CENTENARY SECONDARY SCHOOL DEPARTMENT OF BUSINESS, COMMERCE AND MANAGEMENT STUDIES

ECONOMICS : GRADE 11 Notes and Activities

TERM TWO : CORE CONTENT • Price elasticity • Effects of costs and revenue Forms of price elasticity of supply

Income elasticity of demand

Definition Measures the degree to which consumers respond to a change in their incomes by buying more or less of a particular good. Calculating income elasticity of demand (EDy)

percentage change in quantity demanded percentage change in income

• The value for EDy can be positive or negative. • A positive value means that the demand will move in the same direction as

income. Most goods have positive income elasticity. • This means that in most cases an increase in income will cause an increase in

the quantity demanded e.g. a 5% increase in income will lead to a 10% increase in the demand for cars.

• A negative value means that the demand will move in the opposite direction to income i.e. a decrease in income will lead to a decrease in quantity demanded.

Three types of income elasticity can be distinguished :- 1. Positive income elasticity. These are called normal goods and have an elasticity greater than one. If Edy is slightly greater than one, the good is a necessity eg. clothing If it is much higher than one, it is a luxury (or superior) good eg. jewellery 2. Negative income elasticity Such goods are called inferior or Giffen goods. Egs. Bread, maize meal, rice If income increases, demand for these goods will decrease. 3. When demand does not change as income changes income elasticity is zero This applies to goods for which demand is static eg. salt

Cross elasticity of demand Cross price elasticity (XED) measures the responsiveness of demand for good X

following a change in the price of a related good Y. We are looking here at the effect that changes in relative prices within a market

have on the pattern of demand. With cross elasticity we make an important distinction between substitute and complementary products.

a) Substitutes With substitute goods such as brands of cereal, an increase in the price of one

good will lead to an increase in demand for the rival product. The cross price elasticity for two substitutes will be positive. Another example is the cross price elasticity of demand for music. Sales of digital

music downloads have been soaring with the growth of broadband and falling prices for downloads. As a result, sales of music CDs have fallen sharply.

b) Complements Complements are in joint demand The value of CPED for two complements is negative. The stronger the relationship between two products, the higher is the co-efficient

of cross-price elasticity of demand When there is a strong complementary relationship, the cross elasticity will be

highly negative. An example might be games consoles and software games.

c) Unrelated products

Unrelated products have a zero cross elasticity for example the effect of changes in taxi fares on the market demand for cheese.

Goods with zero cross elasticity of demand are referred to as independent goods.

COSTS AND REVENUE Introduction • In a market economy, firms are responsible for the production of goods and

services. • To produce the goods and services, they combine the factors of production and

they have to pay costs. • The cost of producing a good or service as well as the revenue that firms receive

plays an important role in the decision of firms to supply goods and services. Objectives of businesses • When entrepreneurs start businesses, they may have different objectives in mind

that they would like to achieve with the business. • A business can strive for many objectives. • These objectives include: = maximising the profit of the business. = maximising the sales revenue. = growing its target market share by decreasing the price of its product or improving the firm’s marketing campaign. • Profit is the positive difference between total revenue and total costs. • Total revenue is the total income a firm receives from the sale of its products. • Total revenue depends on the price the business receives for its products and the

number of units it sells. • Profit maximisation occurs where the positive difference between total revenue

and total cost is the highest or where marginal revenue is equal marginal cost. Cost and Profit • Economists and accountants look differently at the concept of cost of production

and therefore calculate profits differently. • The main difference is that accountants only take explicit costs into account,

while economist use the opportunity cost principle. • The reason for using the opportunity cost principle is that economists are

interested whether resources are used efficiently for the production of goods and services.

• They make use of the concept of implicit cost. Explicit costs • Explicit costs are directly linked to business operations. • Explicit costs are all expenses a business has to pay for the use of the factors of

production. • Explicit costs include payments for labour (wages), materials, transport, rent

payments, water and electricity payments. Implicit costs • Implicit costs are hidden costs.

• Measures the opportunity costs of the use of all self-owned resources in the production of goods and services.

• Implicit costs include an acceptable remuneration for the entrepreneur and the opportunity cost of the factors of production.

• The entrepreneur needs to receive remuneration for his time and effort and for being willing to take the risk of starting a business.

• Opportunity cost is the income from the next-best method of using the factors of production.

• For example, if an entrepreneur invests all of his money in a financial institution instead of using it to run a business, he may earn 10% interest.

• To ensure that the entrepreneur keeps on employing his factors of production in his business – he has to make a profit of at least more than 10%.

• The entrepreneur will keep running his business only if the profit is high enough to cover the opportunity cost.

Example You run your own business. The total revenue from the business is R80 000 and the total cost is R35 000. If you were not self-employed you could have earned R50 000 working for another firm.

Accountant Economist Profit = total revenue – total cost = R80 000 – R35 000 = R45 000

Profit = total revenue – (explicit + implicit cost) = R80 000 – (R35 000 + R50 000) = - R5 000

• According to the economist you are losing money by running your own business. Better off financially if you sold your labour to another firm.

Short run costs • A firm will combine a specific quantity of fixed inputs with a quantity of variable

inputs in order to produce a specific quantity of outputs. • Fixed inputs are the factors of production and other intermediate inputs of which

the quantity used remains constant as the level of production increases. • Variable inputs are the factors of productions and other intermediate inputs for

which the quantity used increases as the level of production increases. • In the short run at least one input is considered fixed – examples of such inputs

are the size of the factory in which production takes place and the machines that are used.

• Fixed inputs do not change in the short run. • Variable inputs do change, for example electricity. • The long run is defined as a period that is long enough so that all factors of

production and intermediate inputs can become variable. • All the factors of production and intermediate inputs can be changed as the

output level changes. • In the long run, there are no fixed factors of production or other fixed intermediate

inputs.

Total cost (TC) • These are certain costs that a business always has to pay. • A firm has fixed costs and variable costs. Fixed costs (FC) • Fixed costs remain the same even when the number of units produced changes –

whether a business produces one product per month or a thousand the fixed costs will stay exactly the same.

• Fixed costs include maintenance of a building, lease payments on equipment and machinery, rent or interest payments for buildings and vehicles and insurance payments.

• The quantity produced in the short run will not influence fixed costs – stay constant.

• Fixed costs are also called overhead costs, indirect costs or unavoidable costs. Variable costs (VC) • Variable costs change with the number of units produced. • Are those costs that change with the level of output. • Represent the cost of variable inputs. • As more of a good or service is produced – the variable cost increase. • Variable costs include payments for raw materials, power/electricity, water and

labour services. • Variable costs are also called direct costs, prime costs or avoidable costs. The total cost of production is the sum of the fixed costs and the variable costs.

Total cost = fixed costs + variable costs

TC = FC + VC Average cost (AC) • Defined as the total cost per unit. • Calculated to determine the cost of each unit that is produced. • The following equation is used to determine the average cost:

AC = Total costs Number of units produced • The average cost must consist of average fixed costs (AFC) and average

variable costs (AVC). Equation : AC = AFC + AVC Average fixed cost (AFC)

• Fixed costs divided by the number of units produced. • The following equation is used to determine the average fixed costs:

AFC = Fixed cost Quantity

Average variable cost (AVC) • Variable costs divided by the number of units produced. • The following equation is used to determine the average variable costs:

AVC = Variable cost Quantity Average total cost (ATC) • Total cost divided by the number of units produced. • The following equation is used to determine the average total costs:

ATC = Total cost Quantity

Marginal cost (MC) • Marginal cost can be defined as the additional or extra cost a firm has incurred by

producing one additional or extra unit of its product. • Additional cost of producing one additional unit of a product. • Marginal cost indicates by how much the total cost has increased if one additional

unit of the product is produced. Marginal cost and marginal revenue • When the marginal cost is less than the marginal revenue – the business will

produce more units of a product. • When the marginal cost is more than the marginal revenue – the business will

produce fewer units of a product. Cost schedules • All the different costs can be presented in a cost schedule.

Illustrative example: a cost schedule for producing bread

Quantity Fixed Costs

Variable Costs

Total Costs

Average Fixed Costs

Average Variable

Costs

Average Total Costs

Marginal costs

Q FC VC FC+VC FC÷Q VC÷Q TC÷Q 0 10 0 10 1 10 4 14 10 4 14 4 2 10 6 16 5 3 8 2 3 10 10 20 3,3 3,3 6,6 4 4 10 16 26 2,5 4 6,5 6 5 10 30 40 2 6 8 14 6 10 45 55 1,7 7,5 9,2 15

Discussion 1. Fixed costs stay the same for all quantities. 2. Variable costs increase as quantity increases. 3. Total cost is the sum of the fixed costs and variable costs.

4. Average fixed cost is fixed cost divided by the number of units produced. Average fixed costs decreases as quantity increases – shows economies of scale (cost per unit decreases while quantities produced increase)

5. Average variable cost is variable cost divided by the number of units produced. Average variable costs first decrease and then increase – law of diminishing returns. The law of diminishing returns states that as more of a variable input is added to a fixed input – the returns from the variable input decreases. For example, when you double the number of bakers and double the ingredients, you will not be able to bake double the number of bread, because you will still have only one oven in which you can bake the bread.

6. You can calculate the average total cost by dividing total cost by quantity. 7. Marginal cost is the change in the total cost of each consequent unit produced.

Marginal cost first decreases, reaches a minimum and then increases. Cost curves

1. Fixed cost Discussion The fixed cost curve is a horizontal line, because fixed costs stay the same for all quantities. 2. Variable cost and Total cost curve Discussion • The variable cost curve begins at 0, and then slopes upwards from left to right and more sharply at the last quantities produced, because it increases then with a higher percentage for each quantity produced. • The total cost curve begins on the horizontal line of the fixed cost curve. The curve then slopes upwards to the right. It has the same shape as the variable cost curve.

Average and marginal cost curves Discussion • The average fixed cost (AFC) curve slopes downwards from left to right, because its value decreases for each quantity. • The average variable cost (AVC) curve is roughly U-shaped, because it first decreases and then increases. • The average total cost (ATC) curve has the same U-shape as the AVC curve. The curve will always be above the AVC curve because the ATC curve is the sum of the AFC curve and AVC curve. • The marginal cost curve first slopes downwards sharply, and then gradually slopes upwards, because it is the change in total costs.

Long – run costs • In the long run, all inputs can be changed and so all costs are variable. • A business has enough time over the long run to buy a larger factory, more

vehicles and more or improved machinery and equipment. • It is possible for the firm in the long run to adapt the size of its factory, and also to

introduce new product ranges and technology in its production processes.

Discussion • The curve consists of a number of consecutive short-run ATC curves. • Each time a business increases its size, it will have a new short run ATC curve. • The long run average cost curve is also called the planning curve, because it reflects the increase in the level of production as planned. • The U-shape long-run average cost curve • The word “scale” refers to the extent, size or level of production that takes place.

Discussion • The curve shows the three different phases of the LRAC. • As long as the LRAC decreases, the firm experiences economies of scale.

• Eventually the firm will reach a stage where the LRAC remains constant as the level of production increases – at this level of production the firm experiences constant economies of scale.

• If the firm expands its production capacity beyond a specific level – the LRAC will start to increase – this indicates that the firm then experiences diseconomies of scale.

Economies of scale (increasing returns to scale) • When the business produces more, the costs of the additional units will be lower

than the previous units. • Reasons for lower costs:

1. Fixed costs can be divided among more quantities. 2. Discounts can be received when buying in bulk. 3. Resources can be used more effectively.

Constant returns to scale • Constant returns to scale imply that when the business produces more – the

additional units will have the same costs as the previous units. Diseconomies of scale • When the business produces more – costs of additional units will be higher than

those of the previous units. • Diseconomies of scale happen when a business becomes difficult to control and

coordinate because it is too large. • For example, when a business expands it puts a lot of strain on management, the

workforce and existing machinery. • Workers must work overtime and machines must run for longer periods per day. Revenue calculations • To achieve maximum profit, a business strives to keep its revenue as high as

possible. What is revenue? Revenue is the total income that a firm generates when it sells goods or services to consumers. Total revenue • The total revenue (TR) is the total income that a firm receives from the sale of its

products. • It is calculated by multiplying the quantity sold by the price of the product. • TR = Price X Quantity sold

TR = P X Q

Total revenue curve Discussion • The more units a business sells the more total revenue it earns. • This is why the total revenue curve slopes upwards from left to right.

Average revenue (AR) • Average revenue is the total revenue divided by the quantity sold. • The following formula is used to calculate the average revenue (AR):

AR = Total revenue Quantity sold

• In the case of perfect competition all products will be sold at the market price. • In this case the average revenue will be equal to the market price. Marginal revenue • Marginal revenue is defined as the change in total revenue if one additional unit

of a product is produced. • It refers to the increase in total revenue if one extra unit of a product is sold. • The following formula is used to determine the marginal revenue of a firm:

New TR – Previous TR New quantity sold – Original quantity sold

Profits and losses • Profit can be described as the positive difference between total revenue and total

cost of a firm. • In order to make a profit, the total revenue of the firm must be greater than the

total cost of the firm. • A firm will make a loss if the firm’s total cost is greater than its total revenue. Different types of profits 1. Accounting profit (total profit) • The difference between total revenue from sales and total explicit costs

(payments made for the factors of production and other inputs that are used in the production process).

2. Normal profit • Is equal to the best return that the firm’s self-owned, self-employed resources

could earn elsewhere. • Normal profit includes the cost of the owner’s time and capital and is included in

the firm economic costs. • The minimum return that is required by the owners of a firm in order for them to

continue with the business. • This profit should be large enough to justify the continuation of the business. 3. Economic profit • Is the extra profit that a firm makes. • Is the profit that the business makes in addition to the normal profit. • Sometimes called excess profit, abnormal profit, supernormal profit or pure profit. There are two ways of determining when the profit of a firm will be at a maximum. Profit maximisation: Total Revenue and Total Cost Approach

Quantities sold

Total revenue (TR)

Total costs (TC)

Profit/Loss (TR-TC)

1 10 14 -4 2 15 15 0 3 20 17 3 4 25 19 6 5 30 26 4

Discussion • At the first quantity, the business will suffer a loss of -4. • At the second quantity – break-even point – total revenue is equal to total cost. • This is also the level at which the firm makes normal profits. • The highest profit will be generated when the difference between total revenue

and total costs is the most. • At the fourth quantity, the business will make the highest profit of 6. • The fourth quantity is the ideal level of production at which profits can be

maximised – called maximum economic profit. 1. A normal profit is made when total revenue is equal to total cost. 2. An economic profit is made when total revenue exceeds total cost. 3. A loss is made when total revenue is less than total cost.

Total revenue and total cost curves

Discussion • The losses and economic profits are represented by the vertical distance

between total cost and total revenue. • The two curves intersect at A – shows break-even point (normal profit). • When the total cost curve is above the total revenue curve – loss/economic loss. • Profit will be maximised when total revenue lies above total cost and where the

vertical distance between total revenue and total cost is the biggest. • In order to maximise its profits – the firm must produce the quantity where the

vertical distance between total revenue and total cost is the greatest. Profit maximisation: Marginal revenue and marginal cost • When the marginal revenue is more than the marginal cost (MR>MC), the

business will increase its level of production because the added benefit is more than the added cost.

• When the marginal revenue is less than the marginal cost (MR<MC), the business will reduce its level of production because the added benefit is less than the added cost.

• It will benefit a business to produce at the level of production where the additional income received from the additional unit is equal to the additional cost of producing that unit (MR=MC).

• The business will want to produce at the level of production where the additional income received from the unit is equal to the additional cost of producing that unit.

• To locate the level of production at which the business operates – where the marginal revenue (MR) curve intersects the marginal cost (MC) curve.

• The position of the ATC curve – determine the profit or loss.