GAUTENG DEPARTMENT OF EDUCATION

ECONOMICS TERM 2 - MICROECONOMICS

NOTES FOR LEARNERS

ContentsMODULE 2: UNIT 1.............................................................................................................................2

PERFECT MARKET / COMPETITION.......................................................................................................2

MODULE 2: UNIT 2...........................................................................................................................14

ELASTICITIES........................................................................................................................................14

1

.............................................................................................................................................................20

IMPERFECT MARKETS / COMPETITION..............................................................................................22

Explain relevant concepts, deducing, interpretation, drawing of profit curves (short – and long run) and explaining and interpreting graphs...............................................................................................22

To explain relevant imperfect markets and comparing them with a perfect market..........................22

MODULE 2 / UNIT 3...........................................................................................................................33

MICRO ECONOMICS - MARKET FAILURE & COST BENEFIT ANALYSIS (CBA)..................................33

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PERFECT MARKET / COMPETITIONIntroduction

The circular flow introduced the learners to the economic participants, and some of their interactions were analysed. Different types of markets and their roles in an open economy were discussed. Here we turn to the markets in which they interface. Markets owe their origin to the interactions of buyers and sellers. Markets are the centre of economic activities and provide the dynamics for the performance of economies. We distinguish between four broad types of market structures, namely perfect competition, monopolistic competition, oligopoly and monopoly. Perfect competition occurs in a market structure with many participants where no single buyer or seller can influence the price of the goods or services. The topic of perfect competition starts in grade 10 and progresses to grade 11 and 12.

Overview

The focus is on the review of costs and revenue schedules and curves, characteristics, market structure, output, profits, losses and supply as well as competition policies.

Specific Objectives

Use various teaching methodologies and assessment methods to teach the learners how to calculate costs and profits.

Draw graphs relating to costs and revenue curves, the demand curve of an industry, demand curve of an individual supplier, economic profit, normal profit, economic loss, long-run profit and the shut-down point of a perfect competitor.

Give the participants the opportunity to design assessment activities that meet the standards set in the 2017 Examination Guidelines based on perfect competition.

Content (big Ideas on the topic)

You will study this module through the following units:

Unit 1: Perfect competition

Content Progression

Every year, it is indicated in the matric diagnostic analysis that grade 12 learners lack the skill to draw and interpret graphs. Micro-economics is a topic which must be taught with the aid of graphs.

More emphasis should be given to topics which progress from lower grades (7-11) to grade 12.

Such topics should be taught in-depth by lower grades (7-11) teachers.

Team planning and team teaching is highly recommended amongst the EMS and Economics teachers.

Baseline assessment is required to test prior knowledge of the learners.

The learners should be encouraged to use calculators.

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NOTE:

1. Review cost and revenue tables and curves done in Grade 11.2. Differentiate between the short and long run.3. The examination of individual business and industry should be accompanied by an analysis of

tables and graphs.4. Comparison and contrasting of four market structures should be discussed in detail after the

completion of all four market structures.5. Relate the industry equilibrium positions to the individual firm’s equilibrium positions with

graphs, i.e. how entry and exit into the market influence equilibrium position from the short run to the long run.

6. Give your opinion about the successes / failures of the competition policy. (Relate to current examples).

TERM DESCRIPTIONEconomic profit Profit that is made in addition to normal profit. When average revenue is

greater than average cost the firm makes an economic profit.Economic loss When total costs are greater than total revenue. When average revenue is

lower than average cost the firm makes an economic loss.Explicit cost Actual expenditure of business, e.g. wages and interest.Implicit cost Value of inputs owned by entrepreneur and used in the production process

(forfeited rental, interest + salary).Long run The period of production where all factors can change. The time is long

enough for variable and fixed factors to change.Market An institution or mechanism that brings together buyers and sellers of goods

or services.Market structure How a market is organised.Normal profit The minimum earnings required to prevent an entrepreneur from leaving the

industry. When average revenue equals average cost the firm makes a normal profit.

Perfect competition

A market structure with large numbers of producers and buyers.

Price taker Has no influence on price. Takes price that is determined by the market.Short run The period of production where only the variable factors of production can

change while at least one factor is fixed.Shut-down point Business will close where MC = AVCThe Competition Appeal Court

An institution whose main functions is to review orders made by the Competition Tribunal and amend or confirm these orders.

The Competition Commission

An institute that investigates restrictive business practices, abuse of dominant positions and mergers in order to achieve equity in the South African economy.

The Competition Tribunal

An institution whose main function is to approve large mergers, adjudicate in the case of misconduct and issue orders on matters presented to it by the Competition Commission.

BRIEF EXPLANATION

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Briefly describe the concept Perfect competitionPerfect competition occurs when none of the individual market participants can influence the market price of the product. A participant in a perfect market is insignificant, because it is a very small part of the total market. For an example, an individual business is so small that it has no control over the market price.

Examine the following characteristics of a perfect market:

Many buyers and sellers Many sellers are price-takers No preferential treatment No collusion between sellers Complete freedom of entry and exit Buyers and sellers have full knowledge Products are homogenous All factors of production are completely mobile Effective transport and communication No government intervention

The demand for a product of a firm in a perfect market

In a perfect market, the market price of a product is determined by supply and demand (Figure 1), the individual firm is a price taker and can sell as many of the products as it chooses to at the market price. None of the firms will sell the same product at a higher price than the current market price, as they will lose customers to competitors. Firms will not lower the price of the product below the current market price either, as they can sell as many of the product as they want to at the higher market price. The demand curve for the individual firm will run horizontally (Figure 2).

The perfect market - Figure 1

Price

D S

P1

Quantity

The individual firm - Figure 2

Price

P1 D = AR = MR

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Quantity

The cost concepts

Economists determine the cost of production by taking both implicit and explicit costs into account.

Explicit cost is the actual expenditure incurred by the enterprise to buy or hire inputs.

Implicit cost refers to the value of inputs owned by the enterprise itself utilised in the production process.

Short run

The short run refers to a period of time that is so short that the enterprise is not able to alter the size, but only the utilization of its production plant. Though the capacity of the firm remains unchanged, production is easily increased (decreased) by altering the amount of labour and raw material used in the production process.

Fixed and variable costs

The costs incurred by a firm comprise both fixed and variable costs.

The quantity of fixed inputs utilised in the production process cannot be changed in the short run. The price of rent for the land is fixed and represents the opportunity cost of the land.

The quantity variable inputs utilised in the production can be changed in the short run. The price per labour unit is given and represents the opportunity cost of labour. The cost of labour for a firm is calculated by multiplying the price per labour unit by the quantity of labour units employed. Although the price per labour unit is fixed, the quantity of labour can easily be changed and, therefore, the cost of labour is variable

The total fixed cost curve is represented through a straight line parallel to the x-axis. The fixed cost remains constant, regardless of the level of production.

The total variable cost curve has a reverse s-shape that starts from the origin and increases with a decreasing rate up to a point, from where it will decrease at an increasing rate.

The total cost curve has the same shape as that of the total variable cost curve, except that it does not start form the origin of the curve but from the same point on the y-axis as the fixed cost curve. Thus, the vertical distance between the fixed total cost curve and the total variable cost curve will always be equal to the fixed cost.

Long run costs

The long run refers to a period of time that is long enough for enterprises to change the quantities of all their inputs utilized in the production process. This means that the capacity of the plant can be altered in the long run.

In the long run, all inputs are variable. This means that all of the inputs utilised in the production process can be altered. Businesses can expand their capacity with the purchase of new equipment or bigger premises. There will be no fixed cost, total fixed cost and average fixed cost in the long run.

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Revenue

The primary objective of all enterprises is to maximise their profit.

Total revenue (TR)

Businesses earn money by selling their output. Total revenue is calculated by the number of products sold (Q) multiplied by the price of the product (P).

TR = P x Q

Average revenue (AR)

Average revenue is the amount that is earned by the firm for every unit of output sold and is

calculated by dividing the total revenue (TR) by the quantity of output.AR=TR

(Q )

Marginal revenue (MR)

Marginal revenue is the extra income earned from selling one additional unit. It is calculated in the same way as marginal cost: the change in total revenue divided by the change in output.

MR=ΔTRΔQ

Summary of market structures

Criteria Perfect Competition

Monopolistic Competition Oligopoly Monopoly

Number of firms So many that no firm can influence the market price

So many that each firm thinks others will not detect its actions

So few that each firm must consider the others’ actions and reactions

One

Nature of product

Homogeneous Heterogeneous / differentiated

Homogeneous or heterogeneous

Only one product with no close substitutes

Entry Completely free Free Varies from free to restricted

Completely blocked

Information Complete Incomplete Incomplete Complete Collusion Impossible Impossible Possible Unnecessary Control over the price

None Some Considerable, but less that in monopoly

Considerable, but limited by goal of profit maximisation

Demand curve Horizontal (perfectly elastic)

Downward sloping Downward sloping, may be kinked

Equals market demand curve: downward sloping

Long run economic profit

Zero Zero Can be positive Can be positive

Decision Making Decisions have no impact on other suppliers - profit driven

Use non–price measures to influence consumer decisions

Level of dependence on each other

They decide on production levels.

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Criteria Perfect Competition

Monopolistic Competition Oligopoly Monopoly

Examples International commodity markets e.g. oil and gold / Farmers

Fast food outlets/ Clothes / Cars

Cell phone / Banking market

Eskom

Note: this part should be discussed in detail on completion of all four market structures.Profit and loss

Different perspectives on calculating profit - Simply stated, profit is equal to revenue minus cost. The enterprise makes a profit when revenue exceeds cost and incurs a loss when cost exceeds profit.

We can also express profit as average revenue (AR) minus average costs (AC).

The formulae for calculating profit are:

TP = TR – TC

Profit/Economic profit – Figure 3

Figure 3 - A firm making a profit (as shown by grey rectangle) under perfect competition when the price of the product is above the total average cost curve.

Normal profit – Figure 4

Normal profit: This occurs when AC = AR

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MC

Explanation: Please note normal profit is the amount that the business must make in order to keep its doors open. Once all costs such as the running costs and fixed costs are covered the business can keep its doors open.

In this instance (figure 4) the firm makes zero profit because the average total cost is equal to total revenue. The firm breaks even. Point e.

In the graph, the market is determined independently at P₃ per unit. The business cannot change or influence this price and therefore the market price should be accepted as given.

The MC intersects AC at its lowest point (M) on the graph. The MC curve intersects the MR at point E₃. This will determine the level of output that the

business is willing to produce at the given price. This firm will produce Q₃ at a market price of P₃. The total cost is represented by C₃. Therefor

TC of the business is greater than the TR. The business is making an economic loss. The economic loss is represented by the shaded area in Figure 5. The business will not close down immediately, since it is still able to pay some of its production

costs. It will try to minimise its loss by reducing the level of output according to the profit maximising or loss minimising rule.

Profit and loss using total cost and total revenue

Figure (graph) 6 below illustrates short-run profits using Total revenue (TR) and total cost (TC). At an output of Q₁, the TR and TC are equal to each other at point a. This is called a break-even

point. At a slightly higher output level (Q₂) at point c, the TR is increasing at a faster rate than

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In the case below the firm is making a loss because the price is below the total average cost. The loss is indicated by the shaded area P3C3ME3 – grey area.

In the long run, the firm is not hindered by fixed inputs. The long-run is the period of time where all of the factor inputs are variable and can be

increased. An economic loss occurs when the average cost of the business is greater than the average

market price. The business will minimise its loss at the level of output where the marginal revenue is equal to the marginal cost.

Figure/Graph 5 below illustrates the position of a business that is making an economic loss.

Figure 5

the TC. However, eventually the TC catches up with the TR at point d; and the break-even point is reached again at Q₃. Any quantity beyond Q₃ will result in a situation where TC exceeds TR.

A break-even point is a point at which revenue of the firm from selling its product is just enough to cover all costs.

Figure 6

The shut-down point

Figure 7

In figure 7, the firm has to make decisions regarding the level of output every time the market price changes.

If the market price is R40, this means AR and MR of the business is also R40. Under perfect market P = AR = MR.

The MC curve intersects the MR curve at point b. The MC curve also intersects the AC curve at point b.

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TR1

TR \

TC

Q1 Q2 Q3 Output

c

TRTC

w

a

b

d

If the market price is R40, the firm will make a normal profit by producing an output of Q₃, since the MC curve intersects the AC curve at point b – its lowest point. Point b is also known as the break-even point since the business is able to realise a normal profit at this price level.

If the market price is increased to R50 , the MR curve intersects the MC curve at point a. Point a lie above the AC curve. This implies that if the market price is above the AC curve, the business will increase its level of production to Q₄. Due to the increase in the level of output the business will realise an economic profit at a market price of R50.

The economic profit will attract new businesses to the market. This will increase the market supply. If the market demand remains constant while the market supply increases, the market price will decrease, and all the businesses will make normal profit. New businesses will no longer be interested in entering the market.

If the market price decreases to R30, the businesses will make an economic loss. Profit maximisation will take place at point c where MR = MC.

Point c lies underneath the AC curve. The business is no longer able to cover all its production costs. However, the business owners will not close down the business immediately. They will introduce the means to minimise the loss by reducing output to Q₂.

At the market price of R30, the business can still pay its average variable costs and part of its fixed costs. Although they are making a loss the business will be kept operational with the hope that the market price will increase in the near future and the business will break-even once more.

At a market price of R20, the quantity produced will be Q₁ since MR = MC. The market price is now so low that the business is only able to pay its variable costs. At point d, the business should close down or shut down. Point d is known as the close-down or shut-down point because MC intersects with AVC at its lowest point. This is where the supply curve (MC) begins.

The business will not produce at point e because the market price (R20) is less than the AVC.

The supply curve of the firm

Refer to figure 7 above. The rising part of the businesses’ marginal cost curve above the minimum of its average cost curve represents the supply curve of the business.

The supply curve of the business starts at point b and slopes upward from there. The reasons why the supply curve of the business slopes upward is because the marginal

cost increases as output increases.

The long-run equilibrium output level

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Figure 8

In the long run, two things can change:

New firms can enter the industry and existing firms can leave. All factors of production became variable and existing firms earning economic profit in the

short run may decide to expand their plant size to realize economies of scale.

Economic profit

In Figure 8- Suppose the business's short-term plant is represented by SAC1.

If the market price is P1 the business is making an economic profit of P1E1FP2 with the

short-term plant-size represented by SAC1.

At a price of P1 the business will maximise profit in the short-term at point E1 where the

profit maximisation (MR = MC) applies, and the quantity q1will be produced.

Bigger plant, lower unit cost

If the producer does a cost estimate, he/she will realize that, if he/she will be able to produce at a lower unit cost in the long run.

As illustrated by the downward sloping portion of the LAC curve in Figure 8. The prospect of increased profit would therefore encourage the producer to build a bigger

plant. The business would however not be interested in producing output levels greater than those

presented by the minimum point E2. Of the LAC because such output levels are only possible at higher cost levels – internal scale

disadvantages cause the LAC to rise to the right of point E2.

New entrants, increased supply

The economic profit that businesses make is likely to attract new businesses to the industry.

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Because the quantity offered on the market increases as a result of expansion by existing businesses and the entry of new businesses. Figure 8 - The supply curve on the market will shift to the right from S to S1 and the price will drop until it eventually reaches P.

At the price P, which is at the same level as the minimum point of the LAC curve, total revenue (0P X 0q) is equal to total cost 0q2 X q2 E2).

And the business is making normal profit, because it is exactly covering its total cost. Over time all the businesses in the industry will make normal profit and will be in long-term

equilibrium.

Initial losses

Individual firms can be in equilibrium in the short run where it makes an economic profit or an economic loss.

These positions, however, are not sustainable in the long run under conditions of perfect competition.

If the market price is below the minimum point of the long-term average cost curve, the adjustment process simply works the other way around.

Eventually the LAC curve will also form a tangent with the demand curve and the businesses that have remained in the industry will be making normal profit.

Price in the long term

The above analyses lead to the conclusion that under perfect competition the price of a product in the long term will settle at a level that corresponds to the lowest point of the LAC curve.

Figure 8 - A point such as E2 represents the equilibrium point of the business in the long run.

The business is making normal profit and there will be no incentive to leave or enter the industry.

When a market price has been established under perfect competition at a level where each business is in equilibrium at the minimum point of its LAC curve and only making normal profit, the industry will also be in long-term equilibrium.

Equilibrium

Once long-term equilibrium has been achieved, and provided that there are no changes in the technology or the factors of production, there will be no further entry or exit of businesses.

Competition policies

The main objective of the Competition Commission is to investigate and evaluate restrictive business practices.

The main aim:

To prevent abuse of monopoly power. To regulate the market through mergers and takeovers. To prevent price fixing and collusion.

The Competition Act of 1998 makes provision for the Competition Commission and the Competition Tribunal. The Competition Tribunal accepts or rejects the investigation and recommendation of the Competition Commission. The Competition Appeal Court accepts or rejects the recommendation of The Competition Tribunal.

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IMPERFECT MARKETS / COMPETITIONIntroduction

IMPERFECT COMPETITION

Topic 5 in Grade 10 - Dynamics of Markets and Topic 6 – Dynamics of markets: Relationship between markets in Grade 11. Learners should know what the difference is between perfect markets and imperfect markets and the characteristics of the four-market structure.

Overview

Explain relevant concepts, deducing, interpretation, drawing of profit curves (short – and long run) and explaining and interpreting graphs.To explain relevant imperfect markets and comparing them with a perfect market.

Specific Objectives

Show participants how to explain the imperfect markets revenue and costs curves. Show participants how to examine the characteristics of the monopoly, oligopoly and

monopolistic competition markets in detail, how to explain, with the aid of graphs, economic profit, economic loss and normal profit of the imperfect market structures.

Show participants how to compare the imperfect market structures with a perfect market.

KEY CONCEPTS

TERM DEFINITIONImperfect Competition

Occurs in a market where some of the producers and/or consumers are able to affect the price and quantity of goods by their action alone. Any market or industry that does not match the criteria for perfect competition is an example of imperfect competition.

Monopoly A market structure where only one seller operates. Entry is blocked and the product has no close substitute.

Oligopoly Exists when a small number of very large firms produce similar or identical products.

Monopolistic competition

A market structure with many buyers and sellers where entry is relatively easy, but the product is differentiated, e.g. toothpaste

Allocative efficiency When the market produces the BEST possible MIX of goods and services desired by consumers.

Technical (or productive) efficiency

When the market produces the maximum quantity goods and services from a given set of resources.

Collusion Formal or informal agreement between two or more firms to divide the market, set prices or limit production in order to gain unfair advantage in the market.

Cartel A group of producers who make a formal agreement to collude in order to fix prices, limit supply and limit competition.

Price discrimination When a seller charges different prices for the same product for different groups

Price leadership When one business in the industry makes price decisions on behalf of the whole group of oligopolists

Duopoly When there are only two oligopolies in the market

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TERM DEFINITIONMerger When two firms join together to form a single firm Acquisition When one firm takes over another firm and that firm then ceases to exitPatent Gives the holder the exclusive rights to produce a product for as long as

the patent right are valid Differentiated products

Products that differ slightly in physical appearance, packaging, service and/or brand names

BRIEF EXPLANATION

Discuss the monopoly in detail (Possible long Question as per Exam Guidelines -2017)

• Briefly describe the concept

- Emphasise and highlight good practical examples of businesses in this market

• Examine the characteristics in detail

• Distinguish between natural and artificial monopolies

• Explain the downward slope of the demand curve (AR)

• Explain the marginal revenue curve (Show the relationship between the demand curve (AR) and the MR curve graphically)

• Explain, with the aid of graphs, economic profit and economic loss

• Explain the long-run equilibrium position with the aid of a graph

• Compare the monopoly with a perfect competitor in terms of demand curves, products, prices, output, and equilibrium positions

Monopolies

A pure monopoly exists when a single firm is the sole producer of a product for which there are no close substitutes.

Types of monopolies

Legal monopoly – It is based on laws preventing other companies from competing (State monopoly).

Local monopoly – A local monopoly will control the market in a particular area or town, e.g. if there is only one petrol station.

Natural monopoly – This arises in industries where economies of scale are so large that a single business can supply the entire market, e.g. electricity. High development costs prevent others from entering the market and therefore the government supplies the product

Horizontal monopoly – This occurs when a parent company takes control over several smaller companies, e.g. Naspers in the printing business.

Vertical monopoly – This occurs when 1 firm will supply and produce the product, e.g. Eskom.

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Coercive monopoly – This occurs as a result of any activity that violates the principles of a market economy.

Artificial monopolies – the barriers to entry are not economic of nature. A patent restricts

Characteristics of a monopoly

NUMBER OF FIRMS

The monopoly consists out of one single firm.

The monopoly is also the industry.

Example: Eskom or De Beers – diamond-selling

NATURE OF PRODUCT

The product is unique with no close substitute.

Example: Diamonds are unique.

MARKET ENTRY

Refers to how easy or difficult it is for businesses to enter or to leave the market

Is entirely/completely blocked.

A number of barriers to entry that may give rise to monopoly can be:

- Economies of scale

- Limited size of the market

- Exclusive ownership of raw materials

- Patents

- Licensing

- Sole rights

- Import restrictions

THEY DECIDE ON THEIR PRODUCTION LEVEL

The monopolist cannot set the level of output and the price independently of each other. If a monopolist wants to charge a higher price, it has to sell fewer units of goods.

Alternatively, a reduction in price will result in a higher output sold.

A MONOPOLIST IS CONFRONTED WITH A NORMAL MARKET DEMAND CURVE

The demand curve slopes downwards from left to right. Any point on the monopolist’s demand curve (D) is an indication of the quantity of the

product that can be sold and the price at which it will trade.

THEY ARE EXPOSED TO MARKET FORCES

Consumers have limited budgets and a monopoly can therefore not demand excessive prices for its product.

The monopolist’s product has to compete for the consumer’s favour and money with all other products available in the economy.

THEY FACE SUBSTITUTES

There are few products that have no close substitutes. For example, cell phones can compete with telephone services.

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THEY MAY ENJOY FAVOURABLE CIRCUMSTANCES

Sometimes an entrepreneur may enjoy favourable circumstances in a certain geographical area.

For example, there may be only one supplier of milk in a particular town.

THEY MAY EXPLOIT CONSUMERS

Because a monopolist is the only supplier of a product, there is always the possibility of consumer exploitation.

However, most governments continually take steps to guard against such practices.

MARKET INFORMATION

All information on market conditions is available to both buyers and sellers.

This means that there are no uncertainties.

CONTROL OVER PRICE

In the case of a monopoly there are considerable price control but limited by market demand and the goal of profit maximisation.

LONG-RUN ECONOMIC PROFIT

Can be positive

Because new entries are blocked, and short-run economic profit therefore cannot be reduced by new competing firms entering the industry

The monopoly can thus continue to earn economic profit as long as the demand for its product remains intact

Revenues

Any point on the demand curve (D) represents the amount of the unique product that will be sold and at what price it will be sold.

The monopolist’s demand curve is also his average revenue curve (AR). Total revenue (TR) is calculated by repeatedly multiplying the price (P) by the amount (Q). Marginal revenue (MR) reflects the changes in total revenue that result from selling one additional unit of the product.

The demand curve for a monopolist is the market demand curve and slopes downwards from left to right.

The monopolist will try to fix the price above the centre of the demand curve, because only then will his total revenue increase.

The main constraint for the monopoly is the demand curve for the product – the monopoly is controlled by the demand curve.

Monopolist should have adequate knowledge of the market in order to predict how consumers will react to a price change and accordingly choose the quantity to supply and the price of the product.

Short-run profits and losses

If a monopolist wants to sell more goods, he will have to lower his prices. In the short run, the monopoly firm can make economic profits, normal profits or economic

losses. It is possible but unlikely that a monopoly makes an economic loss.

Long-run equilibrium

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The monopolist strives to make a maximum profit, like any other business, and will therefore increase his output until MR = MC. It will charge the highest price per unit at which this quantity of output can be sold.

In the long run, a monopoly can make economic or normal profits only. Example of things changing is consumers’ tastes and that reduces the demand. This results in

a fall in: The price The profit maximising output The monopoly’s profit

A long-run equilibrium only exists when there are no changes in the demand for the product or in the cost of production.

HOW TO DRAW GRAPHS

YES, then it is a perfect competition

1. Horizontal Line NO then it is an imperfect competition

MR AR/D

2. A tick or Nike sign for Marginal cost

3. A smile or u-shape bakkie for Average costs

4. The MC cuts through the AC at its lowest point and only once

5. The FOUR STEPS

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1. Find MC = MR this is profit maximisation point

2. Find AC

3. Find AR

4. If AC AR, then Economic Profit

If AC AR, then Economic Loss

If AC = AR, the Normal Profit

Short run/Long run

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Cost, Revenue

Cost, Revenue

AR

AC

AR

AC

Comparison with perfect markets

The crucial difference between a pure monopolist and a purely competitive seller lies on the demand side of the market.

The purely competitive seller faces a perfectly elastic demand at the price determined by market supply and demand.

Because the pure monopolist is the industry, its demand curve is the market demand curve. Because market demand is not perfectly elastic, the monopolist’s demand curve slopes

downwards. The quantity demanded increases as the price decreases, as the typical supply curve you

know declines from the top of the left-hand side to the bottom of the right-hand side.

Examine the oligopoly in detail (Possible long question as per exam guidelines 2017)

• Briefly describe the concept

- Emphasise and highlight good practical examples of businesses in this market

• Examine the characteristics of the oligopoly

• Briefly discuss non-price competition

• Briefly discuss collusion (relate to current examples of collusive behaviour)

- Distinguish between overt collusion (cartels) and tacit collusion (price leadership)

• Broad outline of prices and production levels

• Broad outline of the rationale of the kinked demand curve

• Use the graph and briefly explain why oligopolists are reluctant to compete on prices.

• Compare the oligopoly with a perfect competitor in terms of demand curves, products, prices, output, equilibrium positions and non-price competition.

Oligopolies

An oligopoly is a market dominated by a few large producers of a homogeneous or differential product.

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Characteristics of an oligopoly

Nature of the product

Products sold may be homogenous or differentiated. If products are homogeneous it is called a homogeneous oligopoly– many industrial products

are standardised for example steel products. If products are differentiated it is a differentiated oligopoly– these firms produce goods such

as household appliances, electronics equipment, breakfast cereals.

Control over price

Producers have considerable control over the price of their products, although not as much as in a monopoly.

Oligopolies can frequently change their prices in order to increase their market share. This can result in a price war.

Collusion

Collusion takes place when rival firms cooperate by raising prices and by restricting production in order to maximise their profits.

Cartel

When there is a formal agreement between firms to collude, it is called a cartel. A cartel is a group of producers whose goal is to form a collective monopoly in order to fix

prices and limit supply and competition. In general, cartels are economically unstable because there is a great incentive for members

not to stick to the agreement, to cheat by cutting prices, illegally and to sell more than the quotas set by the cartel.

Although there is an incentive to collude there is also an incentive to compete. This has caused many cartels to be unsuccessful in the long term. Some well-known cartels

are the Organisation of Petroleum Exporting Countries (OPEC) and De Beers diamonds in South Africa.

Overt/formal collusion

Overt/Formal collusion e.g. cartels are generally forbidden by law in most countries. However, they continue to exist nationally and internationally.

Tacit collusion

Sometimes in an oligopoly market, a dominant firm will increase the price of a product in the hope that its rivals will see this as a signal to do the same

This is referred to as price leadership. Limited competition – Only a few suppliers of the same product dominates the market. Interactivity – If one company makes a decision, it influence the decisions the other

companies make. Price changes – They will more frequently change their prices in order to increase their

market share. Cost advantage – They have an absolute cost advantage over the rest of the competitors. Joint decision making – It is a key instrument to make decisions together in order to

dominate the market. Difficult entry – New firms will experience high barriers to enter. High profits – Abnormal high profits may be result of joint decisions. Examples: Cell phone industry, Banking industry

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Kinked demand curve for the oligopolist

An oligopolist faces a kinked demand curve. This demand curve consists of two sections. The top section, the section that relates to high prices is a very elastic slope (i.e. demand is

very sensitive to a price change.) The bottom section, the section that relates to lower prices is very inelastic (i.e. demand is

not sensitive to a price change)

Suppose the oligopolist is selling at the original / present price of R10 and 9 units of output are sold. Total revenue is R10x9=R90

If the firms tries to increase profits by increasing the price by R2 toR12, quantity demanded would fall to 2 units and total revenue would decrease to R24 (R12x2) This will happen as the other companies did not increase their price and the customers will go to them to buy their cheaper similar product.

If the firm tries to increase profit by reducing the price by R2 to R8 and increasing sales, total revenue would be R80. Not ‘n big increase in demand as all the other companies will also lower their price and their customers will not come to this firm’s lower price as they are also receiving a lower price from the other firms.

Non-price competition

The oligopolist often uses methods other than price wars to win a market for his products.

Non-price competition includes the following:

Product differentiation: product is slightly different from the others. Product proliferation: different range of products to cater for many different markets. Advertising: oligopoly firms advertise their products heavily. Extended shopping hours and business hours Doing business over the internet After-sales service Offering additional services

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2

R8

R10

R12

9 10

E

Loyalty rewards for customers Door-to-door deliveries Brand loyalty Product proliferation – each firm produces a range of products to cater for as many different

markets as possible.

Oligopolies can increase their market share by using various strategies such as:

Engaging in product differentiation, where the products are made to be slightly different in terms of physical appearance, packaging etc.

Improving after-sale-services that are far more important to customers and will ensure a long-term relationship with that business

Aggressive advertising to lure consumers onto their side Establishing brand loyalty, because oligopolies want consumers to believe that its brand is

the best and to buy only that brand Engaging in product proliferation whereby oligopolies produce many different ranges of

products to cater for many different markets Extending shopping hours to encourage greater flexibility to households Selling products online to make it easier for customers to shop around without any

additional costs and a variety of goods is made available to make comparisons. Paying loyalty rewards to customers for continued support

Collusion

Collusion means co-operation with rivals. Suppose an industry consists of only two businesses.

One way of increasing profits is to lower prices in order to acquire a larger share of the market.

The alternative is to enter into an agreement with your competitor so that both businesses follow a high pricing strategy.

Explicit collusion / Overt collusion

Is open and happens when oligopolies formally meet to decide on prices and production. It is usually illegal.

Cartel

When there is a formal agreement between firms to collude, it is called a cartel. A cartel is a group of producers whose goal is to form a collective monopoly in order to fix

prices and limit supply and competition. They act together to determine market share, advertising strategies and product

development. Example - The Organisation of Petroleum Exporting Countries (OPEC).

Implicit collusion / Tacit collusion

Is hidden and unspoken collusion amongst oligopolies. They act together to determine the price and the output, but they do it in such a way that it

is very difficult to prove that they have colluded.

Price leadership

Sometimes in an oligopolist market, a dominant firm will increase the price of a product in the hope that its rivals will see this as a signal to do the same and this is an example of a tacit collusion.

One business in the industry makes price decisions on behalf of the whole group.

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The price leader is normally the largest business in the industry.

Interdependence

Another key characteristic of oligopoly firm is that they are interdependent. The decisions that an oligopoly firm makes with respect to quantity, marketing strategies

and location, for example, depend largely on what it thinks the other firm in the industry will do in response to its actions.

Each seller is influenced by the actions of the other sellers.

Comparison with perfect markets

Contrary to the perfect market, the oligopolies can also make an economic profit in the long run.

The consumers do not get their products at the lowest possible prices as in the case of perfect competition, because the oligopolies will probably stop producing before his long-run average cost curve (LAC) reaches its lowest point.

The price of a product in an oligopoly is higher than the marginal cost (P>MC). The community therefore adds more value to an additional unit than to the resources necessary to produce it. Resources are therefore not applied as effectively as possible.

Once the price has been set in the oligopoly, it is more stable than in perfect competition. This is because the oligopoly is reluctant to change the price because it may initiate a price war.

Monopolistic competition

Characteristics of a Monopolistic competition

There are a large number of firms in the market. Each firm produces a different product, though similar to products of other firms. There are no restrictions that hinder entry to, or exit from, the market. There are many sellers, however, each firm has the monopoly of its own differentiated

product and is therefore able to exercise some market power. Freedom to enter or exit the market. Incomplete knowledge about the market, Make economic profit only in the short term (same as perfect competition) Can only make

normal profit in the long term (same as perfect competition) Examples: McDonalds, Steers, Sterns

Comparing monopolistic competition and perfect competition

Prices are higher and output levels are lower in monopolistic competition than they would be in perfect competition markets.

Some consumers are excluded from this market. In both cases only normal profits are made in the long run. The monopolistic competition

leads to less efficient allocation of resources than a perfect competition.

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MICRO ECONOMICS - MARKET FAILURE & COST BENEFIT ANALYSIS (CBA)Introduction

Market failure occurs when the resources of the community are allocated inefficiently. It is important to expose the learners to the terms and concepts found in this unit in order to equip them with the relevant Economics vocabulary. This subtopic is divided into the following sections: the causes of market failures, inefficiencies, externalities, consequences of market failures and the Cost-benefit analysis. It is important that this unit should be taught with the aid of graphs and practical examples. Inefficiencies and public-sector involvement and intervention are also taught in grade 10 during term 2. Therefor baseline assessment and liaison between the grade 10 and 12 teachers is required.

Overview

The focus is the causes and consequences of market failures, government intervention and Cost Benefit Analysis.

Specific Objectives

Use various teaching methodologies and assessment techniques to demonstrate to the participants how market failures and CBA can be made practical with the aid of cost and revenue curves.

Demonstrate to the participants how various cognitive levels can be used to design assessment activities which meet the standards set in the 2017 Examination Guideline based on market failures and CBA.

Give the participants the opportunity to design assessment activities which meet the standards set in the 2017 Examination Guideline based on market failures and CBA.

Content (big Ideas on the topic)

You will study this module through the following units:

Unit 3: MARKET FAILURES & COST BENEFIT ANALYSIS (CBA)

Prior knowledge of grade 10 graphs is a pre-requisite for this topic. Knowledge of demand and supply curves as well as the shifts in demand and supply curves will enable the grade 12 learners to draw and interpret graphs for negative and positive externalities, taxation, subsidies, minimum wages, minimum prices and maximum prices.

The topic of production possibility curve (PPC) starts in grade 10 but it is not taught in grade 11 and it progresses to grade 12. In grade 12 PPC is used to explain inefficiencies as consequences of market failures. This is the same with the grade 10 topic of government involvement and intervention which is not taught in grade 11 but progresses to grade 12. Public sector involvement in grade 10 is related to consequences of market failures in grade 12. As a result, grade 10 teachers must teach all public sector involvement sub-topics thoroughly in order to build / lay a good foundation for grade 12 teachers.

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CONTENT PROGRESSION FROM GRADE 10 TO GRADE 12

Grade 10 Grade 12

The effects (in terms of prices and quantities) of the public sector’s involvement and intervention in the market, with the aid of graphs.

Methods of involvement:

• Indirect taxes

• Subsidies

Kind of subsidies:

producer

consumer

export

employment

income

• Maximum and minimum prices (with a graph)

• Production (without graph)

• Minimum wages (without graph)

• Welfare (without graph)

Explanation of the reasons for and consequences of market failures.

Consequences of market failures:

• Inefficiencies

• Externalities

• Direct control

• Imperfect markets

• Minimum wages

• Maximum prices

• Minimum prices

• Taxes and Subsidies

• Subsidies on goods and services

• Redistribution of wealth

• Government involvement in production

KEY CONCEPTS

TERM DEFINITION

Positive externalities The benefit gained by a third party which is not included in the market price.

Negative externalities A cost to a third party which is not included in a market price of a good. The difference between social cost and private cost.

Social benefit The benefit gained by society from the use of a good or service. It is calculated by adding the private benefit and the positive externalities.

Social cost The cost of a good or service which is paid by society. It is calculated by adding the private cost and negative externalities together.

Private benefit The gain a consumer gets from the use of a goods or the gain a producer gets from the sale of a product.

Private cost The actual cost paid by a consumer when a good is purchased.Price discrimination When identical goods and services are sold at various prices to

different consumers. Public goods Goods that the free market does not provide because they have

non-rivalry and non-excludability.

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TERM DEFINITION

Merit goods Are goods that society feels should be consumed by its citizens because it increases the welfare of the individual person and of society as a whole.

Demerit goods Are goods that society feels its citizens should not consume, they are regarded as harmful.

Non-rivalry The consumption of a product by one person will not prevent other from enjoying it too.

Non-excludability Users who do not pay to use goods (free riders) cannot be excluded from using them.

Productive / technical inefficiency

Occurs when businesses do not allocate resources correctly and produce goods and services that consumers do not want.

Allocative inefficiency Occurs when businesses do not maximise output from the given inputs.

Market failure Market failure occurs when the resources of the community are allocated inefficiently.

Cost-benefit analysis A CBA is a method used to compare the total social cost and benefits of alternative projects, activities or investments.

Pareto efficiency Refers to the situation where resources cannot be reallocated to make one person / group better off without making another person / group worse off.

Black market An illegal market in which illegal goods are bought and sold or illegal prices are charged.

GRADE 10

The Production Possibility Curve (PPC) / Production Possibility Frontier (PPF)

• The PPC/PPF starts in grade 10 according to the Annual Teaching Plan (ATP).

• The Production possibility curve (AA) below, shows a combination of two goods that can be produced using all the available resources e.g. wheat and flour.

• The producer may allocate all its resources to produce only sweetcorn or produce flour only.

• However, it is possible for the producer to allocate his resources and produce a combination of sweetcorn and flour.

• Any output to the right of the PPC is impossible, because the producer does not have the resources due to scarcity problem.

• Any point on the curve shows a combination of goods where resources will be used efficiently. However, whenever the producer chooses to produce at any point on the PPC, opportunity cost comes into play. What the producer gains from producing extra units of sweetcorn, it sacrifices in the production of flour and vice versa.

• The indifference curve (I1) shows a combination of two goods which gives the consumer the same level of satisfaction.

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Externalities

Externalities are costs not included in the pricing of goods/services, and consequently there is a

difference between the private costs/benefits and the social costs/benefits of production.

• Private costs: the cost of producing the good or service which translates into the prices that

consumers pay. Also called internal costs.

• Private benefits: internal benefits that accrue to those who produce goods and buy these goods,

e.g. producing a bicycle (for producer) and using the bicycle (consumer).

• Social costs: these are total costs incurred by society as a whole. For example, the social cost of

electricity includes the cost of capital, labour, inputs and the cost of the externalities such as dirty

water and air. Social cost = private costs plus external costs.

• Social benefits: this includes the total benefit experienced by society as a whole. For example,

municipalities provide clean water to society which results in fewer illnesses. Social benefits =

private benefits plus external benefits.

Negative externalities are things like pollution, tobacco smoking and alcohol abuse. The costs of

negative externalities are paid by society rather than by the producers. For example, Stuyvesant

produces cigarettes, many illnesses are related to smoking. The treatment for these illnesses is paid

for by society.

Positive externalities are the positive effects of products to third parties which are not paid for.

Negative externalities are often over-produced while positive externalities are under-produced. This

leads to market failure.

STATE INTERVENTION AS A CONSEQUENCE OF MARKET FAILURE

a) Direct controls

b) Imperfect markets

c) Establishing minimum wages

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When the government enforces a minimum wage, it means workers have to be paid a certain wage amount and not anything less than this.

The Figure below shows that if the wage rate is set at W, the corresponding demand and supply of labour will be Q.

If a minimum wage of W1 is set, the demand for labour will decrease from Q to Q1. Some people may become unemployed due to the introduction of a minimum wage.

However, the quantity of labour supplied will increase from Q to Q2. More people will offer their labour because of the higher wage.

d) Setting maximum prices/price ceilings

The government sets a maximum price ceiling below the market price to make goods more affordable.

Maximum prices allow the poor greater access to certain goods and services. A maximum price is set on goods such as basic foods, housing and transport. In South Africa the price of petrol, diesel fuel and paraffin are controlled at their maximum

prices.

Initially the market equilibrium price is P and equilibrium quantity is Q. The government intervenes and passes a law that milk cannot be sold for more than P1. The effect of this maximum price is that quantity supplied decreases to Q1, and quantity

demanded increases to Q2. There is a shortage of milk equal to the difference between Q1 and Q2. A shortage creates a problem of how to allocate milk to consumers.

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MINIMUM WAGES

MAXIMUM PRICES

Black markets often develop where people can obtain milk. A black market is an illegal market in which either illegal goods are bought and sold, or illegal prices are charged.

Maximum prices may cause a shortage of goods, but they do improve the welfare of some consumers since goods can be purchased at lower prices.

e) Setting minimum prices/price floors

The government sets a minimum price at some point above the market price. This is done to enable producers to make a comfortable profit and thus encourages them to

supply important essential goods.

Consider the market for wheat. The market equilibrium price is P and the equilibrium quantity is Q. If the government sets a minimum price at P1, farmers will be earning greater profits and

supply more wheat. Quantity supplied will therefore increase to Q2. However, quantity demanded will decrease to Q1. There would be a surplus of wheat equal to the difference between Q2 and Q1. A surplus means the government will have to buy the extra wheat and dump it locally or

abroad. Although minimum prices may cause a surplus, they do encourage the supply of important

food stuffs.

f) Taxes and subsidies

Merit and demerit goods

Merit goods – a good that is underprovided by the market mechanisms or goods that the government or society deem good for people, something they should have, e.g. education, health services.

Demerit goods - a good that is overprovided by the market mechanisms or goods that the government or society deem bad for people, something they should not have, e.g. drugs, alcohol, tobacco.

g) Redistribution of wealth

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MINIMUM PRICES

Traditional methods e.g. the levying of various taxes and the provision of free services, services in kind and cash benefits to the poor.

Implementing Redress methods e.g. the use of law to enforce redistribution. It includes BBBEE, affirmative action, empowerment, land restitution, land redistribution and property subsidies (for RDP houses).

The government can use other ways to improve income distribution and overcome market failure:

Transfers income directly to the poor e.g. child support grants, unemployment benefits, etc. Provides goods free of charge e.g. community goods, education, etc. Implements employment creation programmes e.g. public works programme. Subsidising merit goods e.g. subsidising arts and cultural events. Imposes taxes and laws on demerit goods to discourage consumption. Uses fiscal and monetary policy to achieve macroeconomic stability. Makes sure that consumers are informed about products through legislation. The South

African Bureau of Standards (SABS) checks consumer goods in South Africa. Tries to prevent misleading advertising. (Advertising Standards Authority)

h) Government involvement in production

Government are involved in producing goods and services themselves.

Public goods

In incomplete markets government will intervene and supply the desired goods directly. They raise taxes to provide these goods. Community goods are provided free of charge, examples police, defence force, etc. Collective goods are provided for a user fee examples refuse removal, waste disposal, etc.

Macroeconomic stability

If the Macroeconomic aims of government (economic growth, employment, price stability, exchange rate stability and income equality) are not achieved government will see this as market failure and intervene.

The focus will be on either the demand-side or the supply-side of the economy. The demand-side: they will use monetary and fiscal policies to stimulate or cool down

demand. The supply-side focuses on the capability of the economy and on policies to expand the

stock of factors of production, infrastructure and the flexibility of markets.

COST-BENEFIT ANALYSIS

a) The concept of cost-benefit analysis Cost-benefit analysis (CBA) is a standard method used to compare the social cost and benefits

of alternative projects or investments. Cost and benefits are measured and then weighed up against each other in order to generate

criteria for decision-making.

We use one of 3 decision criteria:

Net present value (NPV)Internal rate of return

(IRR)Benefit-cost ratio

(BCR)The present value of an investment The interest rate at which The BCR for a

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project, found by discounting all present and future receipts and outgoings at an appropriate rate of interest; if the net present value calculated is positive, it is worthwhile investing in a project.

the net present value of a project is zero (0); a project is worth investing in if its IRR is greater than the rate of interest.

project is the ratio between the sum of expected benefits and its cost.

CBA is, in essence, an accounting procedure for investment whereby the total cost of the particular project is weighted against its total benefits. Government usually uses CBA to see whether they should undertake a certain project.

b) The reason for cost-benefit analysis

This includes understanding the rate of return on a project and the idea that future costs and benefits can be discounted in reverse to give its present value. This determines the rate of return on a project and allows informed decisions to be made that are in the best interests of society.

Price mechanisms

The procedure involves estimating the money equivalent of the benefits of a project and comparing these benefits estimates with the cost of providing the good or service.

It is relatively easy to measure private costs and benefits as they go through the price mechanism.

But in practice, it is more difficult to attach monetary values to external costs and benefits. One way is by using shadow prices, based on opportunity costs. Description of shadow prices: Relative prices of goods, services and resources that are

proportional to their true opportunity cost for the economy, taking account of any external economies and diseconomies.

E.g. to place a value on the benefits drivers would receive on completion of a new freeway, we could estimate the driving time that would be saved, and then multiply this by the average wage rate.

Money now is worth more than money later. The relative levels of costs and benefits as well as the distribution of these must be considered.

E.g. a project should go ahead if the investors (those who gain) can compensate those who lose, and still experience a net gain.

c) Cost-benefit analysis in practice

The calculation of a CBR is often the end result of the study. The numerator of this ratio is defined as the present value of all of the expected economic

benefits attributable to a proposed undertaking. E.g. to calculate the monetary value for a public park or an art museum, shadow prices (benefits)

may be used to calculate the value of the enjoyment of these facilities. The denominator of the CBR is defined as the present value of the cost of undertaking and

operating the project. If it is a large capital investment project there are 2 types of costs: capital cost and operation, maintenance and repair cost.

Capital costs occur before the project begins to produce outputs; the remaining costs are future expenses.

Based on these definitions, the CBR is defined as the value of benefits of a programme to the value of the programme’s cost:

CBR = Present value of economic benefits

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Present value of economic costs

If the ratio is greater than 1, the project is judged economically worthwhile. If the ratio is equal to1, public expenditure adds nothing. If the ratio is below 1, it detracts from economic well-being.

In practice, a CBA tries to answer the question: ‘Do the gains to the people exceed the sacrifices required of them?’ If the answer is yes – CBA >1 If no – CBA < 1

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