Upload
dangthuy
View
253
Download
5
Embed Size (px)
Citation preview
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.
MBA Year 1
1 MANAGERIAL ECONOMICS
MBA Year 1
2 MANAGERIAL ECONOMICS
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
MBA Year 1
3 MANAGERIAL ECONOMICS
MBA Year 1
4 MANAGERIAL ECONOMICS
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.
MBA Year 1
5 MANAGERIAL ECONOMICS
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)
MBA Year 1
6 MANAGERIAL ECONOMICS
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.
MBA Year 1
7 MANAGERIAL ECONOMICS
? 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.
MBA Year 1
8 MANAGERIAL ECONOMICS
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
MBA Year 1
9 MANAGERIAL ECONOMICS
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.
MBA Year 1
10 MANAGERIAL ECONOMICS
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.
MBA Year 1
11 MANAGERIAL ECONOMICS
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.
MBA Year 1
12 MANAGERIAL ECONOMICS
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.
MBA Year 1
13 MANAGERIAL ECONOMICS
MBA Year 1
14 MANAGERIAL ECONOMICS
PART I: Introduction
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.
MBA Year 1
15 MANAGERIAL ECONOMICS
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.
MBA Year 1
16 MANAGERIAL ECONOMICS
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
MBA Year 1
17 MANAGERIAL ECONOMICS
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.
MBA Year 1
18 MANAGERIAL ECONOMICS
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.
MBA Year 1
19 MANAGERIAL ECONOMICS
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.
MBA Year 1
20 MANAGERIAL ECONOMICS
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
MBA Year 1
21 MANAGERIAL ECONOMICS
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.
MBA Year 1
22 MANAGERIAL ECONOMICS
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
MBA Year 1
23 MANAGERIAL ECONOMICS
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)
MBA Year 1
24 MANAGERIAL ECONOMICS
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.
MBA Year 1
25 MANAGERIAL ECONOMICS
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
MBA Year 1
26 MANAGERIAL ECONOMICS
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.
MBA Year 1
27 MANAGERIAL ECONOMICS
MBA Year 1
28 MANAGERIAL ECONOMICS
PART I: Introduction
SECTION 2:
Microeconomics, Macroeconomics
& the Circular Flow
Specific Learning Outcomes
The overall outcome for this section is that, on its completion, the student should be
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.
MBA Year 1
29 MANAGERIAL ECONOMICS
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
MBA Year 1
30 MANAGERIAL ECONOMICS
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.
MBA Year 1
31 MANAGERIAL ECONOMICS
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
MBA Year 1
32 MANAGERIAL ECONOMICS
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
MBA Year 1
33 MANAGERIAL ECONOMICS
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
MBA Year 1
34 MANAGERIAL ECONOMICS
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
MBA Year 1
35 MANAGERIAL ECONOMICS
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
MBA Year 1
36 MANAGERIAL ECONOMICS
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
MBA Year 1
37 MANAGERIAL ECONOMICS
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
MBA Year 1
38 MANAGERIAL ECONOMICS
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).
MBA Year 1
39 MANAGERIAL ECONOMICS
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.
MBA Year 1
40 MANAGERIAL ECONOMICS
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
Source: Econometrix (2015)
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.
MBA Year 1
41 MANAGERIAL ECONOMICS
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
MBA Year 1
42 MANAGERIAL ECONOMICS
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.
MBA Year 1
43 MANAGERIAL ECONOMICS
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
MBA Year 1
44 MANAGERIAL ECONOMICS
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.
MBA Year 1
45 MANAGERIAL ECONOMICS
Figure 9 The Circular Flow of Income
Source: Mohr (2012:9)
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.
MBA Year 1
46 MANAGERIAL ECONOMICS
Figure 10 The Participation of Government
Source: Mohr (2012:10)
QUESTIONS FOR REFLECTION
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.
MBA Year 1
47 MANAGERIAL ECONOMICS
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,
MBA Year 1
48 MANAGERIAL ECONOMICS
MBA Year 1
49 MANAGERIAL ECONOMICS
PART 2: Economic Environment of Business
SECTION 3:
Demand, Supply & Elasticity
Specific Learning Outcomes
The overall outcome for this section is that, on its completion, the student should be
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.
MBA Year 1
50 MANAGERIAL ECONOMICS
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 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
Janse Van Rensburg, J.J., McConnell, C., Brue, S., (2011) Economics
Southern African Edition Boston: McGraw Hill.Chapter 8: Monopolistic
Competition and Oligopoly).
Journal Articles & Reports
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.
MBA Year 1
51 MANAGERIAL ECONOMICS
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:
MBA Year 1
52 MANAGERIAL ECONOMICS
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:
MBA Year 1
53 MANAGERIAL ECONOMICS
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
Source: Econometrix (2015)
Figure 11 Demand Curve
Source: Econometrix (2015)
High price, low quantity demanded
Low price, high quantity demanded
MBA Year 1
54 MANAGERIAL ECONOMICS
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
MBA Year 1
55 MANAGERIAL ECONOMICS
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.
MBA Year 1
56 MANAGERIAL ECONOMICS
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
MBA Year 1
57 MANAGERIAL ECONOMICS
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.
MBA Year 1
58 MANAGERIAL ECONOMICS
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
MBA Year 1
59 MANAGERIAL ECONOMICS
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
MBA Year 1
60 MANAGERIAL ECONOMICS
(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.
MBA Year 1
61 MANAGERIAL ECONOMICS
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.
MBA Year 1
62 MANAGERIAL ECONOMICS
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.
MBA Year 1
63 MANAGERIAL ECONOMICS
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.
MBA Year 1
64 MANAGERIAL ECONOMICS
Figure 15 The Different Cases of Price Elasticity of Demand
Source: Mohr and Fourie, 2013:111
MBA Year 1
65 MANAGERIAL ECONOMICS
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
MBA Year 1
66 MANAGERIAL ECONOMICS
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).
MBA Year 1
67 MANAGERIAL ECONOMICS
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.
MBA Year 1
68 MANAGERIAL ECONOMICS
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.
MBA Year 1
69 MANAGERIAL ECONOMICS
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.
MBA Year 1
70 MANAGERIAL ECONOMICS
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
MBA Year 1
71 MANAGERIAL ECONOMICS
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
MBA Year 1
72 MANAGERIAL ECONOMICS
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?
MBA Year 1
73 MANAGERIAL ECONOMICS
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
Source: Econometrix (2015)
MBA Year 1
74 MANAGERIAL ECONOMICS
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
Source: Econometrix (2015)
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.
MBA Year 1
75 MANAGERIAL ECONOMICS
Figure 17 Shifts in supply
Source: Mohr & Fourie (2008)
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.
MBA Year 1
76 MANAGERIAL ECONOMICS
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.
MBA Year 1
77 MANAGERIAL ECONOMICS
Figure 18 Excess Demand and Supply
Source: Mohr & Fourie (2008)
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).
MBA Year 1
78 MANAGERIAL ECONOMICS
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
MBA Year 1
79 MANAGERIAL ECONOMICS
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?
MBA Year 1
80 MANAGERIAL ECONOMICS
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
(Mohr and Fourie, 2008: 144)
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
MBA Year 1
81 MANAGERIAL ECONOMICS
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.
MBA Year 1
82 MANAGERIAL ECONOMICS
Figure 20 Price of beef
(Mohr and Fourie, 2008: 145)
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.
MBA Year 1
83 MANAGERIAL ECONOMICS
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 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.
MBA Year 1
84 MANAGERIAL ECONOMICS
MBA Year 1
85 MANAGERIAL ECONOMICS
PART 2: Economic Environment of Business
SECTION 4:
The Macro- Economic
Environment of Business
Specific Learning Outcomes
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.
MBA Year 1
86 MANAGERIAL ECONOMICS
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
MBA Year 1
87 MANAGERIAL ECONOMICS
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.
MBA Year 1
88 MANAGERIAL ECONOMICS
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
MBA Year 1
89 MANAGERIAL ECONOMICS
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
Source: Econometrix (2015)
MBA Year 1
90 MANAGERIAL ECONOMICS
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.
MBA Year 1
91 MANAGERIAL ECONOMICS
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.
MBA Year 1
92 MANAGERIAL ECONOMICS
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.
MBA Year 1
93 MANAGERIAL ECONOMICS
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.
MBA Year 1
94 MANAGERIAL ECONOMICS
Figure 24 CPI Inflation
Source: Econometrix (2015)
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.).
MBA Year 1
95 MANAGERIAL ECONOMICS
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).
MBA Year 1
96 MANAGERIAL ECONOMICS
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.
MBA Year 1
97 MANAGERIAL ECONOMICS
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.
MBA Year 1
98 MANAGERIAL ECONOMICS
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
MBA Year 1
99 MANAGERIAL ECONOMICS
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
Source: Econometrix (2015)
MBA Year 1
100 MANAGERIAL ECONOMICS
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)
MBA Year 1
101 MANAGERIAL ECONOMICS
QUESTIONS FOR REFLECTION
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
MBA Year 1
102 MANAGERIAL ECONOMICS
MBA Year 1
103 MANAGERIAL ECONOMICS
PART 3: Market Structures
SECTION 5:
Perfect Competition and Monopoly
Specific Learning Outcomes
The overall outcome for this section is that, on its completion, the student should be
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.
MBA Year 1
104 MANAGERIAL ECONOMICS
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 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).
Janse Van Rensburg, J.J., McConnell, C., Brue, S., (2011) Economics
Southern African Edition Boston: McGraw Hill.Chapter 7: Pure
Competition and Pure Monopoly (pp 141 – 167).
Janse Van Rensburg, J.J., McConnell, C., Brue, S., (2011) Economics
Southern African Edition Boston: McGraw Hill.Chapter 8: Monopolistic
Competition and Oligopoly (pp 169 – 189).
Journal Articles & Reports
.
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
MBA Year 1
105 MANAGERIAL ECONOMICS
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
MBA Year 1
106 MANAGERIAL ECONOMICS
Figure 28 Market Structures
Key features of a market structure:
Adapted: (Mohr and Fourie, 2011)
MBA Year 1
107 MANAGERIAL ECONOMICS
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.
MBA Year 1
108 MANAGERIAL ECONOMICS
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
MBA Year 1
109 MANAGERIAL ECONOMICS
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
MBA Year 1
110 MANAGERIAL ECONOMICS
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
MBA Year 1
111 MANAGERIAL ECONOMICS
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)
MBA Year 1
112 MANAGERIAL ECONOMICS
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
Adapted: (Mohr and Fourie, 2011)
MBA Year 1
113 MANAGERIAL ECONOMICS
Figure 33 Normal profit or Breakeven
Adapted: (Mohr and Fourie, 2011)
Figure 34 Economic loss.
Adapted: (Mohr and Fourie, 2011)
MBA Year 1
114 MANAGERIAL ECONOMICS
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).
MBA Year 1
115 MANAGERIAL ECONOMICS
5.8.1 An entry –attracting price
Figure 35 The individual firm and the industry when the firm initially earns an
economic profit
Adapted: (Mohr and Fourie, 2011)
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).
MBA Year 1
116 MANAGERIAL ECONOMICS
5.8.2 An exit-inducing price.
Figure 36 The individual firm and the industry when the firm initially makes an
economic loss
Adapted: (Mohr and Fourie, 2011)
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).
MBA Year 1
117 MANAGERIAL ECONOMICS
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
Adapted: (Mohr and Fourie, 2011)
? 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?
MBA Year 1
118 MANAGERIAL ECONOMICS
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).
MBA Year 1
119 MANAGERIAL ECONOMICS
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
MBA Year 1
120 MANAGERIAL ECONOMICS
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.
MBA Year 1
121 MANAGERIAL ECONOMICS
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. 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?
MBA Year 1
122 MANAGERIAL ECONOMICS
MBA Year 1
123 MANAGERIAL ECONOMICS
PART 3: Market Structures
SECTION 6:
Monopolistic Competition and
Oligopoly
Specific Learning Outcomes
The overall outcome for this section is that, on its completion, the student should be
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.
MBA Year 1
124 MANAGERIAL ECONOMICS
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
MBA Year 1
125 MANAGERIAL ECONOMICS
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
Adapted: (Mohr and Fourie, 2011)
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).
MBA Year 1
126 MANAGERIAL ECONOMICS
Figure 41 Long-run condition of a monopolistic competition
Adapted: (Mohr and Fourie, 2011)
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.
MBA Year 1
127 MANAGERIAL ECONOMICS
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.
MBA Year 1
128 MANAGERIAL ECONOMICS
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.
MBA Year 1
129 MANAGERIAL ECONOMICS
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
MBA Year 1
130 MANAGERIAL ECONOMICS
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.
MBA Year 1
131 MANAGERIAL ECONOMICS
QUESTIONS FOR REFLECTION
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.
MBA Year 1
132 MANAGERIAL ECONOMICS
MBA Year 1
133 MANAGERIAL ECONOMICS
PART 4: Economic Concepts for Global
Managers
SECTION 7:
International Trade
Specific Learning Outcomes
The overall outcome for this section is that, on its completion, the student should be
able to understand the interaction between the national economy and the global one.
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 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.
MBA Year 1
134 MANAGERIAL ECONOMICS
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.
MBA Year 1
135 MANAGERIAL ECONOMICS
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
MBA Year 1
136 MANAGERIAL ECONOMICS
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.
MBA Year 1
137 MANAGERIAL ECONOMICS
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.
MBA Year 1
138 MANAGERIAL ECONOMICS
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
MBA Year 1
139 MANAGERIAL ECONOMICS
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).
MBA Year 1
140 MANAGERIAL ECONOMICS
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
MBA Year 1
141 MANAGERIAL ECONOMICS
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.
MBA Year 1
142 MANAGERIAL ECONOMICS
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.
MBA Year 1
143 MANAGERIAL ECONOMICS
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
MBA Year 1
144 MANAGERIAL ECONOMICS
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
MBA Year 1
145 MANAGERIAL ECONOMICS
removed all tariffs on trade among themselves. Then each country signed a free-trade-
area agreement with the EEC (Lipsey and Chrystal, 2011).
QUESTIONS FOR REFLECTION
After completing your study of international trade, 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. 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?
MBA Year 1
146 MANAGERIAL ECONOMICS
MBA Year 1
147 MANAGERIAL ECONOMICS
PART 4:
Economic Concepts for Global Managers
SECTION 8:
Exchange Rates
Specific Learning Outcomes
The overall outcome for this section is that, on its completion, the student should be
able to demonstrate an understanding of what the exchange rate refers to and how the
value of the Rand Dollar exchange rate is determined.
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 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
MBA Year 1
148 MANAGERIAL ECONOMICS
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.
MBA Year 1
149 MANAGERIAL ECONOMICS
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.
MBA Year 1
150 MANAGERIAL ECONOMICS
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:
MBA Year 1
151 MANAGERIAL ECONOMICS
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
MBA Year 1
152 MANAGERIAL ECONOMICS
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.
MBA Year 1
153 MANAGERIAL ECONOMICS
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.
MBA Year 1
154 MANAGERIAL ECONOMICS
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).
MBA Year 1
155 MANAGERIAL ECONOMICS
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
MBA Year 1
156 MANAGERIAL ECONOMICS
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).
MBA Year 1
157 MANAGERIAL ECONOMICS
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
MBA Year 1
158 MANAGERIAL ECONOMICS
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
MBA Year 1
159 MANAGERIAL ECONOMICS
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
MBA Year 1
160 MANAGERIAL ECONOMICS
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‖.
MBA Year 1
161 MANAGERIAL ECONOMICS
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)
Source: Econometrix (2015)
MBA Year 1
162 MANAGERIAL ECONOMICS
QUESTIONS FOR REFLECTION
After completing your study of exchange rates, 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. 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.
MBA Year 1
163 MANAGERIAL ECONOMICS
MBA Year 1
164 MANAGERIAL ECONOMICS
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.
MBA Year 1
165 MANAGERIAL ECONOMICS
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
MBA Year 1
166 MANAGERIAL ECONOMICS
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?
MBA Year 1
167 MANAGERIAL ECONOMICS
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.
MBA Year 1
168 MANAGERIAL ECONOMICS
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.
MBA Year 1
169 MANAGERIAL ECONOMICS
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.
MBA Year 1
170 MANAGERIAL ECONOMICS
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.
MBA Year 1
171 MANAGERIAL ECONOMICS
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
MBA Year 1
172 MANAGERIAL ECONOMICS
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
MBA Year 1
173 MANAGERIAL ECONOMICS
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
MBA Year 1
174 MANAGERIAL ECONOMICS
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
MBA Year 1
175 MANAGERIAL ECONOMICS
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
MBA Year 1
176 MANAGERIAL ECONOMICS
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
MBA Year 1
177 MANAGERIAL ECONOMICS
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.