Download title of document

MBA ECONOMICS
2012 EXAM WORKSHOP
Prepared by: H.Matsongoni
ROAD MAP / AGENDA TIME :180 MINUTES
1. Introduction to Economics
(i) What economics is all about?
(ii) The interdependence between the major sectors, markets and flows in the mixed economy.
2.
Demand, Supply, Consumer equilibrium and price elasticity.
(i) The circular flow of income and spending
(ii) Government intervention
3.
Imperfect Competition
(i) Market Structures
4.
Key macroeconomic concepts
(i) Inflation
(ii) Economic growth and development
5.
International Economics
(i) International Trade
6.
Examination guide
1. WHAT IS ECONOMICS ?
The word economics is derived from the Greek word oikos, meaning house and
nemein, meaning manage.
Economics is the study of how societies use scarce resources to produce valuable
commodities and distribute them among different people. –Paul Samuelson
Economics is the study of how society manages its scarce resources – Ngregory
Mankiw
Economics is the study how scarce resources are allocated among different uses –
Richard Eckhaus
Economics also seeks to describe, explain, analyse and predict a variety of
phenomena such as economic growth, unemployment, inflation, trade between
individuals and countries, the prices of different goods and services, poverty, wealth,
money, interest rates, exchange rates and business cycles.
SCARCITY, CHOICE AND OPPORTUNITY COST
Economics is concerned with scarcity. The basic fact of economic life is that there are
simply not enough goods and services to satisfy everyone wants.
Wants are unlimited but the means with which the wants can be satisfied are
limited.
Distinguish between wants and needs.
Wants are human desires for goods and services.
Individuals have biological, spiritual, material, cultural and social wants while people
as a group have collective wants for things such as law and order, justice and social
security.
Needs are necessities, the things that are essential for survival, such as food, water,
shelter and clothing. Needs unlike wants , are not absolutely unlimited.
FACTORS OF PRODUCTION
Resources are limited.
There are three types of resources
i. Natural e.g. agricultural land, minerals and fishing resources
ii. human resources (such as labour).
iii. Man made resources (such as machines).
These resources are the means with which goods and services can be produced. In
economics we call these resources factors of production.
Since the resources are limited, it follows that the goods and services with which we
can satisfy our wants are also limited. Therefore we have to make choices.
e.g. Herrison has R20 in his pocket. R20 is the resource. He therefore has to choose
what to buy and what to sacrifice.
ECONOMIC DECISIONS AND OPPORTUNITY COST
Economic Decisions
In the above cases difficult choices have to be made. Some wants will be satisfied
but many will be left unsatisfied.
In each case it has to be decided which of the available alternatives will have to be
sacrificed.
Economic decisions are all difficulty.
Opportunity Cost
Since resources are scarce, the use of resources can never be costless. The are
always costs involved even if these costs are not always apparent to consumers of the
goods or services in question.
Scarcity must not be confused with poverty. Scarcity affects everyone. The rich are
also subject to scarcity.
ECONOMIC DECISIONS & OPPORTUNITY COST CNT’D
Even the richest person on earth will have unsatisfied wants and will make economic
decisions.
For example, no matter how rich you are in terms of money or material wealth, you
only have 24 hours a day in which to sleep, eat, work and relax.
Everyone has to deal with the fact that time is a limited resource.
Although scarcity is an essential element of the economic problem, the need for
decision making only arises when the scarce resources have to be allocated between
competing alternatives.
However, with only one goal you will not have an economic problem to solve, since
you do not have a problem on how to allocate your limited resources.
OPPORTUNITY COST
This is not a realistic example since no-one has only one goal in life, but it does
illustrate the importance of choosing between alternatives in making economic
decisions.
When we are faced with such a choice we can measure the cost of the alternative
we have chosen in terms of the alternative that we have to sacrifice. This is called
opportunity cost.
For example , if Tony has to choose between studying and going to the movies, the
opportunity cost of studying would be the visit to the movies that he has to forgo.
The opportunity cost of a choice is the value to the decision maker of the best
alternative that could have been chosen but was not chosen. In other words, the
opportunity cost of a choice is the value of the best forgone opportunity.
Every time a choice is made, opportunity costs are incurred and economists always
measure costs in terms of opportunity costs.
PRODUCTION POSSIBILITY CURVE (PPC)
Scarcity, choice and opportunity cost can be illustrated with the aid of a production
possibilities curve, also called a production possibilities frontier.
Consider the example where a farmer has to make a choice between planting
oranges or apples.
There are different possibilities with different levels of output per year for the
different types of fruit, shown as follows:
PRODUCTION POSSIBILITY CURVE
POSSIBILITY
ORANGES
(TONS OF OUTPUT)
APPLES
(TONS OF OUTPUT)
A
20.00
0.0
B
19.0
10.0
C
16.5
18.0
D
12.5
24.0
E
6.5
28
F
0.0
30.0
PRODUCTION POSSIBILITY CURVE
PRODUCTION POSSIBILITY CURVE EXPLANATION
Each point on the production possibility curve represents an alternative mix of
output. It shows the combination of oranges and apples that can be produced with the
available resources.
As we move along the Production Possibility Curve, the production of apples
increases whilst
the production of oranges decreases.
To produce 10 tons of apples, the farmer had to give up 1 ton of oranges (the
movement for possibility point A to B).
To produce a further 8 tons of apples (movement from B to C), the farmer had to
give up 3.5 tons of oranges.
The opportunity cost to produce an additional ton of apples increases as we move
along the production possibility curve. This is why the curve bulges outwards
from the origin (concave).
PPC FURTHER EXPLANATION
The production possibilities curve is a very useful way of illustrating, scarcity, choice
and opportunity cost.
Scarcity is illustrated by the fact that all points to the right of the curve (outside the
curve) are unattainable.
The curve thus forms a frontier or boundary between what is possible and what is
not possible.
Choice is illustrated by the need to choose among the available combinations along
the curve.
Opportunity cost is illustrated by the negative slope of the curve, which means that
more of one good can only be obtained by sacrificing the other good.
Opportunity cost therefore involves what we call a trade-off between the two
goods.
PPC FURTHER EXPLANATION
The production possibility curve illustrates two important principles;
 Scarce resources: There is a limit to the amount that we can produce in a given
time period with the available resources and technology;
Opportunity costs: We can obtain additional quantities of any desired good only
by reducing the potential production of another good.
The Production Possibility Curve shows potential output and does not necessarily
reflect actual output.
At every point along the production possibility curve, we are getting the maximum
output from available resources.
Thus we say that all points on the production possibility curve are efficient.
PRODUCTION POSSIBILITY CURVE AND EFFICIENCES
PPC AND EFFICIENCES CONTINUED
If the farmer is operating at less than the potential output, illustrated by a point
inside or below the production possibility curve, some of the available resources are
unemployed or not employed efficiently.
 In such a case, it is possible to expand production simply by using the existing
resources fully and more efficiently (given the state of technology).
The production possibilities curve indicates the combinations of any two goods or
services that are attainable when the community’s resources are fully and efficiently
employed.
MACROECONOMICS VERSUS MACROECONOMICS
The Study of Economics is usually divided into two parts: microeconomics and
macroeconomics.
Microeconomics - the focus is on individual parts of the economy The prefix micro
comes from the Greek mikros meaning small.
Individual consumers , households - what to do , what to buy
Individual firms – what goods to produce, how to produce them, what prices to
charge . Other organizations are considered in isolation from the rest of the economy.
These individual elements of the economy are, figuratively speaking, each put under
the microscope and examined in detail.
It also includes the study of the demand, supply and prices of the individual goods
and services like petrol, maize, haircuts and medical services.
MICROECONOMICS VERSUS MACROECONOMICS
Macroeconomics is concerned with the economy as a whole.
 The prefix macro comes from the Greek word macros meaning large.
We develop an overall view of the economic system and we study total or aggregate
economic behaviour.
The emphasis is on topics such as;
• total production
•income and expenditure
• economic growth
•aggregate unemployment
•the general price level
•inflation and
• the balance of payments.
Macroeconomics is therefore the world of totals.
MICROECONOMICS VERSUS MACROECONOMICS
EXAMPLES
MICROECONOMICS
MACROECONOMICS
The price of a single product
The consumer price index
Changes in the price of a product e.g. oranges
Inflation (i.e. the increase in the general level of prices
in the country)
The production of cars
The total output of all goods and services in the
economy
The market of individuals e.g. apples
The market for all goods and services in the economy
The demand for a product e.g. maize
The total demand for all goods and services in the
economy
An individual’s decision to export its product
The total exports of goods and services to other
countries
A firm’s decision to import from abroad
The total imports of goods and services from other
countries
WHY ECONOMISTS DISAGREE?
They might make different value judgments
They might not agree on the facts
They might be biased
They might hold different views about how the economy operates
They might have different time perspectives
2.THE CIRCULAR FLOW OF INCOME AND SPENDING
INTERACTIONS OF THE GOVT AND THE PARTICIPANTS
Consumers: government provide services to consumers while consumers provide labour.
Factor markets: government acquires resources in the factor markets and also offers factors of
production to the factor markets.
Business firms: government provides services to business while business provide services to
the government. Thus business firm supply goods and services to product markets ( point A) and
purchase factors of production in the factor markets (B).
Product markets: governments acquires products from the product markets and also provides
product to the product markets.
International participants: the international market provides products and factors of
production that the government utilises.
Government participation is essential to improve the standard of living of people because
government is the largest employer and provides a number of essential services.
OPEN VS CLOSED ECONOMIES
The participation of foreigners results in a distinction between open and closed
economies. In a closed economy, foreigners do not participate in buying and selling of
goods and services.
Thus a closed economy does not take into account international trade while an open
economy takes into consideration imports and exports.
GOVERNMENT INTERVENTION
The changes in demand and supply can only occur if the market forces of supply and
demand are free to establish the equilibrium prices and quantity of goods and services.
Quite frequently, however, consumers, trade unions, farmers, business people and
politicians are not satisfied with the prices and quantities determined by market demand and
supply.
Their dissatisfaction leads them to put pressure on government to intervene to influence
prices and quantities in the market. This intervention can take different forms, including:
Setting maximum prices (price ceilings)
Setting minimum prices (price floors)
Subsidizing certain products or activities
Taxing certain products or activities
MAXIMUM PRICES (PRICE CEILINGS, PRICE CONTROL)
Governments often set maximum prices for certain goods and services.
Price controls were in South Africa during the 1970s.
During the 1980s, however, almost all the price controls were abolished and nowadays most
prices are determined by market forces.
It is nonetheless important to analyse the impact of maximum price fixing.
Many consumers call for price control and there is always the possibility that the government
may reintroduce it.
WHY GOVERNMENT SET MAXIMUM PRICES?
To keep the prices of basic foodstuffs low, as part of a policy to assist the poor.
To avoid the exploitation of consumers by producers, that is, to avoid ‘unfair’ prices.
To combat inflation.
To limit the production of certain goods and services in war time.
MAXIMUM PRICES
If maximum price is set above the equilibrium (or market clearing) price it will have no effect
on the market price or the quantity exchanged.
Prices and quantities will still be determined by demand and supply.
However, when maximum price is set below the equilibrium price (as is usually the case) it will
have significant effects.
MAXIMUM PRICES
EFFECTS OF MAXIMUM PRICES
If the government sets a maximum price of Pm below the equilibrium price of Po, this results
in an excess demand of Q2-Q1 (or ab)
There is thus a market shortage (or excess demand) ab.
But when price control is introduced, different ways have to be found to solve the problem of
excess demand.
The basic problem is how to allocate the available quantity supplied (Q1) between consumers
who demand a total of Q2 of the goods concerned.
WAYS OF MANAGING EXCESS DEMAND
This can be done in various ways:
a.
b.
c.
Consumers can be served on a first come first serve basis resulting in queues or waiting
lists.
Suppliers may set up informal rationing systems e.g. by limiting the quantity sold to each
consumer or by selling to regular customers
Government may introduce an official rationing system by issuing ration tickets or coupons
which have to be submitted when purchasing the product.
WAYS OF MANAGING EXCESS DEMAND CNT’D
d. One possibility is to import to solve the excess demand is to import the difference between
Q2 and Q1, provided such imports are available at price PM or less.
This will eliminate the shortage, but is such imports are available, price control is unnecessary
to start with .
Other effects;
Private cost
Corruption e.g. bribery of rationing officials
Development of black markets: stimulate black market activity by providing an incentive for
people to obtain the good and resell it at a higher price to those household who are willing to
pay higher prices to obtain it.
BLACK MARKETS
Not all black markets are illegal, but in the case of maximum price fixing by government, black
market activity is outlawed.
A black market is therefore often defined as an illegal market in which goods are sold above
the maximum price set by the government.
All price controls (including controls on interest rates, exchange rates and other less obvious
forms of prices) stimulate black market activity as unsatisfied potential purchasers seek to
obtain the good or service concerned.
Price controls are invariably implemented in the sincere belief that they are in the best
interests of society – in many cases they are motivated by an honest concern for the well-being
of poor consumers or low-income citizens.
 Is it always the case ???
RENT CONTROLS
Provides one of the best examples of the problems created by imposing a maximum price
below the equilibrium (or market-clearing) price.
In S. Africa, for example rent controls was introduced in the late 1940s to protect tenants from
being exploited by the owners of rented accommodation during the postwar housing shortage.
This shortage arose because during the war, production had been geared to the war effort and
construction of dwelling units had been curtailed.
The results were permanent shortages of rented accommodation.
EFFECTS OF RENT CONTROLS
When rent controls are imposed , owners of rented accommodation (e.g. flats) can react by;
selling the flats under sectional title
Converting the buildings into offices or other forms of accommodation which are not subject
to rent control.
Lowering their operating costs by skimping on maintenance and repairs (i.e. by reducing the
quality of their service)
EFFECTS OF RENT CONTROL
to erect new rented accommodation – the supply of new rented accommodation falls (while
the population and demand increase) and the shortage becomes worse.
ADMINISTERED PRICES
Following the abolishment of price controls in South Africa, government departments or other
public sector agencies still determine the price of a range of goods and services in S.Africa.
These prices are usually called administered prices, to indicate that they are the result of
administrative processes rather than of market forces of supply and demand. e.g. NERSANational Energy Regulator of South Africa.
Administered prices often feature strongly in the debate on the causes of inflation in S.Africa
and appropriate anti-inflation policy.
20% of the goods and services in the CPI basket in South Africa can be classified as
administered prices. e.g. prices of medical services, petrol and diesel, communication services,
electricity, and education.
Other prices administered by the public sector include those of public transport services,
water and licences.
ADMINISTERED PRICES CONTINUED
The term administered prices was first coined in the USA in the 1930s to indicate private
sector prices that were determined discretionally by suppliers of goods and services instead of
by market forces.
In SA, however, the term is used exclusively to indicate government involvement in price
determination.
The different prices are administered according to different conventions, rules and formulae.
For example, a specific formula is used to determine the monthly adjustments in fuel prices,
while other administered prices are determined in other ways, often on a cost-plus basis.
MINIMUM PRICES
To stabilise farmers’ income, government often introduce minimum prices (or price floors)
which serve as guaranteed prices to producers.
If the minimum price is below ruling equilibrium, the operation of market forces is not
disturbed, but if the minimum price is above the ruling equilibrium price(as is often the case)
there is a surplus (or excess supply).
This is shown in the diagram below;
MINIMUM PRICES
DD and SS represent the demand and supply of beef.
 The equilibrium price is R15 per kg and the equilibrium quantity is 7 million kg.
The introduction of a minimum price of R20 per kg results in a market surplus of 5 million kg
(represented by ab).
FURTHER GOVERNMENT INTERVENTION
When government fixes a minimum price above the equilibrium price, it creates a market
surplus. This usually requires further government intervention.
The options are essentially the following;
Government purchases the surplus and exports it.
Government purchases the surplus and stores it (provided the product is non-perishable)
Government purchases and destroys the surplus
Producers destroy the surplus
FURTHER GOVERNMENT INTERVENTION CNT’D
The artificially high price is usually justified by arguments that it is in consumers’ interest that
farmers receive a stable income (and keep producing the products) or that the surplus can be
exported to earn foreign exchange.
Instead of merely fixing a minimum price, government can also fix a producer price and a
lower consumer price and subsidize producers by the difference.
For example, the producers’ price of maize is set at USD285.00 per tonne and the consumer
price is USD260.00. The difference between the two prices (i.e USD25.00) is paid by government
to producers as a subsidy.
This reduces or eliminates the surplus but still involves a cost to tax payers. It represents a
redistribution of income from taxpayers to users of maize.
What government cannot do is sell the surplus to domestic consumers at a lower price - this
will defeat the whole purpose of setting a price floor.
Another alternative is to give the surplus to the poor. Surpluses of perishables products are
often offered to charitable institutions, but the collection and distribution of the products entail
significant costs and the products are seldom collected.
FURTHER GOVERNMENT INTERVENTION CNT’D
Setting minimum prices above equilibrium prices is a highly inefficient way of assisting small
or poorer farmers, since;
All consumers, including poor households, have to pay artificially high prices.
The bulk of the benefit
companies.
accrues to large farmers or farming concerns owned by big
Inefficient producers are protected and manage to survive .
The disposal of the market surpluses usually entails further cost to taxpayers and welfare
losses to society.
DEMAND
Demand is defined as the ability and willingness to buy specific quantities of a good at
alternatives prices in a given time period, ceteris paribus (holding all things else
constant).
Total market demand is the sum of individual demand.
Construction of a Demand Curve
DEMAND CURVE FOR A POCKET OF POTATOES
DEMAND AND FACTORS AFFECTING DEMAND
Demand
The demand curve illustrates how the quantity demanded changes in response to a
change in the price of that good, if nothing else changes (ceteris paribus).
Demand curve slope downwards.
The law of demand states that the quantity of a good demanded in a given period
increases as its price falls.
Factors affecting demand
Change in Income
Prices of Complementary /Substitute Products
Changes in the number of buyers
Changes in preferences and tastes
Expectations of future prices
MARKET DEMAND AND SUPPLY
Market Demand
The market demand refers to the total quantities of a good or service that people
are willing and able to buy at alternative prices in a given time period. i.e. the sum of
individual demands
Supply
The law of supply states that the quantity of a good or service supplied in a given
time period increases as its price increases, ceteris paribus.
The supply curve is upward sloping suggesting a positive relationship between price
and quantity.
The quantity supplied is directly influenced by a change in the price, whilst the
supply is influenced by factors in the market e.g. prices of inputs, technology ,
expectations, number of sellers.
EQUILIBRIUM POSITION
Equilibrium in the market occurs where quantities demanded exactly balance the quantities
supplied for goods and services, Qd=Qs
This is where the demand and supply curves intersect to determine the equilibrium price and
equilibrium quantities that are bought and sold in this particular market.
DISEQUILIBRIUM POSITION
Whenever the market price is set above or below the equilibrium price, the market will be in
disequilibrium.
This disequilibrium will result in either a market surplus or a market shortage.
To overcome a surplus or shortage, buyers and sellers will change their behaviour and the
market will tend towards equilibrium where no further adjustments will be required.
ELASTICITY
Elasticity is the measure of the responsiveness of demand to a change in price.
The price elasticity of demand is a measure of the sensitivity of quantity
demanded to changes in price.
 It measures the relationship as the ratio of percentage changes between quantity
demanded of a good and changes in its price.
Price Elasticity (EP) = % change in quantity demanded
% change in price
In practise goods are categorised according to their relative elasticity – whether Ep
is larger or smaller than 1. If Ep is larger than 1, demand is elastic.
If Ep is less than 1, demand is inelastic. When demand is inelastic, the percentage
change in quantity demanded is less than the percentage in price, consumers are not
responsive to price changes.
DETERMINANTS OF ELASTICITY
Why are consumers price sensitive (EP greater than 1) with some goods and not (Ep less
than 1) with others?
It is important to note that the elasticity of demand is computed between points on a given
demand curve.
Price elasticity of demand is influenced by all the determinants of demand.
The four factors particularly worth noting are;
i. Necessities (relatively inelastic) Vs Luxuries (relatively elastic
ii. Availability of substitutes
iii. Relative price (to income)
iv. Time
PRICE ELASTICITY OF DEMAND AND TOTAL REVENUE
The price elasticity of demand can be used to determine by how much the total expenditure
by consumers on a product (which is also the total revenue of the firms producing that product)
changes when the price of the product changes.
This is probably the most important reason why economists, business people and
policymakers are so interested in information concerning the price elasticity of demand.
The total revenue (TR) accruing to the suppliers of a good or service (or the total expenditure
by the consumers ) is equal to the price (P) of the good or service multiplied by the quantity (Q)
sold.
There is an inverse relationship between the quantity demanded (Q) and the price of a
product (P). Any change in price leads to a change in the quantity demanded in the opposite
direction to the change in price.
The effect of a price change on total revenue will thus depend on the relative sizes of the price
change and the change in the quantity demanded.
PRICE ELASTICITY OF DEMAND AND TOTAL REVENUE
If the change in price P leads to a proportionately greater change in quantity demanded Q
(i.e. if the price elasticity of demand is greater than one ), total revenue TR will change in the
opposite direction to the price change.
If the change in price leads to an equi-proportional change in the quantity demanded (i.e if
the price elasticity of demand is equal to one ), total revenue will remain unchanged.
If the change in price leads to a proportionally smaller change in the quantity demanded (i.e if
the price elasticity of demand is smaller than one), total revenue will change in the same
direction as the price change.
CHANGES IN TOTAL REVENUE VS PED
As long as the price elasticity of demand is greater that one, total revenue TR (or the total
expenditure by consumers) increases as the quantity sold Q increases.
TR reaches a maximum when the price elasticity of demand is equal to one.
When the price elasticity of demand is less than one, TR falls as the quantity sold Q increases.
The relationship between the price elasticity of demand and total revenue can be explained
further by distinguishing five different categories of price elasticity of demand (PED).
RELATIONSHIP BETWEEN PED AND TOTAL REVENUE
DETERMINANTS OF PRICE ELASTICITY OF DEMAND
Price elasticity of demand is influenced by all the determinants of demand.
The five factors particularly worth noting are;
i.Substitution possibilities
ii.The degree of complementarity of the product
iii.The type of want satisfied by the product.
iv.The time period under consideration
v.The proportion of income spent on the
OTHER DETERMINANTS OF PRICE ELASTICITY OF DEMAND
The following factors can also affect the price elasticity of
demand.
The definition of the product
Advertising
Durability
Number of uses of the product
Addiction
OTHERS : INCOME AND CROSS ELASTICITIES
Income elasticity
The income elasticity of demand relates the percentage change in quantity demanded to
the percentage change in income that is;
Income elasticity of demand = % change in quantity demanded
% change in income
As is the case with price elasticity, income elasticity is computed with average values for
changes in quantity and income.
Cross elasticity
Cross elasticity is a different type of elasticity and involves two related products.
It is defined as the relative change in the quantity demanded of product A, in relation to the
relative change in the price of product B, which caused the change in the quantity demanded
of product A.
Cross-price elasticity of demand is given by % change in quantity demanded of good X
% change in the price of good Y
OTHERS : INCOME AND CROSS ELASTICITIES CN’TD
the cross-price elasticity of demand makes it easy to distinguish substitute and
complementary goods. If cross price elasticity is positive, the two goods are substitutes; if the
cross-price elasticity is negative, the two goods are complements.
Coca-cola and hamburgers are complements because a fall (-) in the price of one leads to an
increases (+) in the demand for the other, in other words, the cross-price elasticity is negative
3. MARKET STRUCTURES
The behaviour of a firm depends on the features of the market in which it sells its
product(s) and on its production costs.
The major organisational features of markets are called market structure.
Four standard forms of market structure will be introduced;
•Perfect competition
•Monopoly
•Monopolistic competition
•Oligopoly
The concept of perfect competition is a theoretical one, which serves as a norm
against which to compare other types of markets.
The latter three types of competition are collectively referred to as imperfect
competition
MARKET STRUCTURES - SUMMARISED
4. KEY MACROECONOMIC CONCEPTS
WHY LEARN MACROECONOMICS ?
1.
2.
The macroeconomy affects society’s well-being.
3.
The macroeconomy affects election outcomes.
The macroeconomy affects your well-being.
MACROECONOMICS OBJECTIVES
Boost economic growth
Full employment / low unemployment
Price stability (inflation)
Balance of payments stability
Equitable distribution of income
INFLATION
Inflation is defined as the continuous and considerable rise of prices in general.
The CPI is used to measure inflation
 CPI is a measurement of the cost of a representative basket of consumer goods and services.
Inflation rate is the % change in CPI from one period to another
(Always expressed as an annual rate)
Inflation is an increase in the average level of prices, not a change in any specific price.
The Average Price
The average price is determined by finding the average price of all output.
A rise in the average price is called inflation.
A fall in the average price is called deflation.
Redistributive Effects of Inflation
Although inflation makes some people worse off, it makes some people better off.
PRICE EFFECTS
Price changes are the most familiar effect of inflation.
The effect on economic welfare is shown in the difference between nominal and real income.
Nominal income is the amount of money income received in a given time period, measured in
current dollars.
Real income is income in constant dollars: nominal income adjusted for inflation.
Two basic lessons about inflation:
Not all prices rise at the same rate during inflation.
Not everyone suffers equally from inflation.
Is Inflation a Problem?
Unpredictable changes in the inflation rate are a problem because they redistribute income in
arbitrary ways between employers and workers and between borrowers and lenders.
A high inflation rate is a problem because it diverts resources from productive activities to
inflation forecasting.
Eradicating inflation is costly because it brings a period of greater than average
unemployment.
CAUSES OF INFLATION
The cause of inflation is rooted in supply and demand.
Types of inflation
Demand pull inflation
Demand-pull inflation results from excessive pressure on the demand side of the economy.
“Too much money chases too few goods” enabling producers to raise prices.
Cost push inflation
The pressure on price could also originate on the supply side.
Higher production costs put upward pressure on product prices.
Demand Pull Inflation
Demand-pull inflation occurs when the aggregate demand for goods and services increases
while aggregate supply remains unchanged.
 This type of inflation is often described as a case of ‘too much money chasing too few goods’.
The excess demand pulls up the prices of goods and services.
Demand pull can be caused by any (or a combination) of the various components of aggregate
demand;
DEMAND-PULL INFLATION
Increased consumption spending by households (C), for example as a result of greater
availability of consumer credit or the availability of cheaper credit as a result of a drop in
interest rates.
Increased investment spending by firms (I), for example as a result of lower interest rates or an
improvement in business sentiment and profit expectations.
Increased government (G), for example to combat unemployment or to provide more or
better services to the population at large.
Increased export earnings (X), for example as a result of improved economic conditions in the
rest of the world or because of increases in the prices of important export products (such as
minerals, in the case of SA.)
All these causes of demand-pull inflation are accompanied by increases in the money supply.
Increases in the money supply do no simply happen – they are usually related to increases in
one or more of the components of aggregate demand in the economy.
DEMAND-PULL INFLATION
DEMAND-PULL INFLATION CNT’D
Demand –pull inflation occurs when aggregate demand for goods and services increases.
This is illustrated by the rightward shift of the AD curve from AD1 to AD2,AD3 and AD4. As
long as there is still excess capacity in the economy, the increases in the price level will be
accompanied by increases in production and income.
However, when full employment is reached further shifts in the AD curve (from AD3 to AD4)
lead to price increases only.
MANAGING DEMAND-PULL INFLATION
To combat demand-pull inflation, the authorities have to keep the aggregate demand for goods and
services in check.
This can be done by applying restrictive monetary and fiscal policies.
Restrictive monetary policy entails raising interest rates and limiting the increase in the money supply.
This raises the cost of credit and also reduces the availability of credit to the various sectors of the
economy.
Restrictive fiscal policy entails a reduction in government spending and / or increased taxation.
These policies will tend to reduce aggregate demand.
COST-PUSH INFLATION
As the term indicates, cost-push inflation is triggered by increases in the cost of production.
Increases in production costs push up the price level.
There are five main sources of cost-push inflation.
Sources of cost-push inflation
increases in wages and salaries. Wages and salaries are the largest single cost item in any
economy – in South Africa the renumeration of labour constitutes about 50 per cent of the cost
of producing the gross domestic product.
Another important source is the cost of imported capital and intermediate goods.
These goods are essential to the functioning of the domestic economy, particularly the
manufacturing sector.
When the prices of imported goods such as oil, machinery and equipment increase, the
domestic costs of production are raised.
These increases could be the result of price increases in the rest of the world or of a
depreciation of the domestic currency against the currencies of the exporting countries.
COST-PUSH INFLATION
Another source is increases in profit margins. Like wages, interest and rent, profit is also
included in the cost of production.
When firms push up their profit margins they are therefore raising the cost of production (
and the prices that consumers have to pay).
Another source is decreased productivity. If the various factors of production become less
productive while still receiving the same remuneration, the costs of producing each unit of
output increases.
Another source is natural disasters, such as droughts or floods, which occur periodically.
They raise the costs of production and the prices of agricultural and other related products.
Cost-push inflation can also be illustrated with aid of the AD-AS model.
Cost-push is reflected in an upward (or leftward) shift of the AS curve, as shown in the next
slide.
COST PUSH INFLATION
COST-PUSH INFLATION CNT’D
Cost-push inflation occurs when the cost of producing at each level of total production Y
increases. This is illustrated by an upward (leftward) shift of the AS curve from AS1 to AS2.
Increases in the price level are accompanied by reductions in aggregate production or income
Y (and therefore also by increases in unemployment).
In the diagram the price level increases from P1 and P2 and the level of income falls from Y1
and Y2.
Cost-push is caused by factors which push up the costs of production. To avoid cost-push
inflation, measures have to be taken to avoid increases in the costs of production.
Increase in wages and salaries and profits have to be kept under control.
Increases in productivity can also help to avoid or combat cost-push inflation
ANTI-INFLATIONARY POLICY
The monetarist approach
Monetarists want the central bank to control inflation by controlling the rate of increase in the
money supply.
They believe that inflation can be avoided by restricting the rate of increase in the money
supply to a rate approximately equal to the growth in real output.
 The first problem with such a policy prescription, however, is that the money supply is not
exogenously determined or controlled by the central bank.
Moreover, even if it were technically possible to control the rate of increase in the quantity of
money, it does not necessary follow that a restrictive monetary policy will affect only nominal
variables such as inflation.
 Output, employment and other real variables might also be affected. A related problem is
that the velocity of circulation of money is probably not as stable as the monetarists would have
us believe.
ANTI-INFLATIONARY POLICY
The structuralist approach and the conflict approach
This point to the need for an incomes policy to combat inflation. Incomes policies, however,
are subject to various practical problems.
Indexation
Means that prices, wages, pensions and so on are linked to prices (for example, the CPI) to
eliminate the distribution effects of inflation.
 Formal indexation has been applied in countries like Brazil and Israel. When the inflation rate
rises to very high levels (say 100% or more) government often have no alternative but to
introduce indexation in all spheres of the economy in an attempt to counteract the distribution
effects of inflation.
Formal indexation can help communities to cope with high inflation or hyperinflation in the
short run. Indexation can only be resorted to in emergency conditions.
ANTI-INFLATIONARY POLICY
Inflation Targeting
Its key features are thus;
The announcement of quantitative targets
The primacy of price stability as the objective of monetary policy
A broad-based, pragmatic approach to the analysis of inflation
Transparency
Accountability
ECONOMIC GROWTH
Economic growth is the expansion of the economy’s production possibilities—an outward
shifting of the PPF.
Economic growth is traditionally defined as the annual rate of increase in total production or
income in the economy.
First production or income should be measured in real terms.
Real GDP—real gross domestic product—is the value of the total production of all the
nation’s farms, factories, shops, and offices, measured in the prices of a single year.
 We measure economic growth by the increase in real GDP.
Second it should be expressed on a per capita basis.
Positive economic growth actually occurs only when total real production or income is
growing at a faster rate than the population.
FLUCTUATIONS IN ECONOMIC GROWTH
In the short-run
Variations in growth of aggregate demand (AD).
In the Long run
The growth in AD determining whether potential output will be realised.
The growth in potential output.
Economic growth
Economic growth is not a smooth process- it can vary significantly from year to year. This
feature of economic growth is related to a phenomenon called the business cycle.
Business Cycle
The business cycle is an irregular and non-repeating up-and-down movement of business
activity that takes place around a generally rising trend and that shows great diversity.
ECONOMIC GROWTH – BUSINESS CYCLES CNT’D
Every business cycle has two phases:
1. A recession
2. An expansion
and two turning points:
1. A peak
2. A trough
Figure 1.1 shows a
business cycle.
An expansion ends at
a peak and a
recession ends at a
trough.
ECONOMIC GROWTH
A recession is a period during which real GDP decreases for at least two successive
quarters.
An expansion is a period during which real GDP increases.
BENEFITS AND COSTS OF ECONOMIC GROWTH
Benefits and Costs of Economic Growth
The main benefit of long-term economic growth is expanded consumption possibilities,
including more health care for the poor and elderly, more research on cancer and AIDS, better
roads, more and better housing and a cleaner environment.
The costs of economic growth are forgone consumption in the present, more rapid depletion
of non-renewable natural resources, and more frequent job changes.
SOURCES OF ECONOMIC GROWTH
These sources can be grouped into two broad categories; supply factors and demand factors.
Economic growth requires an expansion of production capacity of the economy, as well as an
expansion of the demand for goods and services produced in the economy.
Both the supply factors and demand factors are therefore necessary for sustained economic
growth.
SUPPLY FACTORS
These sources can be grouped into two broad categories; supply factors and demand factors.
Economic growth requires an expansion of production capacity of the economy, as well as an
expansion of the demand for goods and services produced in the economy.
Both the supply factors and demand factors are therefore necessary for sustained economic
growth.
SUPPLY FACTORS CNT’D
Natural resources
Labour
Capital
Entreprenuership
CAPITAL
This is the third supply factor is the quantity and quality of the country’s capital (i.e the
manufactured means of production such as buildings, machinery, equipment and roads)
Economic growth requires more and better capital equipment. An increase in the capital stock
may take the form of either capital widening or capital deepening.
Capital widening vs. capital deepening
Capital widening occurs when the capital stock is increased to accommodate an increasing
labour force.
For example, if the stock of capital is expanded by 10% in response to a 10% increase in the
number of workers, there is capital widening.
In this case, the average amount of capital per worker remains unchanged.
CAPITAL WIDENING VS CAPITAL DEEPENING
Capital deepening occurs when the amount of capital per worker is increased, that is, when
the growth in the stock of capital is greater than the growth in the number of workers.
As with other factors of production, the quality of capital is also very important. The quality of
capital is increased by applying new technology to capital equipment.
Technology is such an important factor in the process of economic growth that is often
regarded as a separate factor of production.
DEMAND FACTORS
The supply factors listed above all contribute to the country’s production capacity, or the
potential output of the economy.
Whether or not this potential will be realized will depend upon whether there is sufficient
demand for the goods and services that can be produced.
In other words, an increase in the quantity and quality of the factors of production is not
sufficient to ensure economic growth.
There also has to be an adequate and growing demand for goods and services produced in the
country.
DEMAND FACTORS
Domestic demand
Exports
Import substitution
ECONOMIC DEVELOPMENT
Economic development refers to the improvement of living conditions in the LDCs. It entails an
improvement in the quality of life of the majority of the population as a result of economic
growth, the reduction of inequality and the eradication of absolute poverty.
FEATURES AND PROBLEMS OF DEVELOPING COUNTRIES
Population growth
Natural resources
Agriculture practices
capital
Infrastructure
THEORIES OF ECONOMIC DEVELOPMENT
Economic development is a complex phenomenon that involves a variety of social and
economic processes.
It is therefore not surprising that there is no single theory of economic development.
Various authors and schools of thought have developed theories about the causes of
development or underdevelopment.
ROSTOW ‘S STAGES OF ECONOMIC GROWTH
In 1960 the American economist, WW Rostow, published a theory of the stages of economic
growth which immediately became popular in courses on economic development.
 He proposed that each country passes through certain stages during the course of
development.
His theory was based on the empirical observation that a rise in per capita income in different
countries was accompanied by a fall in the proportion of the labour force employed in
agriculture and a corresponding rise in the production of the labour force employed in
secondary and tertiary activities.
ROSTOW’S MODEL
The model indicated that countries become more industrialised and service oriented as
development proceeds.
ROSTOW distinguished five stages of economic development and maintained that every
country can be classified according to these stages.
Traditional society; this is the first stage during which farming and handicrafts are the main
forms of economic activity. This stage is characterised by low per capita income.
The preconditions for take-off; this is the second stage in which many LDCs find themselves
today. There is some accumulation of capital in the form of infrastructure, as well as a
movement from traditional economic activity to industry.
The take off; this third stage lasts about one generation.
Modern methods of production are spread from leading industries to the rest of the economy
and there is a sharp increase in saving and investment, including foreign investment.
ROSTOW’S MODEL
The drive to maturity; during this fourth stage the benefits of the investments made during
the take-off stage are realised. Industrial activity becomes firmly established.
High mass consumption; This final stage has been reached by DCs such as the United States
and Germany. Material standards of living are high and social welfare systems are also well
developed.
Rostow regarded saving ,investment and foreign aid as critical elements of economic
development.
5. INTERNATIONAL ECONOMICS
REASONS FOR COUNTRIES TO PARTICIPATE IN THE GLOBAL ECONOMY
Trade
Apply political pressure
Invest in other countries
• to increase profits for local companies and to gain access to cheaper labour
•move closer to sources of raw materials.
•To bring money, technology & skills that are not available locally
THE GLOBAL ECONOMY
Why do countries trade?
THE GAINS FROM INTERNATIONAL TRADE
Comparative advantage is the fundamental force that generates
trade between nations.
A country has a comparative advantage in producing a good if it
can produce that good at a lower opportunity cost than any other
country.
Sources of comparative advantage are technology, resource
endowments and differences in trade/demand
Nations can increase the consumption of goods and services when
they allocate resources to the production of those goods and
services for which they have a comparative advantage.
GAINS FROM COMPARATIVE ADVANTAGE
When countries specialize in producing the goods in which they have a comparative
advantage, they maximize their combined output and allocate their resources more efficiently.
Russia
Scotland
Oil (Barrels)
Whisky
(Litres)
10 or
20 or
5
40
One unit of labour in each country can produce either oil OR whisky.
A unit of labour in Russia can produce either 10 barrels of oil per period OR
5 litres of whisky.
A unit of labour in Scotland can produce either 20 barrels of oil OR 40 litres
of whisky.
COMPARATIVE ADVANTAGE
Opportunity Cost = sacrifice/ gain
Russia: if it moved 1 unit of labour from whisky to oil it would sacrifice 5
litres of whisky but gain 10 barrels of oil (OC = 5/10 = ½)
Moving 1 unit of labour from oil to whisky production would lead to a
sacrifice of 10 barrels of oil to gain 5 litres of whisky (OC of whisky is 10/5 =
2).
Scotland: if it moved 1 unit of labour from whisky to oil it would sacrifice
40 litres of whisky but gain 20 barrels of oil (OC = 40/20 = 2)
Moving 1 unit of labour from oil to whisky production would lead to a
sacrifice of 20 barrels of oil to gain 40 litres of whisky (OC of whisky is
20/40 = ½ )
For Scotland the OC of oil is four times higher than that in Russia (2
compared to ½)
COMPARATIVE ADVANTAGE
In Russia, oil can be produced cheaper than in Scotland (Russia only sacrifices 1 litre of whisky
to produce 2 extra barrels of oil whereas Scotland would have to sacrifice 2 litres of whisky to
produce 1 barrel of oil.
There can be gains from trade if each country specialises in the production of the product in
which it has the lower opportunity cost – Russia should produce oil; Scotland whisky.
After specialisation – each country devotes its resources to that in which it has a comparative
advantage.
COMPARATIVE ADVANTAGE VS ABSOLUTE ADVANTAGE
ABSOLUTE ADVANTAGE AND COMPARATIVE ADVANTAGE
A country enjoys an absolute advantage over another country in the production of a product
when it uses fewer resources to produce that product than the other country does.
A country enjoys a comparative advantage in the production of a good when that good can
be produced at a lower cost in terms of other goods.
ARGUMENTS FOR THE USE OF TRADE BARRIERS
Dumping
Infant industries
Export subsidies
Employment
Government revenue
national security
ARGUMENTS AGAINST TRADE BARRIERS
Retaliation by trade barriers
Welfare cost to society
Inefficiency
6. EXAMINATION GUIDE
Understand clearly what is required in the question
• Discuss – investigate or examine by argument; sift & debate; give reasons for & against. Also
examine the implications.
•Explain – make plain, interpret and account for, give reasons
•Differentiate – explain the difference
•Do you agree – take a position and justify your position.
Understand the question e.g. Discuss – investigate or examine by argument; sift & debate; give
reasons for & against. Also examine the implications.
Introduction
-Use interesting opening statements eg
- Orientate the reader
-Map your answer
EXAMINATION GUIDE CNT’D
The main body
-Define key terms
-Present relevant facts
-Use coherent paragraphs and separate ideas by paragraphing
-Use heading/subheadings with eligible writing
-Illustrate material (tables, graphs, maps etc)
Conclusion/ summary
-Give a brief summary of salient points / key issues
-Draw ideas together not diverting away from your ideas
-Do not introduce new ideas in exam
References (including in text referencing) where necessary
Use correct english language
GOODLUCK WITH YOUR EXAMINATION
THANK YOU