematic factors for doing business in

SA are restrictive labour regulations, and a lack of skills.

Figure 21 Problematic Business Factors

Source: World Economic Forum (2015)

The figure is extracted from the World Bank‘s annual ―Doing Business‖ survey. The

output provides objective measures of business regulations and their enforcement

across 189 economies and selected cities at the subnational and regional level. The

latest report finds that local entrepreneurs face a wide array of business obstacles,

depending on when they are doing business. The report also highlights a number of

constructive practices that can be better leveraged within the country to improve the

business climate for local entrepreneurs and firms.

19.8 16.9

14.8 11

9.8 7.4

5.2 3

2.5 2.2 2.1

1.5 1.5

1.2 1

0.2

0 5 10 15 20 25

Restrictive labor regulations

Inadequately educated workforce

Inefficient government…

Corruption

Policy instability

Insufficient capacity to innovate

Crime and theft

Access to financing

Foreign currency regulations

Inflation

Tax regulations

Poor public health

Tax rates

Government instability/coups

Most problematic factors for doing business in SA

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Figure 22 Doing Business Ranking SA

Source: World Bank (2015)

4.2 Economic Indicators

This section of the module is primarily concerned with macroeconomic analysis with

respect to the South African economy and provides insight into how business decisions

may be impacted by conditions prevailing in the domestic macroeconomic environment.

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Unemployment

In SA, unemployment is a consistent problem. Unemployment is of great concern to

government, business and the general population.

The construct below details the different types of unemployment according to Mohr

(2012: 206)

• also known as 'search'unemployment

• arises beacause it takes time to move from one job to another

• as such there will always be some frictional unemployment within any economy

Frictional unemployment

• arises because certain occupations only require workers during certain times of the year

• e.g picking of fruits and tourist industry

• people in these industries may thus be unemployed for a certain part of the year

Seasonal unemployment

• this occurs when unemployment increases due to a slump or recession (changes in the business cycle

• lack of demand for goods and services gives rise to job cuts

Cyclical unemployment

• most serious type of unemployment as it is longer term than the others

• occurs when there is a mismatch between workers qualifications and job requirements OR

• when certain jobs disappear due to sturctural changes in the economy

Structural unemployment

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Statistics South Africa, which is the official government agency tasked with calculating

unemployment in SA, provides the following definition:

―Unemployed persons are those (aged 15–64 years) who:

a) Were not employed in the reference week; and

b) Actively looked for work or tried to start a business in the four weeks preceding the

survey interview; and

c) Were available for work, i.e., would have been able to start work or a business in the

reference week; or

d) Had not actively looked for work in the past four weeks but had a job or business to

start at a definite date in the future and were available.”

Source (Statssa: 2015)

The unemployment rate is the proportion of the labour force that is unemployed. As can

be noted from the graph below, SA has had consistently high unemployment (above

20%) rates for many years now.

Figure 23 Unemployment in SA


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At a certain level of output in an economy, it can be said that all factors of production

are being fully utilised. In such a situation, all workers would be employed, all machinery

would be in use and all usable land would be involved in production. This is called full

employment – all factors of production are in full use.

As such, full employment is important as under-employment or unemployment causes

social and political instability. Most often, unemployment is related with labour, but

unemployment could also relate to the other factors of production that are not being

employed – for example, an unused tract of agricultural land. When speaking of labour

specifically, the unemployment rate is the percentage of the labour force unemployed

(Janse Van Rensburg, 2011:390).

Any form of unemployment should be seen as a loss in potential production, since the

country could have earned more if those who were unemployed were indeed

economically active. Clearly, a drop in the standard of living occurs as production is lost.

High unemployment in an economy does not bode well for business as it means that

there will be reduced demand for goods and services (reduced consumption) produced

by firms.

? THINK POINT

Read the extract from a newspaper article below, and then discuss what interventions

you believe needs to take place in SA by government and/or the private sector to

reduce unemployment.

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Concern over SA unemployment rate

By Marianne Merten, Senior Political Correspondent

Cape Town - DA finance spokesman, David Maynier, has called for a parliamentary

debate on the stubbornly high rate of unemployment.

―We cannot remain silent when 5.2 million people cannot find work and live without

dignity, independence, a sense of self-worth and freedom in South Africa,‖ he said in his

debut in the finance portfolio, after being moved from defence last month.

The call for a parliamentary debate in the national interest came after Statistics South

Africa and showed that unemployment had increased by 321 000 in the first six months

of this year.

―The rate of unemployment is likely to increase given the fact that companies in the

mining, metals and construction sector are planning massive job cuts,‖ he added.

Source:http://www.iol.co.za/business/news/concern-over-sa-unemployment-rate-

1.1892572#.VhY5cPmqqko. Date of access 5 October 2015.

http://www.iol.co.za/business/news/concern-over-sa-unemployment-rate-1.1892572#.VhY5cPmqqko

http://www.iol.co.za/business/news/concern-over-sa-unemployment-rate-1.1892572#.VhY5cPmqqko

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Inflation

Inflation refers to a general rise in the price levels. In South Africa, inflation is measured

by the CPI or Consumer Price Index. It is common knowledge that the price of goods

and services generally increases from one year to the next. The process of increases in

the general level of prices is called inflation.

When economists talk of price stability, they are actually referring to keeping inflation

equal to zero (or more practically as low as possible). An inflation rate of 1% to 2% is

regarded in most Western economies as a ―healthy‖ inflation rate.

Rising prices per se are not a problem, but the accompanying effects are undesirable.

Among these effects are the redistribution of income, the country‘s balance of payments

and social as well as political effects.

Data on the CPI are available from Statistics South Africa. Inflation causes problems for

managers as it makes planning for the future more difficult. Inflation means that the

future costs of resources and prices of products are surrounded by greater uncertainty

than would be the case when prices are stable. Keating and Wilson (2009: 59) also

contend that, during periods of high inflation, managers allocate too much time to trying

to figure out ways to cope with inflation which defers from the energy they put into other

decisions that relate to the professional operation of the business. In the long- run,

therefore, inflation may lead to higher rates of unemployment as well.

In order to calculate inflation, or the CPI stats, SA adopts the following methodology:

Selects the goods and services to be included in the basket;

Assigns a weight to each good or service to indicate its relative importance in the

basket;

Decides on a base year for calculating the CPI;

Decide on a formula for calculating CPI; and

Collects data on prices each month to calculate the value of the CPI for that

month.

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The table below indicates some of the weights assigned to various items:

Table 5 Weightings of items in CPI Basket

Product Weight in CPI basket

Food 14.20%

Alcoholic beverages and tobacco 5.43%

Clothing and footwear 4.07%

Housing and utilities 24.52%

Household content, equipment and

maintenance 4.79%

Health 1.46%

Transport 16.43%

Source: Statistics South Africa (2015)

Based on the above table, one notes that almost a sixth of the basket consists of food,

and more than a sixth of the total basket consists of transport. In this regard, increases

in the price of food, transport and housing have a major effect on the overall CPI, and,

hence, overall inflation.

Another important index for business managers to be aware of is that of the Producer

Price Index (PPI). Whereas the CPI focuses on increases in the price of consumer

goods, the PPI measures increases in price at the ‗factory gate‘ or in the cost of

producing goods.

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Figure 24 CPI Inflation


The above graph shows the trend of CPI inflation in SA from 2008 to 2015.

Price stability is important in any economy, as rapidly rising prices can wreak havoc in

an economy. The following are the negative effects of inflation according to Mohr

(2012:187)

i. Distribution Effects

Inflation benefits debtors (borrowers) at the expense of creditors.

Inflation tends to redistribute income wealth from the elderly to the young.

Redistribution from the private sector to the government.

ii. Economic Effects

Anticipating inflation – Decision makers become more concerned with

anticipating inflation than with seeking profitable new production opportunities.

Speculative practices – People try to outwit each other by speculating in shares,

foreign currency (exchange), price of precious metals etc. instead of engaging in

productive investments (new factories, machinery and other equipment).

Discourages saving – By reducing the value of existing savings, inflation may

also discourage saving in traditional forms (fixed deposits, pension fund

contributions etc.).

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Balance of payment problems – Inflation increases the costs of export industries

and import competing industries. If the inflation rate in SA is higher than that of

our major trading partners and international competitors, then South Africa‘s

international competitiveness could be adversely affected.

iii. Social and Political Effects

Price increases make people unhappy and different groups in society blame one

another for increases in the cost of living.

To keep prices stable and prevent excessive inflation the South African government

introduced inflation targeting in February 2000. The benefit of this policy is that it makes

it very clear to the public that monetary policy is aimed at achieving price stability and

hence it reduces uncertainty and planning for business managers in the private as well

as public sectors.

This policy means that the Reserve Bank tries to control inflation by using the tool of

interest rates. The target band for inflation is 3-6% and hence when inflation reaches

close to the upper end of the target i.e 6%, the Reserve Bank will usually hike interest

rates. This act will lower demand for goods and services in the economy (see Demand

Pull Inflation) and stop prices from increasing due to increased demand.

There are two types of inflation which a business manager needs to understand and be

familiar with the impacts of. These are (i) Cost Push and (ii) Demand Pull Inflation

(i) Cost Push Inflation

Cost push inflation occurs as a result of increases in the cost of producing goods.

For example if the cost of any of the inputs used to produce goods rise (such as

labour, electricity or raw materials) these will hike up the costs of producing a good.

The diagram below shows an inward shift (contraction) of supply, which then causes

prices to rise from P* to P1. Recall from the section on supply and demand, that

when there is an increase in input costs, this causes the supply to decrease

(indicated by a leftward shift in the supply curve).

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Figure 25 Cost Push Inflation

Source: www.econmentor.com (2015)

(ii) Demand pull inflation

Demand pull inflation occurs when the total demand for goods (aggregate demand) is

growing faster than the total supply (aggregate supply) of goods in an economy. In the

diagram below as aggregate demand increases from AD to AD 1, while aggregate

supply AS remains fixed, one notes that the Price level increases from P* to P1. We

refer to this as Demand Pull Inflation.

http://www.econmentor.com/

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Figure 26 Demand Pull Inflation

Source: www.econmentor.com (2015)

The structuralist approach to inflation:

The fact that the demand-pull versus cost-push approach to diagnosing inflation does

not provide a satisfactory explanation of the inflation process, has given rise to an

alternative approach to the diagnosis of inflation. This is called the structuralist

approach. This approach retains the distinction between demand-pull and cost-push but

places it in a much broader context. According to the structuralist approach. the inflation

process is the result of the interaction between three interrelated sets of factors:

the underlying factors, which provide the background against which the inflation

process occurs

the initiating factors, which trigger or intensify a particular inflation process

the propagating factors, which transmit the initiating impulse(s) through the

economy and over time, and in so doing, generate or sustain the process of

rising prices.

http://www.econmentor.com/

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To explain inflation, all three sets of factors have to be taken into account. Moreover, a

sustained process of inflation can occur only if all three are present. For example, even

if the economy is particularly vulnerable to inflation (as a result of the underlying

factors), specific initiating factors are still required to set the inflation process in motion

or to raise the inflation rate. Once this has occurred, the propagating factors are

required to generate or sustain a process of rising prices. Some of the most important

underlying, initiating and propagating factors are summarised in Table 6.

Table 6: Underlying, initiating and propagating factors in the inflation process

Source: Mohr and Fourie, 2013:391

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Economic Growth

A measure known as Gross Domestic Product (GDP) is used to measure economic

growth. GDP refers to the market value of all final goods and services produced by

resources located within the country, regardless of who owns the resources. Since GDP

is often an important measure of the overall health of the economy, GDP data is eagerly

awaited by business managers. In SA, GDP data is produced by Statssa as well as the

Reserve Bank.

If GDP is growing, this signals positive news for business as the outlook for new

products, new investments, and business expansion is higher. A poor GDP growth

signals reduced job creation and less optimism in the economy, which will negatively

affect demand for goods and services provided by business (Keating and Wilson, 2009).

The graph below details the economic growth performance of the SA economy.

According to the National Development Plan, SA requires GDP growth of 5% per

annum in order to generate sufficient jobs and to meaningfully reduce unemployment.

Figure 27 GDP Growth performance of the SA economy


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Periods of high economic growth are generally termed ‗upswing‘ phases in the

economy, while periods during which GDP growth is declining and job losses are

increasing are termed the downswing phase. The table below, created by the Reserve

Bank, details the duration of these phases in the SA Economy since 1946.

Table 7 Phases of the South African economy

South African Reserve Bank (2015)

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After completing your study of this section on The Economic Environment of

Business, reflect on the following questions. (To adequately address these

questions, you will need to have completed all the „essential reading‟ listed at

the beginning of this section.)

1. Critically discuss the high unemployment in SA and its implications for

businesses operating in SA.

2. Discuss the sluggish economic growth faced in SA and its implications for

business confidence and economic growth.

3. Identify some of the macroeconomic impacts of globalisation on your country,

and critically address whether globalisation has a net gain/loss to your country?

Why do you think this is the case?

4. Review the economic integration that your country (or a country that you know)

belongs to, and consider if this integration has benefited or worsened economic

conditions in the country?

5. Distinguish between cost push and demand pull inflation

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MBA Year 1



SECTION 5:

Perfect Competition and Monopoly



able to demonstrate a broad understanding of the various market structures and how

market structures may affect the interests of the business itself, its consumers and its

suppliers. This overall outcome will be achieved through the student‘s mastery of the

following specific outcomes, in that the student will be able to:

1. List the standard forms of market structure and the conditions which have to

be met in each case; and

2. Distinguish between perfect competition and monopoly and the long- term

profit potential of each industry structure.

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ESSENTIAL READING



Textbooks:

Keating, B. and Wilson, J. 2009. Managerial Economics (2nd ed). Atomic

Dog Publishers. USA. (Chapter 9)

Schiller, B.R., Hill, C.D. and Wall, S.L., (2013) The Economy Today 13th

Edition, Boston: McGraw Hill. Chapter 22: The Competitive Firm. (pp 484

– 506).

Schiller, B.R., Hill, C.D., Wall, S.L., (2013) The Economy Today 13th

Edition, Boston: McGraw Hill. Chapters 23 – 26. (pp 510 – 596).


Southern African Edition Boston: McGraw Hill.Chapter 7: Pure

Competition and Pure Monopoly (pp 141 – 167).


Southern African Edition Boston: McGraw Hill.Chapter 8: Monopolistic

Competition and Oligopoly (pp 169 – 189).


.

Naude, C, M, (2003), Industry Concentration in South Africa, University of

Pretoria, Pretoria.

Mncube, L. 2013 Strategic Entry Deterrence: Pioneer Foods and bread

cartel, Journal of Competition Law and Economics 2013 (9)3: 637- 654

Makhaya, T; Roberts, S. 2013. Expectation and Outcomes: Considering

competition and corporate power in SA under democracy, Review of

African Political Economy 2013 40(138): 556 – 571

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5.1 Introduction

This chapter highlights the standard market structures that typically exist and explains

perfect competition and monopoly. The following chapter will explain monopolistic

competition and oligopoly. The construct below ranks the market structures in order of

competition in the industry. As such, it begins with perfect competition where, as the

name implies, competition is rife due to a large number of buyers and sellers, with

competition thereafter diminishing or reducing towards the case of monopoly, where

there is no competition, i.e., only one seller of a good or service in a market.

It is of importance for a manager to understand the market structure in which his/her

firm operates, as this helps in making the correct decisions regarding price, output and

competitor strategies.

Market structure – identifies how a market is made up in terms of:

• Number of firms

• Nature of the product

• Entry

• Information

• Collusion

• Firm‘s control over the price of the product

• Demand curve for the firm‘s product

• Long-run economic profit

Perfect competition, although rarely exiting in the business world, provides a useful

benchmark against which to compare other market forms.

The four different market structures are:

• Perfect competition

• Monopolistic competition

• Oligopoly

• Monopoly

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Figure 28 Market Structures

Key features of a market structure:

Adapted: (Mohr and Fourie, 2011)

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5.2 Rules for all profit maximising firms

Three rules apply to all profit maximising firms, whether or not they operate in perfectly

competitive markets.

Should the firm produce at all?

Is it worth producing under given conditions or shut down? All firms always have the

option of producing nothing. If a firm exercises this option, it will have an operating loss

that is equal to is fixed costs. If it decides to produce, it will add the variable cost of

production to its costs, and the income from the sale of its products to its revenue. It is

recommended for a firm to produce as long as it can find some level of output for which

revenue exceeds variable cost. However, if revenue is less than its variable cost at

every level of output, the firm will actually lose more by producing than by not producing

(Lipsey and Chrystalstal, 2011).

Rule1: A firm should not produce at all if, for all levels of output, the total variable cost

of producing the output exceeds the total revenue derived from selling it or, equivalently,

if the average variable cost of producing the output exceeds the price at which it can be

sold. A firm has to shut down if price (Average Revenue) falls below the Average

Variable Cost.

The shutdown price

The shutdown price is the sale price at which the firm can just cover its average variable

cost when producing at its most profitable level of output. It is also called the breakeven

price. At that price, managers are indifferent between producing and not producing. Any

price below it will result in the firm shutting down.

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How much should the firm produce?

If the firm decides that production is worth undertaking, it must decide how much to

produce. If any production adds more to revenue than it does to cost, producing and

selling that unit will increase profits. However, if any unit adds more to cost than it does

to revenue, producing and selling that unit will decrease profits. If a further unit of

production will increase the firm‘s profits, the firm should expand its output. However, if

the unit produced reduce profits, then the firm should contract output. It follows then,

that the only time the firm should leave its output unaltered is when the last unit

produced adds the same amount to costs, as it does to revenue (Lipsey and Chrystal,

2011).

Rule 2: Whenever it is profitable for the firm to produce some output, it should produce

the output at which marginal revenue equals marginal cost.

Profit maximisation

Profit maximisation rule can be explained in-terms of MR and MC.

Using the marginal approach analysis, profit is maximised where marginal revenue is

equal to marginal cost (MR=MC). Marginal revenue is the rate of change of total

revenue as more of the product is sold. It can also be defined as the additional increase

in total revenue, as one more units of output is sold. Marginal cost on the other hand, is

the rate of change in total cost as more units of output are produced.

Under this rule, if Marginal Revenue is found to be greater than Marginal cost (MR >

MC), an increase in production will increase profit and, if marginal revenue is less that of

marginal cost (MR < MC), an increase in production will decrease profit. Therefore,

profits are maximised where: MR = MC

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Figure 29 Marginal Analysis profit maximising output

Profit maximising out is 9 units where MR=MC. Any output below 9 will decrease

revenue and any output above 9 will decrease revenue. Thus, the firm is advised to stay

at output 9.

5.3 Market Structure of Perfect Competition

The behaviour of a firm depends somewhat on the characteristics of the market in which

it sells its product(s). These market organisational features are called market structure.

These features include the number of sellers and buyers, the degree of product

differentiation, the availability of information and the barriers to entry (and exit).

The structure of the industry, in which a firm operates, largely determines the firm‘s

ability to generate long-term profits, and is thus of importance to business managers.

For example, Microsoft had, for a long time, monopoly power within the computer

operating systems industry and, consequently, was able to generate abnormally high

profits during that time. By contrast, in perfectly competitive markets (where all firms

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compete on an equal footing), the chances of making abnormal profits indefinitely is

limited as high profits act as a signal for new incumbents to enter the profitable market.

5.4 Conditions for perfect competition to exist

Perfect competition can be said to exist when the following conditions are met:

Figure 302 Conditions for perfect competition to exist

5.5 The equilibrium of the firm under perfect competition in the short-

run

Profit is maximised (or losses minimised) when a firm produces an output where

marginal revenue equals marginal cost, provided marginal cost is rising and lies above

minimum average variable cost. P = MC (since P = MR).Why is Profit maximised at MR

= MC? This can be illustrated by table 8 below and figure 31 below.

Many buyers and sellers

• market has many participants such that no individual participant may affect price

free entry and exit

• there are no barriers to entry

• any firm can enter/exit the industry freely

homogeneous product

• the product is standardised

• each firms product is exacly the same as another firm's product

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Table 8 Revenue and Cost of a hypothetical firm

Figure 31 Marginal Revenue and Marginal Cost of a firm operating in a

perfectly competitive market

Adopted: (Mohr and Fourie, 2011)

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5.6 Pricing under perfect competition

Under conditions of perfect competition, the price that prevails in a market is the price

that has been set by the market forces of supply and demand. Individual firms have no

power to influence price. This is because each individual firm is very small compared to

the market, meaning that individual firms are price takers. At the equilibrium price, each

firm produces and sells quantity for which its marginal cost equals price as shown in

figure 31 above, output 4 will be the equilibrium, sold at the price of R10.Given the fixed

inputs, all firms maximise their profits and hence, have no incentive to alter output in the

short-run.

5.7 Short-run equilibrium positions of the firm under perfect

competition.

The following are different possible short-run equilibrium positions of the firm under

perfect competition:

• Economic profit – as long as AR is above AC

• Break even (normal profit) – when AR is equal to AC

• Economic loss – when AR less than AC

•

Figure 32 Economic profit


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Figure 33 Normal profit or Breakeven


Figure 34 Economic loss.


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In the short-run, a competitive firm may suffer losses, break even or make profits, as

shown in the diagrams above. The diagrams indicate a firm with given costs faced with

alternative prices, P1, P2, and P3. At each point, E is where MR=MC=Price. In figure 32,

the firm earns economic profits because its price or average revenue is above the

average cost. The profit is shown by the shaded area. In figure 33, the firm is making

normal profits or breaking even. The price or average revenue is equal to its cost of

production. Thus, profits are equal to zero. Lastly, figure 34 illustrates a firm making a

loss. The price or average revenue is less than the average cost (cost of production).

The firm makes a loss equal to the shaded area (Mohr and Fourie, 2011).

5.8 The long-run equilibrium

In perfect competition, the forces that produce long-run equilibrium of the industry are

created by the entry and exit of firms. The incentive for entry or exit comes from the

existence of profits or loses.

The effect of entry or exit

Firms in short-run equilibrium may be making profits, suffering losses or making ‗just

normal profits‘. Because costs include the opportunity cost of capital, firms that are

breaking even are doing as well as they could do, by investing their capital elsewhere.

Therefore, we don‘t expect such firms to leave the industry. The breakeven condition is

not an incentive for new firms to enter, since they can earn the same return on their

capital elsewhere in the economy. However, if existing firms earn revenues in excess of

all costs, including opportunity cost of capital, new capital will enter the industry

(attracted by these profits). If existing firms made losses, capital will leave the industry

because a better return can be obtained elsewhere in the economy (Mohr and Fourie,

2011).

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5.8.1 An entry –attracting price

Figure 35 The individual firm and the industry when the firm initially earns an

economic profit


If all firms in a perfectly competitive market earn economic profits, new firms will be

attracted to enter the market. If for example, in response to the high profits that the

existing 50 firms attain, 15 new firms would enter. The quantity supplied to the market

will increase by the amount contributed by new entrants. At any price, more products

will be supplied because there will be more producers. With an unchanged demand

curve given the new supply curve, the equilibrium price will change. The increase in

supply is shown by the rightward shift of the market supply curve from S1 to S2. The

resulting effect is the decrease in equilibrium price from P1 to P2. The assumption is

that new firms will continue to enter, until all firms in the industry are ‗just covering their

total costs‘. Thus, all firms will result in earning normal profits (Lipsey and Chrystal,

2011).

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5.8.2 An exit-inducing price.

Figure 36 The individual firm and the industry when the firm initially makes an

economic loss


Assuming the firms in a perfectly competitive market are in a position shown above.

Although the firms cover their variable costs, the return on the capital is less than the

opportunity cost of capital. These firms are not covering their total cost. This is a signal

for the exit of firms. As firms leave the market, we expect the quantity supplied to also

decrease. This is illustrated by the leftward shift of the supply curve from S1 to S2. The

decrease in supply will create a shortage, leading to an increase in price. The old firms

will continue to exit the market until the point when price is equal to average cost. Thus,

losses in a competitive market will create an incentive for the exit of firms. The industry

will contract, driving the market price up until the remaining firms are just covering their

total costs. (Lipsey and Chrystal, 2011).

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Long-run equilibrium of the firm and the industry under perfect competition

The industry will be in equilibrium in the long run only if all firms are making normal

profits as shown below:

Figure 37 Profits of firms


? THINK POINT

Think about examples of firms which you consider to fall under perfect competition.

Compare these with your class mates. Were you able to find many examples of perfect

competition? Why or Why not?

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5.9 Market Structure of Monopoly

We now turn our focus toward monopoly, which was briefly introduced at the beginning

of this chapter. This refers to a market structure in which there is only one seller of a

good or service, which has no close substitutes. A noteworthy characteristic of

monopoly is that the single supplier can influence price, i.e., is referred to a price setter.

As such, monopoly is the polar opposite of perfect competition. A monopoly firm does

not have to compete because there are no rivals with whom the monopolist must share

the market.

5.9.1 Monopoly: But Why?

Barriers to entry

Existence of large economies of scale (natural monopoly). One firm can provide

a lower price than 2 or more.

Limited size of the market

A patent; e.g. a new drug

Sole ownership of a resource; e.g. diamonds (De Beers Consolidated mines)

Licensing

Import restrictions

Formation of a cartel; e.g. OPEC

5.10 Pricing and monopoly

Monopoly is the polar opposite of perfect competition. The monopoly faces a market

demand which is negatively sloping downwards. As such, the monopoly has market

power, and is referred to as price maker because the market allows the monopoly to set

its price. Due to the said market power, a monopoly firm can make economic profits

both in the short- and long-run. (recall that in the case of a monopoly, there are high

barriers, which limit potential new entrants, and, hence, limit competition).

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Monopolies follow the same profit maximizing rule as competitive firms, MR=MC. The

downward sloping demand curve indicates that monopolist can increase its quantity

when it lowers the price of the product. The demand curve of a monopoly is also the AR

curve, and the MR is always below the AR under monopoly.

Figure 38 The short-run equilibrium of the firm under monopoly

Economic Profit

The monopolist will produce at Q1 where MR=MC and will charge price P1, which is

determined by the demand curve. Is the monopolist making an economic profit or loss?

We compare the AR and AC to determine whether the monopolist makes a profit or

loss. AR(=P) > AC, therefore the monopolist is experiencing economic profit (Mohr and

Fourie, 2011).

NB in the long-run due to barriers to entry of firms, monopolist may also make

economic profit or losses

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5.11 The allocative inefficiency of monopoly

Perfectively competitive equilibrium maximises the sum of consumers‘ and producers‘

surpluses by equating marginal cost with the product‘s price. Output under monopoly is

lower and must result in a smaller total of consumers‘ and producers‘, than if it produced

where marginal cost was equal to price.

When a monopoly maximises its profits, it chooses an output where marginal cost is

less than price. When the output between the level that equates marginal cost with

marginal revenue and the level that equates marginal cost with price is not produced,

consumers lose more surplus than the monopolist gains. There is therefore a net loss to

the society as a whole.

Additionally, there exists conflict between the private interest of the monopoly producer

and the public interest of all the nation‘s consumers. This creates the need for

government intervention to prevent the formation of monopolies, if possible, or to control

their behavior.

? THINK POINT

Think about examples of local firms which you consider to fall under monopoly.

If you thought of Eskom, or Telkom before the arrival of Neotel, you would be correct.

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completed all the „essential reading‟ listed at the beginning of this section).

1. Briefly explain the conditions necessary for perfect competition to exist.

2. Briefly explain the conditions necessary for perfect monopoly to exist.

3. Why it is that in the long-run perfectly competitive firms will only make normal

profits?

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SECTION 6:

Monopolistic Competition and

Oligopoly



able to fully understand the implications of the market structure on a firm‘s pricing and

competitiveness and, hence, profitability. The student should understand the difference

between operating in a monopolistically competitive industry vs. an oligopolistic

industry. This has implications for a firm‘s profitability in the long-run. This overall

outcome will be achieved through the student‘s mastery of the following specific

outcomes, in that the student will be able to:

1. Assess the conditions necessary for monopolistic competition to exist;

2. Develop a critical understanding of the conditions necessary for oligopoly to

exist;

3. Evaluate the kinked demand curve model of oligopoly; and

4. Understand and apply collusion to real world situations.

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6.1 Introduction

The previous section discussed perfect competition and monopoly. This chapter

discusses the market structures between these two extremes, namely, monopolistic

competition (not to be confused with monopoly) and oligopoly.

Some industries (like the brick manufacturing industry) consist of a few large firms and a

large number of small ones. Other industries (like motor manufacturing) consist of a few

large firms only. In some industries (like the clothing industry), there are many firms

producing a variety of similar products. In other industries (like the cement industry), a

few large firms produce virtually identical products.

6.2 Monopolistic competition

This refers to a form of market structure where there are many firms selling

differentiated products. These non-homogeneous products are not perfect substitutes

for one another in the eyes of consumers. Monopolistically competitive firms are

frequently characterised by non-price discrimination such as advertising, promotions or

package design. There are no barriers to entry, and entry and exit into and out of the

industry is free. Product differentiation plays a key role for firms which operate in a

monopolistically competitive market.

6.2.1 Characteristics of Monopolistic competitive industries

Figure 39 Characteristics of Monopolistic competitive industries

heterogeneous product

• product is differentaited

no. of firms

• large number of firms in the industry

barriers to entry

• there are no barriers to entry

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6.2 Pricing under monopolistic competition

The monopolistic competitive firm in the short-run will make economic profit as it offers

differentiated products. However, as in the case of perfect competition, these abnormal

profits will attract potential new entrants to the market (since there are no barriers to

entry) which will erode the abnormal profit to normal profits in the long- run as illustrated

below.

Figure 40 Short-run condition for a monopolistic competition


A monopolistically competitive firm faces a downward-sloping demand curve (D) for its

product, which is also its average revenue (AR) curve. The firms marginal revenue

curve (MR) is also downward-sloping. Profit is maximised at the quantity where

marginal revenue (MR) is equal to marginal cost (MC). The short-run profit-maximising

quantity is thus Q1, for which the monopolistic competitor charges a price P1. The

economic profit per unit of production is the difference between average revenue (AR)

and average cost (AC) at Q1. The firm‘s total economic profit is indicated by the shaded

rectangle (Mohr and Fourie, 2011).

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Figure 41 Long-run condition of a monopolistic competition


The short-run equilibrium cannot be sustained in the long-run. The economic profit

attracts new entrants as new firms enter the industry. In the long-run, due to new firms,

the demand curve for the product of the firm also becomes more price elastic, since

there are now more close substitutes for the firm‘s product than before. The process will

continue until economic profits have been eliminated and there is no further entry into

the industry. Thus, in the long-run, monopolistic competition only make normal profits

(Mohr and Fourie, 2011).

6.3 Introduction to Oligopoly

Oligopoly is a market structure characterised by relatively few firms selling a particular

type of product. In this market structure, a few firms together dominate the market. A

noteworthy characteristic of this market structure is that there is interdependence

among firms and, as such, firms watch each other‘s actions closely.

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6.4 Oligopoly

Under oligopoly, a few large firms dominate the market. A duopoly exists when there

are only two firms in the industry. The product may be homogeneous (e.g., steel,

cement, petrol) but it is mostly heterogeneous (e.g., motorcars, cigarettes, household

appliances, electronic equipment, household detergents). When the product is

homogeneous, the market is described as a pure oligopoly, and when the product is

heterogeneous (or differentiated), the market is called a differentiated oligopoly.

Oligopoly is the most common market form in modern economies. When people talk

about "big business" and "market power", they are usually referring to oligopolists.

The main feature of oligopoly is the high degree of interdependence between the firms.

Each oligopolist, therefore, always has to consider how its rivals will react to any action

that it takes. The other important feature of oligopoly is uncertainty. To reduce this

uncertainty, oligopolistic firms often collude (enter into agreements) about prices and

output.

Like a monopolist and a monopolistic competitor, the Oligopolist faces a downward-

sloping demand curve. However, the slope of the curve is uncertain, since this depends

on how its competitors will react to price changes - they may decide to follow or not to

follow any price change. Since oligopoly is dominated by a small number of powerful

firms, the entry of new firms is more difficult than under perfect competition or

monopolistic competition. However, in contrast to monopoly, entry is possible.

Competition is often intense, although it tends to be non-price competition, rather than

price competition. The more intensely Oligopolists compete, the closer they are likely to

come to perfectly competitive output.

6.5 A theory of oligopolistic behaviour: The kinked demand curve

Different oligopoly models are not discussed in this module, but to give you some idea

of what oligopoly models are, one of the classic oligopolistic theories (the kinked

demand curve) is outlined.

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The kinked demand curve, as illustrated, Figure 42 does not explain how price and

output are determined under oligopoly, but it does illustrate the importance of

interdependence and uncertainty in oligopolistic markets. It is one of the possible

explanations for the observed degree of relative price stability under oligopoly.

Figure 42 The Kinked Demand Curve Model of Oligopoly

Source: www.transtutors.com

The kink in the demand curve is at the market price P1 with the amount which the firm

Produces at Q1; this is the point of profit maximisation. The significance of P1 is that

oligopolists will be wary of moving away from it individually because they cannot be

certain of the reactions of their rivals. The curve is relatively elastic above P1 and

inelastic below it.

Reason why the demand curve is kinked:

Hence, if firms raise prices and their rivals do not follow, they will lose market share; if

they cut prices, their rivals will follow to protect their own position, which means that all

firms will end up with lower prices and profits on unchanged market shares.

Consequently, prices will be inflexible at P1.

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6.6 Oligopoly and collusion

Oligopolists can conspire by entering into an agreement, arrangement or understanding,

to limit competition in the industry and maintain high degrees of profitability in the long-

run. Sellers can, for example, agree to charge the same prices for certain products, to

grant uniform discounts, or to limit their marketing and distribution to certain regions. A

specific arrangement among otherwise competitive firms to limit output, to set prices, or

to share the market, is called a cartel. Refer to case study in the appendix for more

information regarding collusion in the construction industry. Oligopolistic firms can agree

to raise prices.

Collusion is only successful if agreements can been forced. When a large number of

sellers are involved, successful collusion is highly unlikely (if not impossible). Some of

the sellers will invariably break the agreement with the hope that others will not notice or

retaliate. With a small number of large producers, the distribution of profits among the

members of a cartel is always a source of dispute. The conditions for successful

collusion include the following;

The number of firms must be small and they must be well known to each other.

The firms should have similar production methods and average costs and

therefore have an incentive to change prices at the same time, by the same

percentage.

The product should be homogeneous rather than heterogeneous, making it

easier to agree on the price.

There should be significant barriers to entry which reduce the possibility (and

fear) of disruption by new firms.

The market should be stable.

There should be no government measures to curb or prohibit collusion.

Entry barriers

Natural barriers to entry are an important part of the explanation of the persistence of

profits in many oligopolists industries (Lipsey and Chrystal, 2011). Among these,

economies of scale are probably the most important. Where such natural barriers do not

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exist, oligopolistic firms can earn profits in the long-run only they can create entry

barriers.

Brand proliferation

By altering the characteristics of a differentiated product, it is possible to produce a vast

array of variations on the general theme of the product. The larger the number of

differentiated products sold by existing oligopolists, the smaller the market share

available to a new firm entering with a single new product.

Advertising

Existing firms can create entry barriers by imposing significant fixed costs on new firms

that enter their market space. Advertising serves the useful function of informing buyers

about their alternatives, thereby making markets work more smoothly. It is essential to

make consumers aware of new products, whether these are produced by existing firms

or new entrants.

However, advertising can also operate as a potent entry barrier by increasing the set-up

costs of new entrants. Where heavy advertising has established strong brand images

for existing products, a new firm may have to spend heavily on advertising to create its

own brand images in consumers‘ minds. If the initial sales are small, advertising costs

per unit sold will be large, and price will have to be correspondingly high to cover those

costs (Lipsey and Chrystal, 2011).

Product innovation and new technologies

New products, protected by patents rights for up to 20 years give the inventing company

a period in which they can make profits. Good examples of these are the

pharmaceutical and electronic industries. Thus, in these industries, innovation acts as a

barrier to entry. Concerning industries, the race is to continue inventing and be

protected by patents rights.

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After completing your study of market structures, reflect on the following questions. (To

adequately address these questions, you will need to have completed all the

„essential reading‟ listed at the beginning of this section.)

1. Discuss the difference between monopolistic competition and oligopoly.

2. Discuss why the oligopoly market structure is characterised by the ―Kinked

demand curve‖.

3. Discuss why firms operating in an oligopoly market structure can become

involved in collusion.

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PART 4: Economic Concepts for Global

Managers

SECTION 7:

International Trade



able to understand the interaction between the national economy and the global one.



1. Critically evaluate international trade along with the benefits and drawbacks it

poses for nations who engage in free trade;

2. Decisively analyse how the advent of globalisation had led to increased trade

between the nations of the world; and

3. Discuss tariffs, quotas and embargoes and their effects on international trade.

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7.1 Introduction

The rise in popularity of international trade can be said to coincide with the advent of

globalisation. The Economist explains the concept of globalisation as:

―A buzz word that refers to the trend for people, firms and governments around

the world to become increasingly dependent on and integrated with each other.

This can be a source of tremendous opportunity, as new markets, workers,

business partners, goods and services and jobs become available, but also of

competitive threat, which may undermine economic activities that were viable

before globalisation.‖

Source: http://www.economist.com/economics-a-to-z [Accessed 21 December 2015]

The term first surfaced during the 1980s to characterise huge changes that were taking

place in the international economy, notably the growth in international trade and inflows

of capital around the world. Globalisation has also been used to describe growing

income inequality between the world‘s rich and poor; the growing power of multinational

companies relative to national government; and the spread of capitalism into former

communist countries. Usually, the term is synonymous with international integration, the

spread of free markets and policies of liberalisation and free trade. The process is not

the result simply of economic forces. The decisions of policymakers have also played

an important part, although not all governments have embraced the change warmly.

The driving force of globalisation has been multinational companies, which, since the

1970s, have constantly, and often successfully, lobbied governments to make it easier

for them to put their skills and capital to work in previously protected national markets.

Firms enjoying some national protection, and their (often unionised) workers, have been

some of the main opponents of globalisation, along with advocates of fair trade. See

the case study in the Appendix regarding the arrival of Walmart in SA for more

information on this aspect.

http://www.economist.com/economics-a-to-z

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Globalisation is not a new phenomenon. Globalisation or viewing the ‗world as a whole‘

seems to be rather quintessentially at first glance. Ever since mankind started to explore

‗new‘ worlds, the opportunity to interact with each other became more apparent. In

doing so, foreigners exchanged ideas, goods and services, and many other things with

locals and the natural outcome of this caused a convergence in society.

Gills and Thompson (2006) claim that growing interdependence enriches some people

and marginalises others. Selected poorer areas gain new jobs while other areas lose

employment to places with lower wage structures. There are also clearly other losses as

globalised crime and pollution, as well as the more rapid dissemination of disease.

Some professional observers counsel that these economic changes are inevitable,

while others mobilise in protest and opposition to unregulated and often rapid change.

The purpose of this chapter is to present economic concepts and tolls needed by any

professional employed by a corporation dealing in international markets. Since the end

of apartheid, SA has been involved in international trade and has become increasingly

globalised. Figure 43 shows that SA has also begun to trade with other African

countries.

Figure 43 Exports by Region

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As a result of growing international trade between countries, the concept of the balance

of payments of an economy is important. The balance of payments of a country may be

viewed as a summary record of all transactions involving payments or receipts of

foreign exchange between that country and the rest of the world.

7.2 International Trade

Foreign trade involves payment in foreign currencies such as the euro (€), pound

sterling (£), US dollar ($) and Japanese Yen (¥). South African importers have to pay in

these currencies for the goods and services they buy and are, therefore, obliged to

exchange South African rands for these currencies.

There are basically three ways in which a government can limit or prohibit world trade:

First, it can make imported goods more expensive through tariffs;

Secondly, it can impose quantitative restrictions on the volume of trade with

quotas; and

Third, it can make world trade more difficult or expensive to engage in as a result

of foreign exchange transactions.

Import tariffs are duties or taxes imposed on products imported into a country. They are

used to protect domestic firms against competition from imports or to raise government

revenue. For the two categories of tariffs: ad valorem and specific, refer to Mohr and

Fourie (2008: 377).

Ad Valorem means ‗according to value‘ and this type of tariff is levied on a good based

on its value.

A specific tariff is a fixed fee levied on one unit of an imported good and this tariff can

vary according to the type of good imported.

Trade tariff are designed to:

Protect new or infant industries from foreign competition

Aging and inefficient domestic industries from foreign competition

Domestic producers from dumping (explained below) by foreign companies and

or governments.

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Ultimately, tariffs increase the price of imported goods, which intends to curb excessive

imports and support local production instead.

The construct below summarises the main barriers to trade which can be implemented

by governments:

Figure 44 Main Barriers to Trade

Tariff

• Tariffs are a more frequent and commonly used trade barrier.

• A tariff is a special tax imposed on imported goods making these goods more expensive in the local market.

• As a result, these imported goods become less competitive in domestic markets. Tariffs also serve another important function in that it is a source of revenue for governments.

• While tariffs have the benefit of protecting local producers against a deluge of cheap foreign brands, it also has a ‘hidden’ cost in that consumers end off paying more for a same product under a tariff scheme.

Quota

• A quota works similarly to a tariff but whereas a tariff imposes a tax on an imported item, making it more expensive and thus limiting the quantity imported, a quota simply limits the quantity that is allowed to be imported. In other words, quotas work more directly by limiting the quantity that can be imported.

Embargo

• A trade embargo is an absolute instrument in that it prevents any form of trade from occurring at all.

• An embargo is a prohibition of either exports and/or imports.

• For example, South Africans are not allowed to import any form of narcotic drugs into the country. Any person caught violating this trade embargo (apart from violating numerous other anti-narcotic laws) would face severe penalties.

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7.3 The case for protectionism and free trade

Lipsey and Chrystal (2011) accepts the view that free trade allows the maximisation of

world production for any given set of world costs, thus making it possible for each

consumer in the world to consume more goods, that he or she could without free trade.

Is it possible free trade improve everyone‘s living standards? The answer is yes. But

does free trade infact always do so? The simple answer is no. This raises the issue of

protectionism.

7.3.1 Arguments for protectionism

Protection of infant industries.

If a firm has large economies of scale, costs will be lower. Costs will be high when the

industry is small, but will fall as the industry grows. The firms in the country which were

‗first in the field‘ have tremendous advantage. A newly developing country may find that

in the early stages of development, its industries are unable to compete with established

foreign rivals. For example, consider the case in South Africa about the Brazilian

chickens vs the South African. South African firms are still growing, hence they were out

competed. A trade restriction may protect these industries from foreign competition

while they ‗grow up‘. When these industries are large enough, they will be able to

produce as cheaply as foreign rivals, and thus be able to compete without protection

(Schiller, 2013)

The form emphasises that technology is constantly changing endogenously and that

those countries at the frontier of technological advance have an enormous advantage of

experience and have acquired ability in inventing and innovating, over those who

industrialised at a later stage. To develop these abilities, a country needs to protect its

domestic industries during the early stages.

Encouragement of learning by doing

The dynamic version of the infant industry argument is supported by the argument

based on learning-by-doing. The argument is that skills and other things that help create

comparative advantages, which are not fixed forever, can be learned by producing the

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new products if enough time is allowed for the learning to take place. Thus, learning by

doing suggests that the pattern of comparative advantage can be changed. For

example, the success of Newly Industrialising Countries (NICs), i.e. Brazil, Hong Kong,

South Korea, Singapore and Taiwan, are largely based on acquired skills (Lipsey and

Chrystal, 2011).

Creation or exploitation of a strategic trade advantage.

According to Lipsey and Chrystal (2011), a recent argument for tariffs or other trade

restrictions is to create a strategic advantage in producing or marketing some new

product that is expected to generate profits. The first firm to develop and market a new

product successfully may earn a substantial pure profit over all of its opportunity costs,

and become one of the few established firms in the industry. If protection of the

domestic market can increase the chance that one of the protected domestic firms will

become one of the established firms in international market, the protection may payoff.

Protection against unfair actions by foreign firms and governments.

Tariffs may be used to prevent foreign industries from gaining an advantage over

domestic industries by use of predatory practices that will harm domestic industries and

hence, lower national income. One of these practices is called dumping (Mohr and

Fourie, 2011).

Risk Specialisation

For a country specialising in the production of only a few products-may involve risks that

the country does not wish to take. Technological advances may render a country‘s

product obsolete and thus leads to employment problems as jobs might have to be cut.

(Lipsey and Chrystal, 2011).

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7.3.2 Arguments for free trade

Infant industries never abandon their tariff protection.

Granting protection to infant industries will make them stop growing and be efficient

enough to compete with fully grown ones. If the industry never grows, permanent tariff

protection would be required to protect a weak industry that will never be able to

compete on an equal footing in the international market. It is also argued that infant

industries protection disadvantage consumers from having cheaper products from other

countries. Thus protection leads to loss of consumer welfare.

7.3.3 Fallacious arguments for protectionism

It prevents exploitation

According to the exploitation theory, trade can never be mutually advantageous; one

trading partner must always reap gain at the other‘s expense. Thus, the weaker trading

partner must protect itself by restricting its trade with the stronger partner. By showing

that both parties can gain from trade, the principle of comparative advantage refutes the

exploitation doctrine of trade. When opportunity-cost ratios differ in two countries,

specialisation and the accompanying trade make it possible to produce more of all

products. This makes it possible for both parties to consume more as a result of trade

than they could get in the absence (Mohr and Fourie, 2011).

It protects against low-age foreign labour

Lipsey and Chrystal (2011) argue that, in industrialized nations, the products of low-

wage countries will drive domestic products from the marker, and high domestic

standard of living will be dragged to that of its poorer trading partners. Arguments of this

sort have swayed many voters through the years.

Exports raise living standards; imports lower them

Exports create domestic income and employment; imports create income and

employment for foreigners. Thus, other things being equal, exports tend to increase our

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total national income and imports reduce it. Surely, then, it is desirable to encourage

exports by subsidising them and to discourage imports by taxing them.

This is an appealing argument, but it is incorrect. Exports raise national income by

adding to the value of domestic output, but they do not add to the value of domestic

consumption. In fact, exports are goods produced at home and consumed abroad, while

imports are goods produced abroad and consumed at home. The standard of living in a

country depends on the goods and services available for consumption, not on what is

produced.

The living standards of a country depend on the goods and services consumed in that

country. The importance of exports is that they permit imports to be made. This two-way

international exchange is valuable because more goods can be imported than those

that could be obtained if the same goods were produced at home (Lipsey and Chrystal,

2011).

It creates domestic jobs and reduces unemployment

Suppose that tariffs or import quotas cut the imports of Japanese cars, Chinese textiles,

US computers, and Polish vodka to EU for example. Surely, the argument maintains,

this will create more employment in local industries producing similar products. The

answer is that it will – initially. But the Japanese, Koreans, Americans, and Poles can

buy from the EU only if they earn euro by selling things to (or by borrowing euro from)

the EU. The decline in their sales of cars, textiles, computers and vodka will decrease

their purchases of Spanish vegetables, French fruit, wine, and holidays in Greece. Jobs

will be lost in EU exports industries, and gained in those industries that formerly faced

competition from imports. The likely long-term effect is that overall employment will not

be increased but merely redistributed among industries. In the process, living standards

will be reduced because employment expands in inefficient imports-competing

industries and contracts in efficient exports industries (Lipsey and Chrystal, 2011).

Industries and unions that compete with imports often favour protectionism, while those

with large exports usually favour more trade. Protection is an ineffective means to

reduce unemployment.

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7.4 Global commercial policy

Before 1947, most countries were free to impose any tariffs on their imports. However,

when one country increased its tariffs, the action often triggered retaliatory actions by its

trading partners. The Greatest Depression of the 1930s saw a high-water mark of world

protectionism, as each country sought to raise its unemployment by raising its tariffs.

The end results were lowered efficiency, and less trade but no increase in employment.

Since then, much effort has been devoted to reducing tariff barriers, on both a

multilateral and regional basis.

7.4.1 The GATT and the WTO

One of the most notable achievements of the post-war era was the creation of the

General Agreement on Tariffs and Trade (GATT). An important rule of the GATT was

that each member country agreed not to make unilateral tariff increases. This prevented

the outbreak of tariff warm in which countries raise to protect particular domestic

industries, and to retaliate against other countries‘ tariff increases. Such wars usually

harm all countries as mutually beneficial trade shrinks under the impact of escalating

tariffs barriers.

World Trade Organisation (WTO) was the organisation that superseded the GATT in

1995. It also created a new legal structure for multilateral trading. Under this new

structure, all members have equal/ mutual rights and obligations. Until the WTO was

formed, developing countries who were GATT enjoyed all the GATT rights but were

exempt from most of it obligations to liberalise trade—obligations that applied only to the

developed countries.

7.4.2 Types of regional agreements

According to Lipsey and Chrystal (2011), regional agreements seek to liberalise trade

over a much smaller set of countries, than multilateral agreements undertaken through

the WTO do. Four standard forms of regional trade-liberalising agreement are: free-

trade areas, custom unions, common markets, and economic unions.

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Free-trade area (FTA)

It allows for tariff-free trade among the member countries, but it leaves each member

free to impose its own trade restrictions on imports from other countries. As a result,

members must maintain custom points at other common borders to make sure that

imports into the free-trade area do not all enter through the member that is levying the

lowest tariff on each item. They must also agree on rules of origin to establish when a

good is made in a member country, and hence is able to pass duty-free across their

borders, and when it is imported from outside the free-trade area, and hence is liable to

pay duties when it crosses borders within the free-trade area.

Customs union

This refers to a free-trade agreement to establish common barriers to trade with the rest

of the world. Because they have common tariffs against the outside world, the members

need neither customs controls on goods moving among themselves nor rules of origin.

Common market

Is a customs union that also has free movement of labour and capital among its

members.

Economic union

Takes things further and creates an area that shares many other aspects of economic

policy and harmonised legal structures, such as in the European Union today.

7.4.3 Trade creation and trade diversion

A major effect of regional trade liberalization is on resource relocation. Economic theory

divides these efforts production into two categories:

Trade creation

Occurs when producers in one member country find that they can undersell producers

in another member country, because the latter have lost their tariff protection. For

example, when the North American Free Trade Agreement (NAFTA) came into force,

some Mexican firms found that they could undersell their US competitors in some

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product lines, while some US firms found that they could undersell their Mexican

competitors in others, once tariffs were eliminated. As a result, specialisation occurred

and new international trade developed (Lipsey and Chrystal, 2011).

Trade diversion

Occurs when exporters in one member country replace foreign exporters, as suppliers,

to another member country, as a result of preferential tariff treatment. For example, US

trade diversion occurs when Mexican firms find that they can undersell competitors from

the EU in the US market, not because they are the cheapest source of supply, but

because their tariff-free prices are lower than the tariff-burdened prices of imports from

Europe. This effect is a gain to Mexican firms but a cost to the United States—which

now has to pay more for any given amount of imports than before the trade diversion

occurred.

From the global perspective trade diversion represents an inefficient use of

resources.

From the narrower national points of view of Mexico and the United States, however,

trade diversion brings some gain as well as some loss. In so far, as there is a shared

desire to increase domestic manufacturing production, trade diversion brings mutual

benefit to both countries. It gives producers within the two countries an advantage over

producers in the rest of the world, which has the effect of increasing the total amount of

production and trade that occurs among the member countries while reducing what

comes in from third countries.

EFTA, NAFTA, and other FTAs

The first important free-trade area in the modern era was the European Free Trade

Association (EFTA). It was formed in 1960 by a group European countries that were

unwilling to join the European Economic Community, as the EU was then called,

because of its all-embracing character. Not wanting to be left out of the gains from

trade, they formed an association whose sole purpose was tariff removal. First, they

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removed all tariffs on trade among themselves. Then each country signed a free-trade-

area agreement with the EEC (Lipsey and Chrystal, 2011).


After completing your study of international trade, reflect on the following



1. International trade is often seen in a positive light. Based on this fact, any form of

trade protection is considered ‗inefficient‘ as any producers who are unable to be

internationally competitive should rather move their resources into production

areas where they can be internationally efficient. What are your feelings

regarding this assertion? Do you agree/disagree with the above assertion?

2. The World Bank Report (2012) on global trade patterns indicate that the volume

of trade into Africa has been steadily increasing in recent years. Why do you

think this has been the case? In addition, do some investigation into inter-Africa

trade. How has this been changing in recent years and has SA adequately taken

advantage of the growth in Africa?

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PART 4:

Economic Concepts for Global Managers

SECTION 8:

Exchange Rates



able to demonstrate an understanding of what the exchange rate refers to and how the

value of the Rand Dollar exchange rate is determined.



1. Evaluate what is meant by appreciation/depreciation of the rand;

2. Critically analyse the implications for the business and the economy of an

appreciation in the rand and that of depreciation in the rand; and

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8.1 Introduction

When businesses engage in international trade, importing and/or exporting requires

knowledge of exchange rates. As was explained in the previous section, globalisation is

becoming more prevalent in modern day business. As the world adapts and modernises

to ever changing trends, products and resources tend to move over international

boundaries. Implicit within this growth is the ‗oil‘ that lubricates the massive cogs which

drive international trade, and this oil can be referred to as the exchange rate. Every

transaction is accompanied with a corresponding exchange of currency. It is, therefore,

not surprising then that the value of relative currencies (the exchange rate) between

trading nations has become pivotal in international trade.

8.2 What the exchange rate refers to

The exchange rate is simply the price at which one currency exchanges for another

currency. In other words, the exchange rate is the price of one country‘s currency

expressed in terms of another country‘s currency. It is the domestic price of a foreign

currency. For example, if you exchange 12 South African Rands (ZAR) for every one (1)

United States Dollar ($), the exchange rate is simply R12.00 = $1.

It must be emphasized that this exchange rate will fluctuate on a daily basis and part of

an effective business leader‘s challenge is to anticipate or forecast future exchange

rates (called the forward rate) and make decisions now based on that forecast. For

more information on these daily exchange rate fluctuations, go to the South African

Reserve Bank website and click on exchange rates.

8.3 The foreign exchange market

Exchange rates are determined in foreign exchange markets. The foreign exchange

market is the market where the currency of one country can be exchanged for the

currency of another country. It is important to realise that the foreign exchange market is

not a physical place but extends beyond international boundaries. It is simply individuals

(or firms) wanting to exchange one currency for another. These individuals are usually

importers and exporters, banks, international travellers, and foreign exchange traders.

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The foreign exchange market exists simply because there is always a demand and

supply for currencies. Participants will demand and supply currency in the foreign

exchange market due to exports, imports, investments, interest rates differentials, and

future expectations.

Demand for Rands in the foreign exchange market. People will demand foreign

exchange for a number of reasons. For example, when Walmart entered the South

African market, it required South African Rands (ZAR) in order to invest (and buy) in

Massmart. In other words, Walmart, which is American based, needed to exchange

their USD for ZAR in order to invest in South Africa. What would happen when

foreigners (people living outside South Africa) demand South African goods and

services? When South Africa exports goods to Japan, for example, the Japanese will

need to exchange their Yen for ZAR in order to pay the South African exporter. There

will also be a demand for ZAR when foreigner tourists visit South Africa. These tourists

will need to exchange their foreign currency for ZAR in order to buy local products and

services.

Thus, the quantity of ZAR demanded is the amount that all participants plan to buy at

the prevailing exchange rate at a given point in time. This quantity will depend on a

number of factors but the most common (Parkin 2010: 578) are:

The Exchange Rate;

The expected future Exchange Rate;

World (or foreign) demand for South African exports;

World (or foreign) demand for South African tourism;

World (or foreign) demand for South African investments;

Interest Rate differentials between South Africa and the world; and

Speculation.

An increase in

the value (price) of one currency in terms of another currency (appreciation) automatically implies a

decrease (depreciation) in the value of the other currency.

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The demand curve for the South African Rands (ZAR) will depend on the prevailing

exchange rate. If the exchange rate depreciates, ceteris paribus, then the demand for

Rands will increase and there is a downward movement along the demand curve for

ZAR. If the exchange rate appreciates, then the demand for ZAR will decrease.

8.4 Supply of South African Rands

Just as people demand ZAR in the foreign exchange market, so, too, will people supply

ZAR into the foreign exchange market. For example, when Anglo American imports

huge capital equipment from Germany earmarked for mining operations in South Africa,

it would need to convert ZAR into the Euro in order to pay the German supplier. When

South African businesses want to set up subsidiary in foreign countries, they would

need to convert their ZAR into the currency of that country where the subsidiary is to be

opened. Similarly, when South Africans go abroad on holiday, they will need to convert

their ZAR into the local currency of the country they are visiting.

Thus, the quantity of ZAR supplied is the amount that all participants plan to sell at the

prevailing exchange rate at a given point in time. This quantity will depend on a few

factors of which the most common, as mentioned in the previous section (Parkin

2010:580) are:

The Exchange Rate;

The expected future Exchange Rate;

South African demand for imports;

South African demand for foreign tourism;

South African demand for foreign investments;

Interest Rate differentials between South Africa and the world; and

Speculation.

The supply curve for the South African Rand (ZAR) will thus depend on the prevailing

exchange rate. If the exchange rate depreciates, ceteris paribus, the supply of Rands

will decrease and there is a downward movement along the supply curve for ZAR. If the

exchange rate appreciates, then the supply for ZAR will increase. Janse Van Rensburg

(2011:516) explains that the following determinants can influence the demand and/or

supply of a certain currency:

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Changes in Tastes;

Relative Income Changes;

Relative Price Level Changes;

Relative Interest Rates; and

Speculation.

Both Janse Van Rensburg (2011) and Schiller (2013) provide explanations on the

supply for currencies and you need to be able to explain each of these determinants.

Make sure that you understand how each of the determinants influence the demand

and/or supply of a currency.

8.5 Market equilibrium in the market for Rands

Figure 35 Market equilibrium

Market equilibrium, as was the case in both the goods and factor markets, simply exists

where the demand for ZAR equals the supply of ZAR. This is where the demand curve

and the supply curve intersect each other. At the exchange rate of R12 = $1, there is

neither a shortage nor surplus in the market. The market is ‗orchestrated‘ into

equilibrium by the individual forces of demand and supply. This would only be the case

in the absence of zero central bank intervention which is rather rare in reality. Towards

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the end of this chapter, we discuss exchange rate policies and explain how the central

bank can influence the exchange rate should it choose to do so.

8.6 Balance of Payments

A country‘s balance of payments is the sum of all the transactions that take place

between the residents of a country and the residents of all foreign nations. Those

transactions include exports and imports of goods, exports and imports of services,

tourist expenditures, interests and dividends received and paid abroad, and purchases

and sales of financial and real assets abroad (Janse Van Rensburg, 2011:510).

Stated simply, the Balance of Payments account is a recording of all the above

mentioned transactions, separated or broken up into a current account and a financial

account. This means, like most other accounting records, the balance of payments

could be either in a deficit or surplus. Balance of payments stability means that this

balance is managed over time and that there are not unwarranted changes to it. Clearly,

the exchange rate is critical in a country‘s balance of payments as it determines the

quantum of imports and exports

8.6.1 Balance of payment accounts

The Current account

Merchandise exports and merchandise imports simply reflect the Rand value of

the goods exported and imported during the period.

Together with net gold exports, they constitute what is referred to as the trade

balance.

A particular feature of South Africa‘s balance of payments is the appearance of

net gold exports as a separate item – this is because gold is our most important

export.

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Service receipts and payments for services: Trade in services includes the

transportation of goods and passengers between countries, travel, construction

services, financial and insurance services, various business, professional and

technical services, as well as personal, cultural and recreational services, and

government services. Money spent by tourist on food and accommodation while

traveling in foreign countries falls in this category as well. In South Africa‘s case,

the payments for services are larger than the service receipts.

Income receipts and income payments: Income receipts refer to income earned

by South African residents in the rest of the world, while income payments refer to

income earned by non-residents in South Africa. Note that income receipts in the

balance of payments are equal to the ―primary income from the rest of the world‖

identified in the national accounts. Likewise, income payments in the balance of

payments are equal to the ―primary income to the rest of the world‖ identified in

the national accounts.

Current transfers: This entry includes social security contributions and benefits,

taxes imposed by government, and private transfers of income such as gifts,

remittances and donations. By transfers we mean money, gifts or services

transferred without anything tangible being received in return.

If there is a surplus on the current account, it indicates that the value of the country‘s

exports exceeded the value of its imports during the period under review. If there is a

deficit, then imports were greater than exports (Mohr and Fourie, 2011).

The Financial account

This account records transactions in assets and liabilities. The financial account has

three main components:

Direct investment: the purpose is to gain control of, or have considerable influence

over, the management of an enterprise. This can be either via the acquisition of

an existing operation or starting a new operation.

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Portfolio investment: the purchase of assets such as shares and/ or bonds where

the investor is interested only in the expected financial return on the investment.

Other investments: Are all financial transactions not included in the above two

categories. These include loans, currency and deposits. Short term trade credit

falls in this category.

If there is a surplus on the financial account, it indicates that more funds flowed into the

country than flowed out during the period concerned. In this case we say that there was

a net inflow of foreign capital into the country. If there is a deficit, it indicates that there

was a net outflow of foreign capital (Mohr and Fourie, 2011).

Unrecorded transactions

The unrecorded transactions are the next entry on the BOP. Since the double entry

system is used to record transactions on the BOP, the net sum of all credit and debit

entries, should equal the change in the countries net gold and other foreign reserves. In

reality this does not happen. All mistakes and omissions are recorded in the

―unrecorded transactions‖.

Gold and other Foreign Reserves

A country receives foreign exchange (forex) for exports and also has to pay forex (for

imports). If the income (receipts) of forex exceeds forex payments, then the country‘s

forex reserves will rise. If the country has to pay out more forex than it receives, then

the forex reserves will fall. The sum of all the accounts we have discussed thus far will,

therefore, be reflected in the change in foreign reserves. A part of South Africa‘s gold

production is held by the SARB as part of foreign reserves. If necessary, the

government can sell their gold holding on the foreign market to secure more foreign

exchange (forex) reserves. (Mohr and Fourie, 2011).

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The balance of payments and economic activity in South Africa

In South Africa, exports are a major source of demand for domestically produced goods,

and therefore also of production, income and employment. A large percentage of

domestic spending in South Africa is on imported goods and services, particularly on

capital and intermediate goods required by the domestic industry. As economic activity

in South Africa increases, imports always increase as well. When demand for imports

increases, the demand for foreign exchange increases. If foreign exchange is lacking, or

if there is no intervention, the rand will depreciate against other currencies. This will

assist exporters in the short run, but will also lead to higher import prices which

stimulate inflation.

The SARB can prevent sharp fluctuations in the value of the rand if it has sufficient

reserves; if not, the demand for imports must be cut back. Reducing domestic demand

will be accompanied by a fall in imports, but this means that domestic production,

income and employment have to be sacrificed. When there are large deficits on the

financial account (in South Africa, this occurred during 1985 – 1993), these deficits have

to be balanced by surpluses on the current account (Mohr and Fourie, 2011).

8.7 Trade balance and exchange rate

Exports effect

The exports effect is dependent on the relative exchange rate and simply means ‗the

larger the value of South African (or any other country for that matter) exports, the larger

the quantity of ZAR demanded in the foreign exchange market (Parkin, 2010).

It is best explained using an example.

Assume Cindy from the US wants to import a single bottle of South African wine (selling

for $1 per bottle) into United States and assume that the exchange rate is $1 = R4

(notice that the dollar is expressed in terms of ZAR given that this is how Americans will

express the exchange rates from their perspective). This means that Cindy will demand

4 ZAR in the foreign exchange market (and supply 1 dollar). If the ZAR weakened to

say R8 = $1, then Cindy could now get 8 ZAR for the same $1 being spent, or spend 50

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American cents and buy that same bottle of wine. If she still wanted to spend a total of

$1, she could now buy two bottles of wine instead of just a single bottle. This means

that the volume of exports from South Africa will increase (more wine being exported).

All other factors being equal, a depreciation of the ZAR will cause exports to increase

and this is called the exports effect.

Imports

Generally, the weaker the rand, the more expensive imports will become. This will affect

businesses which import components negatively. The imports effect also relates to the

relative strength of a currency and simply means the greater the value of South African

imports, the greater the quantity of ZAR supplied in the foreign exchange market (Parkin

2010). Assume Thabo wants to import an orange from United States and assume that

the selling price of this orange in United States is $1 (for the purposes of simplicity). If

the Rand/Dollar exchange rate is R8 = $1, Thabo will need to supply the foreign

exchange market R8, convert this to $1, and then import the orange into South Africa.

What would happen if the ZAR appreciated to say R4 = $1? If Thabo still wanted to

spend R8 for oranges, he now receives $2 and can now buy 2 oranges. This means

that the volume of South African imports increases with an appreciation of ZAR and this

is referred to as the imports effect. In other words, a stronger ZAR will aid imports into

South Africa.

8.7.1 Patterns of trade and the J-curve effect.

The above assumptions on the import and export effect is that if a currency depreciates,

exports will improve and imports decreases and when the country‘s currency

appreciates, exports will suffer and imports improves.

Marshall-Lerner condition states that a depreciation of domestic currency can improve a

country‘s balance of payments only when the sum of the demand elasticity of exports

and the demand elasticity of imports exceeds (McConnell, 2006).

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In the short term, a devaluation or depreciation of the exchange rate may not improve

the current account deficit of the balance of payments. This is due to the low price

elasticity of demand for imports and exports in the immediate aftermath of an

exchange rate change. The diagram below shows this possibility.

Figure 46 The J-curve

Adopted: (McConnell and Brue, 2011)

Assuming that the economy begins at position A with a substantial current account

deficit, there is then a fall in the value of the exchange rate. Initially, the volume of

imports will remain steady partly because contracts for imported goods will have been

signed.

However, the depreciation raises the price of imports, causing total spending on imports

to rise. Export demand will also be inelastic in response to the exchange rate change in

the short term; therefore the earnings from exports may be insufficient to compensate

for higher spending on imports. The current account deficit may worsen for some

months. This is shown by the movement from A to B on the diagram.

BP Surplus

BP Deficit

t0 t1 t20

Time

e↑

A

B

C

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Providing that the elasticities of demand for imports and exports are greater than

one in the longer term, then the trade balance will improve over time. This is known as

the Marshall-Lerner condition.

In the diagram above showing the J curve effect; as demand for exports picks up and

domestic consumers switch their spending away from imported goods and services, the

overall balance of payments starts to improve. This is shown by the movement A to C

on the diagram.

Reasons for J-Curve Effect:

Recognition lags of changing competitive conditions;

Decision lags in forming new business connections and placing new orders;

Delivery lags between the time new orders are placed and their impact on trade

and payment flows is felt;

Replacement lags in using up inventories and wearing out existing machinery

before placing new orders;

Production lags involved in increasing the output of commodities for which

demand has increased.

8.8 Change in demand and supply

As was the case in the goods market, there are also determinants of demand and

supply which may shift the demand and/or supply curve in the foreign exchange market.

Depending on the actual determinant under consideration, the demand or supply curve

could shift, thereby causing a change in the demand or supply of the currency. You

need to be able to explain how the determinant will influence either the demand and/or

supply curves for a certain currency. Given the macroeconomic impacts stemming from

currency volatility, it is not surprising that most governments around the world have an

Exchange Rate Policy. This policy is implemented when the government or central bank

wishes to influence the exchange rate in some way. For example, the central bank may

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intervene when the exchange rate has displayed enormous volatility and wishes to

‗buffer‘ this volatility.

Figure 47 Change in demand and supply

8.9 Exchange rate policy

• A fixed exchange rate is a rate set and maintained by the government in conjunction with its Central Bank

• (e.g. South African Reserve Bank).

Fixed exchange rate

• A floating exchange rate is a rate determined in free markets by the law of supply and demand

Floating exchange rate

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Both Janse Van Rensburg (2011: 519) and Schiller (2013:800) provide explanations on

exchange rate interventions and you need to understand the different types of

interventions. Listed below is a synthesis of the different types of interventions.

Flexible Exchange Rate – occurs when there is minimal central bank intervention in the

foreign exchange market and the exchange rate is determined mainly through the

forces of supply and demand. Most countries – and South Africa is among them – adopt

a flexible exchange rate regime as a result of being members of General Agreement on

Trade and Tariffs (GATT) and the International Monetary Fund (IMF).

Flexible exchange rates are also sometimes referred to as floating exchange rates and,

in recent times, there have been many critics of this system. Calvo and Reinhart (2000)

presented a paper called ‗The Fear of Floating‘ where they claim that some countries –

mainly the emerging market – prefers a smoother (less volatile) exchange rate to a

floating exchange rate regime. This is due to many of these countries having

macroeconomic shocks as a consequence of the financial crisis in the last two decades.

Even though these countries claim to adopt flexible exchange rate systems, they are

actually reluctant to let the nominal exchange rate fluctuate in response to

macroeconomic shocks.

Those in support of GATT and WTO, on the other hand, try and advocate a system

premised on being purely flexible. They claim that a flexible exchange rate system

facilitates free trade and allows international trade to flourish. Director-General Pascal

Lamy, in opening the WTO Seminar on Exchange Rates and Trade on 27 March 2012,

said that ―the international community needs to make headway on the issue of reform of

the international monetary system. Unilateral attempts to change or retain the status

quo will not work. We need an international monetary system which facilitates

international trade‖.

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Fixed Exchange Rate– occurs when the exchange rate is pegged to a predetermined

value set by the government or central bank. In such a case, the central bank blocks the

forces of supply and demand by direct intervention in the foreign exchange market.

Interestingly, the world economy operated on a fixed exchange rate regime since the

end of World War 2 right up to the early 1970s. China adopted a fixed exchange rate

system until only recently. However, despite adopting a flexible exchange rate system,

they do not seem in essence to really have a flexible exchange rate. They frequently try

and undervalue the Yuan in an effort to influence their level of exports.

Crawling Peg – this type of intervention occurs when the central bank or government

selects a target path for the exchange rate and then intervenes in the foreign exchange

market to achieve this target. The crawling peg is sometimes favoured because it

prevents the economy from unintended macroeconomic shocks given global financial

problems (which can occur in a flexible rate regime) and also to avoid the problems of

running out/stockpiling of reserves under a fixed exchange rate regime.

The figure below (Figure 48) provides some insight for the business manager into the

performance of the rand exchange rate vs. the dollar since 1995.

Figure 48 Performance of the rand exchange rate vs. the dollar (since 1995)


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After completing your study of exchange rates, reflect on the following



1. Changes to the exchange rate can have considerable effects on a country‘s

trading position, and impacts on macroeconomic variables. List and explain what

will likely happen to a country‘s balance of payments, unemployment levels,

economic output, and inflation when the currency of that country

appreciates/depreciates against other currencies.

2. The Chinese government has recently (in 2015) devalued its currency. Explain

the impact of this on the Chinese economy and on the major trading partners of

China, such as Africa.

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BIBLIOGRAPHY

In addition to the texts referenced under ―Essential Reading‖ at the beginning of each

section of this Study Guide, the following additional texts were utilised in the preparation

of this Study Guide:

Ahlersten,K. 2008. Essentials of microeconomics. Bokboon.com. Available at

http://bookboon.com/en/microeconomics-uk-ebook. Date of Access: 6 October 2015.

Atmanand, D. 2005. Managerial Economics. Excel Books. New Delhi. Date of Access: 6

September 2015.

Calvo, G.A. and C.M. Reinhart. 2000. ―Fear of Floating.‖ University of Maryland.

January

Davies, H and Lam, P.L 2001. Managerial Economics: An Analysis of Business Issues,

third edition. Prentice Hall.

Econometrix. 2015. Client Presentation. Johannesburg.

Froeb, L.M. et al. 2014. Managerial Economics: A Problem Solving Approach. Cengage

Learning. United States of America

Hammermesh, D. 2004. Economics is Everywhere, Second Edition. New York. McGraw

Hill.

Hirshey, M and Bentzen, E. 2014. Managerial Economics , thirteenth edition, Cengage

Learning. United States of America

Investopedia. 2015. www.investopedia.com. Date of Access: 6 October 2015

Janse Van Rensburg, J., McConnell, C. and Brue,S. 2011. Economics Southern African

Edition. Boston. McGraw Hill.

Keating, M. & Wilson, A. (2009) ‗Renegotiating the state of autonomies: statute reform

and multilevel politics in Spain‘, West European Politics, vol. 32, no. 3

Klein, G., Bauman, Y. 2010. The Cartoon Introduction to Economics – Volume one:

Microeconomics. New York. Hill and Wang.

Lipsey, R and Chrystal, A. 2011. Economics. Oxford University Press Inc, New York.

McConnell C.R, Brue, S.L. 2011. Economics, problems and Policies. McGraw-Hill Irwin.

http://bookboon.com/en/microeconomics-uk-ebook

http://www.investopedia.com/

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Mohr, P., Fourie, L. and Associates. 2008. Economics for South African students, fourth

edition. Pretoria: Van Schaik Publishers.

Mohr, P. Fourie, L. 2011. Economics for South African students. Van Schaik. Cape

Town.

Mohr, P. 2012. Understanding Macroeconomics. Van Schaik. Cape Town.

Mote, V., Paul, S. and Gupta, G. 2005. Managerial Economics Concepts and Cases.

New Delhi. Tata McGraw Hill Publishing Company Limited.

Parkin, M. 2010. Microeconomics 9th Edition. Addison Wesley

Peterson, C. and Lewis, C. 2005. Managerial Economics, Fouth Edition. New Delhi.

Prentice-Hall India.

Schiller, B.R. and Hill, C.D. 2013. The Economy Today (13th ed), Boston: McGraw Hill.

South African Reserve Banks. 2015. Phases of the Economy. Available at:

https://www.resbank.co.za/Lists/News%20and%20Publications/Attachments/6776/01Ful

l%20Quarterly%20Bulletin%20%E2%80%93%20June%202015.pdf.

Statistics South Africa. 2015. Labour Market Dynamics in South Africa, 2014. Available

at http://www.statssa.gov.za/?page_id=737&id=1. Date of Access: 6 September 2015

Statistics South Africa. 2015. www.statssa.gov.za. Date of access: 1 October 2015.

World Bank. 2015. Doing Business in South Africa, 2015. Available at

http://www.doingbusiness.org/~/media/GIAWB/Doing%20Business/Documents/Subnati

onal-Reports/DB15-South-Africa.pdf. Date of Access: 6 October 2015.

World Economic Forum. 2014. The Global Competitiveness Report 2014–

2015.Available at:

www.weforum.org/reports/global-competitiveness-report-2014-2015

https://www.resbank.co.za/Lists/News%20and%20Publications/Attachments/6776/01Full%20Quarterly%20Bulletin%20%E2%80%93%20June%202015.pdf

https://www.resbank.co.za/Lists/News%20and%20Publications/Attachments/6776/01Full%20Quarterly%20Bulletin%20%E2%80%93%20June%202015.pdf

http://www.statssa.gov.za/?page_id=737&id=1

http://www.statssa.gov.za/

http://www.doingbusiness.org/~/media/GIAWB/Doing%20Business/Documents/Subnational-Reports/DB15-South-Africa.pdf

http://www.doingbusiness.org/~/media/GIAWB/Doing%20Business/Documents/Subnational-Reports/DB15-South-Africa.pdf

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APPENDIX A

CASE STUDY 1:

Collusion behaviour during

Building of SA World Cup

Stadiums

Instructions to Students

Read the article below. This article has been extracted from Business Day Live.

The questions that you are required to address in analysing the case study are:

1. Discuss the role and mandate of the Competition Commission in South Africa.

2. The article makes reference to collusion. Discuss the industry structure under

which you believe the construction industry in SA operates, and explain the

characteristics of this industry structure.

3. How do you believe society loses out when firms collude?

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Prosecution looms over collusion on stadiums

Nov 12, 2014 | Amanda Visser and Mark Allix

CONSTRUCTION companies implicated in alleged collusive tendering during the

construction of soccer stadia before the 2010 Soccer World Cup on Wednesday said

they noted the first case to be referred for prosecution.

The first case to be referred relates to meetings between the different players in the

construction industry during or around 2006, where Group Five, Murray & Roberts,

Stefanutti Stocks and Basil Read allegedly allocated the Mbombela, Peter Mokaba,

Moses Mabhida, Soccer City, Nelson Mandela Bay and the Greenpoint stadia tenders

amongst them and exchanged cover prices.

The firms allegedly also agreed at those meeting that they should all aim to obtain a

17.5% profit margin in all the stadia projects. Stefanutti Stocks CEO Willie Meyburg said

as far as they were concerned they have settled all outstanding matters arising from the

Competition Commission‘s investigation into the construction industry and the World

Cup Stadia in particular. "The commission‘s statement is generic and accordingly

impossible to respond to with any precision," he said.

Several firms refused to settle with the Competition Commission during the initial fast

track process initiated by the commission in 2011. In that process 15 companies settled

and collectively paid a fine of R1.5bn. The commission‘s construction cartel

investigation involved 140 projects worth R47bn. WBHO paid a fine of R311m, Murray &

Roberts paid R309m, Stefanutti R307m, and Basil Read paid R95m.

The fines included all the matters they settled. The commission is still considering the

referral of 15 separate matters where companies were implicated, but which they

refused to settle with the commission during the initial phase. These cases will be run

separately once the commission has finalised its investigations, Competition

Commissioner Tembinkosi Bonakele said on Wednesday.

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He said they were in discussions with the firms, and if the commission was convinced

that its evidence was not strong enough to stand before the Competition Tribunal it

might drop a case.

"However we have made a promise that cases which were not settled will be

prosecuted in order to safeguard the integrity of our process," Mr Bonakele said.

The firms who refused to settle some of the projects they were implicated in during the

initial fast track process will now have to prove their innocence before the tribunal or

face far larger fines than the ones paid in the settlement process.

Murray & Roberts Group Communications Executive Ed Jardim said the firm received

leniency from prosecution in the matter that was now referred and was not required to

"settle" anything with the commission. "This referral is not related to any new cases of

alleged collusion, but refers to the historical cases as previously disclosed to the

commission," he said.

The second phase of the commission‘s investigation evolved around those firms who

participated in the fast track settlement process, but refused to settle some of the

projects they were implicated in, those who did not want to settle some of the projects

they disclosed and those firms who did not participate at all in the fast track process, but

were implicated by firms who participated in the process.

WBHO refused to settle with the commission on three projects, which includes the

meetings the commission has now referred for prosecution. Basil Read refused to settle

with four projects they were implicated in. Basil Read CEO Neville Nicolau said they

noted the commission‘s decision to refer a case of collusive tendering in respect of

tenders for the construction of 2010 FIFA World Cup stadia.

"We are confident that the outcome of this process will confirm that Basil Read was not

involved in anti-competitive behaviour and has not contravened the Competition Act

with respect to these tenders," Mr Nicolau said.

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Group Five has refused to settle four matters in which the company was implicated

during the fast track process. The firm said they have anticipated the development for a

while. The firm said it has engaged in lengthy discussions with the commission

regarding its involvement in the World Cup. It has elected to assess its position during

the process before the tribunal after not having reached consensus on the allegations

made against it.

A competition law expert said she did not expect the case to be heard before the

tribunal within the next year. She said it all depended on the amount of procedural

challenges that might be brought against the commission, the schedule of the tribunal

and when the parties have filed their pleadings.

The commission‘s second investigation, after the fast track process, also found that 24

firms were implicated in construction cases but did not participate in the process. The

firms were implicated in 31 projects.

Source:http://www.bdlive.co.za/business/trade/2014/11/12/prosecutionloomsovercollu

siononstadiums?service=print 2/2. Date of access 6 October 2015.

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APPENDIX B

CASE STUDY 2:

Wal-Mart in South Africa

Instructions to Students

Read the case study below from Consultancy Africa‘s website regarding the pros and

cons of international retail giant Wal-Mart entering the SA market.

The questions that you are required to address in analysing the case study are:

1. Why were unions in SA opposed to Walmart‘s purchase of a 51% stake in

Massmart?

2. What are some of the benefits to the South African economy of having the

presence of a retail giant such as Walmart in our country?

3. Discuss what you think the impact will be on local businesses with a competitor

like Walmart in the market place.

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Wal-Mart in South Africa: The good, the bad and the ugly

Written by Micaela Flores-Arraoz and Vas Musca Monday, 17 October 2011 08:08

In one of its historically largest purchase operations, American retail giant Walmart

bought 51% of South African retailer Massmart in May 2011 by paying US$ 2.4 billion.

Massmart sells in 14 African countries, but the majority of its operations are in South

Africa (265 retail stores in South Africa versus 25 in the other 13 countries. The

Massmart group is based in Johannesburg and includes Game, Dion Wired, Makro,

Builder‘s Warehouse and Masscash. Walmart‘s revenues stand above the US$ 400

billion mark, over South Africa‘s GDP of approximately US$ 350 billion. They operate in

14 countries apart from the US, have a procurement division that employs 1,400

individuals, and work with 6,000 factories all over the world but mainly from China. The

transaction reflects Walmart‘s clear intention of profiting from the opportunities of a

country with a sharp increase in consumer spending power and where the supermarket

buying experience reaches almost all socio-economic levels of the population.

Local perceptions and reasons for concern

Before being cleared by South Africa‘s authorities, the operation suffered ample

resistance from local groups, especially from South African Commercial, Catering and

Allied Workers‘ Union that feared the aforementioned purchase would represent

important job losses and respective declines in local manufacturing and

production. They opposed the transaction arguing that the unrestrictive entrance of

Walmart into South Africa‘s retail market would cause the closure of local businesses

and consequently the loss of many jobs due to the expected increase of imports by

Walmart and by its followers.

Given the opposing views and relatively pacific protests of local unions and the high rate

of unemployment (close to 25% according to official figures, but 40% unofficially, South

Africa‘s antitrust commission approved the takeover, imposing some general conditions

to protect local jobs: no job cuts will be conducted for two years after the takeover,

existing labour agreements will be honoured for the next three years (the South African

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Commercial, Catering and Allied Workers‘ Union will remain as the firm‘s main

bargaining partner) and US$ 14.6 million will be oriented towards creating a fund to

develop local suppliers. Even after these conditions were established, some union

leaders manifested their discontent, stating that there was no guarantee that Walmart

was going to respect these contractual clauses.

At the same time, the ruling African National Congress is being pressed by its

radicalised youth wing to adopt a more protectionist stance. Three Government

departments (the Economic Development Department, the Department of Trade and

Industry and the Agriculture Department) and the shopworkers' union, Saccawu, have

lodged an appeal with the South African competition tribunal asking it to review its initial

decision. The unions estimate that as many as 4,000 jobs could be lost from industries

such as general merchandise, and in food and beverage production if Massmart were to

shift some of its procurement from local to imported sources. The unions are presenting

the example of how Walmart has stoked controversy in the US with allegations of anti-

union policies, overpriced health insurance, predatory pricing and poor relations with

staff, some of whom, it is claimed, have been paid below the minimum wage.

Walmart indirectly responded to these questionings by showing a clear interest in

investing in Africa‘s largest and most developed market and by explicitly communicating

its intention of expanding to other economies. For example, they indicated they plan to

buy most of its fresh food locally, leveraging from South Africa‘s offering and from their

global sustainable agricultural practices. They stated they will open 54 new stores (net)

over the next three years and add 6,300 new hires to its 27,000 existing employees.

Walmart has made clear they will respect local regulations and will exploit the

opportunities the local market offers in a responsible way. Still, its detractors remain

worried about the retail giant‘s purchase power and the effects of massive and cheap

imports over local suppliers and other retail players.

The South African Government has already voiced its concern over the merge,

mentioning that the sheer scale of Walmart‘s international operations made

Government‘s intervention necessary. Walmart‘s revenue is estimated to be US$408

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billion – larger than South Africa‘s GDP. In 2004, Walmart, if it was measured as a

country, would have been China‘s 8th largest trade partner and would have a GDP

larger than 75% of countries worldwide. Walmart‘s procurement division employs more

than 1500 employees sourcing from over 6000 factories across the world (though

largely from China).

Many still see Walmart as an enormous corporation that has been criticised in the past

for its ―easy hire-easy fire‖ approach and for not promoting enough the female

workforce; things have changed, however, and Walmart has made important

improvements in employment and in eco-friendly policies. For instance, over the last

years, Walmart has significantly focused on climate change issues by implementing

zero waste corporate initiatives, and has also launched relevant sustainable agriculture

policies, including supporting farmers and their communities, producing food that

consumes fewer resources and creates less waste, and helping develop eco-

conscience. If implemented in South Africa, this type of programs could have a positive

impact in the local market by encouraging a more efficient allocation of resources, by

sending a positive signal to the investment community and clients, and by indirectly

pushing other players to adhere to the industry‘s best practices. Some local stores like

Woolworths and Pick ‗n‘ Pay have timidly started to show some sensibility towards

green policies, but many of them still fly numerous products from different parts of the

world, contributing to global warming and pollution problems.

A brief comparative analysis of Walmart’s influence in other emerging markets

If we consider conditions in emerging markets to be somewhat similar (in terms of a

less structured government vision and strategy, a less unionised workforce, rapidly

growing internal demand and also an over-reliant dependency on imports for many

consumer goods) then we can try to use Mexico‘s and Brazil‘s example as what could

possibly happen in South Africa.

Walmart in Mexico (Walmex) provides access to a larger market, but it puts continuous

pressure on its suppliers to improve their product's appeal, while forcing them to accept

relatively low prices relative to product appeal. Simulations of various models (such as

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the one from the US-based National Bureau of Economic Research) show that the

arrival of Walmex separates potential suppliers into two groups: those with relatively

high-appeal products choose Walmex as their retailer, whereas those with lower appeal

products do not (and in effect, cannot, as lower appeal products have a low frequency

of purchase). For the industry as a whole, the associated market share reallocations,

adjustments in innovative effort, and exit patterns increase productivity and the rate of

innovation. Another positive impact of Walmart‘s presence in Mexico is that the retail

sector modernised its warehousing, distribution, and inventory management. The

profound changes in the retail sector, initiated by Walmex and partially diffused to other

retailers, have resulted in a significant decline in distribution costs faced by Mexican

suppliers while the spectacular expansion of Walmex‘s retail network has allowed its

suppliers to reach a larger segment of the Mexican market. Overall, the high-quality

firms have sold more and become more productive in response to Walmex‘ investment

in Mexico, while low-quality firms have lost ground in both dimensions.

Walmex had succeeded for two main reasons: one, because it started out being so big;

by the mid-1990s Walmart had gradually acquired 62% of Cifra, the largest retailer in

Mexico; second (and of critical importance), Cifra brought with it a thorough

understanding of the Mexican consumer.

Walmart entered Brazil in 1995, raring to replicate its success in Mexico. The country

was still emerging from decades of hyper-inflation and economic mismanagement.

However, a price war soon ensued between Walmart and Careffour, and Walmart saw

its business waver; it also made the mistake of not making big acquisitions until 2004.

However, even as it bought Bompreço in the country‘s north-east, and Sonae in the

south, its sales have suffered as it has tried to convert them to its trademark ―everyday

low prices.‖ Walmart‘s unchanging cheap prices contrast with the more dynamic ―high-

low‖ strategy of discounts and mark-ups, and Brazilians have not got used to the

American way.

Columbia Business School Professor Nelson Fraiman argues that ―Large firms like

Walmart have gone to countries like Brazil and failed — the same way they‘ve gone to

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countries like Korea and failed, the same way they‘ve gone to countries like Germany

and failed — mainly because of not understanding the local culture. The U.S. can

become better at learning about the people and working together as equals, rather than

imposing a series of systems and procedures that work here, but don‘t necessarily work

there.‖ ―Little details are what usually kills American companies that forget to pay

attention.‖

If Walmart is able to leverage on its experience in other developing nations like Brazil

and Mexico and adapt its good governance and operational practices to South Africa‘s

market, it could solidify its position in the global retail market, but most importantly in

emerging Africa. This won‘t come without its challenges though. Walmart will need to be

clever in managing and training a comparatively less educated workforce when

compared to the US and even to some developing countries, and in ensuring optimal

productivity levels. It will have to comply with the particularities of local laws (including

the Black Economic Empowerment Act), adapt to the local culture and to successfully

replicate its model on African soil in order to extract the most out of its operation in this

continent.

Moving towards a coherent regional strategy

The incursion of Walmart in Africa, initially through South Africa but with expansion

plans to other countries of the region, not only denotes the importance of the emerging

middle-class consumer market for global corporations and its expected growth, but also

sends a positive signal to the investment community regarding the openness and

possibilities of doing business in the continent.

Walmart also plans to open two stores in Nigeria, according to Nigeria‘s Ambassador to

the United States, Prof. Ade Adefuye, who mentioned in June 2011 that representatives

from the famous retail store had visited him at the Nigerian Embassy in Washington DC

as regards the plan to open the retail store in Nigeria. ―It is an indication of the growing

confidence in Nigeria‘s economy,‖ Adefuye stated, adding that he was currently

engaging with the leading US store on the conditions and requirements that would have

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to be met to do business in Nigeria. Walmart is also planning to enter Senegal, Angola

and the Democratic Republic of Congo.

A win-win move?

The somewhat measured and appropriate intervention of the local antitrust authorities

when local opposition was high helped dissolve any doubts regarding potential

government intervention or inadequate popular measures that could end up affecting

the entire deal and perspectives for future operations.

Libertarian Ludwig von Mises Institute is also optimistic about Walmart: ―Walmart is one

of the great shining examples of what a market economy can achieve. If I were to give a

tour of the United States to visitors from a socialist country, who are used to

experiencing chronic shortages of almost everything, Walmart would be one of the first

places I would take them. It is a perfect symbol of one of the most remarkable things

that we have — an enormous variety of high quality, low cost products that are available

to virtually everyone throughout the United States.‖

While increases in productivity will cause a net gain to the economic system, they also

cause a shift in the points of the economic system where human labor is most valuable,

changing the landscape of the job market. Some jobs disappear, while some jobs come

into existence for the first time.

Also, Walmart could help boost the local SME growth; by allowing small producers to

deliver their products locally (using Walmart‘s modern distribution systems) and have

them distributed nationwide, Walmart can help small producers to become viable

competitors of the larger players. Producers will weigh the larger market size versus the

lower quality-adjusted price they receive when deciding whether to use Walmart as a

retailer.

Additionally, the entrance of a global player like Walmart in South Africa, although

criticised by local unions and other players, could help ―raise the bar‖ in terms of

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productivity, service delivery, transparency and price-efficiency (prices are expected to

go down) within the industry, forcing local players and manufacturers to become more

competitive and creative in order to survive in an open and free market. The presence

of Walmart will also give producers incentives to engage in process or product

innovation. Making product improvements allows suppliers to escape the mandatory

price cuts from one year to the next that kick in when producers do not upgrade their

product. Similarly, suppliers can obtain higher prices by introducing new product

varieties. If that is the case, the most benefited will the local consumer.

Source:http://www.consultancyafrica.com/index.php?option=com_content&view=article

&id=875:walmart-in-south-africa-the-good-the-bad-and-the-ugly&catid=82:african-

industry-a-business&Itemid=266

Date of Access: 5 October 2015.