Mba Eco v6 e f A

MASTER OF BUSINESS ADMINISTRATION Economics

Contact details: Regenesys Business School Tel: +27 (11) 669-5000 Fax: +27 (11) 669-5001 Email: [email protected] www.regenesys.co.za

Version Control: Date of Publication: Publisher: Place of Publication:

6_e_f March, 2014 Regenesys Management Sandton

Document Change History Date 27 August 2013 18 March 2014

Version 5_f 6

Initials FVS CT

20 March 2014 24 March 2014

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Description of Change Formatting Update to: • New textbook (Parkin, M. 2014, Economics, Global Edition, 11th ed., England: Pearson Education Limited) • Revised learning outcomes for 2014 • Emerald articles • Updating of charts Formatting Editing

This Study Guide highlights key focus areas for you as a student. Because the respective topic of study is so vast, it is critical that you consult additional literature.

Copyright © Regenesys, 2014 All rights reserved. No part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form, or by any means (electronic, mechanical, photocopying, recording or otherwise) without written permission of the publisher. Any person who does any unauthorised act in relation to this publication may be liable for criminal prosecution and civil claims for damages.

C ONTENTS 1   WELCOME TO REGENESYS .................................................................................................................... 1   2   INTRODUCTION ......................................................................................................................................... 2   2.1   TEACHING AND LEARNING METHODOLOGY ............................................................................... 2   2.2   ALIGNING ORGANISATIONAL, TEAM AND INDIVIDUAL OBJECTIVES ........................................ 3   3   ICONS USED IN THIS STUDY GUIDE ...................................................................................................... 4   4   STUDY MATERIAL FOR THE MODULE .................................................................................................... 5   5   RECOMMENDED RESOURCES ............................................................................................................... 5   5.1   RECOMMENDED READING ............................................................................................................. 5   5.2   RECOMMENDED ARTICLES ............................................................................................................ 6   5.3   MULTIMEDIA ..................................................................................................................................... 7   5.4   ADDITIONAL SOURCES TO CONSULT ........................................................................................... 7   6   LEARNING OUTCOMES ............................................................................................................................ 9   7   CONTENT SCOPE AND LEARNING GUIDANCE ................................................................................... 10   7.1   INTRODUCTION TO ECONOMICS ................................................................................................ 11   7.1.1   WHAT IS ECONOMICS? ..................................................................................................... 11   7.1.2   SCARCITY, CHOICE AND OPPORTUNITY ....................................................................... 12   7.1.3   THE PRODUCTION POSSIBILITIES CURVE..................................................................... 12   7.1.4   THE THREE CENTRAL ECONOMIC QUESTIONS ............................................................ 13   7.1.5   ECONOMIC SYSTEMS ....................................................................................................... 14   7.1.6   INTRODUCTION TO ECONOMIC THEORIES ................................................................... 18   7.1.7   ECONOMIC AGGREGATES ............................................................................................... 21   7.2   THE SOUTH AFRICAN ECONOMY ................................................................................................ 27   7.2.1   PERFORMANCE OF THE SOUTH AFRICAN ECONOMY ................................................. 27   7.2.2   SOUTH AFRICA’S INTERNATIONAL ECONOMIC POSITION .......................................... 28   7.2.3   BANKING STABILITY IN SOUTH AFRICA ......................................................................... 30   7.2.4   SOUTH AFRICA’S FACTOR ENDOWMENT ...................................................................... 31   7.2.5   SOUTH AFRICA’S LINKS WITH THE REST OF THE WORLD .......................................... 32   7.3   DEMAND AND SUPPLY .................................................................................................................. 36   7.3.1   DEMAND ............................................................................................................................. 36   7.3.2   SUPPLY ............................................................................................................................... 40   7.3.3   MARKET EQUILIBRIUM...................................................................................................... 42   7.3.4   CONSUMER SURPLUS AND PRODUCER SURPLUS ...................................................... 43   7.3.5   CHANGE IN DEMAND ........................................................................................................ 44   7.3.6   CHANGE IN SUPPLY .......................................................................................................... 45   7.3.7   SIMULTANEOUS CHANGES IN DEMAND AND SUPPLY ................................................. 45   7.3.8   GOVERNMENT INTERVENTION ....................................................................................... 46   7.4   ELASTICITY AND TOTAL INCOME ................................................................................................ 47   7.4.1   THE PRICE ELASTICITY OF DEMAND.............................................................................. 47   7.4.2   INCOME ELASTICITY OF DEMAND .................................................................................. 49   7.4.3   CROSS ELASTICITY OF DEMAND .................................................................................... 49   7.4.4   THE PRICE ELASTICITY OF SUPPLY ............................................................................... 49   7.5   THE SOUTH AFRICAN LABOUR MARKET .................................................................................... 53   7.5.1   THE LABOUR MARKET VERSUS THE GOODS MARKETS ............................................. 53   7.5.2   A PERFECTLY COMPETITIVE LABOUR MARKET ........................................................... 54   7.5.3   IMPERFECT LABOUR MARKETS ...................................................................................... 57   7.5.4   WAGE DIFFERENTIALS ..................................................................................................... 58   7.6   INTRODUCTION TO ECONOMIC POLICY ANALYSIS .................................................................. 61   7.6.1   THE NEED FOR GOVERNMENT INTERVENTION............................................................ 61   7.6.2   ECONOMIC TOOLS USED IN ECONOMIC POLICY ANALYSIS ....................................... 64   7.6.3   FURTHER CONSIDERATIONS OF ECONOMIC POLICY ANALYSIS ............................... 65  

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7.7   THE MONETARY SECTOR ............................................................................................................. 66   7.7.1   THE FUNCTIONS OF MONEY............................................................................................ 66   7.7.2   DIFFERENT KINDS OF MONEY......................................................................................... 67   7.7.3   MONEY SUPPLY IN SOUTH AFRICA ................................................................................ 67   7.7.4   FINANCIAL INSTITUTIONS ................................................................................................ 70   7.7.5   THE SUPPLY OF MONEY .................................................................................................. 72   7.7.6   THE DEMAND FOR MONEY .............................................................................................. 74   7.7.7   EQUILIBRIUM IN THE MONEY MARKET........................................................................... 75   7.7.8   THE INSTRUMENTS OF MONETARY POLICY ................................................................. 76   7.7.9   BANK SUPERVISION.......................................................................................................... 78   7.8   THE FOREIGN SECTOR ................................................................................................................. 80   7.8.1   WHY COUNTRIES TRADE ................................................................................................. 80   7.8.2   TRADE POLICY................................................................................................................... 82   7.8.3   THE EXCHANGE RATES.................................................................................................... 83   7.8.4   THE TERMS OF TRADE (TOT) .......................................................................................... 84   7.9   AN INTRODUCTION TO APPLIED ECONOMETRICS ................................................................... 86   7.9.1   ECONOMETRIC TECHNIQUES ......................................................................................... 86   7.9.2   ECONOMETRIC CONCEPTS ............................................................................................. 87   7.9.3   PRACTICAL APPLICATION OF ECONOMETRICS............................................................ 87   7.10  INFLATION AND CAPITAL BUDGETING ....................................................................................... 89   7.10.1   DEFINITION OF INFLATION .............................................................................................. 89   7.10.2   THE MEASUREMENT OF INFLATION .............................................................................. 89   7.10.3   THE EFFECTS OF INFLATION .......................................................................................... 91   7.10.4   THE CAUSES OF INFLATION ............................................................................................ 91   7.10.5   ANTI-INFLATION POLICY .................................................................................................. 92   7.10.6   CAPITAL BUDGETING ....................................................................................................... 93   7.11  THE IMPACT OF GLOBALISATION ................................................................................................ 95   7.11.1   THE DEFINITION OF GLOBALISATION ............................................................................ 95   7.11.2   THE IMPACT OF GLOBALISATION ON SOUTH AFRICA ................................................. 96   7.11.3   BENEFITS OF INTERNATIONAL PORTFOLIO DIVERSIFICATION ................................. 97   7.11.4   OFFSHORE FINANCING .................................................................................................... 98   REFERENCES ........................................................................................................................................ 100  

List of Tables TABLE 1: WELL-KNOWN ECONOMIC THEORIES ....................................................................................... 18   TABLE 2: COMPARISON OF THE VARIOUS ECONOMIC SCHOOLS OF THOUGHT ................................ 19   TABLE 3: SIMULTANEOUS CHANGES IN DEMAND AND SUPPLY ............................................................ 45   TABLE 4: REAL-LIFE ELASTICITY ................................................................................................................ 48   TABLE 5: LABOUR VERSUS GOODS MARKET ........................................................................................... 54   TABLE 6: FUNCTIONS OF MONEY ............................................................................................................... 66   TABLE 7: BASEL III......................................................................................................................................... 72   TABLE 8: ECONOMETRIC CONCEPTS ........................................................................................................ 87  

List of Figures FIGURE 1: THE PRODUCTION POSSIBILITIES CURVE.............................................................................. 12   FIGURE 2: CIRCULAR FLOWS IN A MARKET ECONOMY .......................................................................... 22   FIGURE 3: HIRING VS. SKILLED LABOUR 2012 (WORLDWIDE) ................................................................ 29   FIGURE 4: SOUTH AFRICAN CURRENT ACCOUNT (2008 TO 2014) ......................................................... 34   FIGURE 5: AN INDIVIDUAL’S WEEKLY DEMAND FOR TOMATOES .......................................................... 37   FIGURE 6: CHANGE IN DEMAND ................................................................................................................. 38   FIGURE 7: TWO SUBSTITUTES – BUTTER AND MARGARINE .................................................................. 39   FIGURE 8: TWO COMPLEMENTS – CASSETTES AND VCRS .................................................................... 39   FIGURE 9: RELATIONSHIP BETWEEN PRICE AND QUANTITY SUPPLIED .............................................. 41   FIGURE 10: THE EFFECT OF RISING PRICES ............................................................................................ 42   FIGURE 11: DEMAND, SUPPLY AND MARKET EQUILIBRIUM ................................................................... 43   FIGURE 12: CONSUMER SURPLUS AND PRODUCER SURPLUS AT MARKET EQUILIBRIUM ............... 44   FIGURE 13: SOUTH AFRICA MONEY SUPPLY M0 (2004 TO 2014) ........................................................... 67   FIGURE 14: SOUTH AFRICA MONEY SUPPLY M1 (2004 TO 2014) ........................................................... 68   FIGURE 15: SOUTH AFRICA MONEY SUPPLY M2 (2004 TO 2014) ........................................................... 69   FIGURE 16: SOUTH AFRICA MONEY SUPPLY M3 (JAN 2000 TO MAR 2013)........................................... 69   FIGURE 17: THE MONEY MARKET............................................................................................................... 76  

1 WELCOME TO REGENESYS “Have a vision. Think big. Dream, persevere and your vision will become a reality. Awaken your potential knowing that everything you need is within you.” Dr. Marko Saravanja

At Regenesys, we assist individuals and organisations to achieve their personal and organisational goals, by enhancing their management and leadership potential. We approach education and development holistically, considering every interaction not only from an intellectual perspective but also in terms of emotion and spirituality. Our learning programmes are designed to transform and inspire your mind, heart and soul, and thus allow you to develop the positive values, attitudes and behaviours, which are required for success. Having educated over 95 000 students based in highly reputable local and international corporations across over 100 countries since Regenesys' inception in 1998, we are now one of the fastest-growing and leading institutions of management and leadership development in the world. Regenesys’ ISO 9001:2008 accreditation bears testimony to our quality management systems meeting international standards. Regenesys is accredited with the Council on Higher Education. Our work is rooted in the realities of a rapidly changing world and we provide our clients with the knowledge, skills and values required for success in the 21st century. At Regenesys, you will be treated with respect, care and professionalism. You will be taught by business experts, entrepreneurs and academics who are inspired by their passion for human development. You will be at a place where business and government leaders meet, network, share their experiences and knowledge, learn from each other, and develop business relationships. You will have access to a campus, in the heart of Sandton, with the tranquillity of a Zen garden, gym and meditation room. We encourage you to embark on a journey of personal development with Regenesys. We will help you to awaken your potential and to realise that everything you need to succeed is within you. We will be with you every step of the way. We will work hard with you and, at the end celebrate your success with you. Areas of Expertise

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2 INTRODUCTION Welcome to the module on Economics – a core component of the MBA programme. The broad purpose of this module is to facilitate your understanding of the fundamental principles, concepts and processes of economics. This module teaches you about the relationships between various parts of the economy and uses various economic models to illustrate these relationships. It covers application to traditional economic areas, such as macroeconomics, microeconomics, international trade, and monetary economics; as well as applied areas, such as economic policy analysis and econometrics. Students are encouraged to use this Study Guide as a starting point to engage with the given subject matter and should be read in conjunction with the prescribed texts and other current reading materials.

2.1 T EACHING AND L EARNING M ETHODOLOGY Regenesys uses an interactive teaching and learning methodology that encourages self-reflection and promotes independent and critical thinking. Key to the approach utilised is an understanding of adult learning principles, which recognise the maturity and experience of participants, and the way that adult students need to learn. At the core of this is the integration of new knowledge and skills into existing knowledge structures, as well as the importance of seeing the relevance of all learning via immediate application in the workplace. Practical exercises are used to create a simulated management experience to ensure that the conceptual knowledge and practical skills acquired can be directly applied within the work environment of the participants. The activities may include scenarios, case studies, self-reflection, problem solving and planning tasks. Training manuals are developed to cover all essential aspects of the training comprehensively, in a user-friendly and interactive format. Our facilitators have extensive experience in management education, training and development.

Please read through this Study Guide carefully, as it will influence your understanding of the subject matter and the successful planning and completion of your studies.

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2.2 A LIGNING O RGANISATIONAL , T EAM AND I NDIVIDUAL O BJECTIVES This course will draw on a model developed by Regenesys Management, which demonstrates how the external environment, the levels of an organisation, the team and the components of an individual are interrelated in a dynamic and systemic way. The success of an individual depends on his/her self-awareness, knowledge, and ability to manage successfully these interdependent forces, stakeholders, and processes. The degree of synergy and alignment between the goals and objectives of the organisation, the team and the individual determines the success or failure of an organisation. It is therefore imperative that each organisation ensures that team and individual goals and objectives are aligned with the organisation’s strategies (vision, mission, goals and objectives, etc.); structure (organogram, decision-making structure, etc.); systems (HR, finance, communication, administration, information, etc.); culture (values, level of openness, democracy, caring, etc.). Hence, an effective work environment should be characterised by the alignment of organisational systems, strategies, structures and culture, and by people who operate synergistically.

Regenesys’ Integrated Management Model

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3 ICONS USED IN THIS STUDY GUIDE Icons are included in the Study Guide to enhance its usability. Certain icons are used to indicate different important aspects in the Study Guide to help you to use it more effectively as a reference guide in future. The icons in this Study Guide should be interpreted as follows:

Definition

Examples

The definitions provide an academic perspective on given terminology. They are used to give students a frame of reference from which to define a term using their own words.

The example icon is used to indicate an extra/additional text that illustrates the content under discussion. These include templates, simple calculation, problem solution, etc.

Video clip or presentation

Interesting source to consult

This icon indicates a URL link to a video clip or presentation on the subject matter for discussion. It is recommended that students follow the link and listen/read the required sources.

The source icon is used to indicate text sources, from the Internet or resource centre, which add to the content of the topic being discussed

In a nutshell

Calculations

This icon indicates a summary of the content of a section in the workbook and to emphasise an important issue.

This icon indicates mathematical or linguistic formulae and calculations.

Self-reflection

Tasks

Students complete the action of selfreflection in their own time. It requires students to think further about an issue raised in class or in the learning materials. In certain instances, students may be required to add their views to their assignments.

The task icon indicates work activities that contact students must complete during class time. These tasks will be discussed in class and reflected upon by students and facilitators. E-learning students can use these tasks simply to reinforce their knowledge.

Note This icon indicates important information of which to take note.

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4 STUDY MATERIAL FOR THE MODULE You have received material that includes the following: • • •

Study Guide Recommended reading Assignment

These resources provide you with a starting point from which to study the contents of this module. In addition to these, other resources to assist you in completing this module will be provided online via the link to this module. Guidance on how to access the material is provided in the Academic Handbook that you received when you registered for this qualification.

5 RECOMMENDED RESOURCES A number of recommended resources have been identified to assist you in successfully completing this module.

5.1 R ECOMMENDED R EADING The following textbook is recommended and must be used to complete the module: •

Parkin, M. 2014, Economics, Global Edition, 11th ed., England: Pearson Education Limited.

Please ensure you order, or download your textbook, before you start with the module.

Given the analytical nature of the subject, it is highly recommended that you refresh your understanding of graphs used in economic models (refer to the Appendix on pp 15-27 of the recommended textbook).

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5.2 R ECOMMENDED A RTICLES The following journal articles are recommended for the successful completion of this module: •

Abboushi, S. 2014, 'Solar trade tariffs', Competitiveness Review, 24 (1), 59-65.

•

Ali, S., Rabbi, F., Hayat, U., and Ali, N. 2013, 'The composition of public expenditures and economic growth: evidence from Pakistan', International Journal of Social Economics, 40 (11), 1010-1022.

•

Buder, F., Feldman, C., and Hamm, U. 2012, 'Why regular buyers of organic food still buy many conventional products', British Food Journal, 116 (3), 390-404.

•

Dowlah, C. 2014, 'Cross-border labor mobility', Journal of International Trade Law and Policy, 13 (1), 2-18.

•

Ezeani, E. 2013, 'WTO post Doha: trade deadlocks and protectionism', Journal of International Trade Law and Policy, 12 (3), 272-288.

•

Trainer, F. 2014, 'Ethics and the Economy', Humanomics, 30 (1), 41-58.

Additional sources available on the Internet: •

Andrew, T., and Alex, F. n.d. 'A Teaching Note on Offshore Financial Centers', Journal of Advancements in Business Education. https://www.sbrconferences.com/uploads/Vol1-Faseruk_Alex.pdf (accessed 20 March 2014).

•

Department of Trade and Industry, 2013, 'South Africa's Trade Agreements' http://www.thedti.gov.za/parliament/ITED.pdf (accessed 19 March 2014).

•

Financial Times, 2013, 'Inflation Targeting', http://lexicon.ft.com/Term?term=inflation-targeting (accessed 18 March 2014).

•

Ghosh, J. 2013, 'The Global Economic Chessboard and the Role of the BRICS: Brazil, Russia, India, China, South Africa', http://www.globalresearch.ca/the-global-economic-chessboard-and-the-role-of-the-brics-brazilrussia-india-china-south-africa/5357502 (accessed 19 March 2014).

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Marcus, G, 2014, 'Quarterly Economic Review', South African Reserve Bank, Quarterly Bulletin March 2014, https://www.resbank.co.za/Lists/News%20and%20Publications/Attachments/6140/01Full%20Quarterly%20Bull etin%20%E2%80%93%20March%202014.pdf (accessed 20 March 2014).

•

Naidoo, J. (n.d.). 'The impact of HIV/AIDS on crime in South Africa', http://www.sarpn.org/documents/d0001964/HIVAIDS_crime_SA_Naidoo.pdf (accessed 18 March 2014).

•

Weiss, L. 2013, 'The myth of free-market capitalism versus the rest', http://speri.dept.shef.ac.uk/2013/01/15/myth-free-market-capitalism-rest/ (accessed 18 March 2014).

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The following links provide useful country data: •

Indexmundi, 2012, 'South Africa Economy Overview', http://www.indexmundi.com/south_africa/economy_overview.html (accessed 18 March 2014). (Note: Go to the website main page and select a country of your choice).

•

Third World Planet, 2014, 'Third World Planet: The Third World Economies' http://www.thirdworldplanet.com (accessed 18 March 2014) (Note: Click on the side bar to view the different economies, e.g. The Indian Economy)

•

Trading Economics, 2014, http://www.tradingeconomics.com (accessed 18 March 2014). (Note: Selections available include countries, indicators, and markets)

Additional articles that may prompt discussions and further assist you in completing this course will be saved on Regenesys Online under the relevant module. Please visit the site regularly to access these additional sources.

5.3 M ULTIMEDIA •

Ernst and Young, 2012, 'Globalization', [video clip], http://www.youtube.com/watch?v=JvCyRoY6azk (accessed 18 March 2014).

5.4 A DDITIONAL S OURCES TO C ONSULT As a higher education student, you are responsible for sourcing additional information that will assist you in completing this module successfully. Below is a list of sources that you can consult to obtain additional information on the topics to be discussed in this module:

Emerald

This is an online database containing journal articles that are relevant to your modules. Please refer to the attached Emerald manual to assist you to download required articles. Information on how to access Emerald is provided to you in your Academic Handbook. You will receive access to the database once you register as a student.

NetMBA:

This is one of several web addresses that provide a selection of “MBA” constructs and discussion. It is one of the better of these addresses. http://www.netmba.com/

MindTools:

MindTools.com is a very useful source of ideas, constructs, management models, etc. with even more useful commentary and description. http://www.mindtools.com/

Brunel Open Learning Archive:

A Brunel University support-site that provides an easily accessible library of ideas, concepts, constructs techniques, tools, models, etc. http://www.brunel.ac.uk/

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ProvenModels:

ProvenModels' Digital Model Book presents digitalised management models categorised in a clear, consistent and standardised information structure to improve the usability and reusability of management literature. Management models are important generalisations of business situations when applied in context and are powerful tools for solving business issues. http://www.provenmodels.com/

12manage.com:

This is a website on which one can access numerous models as well as global comments on the models and principles. This could also serve as a place where you could voice your ideas and get feedback from all over the world. http://www.12manage.com/

The Free Management Library:

The Free Management Library can be used to improve your organisation, and for your own personal, professional and organisational development. This is by far the most comprehensive overview of all aspects of strategic planning covering all stages of the process. http://www.managementhelp.org/np_progs/sp_mod/str_plan.htm

The Charity Village:

A series of twelve very short articles, by Ron Robinson, an independent Canadian consultant, appeared on Charity Village between November 2001 and October 2002. These articles are refreshing in that they do not advocate a “one best way” for all types of non-profit organisations. They discuss various way of approaching the strategic planning process. https://charityvillage.com/topics/management/planning/strategic-planning.aspx?page1424=2

Trading Economics

For statistical data per country. population lists, jobless data, etc. http://www.tradingeconomics.com

Indicators include, for example, GDP, credit ratings,

There are many more sites and articles available that can help you to successfully complete this module. You are encouraged to post the website addresses or URLs of any additional interesting sites that you come across on the Regenesys Learning Platform. In this way, you can assist other students to access the same wonderful information that you have discovered.

A word of caution – not all information available on the Internet is necessarily of a high academic standard. It is therefore recommended that you always compare information that you obtain with that contained in accredited sources such as articles that were published in accredited journals.

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6 LEARNING OUTCOMES Upon completing this module, students should be able to: • • • • • • • • • • •

Evaluate the different types of economic systems, the ideologies on which they are based, and their application to an organisation Explain and evaluate the impact of macroeconomic and microeconomic policies on a country Understand and analyse the effects of inflation on capital budgeting decisions and the cost of debt Explain how prices are established in the market as well as the restrictions on the market mechanism Explore the relationship between elasticity and total income Discuss and critique the various financial institutions, their functions and the nature of their business Describe and evaluate the benefits of international portfolio diversification Explore critically a country’s labour market and its key development challenges Understand and critically examine the impact of globalisation Identify and evaluate reasons why international trade takes place and the advantages of international trade Understand the application of econometrics to economic phenomenon

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7 CONTENT SCOPE AND LEARNING GUIDANCE A number of topics will be covered to assist you in successfully achieving the learning outcomes of this module. It is important to study each of these sections to ensure that you expand your knowledge in the subject and are able to complete the required assessments. The sections that will be dealt with include: Section 1

Introduction to Economics

Section 2

The South African Economy

Section 3

Demand and Supply

Section 4

Elasticity and Total Income

Section 5

The South African Labour Market

Section 6

Introduction to Economic Policy Analysis

Section 7

The Monetary Sector

Section 8

The Foreign Sector

Section 9

An Introduction to Applied Econometrics

Section 10

Inflation and Capital Budgeting

Section 11

The Impact of Globalisation

A more detailed framework of what is required for each of these topics follows under each section heading. A number of questions to probe discussion and guide you towards comprehension and insight are also provided.

The timetable under each section heading provides guidance on the time to be spent to study each section. It is recommended that you follow the given timetable to ensure that you spend the appropriate amount of time on each section. Following the timetable will ensure that you have covered the required sections relevant to each assignment and have appropriate time to prepare for the examination.

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7.1 I NTRODUCTION TO E CONOMICS Timeframe: Learning Outcome: Recommended Book: Recommended Articles:

•

Section Overview:

7.1.1

Minimum of 14 hours • Evaluate the different types of economic systems, the ideologies on which they are based and their application to an organisation • Chapters 1, 2 and 21 in Parkin, M. 2014, Economics, Global Edition, 11th ed., England: Pearson Education Limited. Trainer, F. 2014, 'Ethics and the Economy', Humanomics, 30 (1), 41-58.

This section looks at the definition of economics and the fundamental principles of economics. It also examines the three central economic questions and how they are solved by the major economic systems.

What is Economics?

Reflect on your understanding of the term “economics”. You may have studied economics in matric – or in further studies. In your own words, define what you understand by “economics”.

In the 1930s, prominent 20th Century British economist, Lionel Robbins (1898-1984) set the tone for most modern definitions of economics as the science that studies human behaviour as a relationship between ends and scarce means that have alternative uses (van Schaik, 2008:5). "Economics is the social science that studies the choices that individuals, businesses, governments, and entire societies make as they cope with scarcity and the incentives that influence and reconcile those choices." (Parkin, 2014:2) The definition above develops Robbins’ idea by bringing to fore the fundamental issues of individuals, businesses, governments, societies and choices, scarcity, and incentives (a broader, more systemic view of economics). Fundamentally, we have unlimited wants on the one hand and limited resources on the other.

Distinguishing between “Wants”, “Needs” and “Demand” Choices have to be made with regard to which wants to satisfy using the limited resources. A want is a human desire for goods and services, it is unlimited and you can do without it. A need is a necessity; it is essential for survival and is not absolutely unlimited. A demand is only made for a good or service if the necessary means to purchase it are available.

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7.1.2

Scarcity, Choice and Opportunity

The term “scarcity” means that the resources available are simply not enough to satisfy the human wants; i.e. the basic fact of economic life. Choice is concerned with the decisions that are made in the allocation of limited resources to competing alternatives. In the process of resource allocation, some alternatives are preferred over others. The opportunity cost of a choice is the value of the best-foregone alternative. Every time a choice is made, opportunity costs are incurred.

Task Questions

1. After reading Pages 32-33 of your prescribed textbook (Parkin, M. 2014, Economics, Global Edition, 11th ed., England: Pearson Education Limited), explain why the production possibility frontier (PPF) in a simple twocommodity world is conventionally depicted as “bulged out” or concave to the origin. 2. Under what circumstances might a linear PPF be plausible?

7.1.3

The Production Possibilities Curve

The concepts of scarcity, choice and opportunity costs can be illustrated using the production possibility curve as shown in the figure that follows. The production possibilities curve indicates the combinations of any two goods or services that are attainable when the available resources (e.g. in a business) are fully and efficiently employed. In the diagram that follows, movement to the right from A to C illustrates an increase in the production of Product B, while the production of Product A decreases. There is a trade-off between Products A and B (we must give up something to get something else). This implies that, at points A, B and C, different levels of Product A and B can be produced. Point Y is unattainable and point X shows that the business is not at full capacity. FIGURE 1: THE PRODUCTION POSSIBILITIES CURVE

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Parkin (2014:33) explains production efficiency as follows: “We achieve production efficiency if we produce goods and services at the lowest possible cost. This outcome occurs at all the points on the PPF." (Parkin, 2014:33)

7.1.4

The Three Central Economic Questions

Task Questions 1. What do you understand by the basic economic questions of “what”, “how” and “for whom” to produce goods and services? Refer to Pages 3-6 in Parkin, M. 2014, Economics, Global Edition, 11th ed., England: Pearson Education Limited.

The three central economic questions are:

What goods and services will be produced? (Output Questions) Goods – such as houses, cars, food etc. – are tangible, and services – such as legal services, financial services, medical services etc. – are intangible. The goods can be categorised into consumer or capital, final or intermediate, private or public, economic or free, and homogeneous or heterogeneous (Mohr and Fourie, 2008: 18-19). Goods and services are produced to satisfy human wants.

How will each of the goods and services be produced? (Input Questions) The production of goods and services requires resources. These resources (factors of production) can be grouped into four categories: Natural resources, labour, capital, and entrepreneurship and technology. The natural resources consist of the free gifts of nature such as water, land, minerals, vegetation etc. Labour is the human effort in the production of goods and services. Capital refers to all the man-made resources that are used in the production of other goods and services such as machines, tools, buildings etc. Entrepreneurship involves the identification of opportunities and a combination of labour, capital and natural resources to produce the desired goods and services. The person who drives the process of entrepreneurship is called an entrepreneur. Technological advancement improves the entrepreneurship process.

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For whom will the various goods and services be produced? (Distribution Questions) The goods and services are produced mainly for those who have the means to demand them. The goods and services are distributed to various sectors and participants in the economy. The distribution issue is a highly emotional question, especially in societies where the distribution is unequal.

Task Questions

1. To what extent can the solutions to the “what” and “for whom” questions be seen as interdependent in a market economy?

7.1.5

Economic Systems

There are basically three economic systems that are used to solve the central economic questions.

The Traditional System This involves the production of the same goods and services that are distributed in the same way by each successive generation. This system is slow to change, rigid and resistant to innovation. Very few economies are still using this economic system – countries still using this type of system are often rural and farm-based (the Inuit tribe of northern Canada is an example of a society that still uses a traditional economy).

The Command System The economy is controlled by a central authority, which decides what to produce, how to produce and to whom to distribute (factors of production are government owned). It is argued that this system is one of the more ‘inefficient’ systems and within it there is much waste. Present day examples of this are North Korea and Cuba.

The Market System This is the most commonly applied economic system to the economic problem. A market is any contact or communication between potential buyers and sellers of a good or service.

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Some characteristics of a market are listed below: • • • • •

There must be at least one potential seller and one potential buyer The seller must have something to sell The buyer must have the buying power The market price must be determined The agreement must be guaranteed by law or tradition

In a market system, only those goods and services with a market value will be produced. The goods and services are produced in the cheapest possible way. The goods and services only go to those who have the means to buy them. Most modern economies are mixed economies and have a market that has a degree of government intervention. If the market economy is allowed to function freely, it will only produce those goods and services for which a market value exists and which can be sold at a price; but what about other goods, for example, street lights or unpolluted air and clean beaches? All consumers want to enjoy these goods and services but, because these are public goods and not exclusive ones, the market system will not produce them. Hence the need for government interference. Read the following case study and then answer the questions that follow. Case Study: The Collapse of Lehman Brothers On September 15, 2008, Lehman Brothers filed for bankruptcy. With $639 billion in assets and $619 billion in debt, Lehman's bankruptcy filing was the largest in history, as its assets far surpassed those of previous bankrupt giants such as WorldCom and Enron. Lehman was the fourth-largest U.S. investment bank at the time of its collapse, with 25,000 employees worldwide. Lehman's demise also made it the largest victim, of the U.S. subprime mortgage-induced financial crisis that swept through global financial markets in 2008. Lehman's collapse was a seminal event that greatly intensified the 2008 crisis and contributed to the erosion of close to $10 trillion in market capitalisation from global equity markets in October 2008, the biggest monthly decline on record at the time. The History of Lehman Brothers Lehman Brothers had humble origins, tracing its roots back to a small general store that was founded by German immigrant Henry Lehman in Montgomery, Alabama, in 1844. In 1850, Henry Lehman and his brothers, Emanuel and Mayer, founded Lehman Brothers. While the firm prospered over the following decades as the U.S. economy grew into an international powerhouse, Lehman had to contend with plenty of challenges over the years. Lehman survived them all – the railroad bankruptcies of the 1800s, the Great Depression of the 1930s, two world wars, a capital shortage (when it was spun off by American Express in 1994), and the Long Term Capital Management collapse and Russian debt default of 1998. However, despite its ability to survive past disasters, the collapse of the U.S. housing market ultimately brought Lehman Brothers to its knees, as its headlong rush into the subprime mortgage market proved to be a disastrous step.

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The Prime Culprit In 2003 and 2004, with the U.S. housing boom well under way, Lehman acquired five mortgage lenders, including subprime lender BNC Mortgage and Aurora Loan Services, which specialised in Alt-A loans (made to borrowers without full documentation). Lehman's acquisitions at first seemed prescient; record revenues from Lehman's real estate businesses enabled revenues in the capital markets unit to surge 56% from 2004 to 2006, a faster rate of growth than other businesses in investment banking or asset management. The firm secured $146 billion of mortgages in 2006, a 10% increase from 2005. Lehman reported record profits every year from 2005 to 2007. In 2007, the firm reported net income of a record $4.2 billion on revenue of $19.3 billion. Lehman's Colossal Miscalculation In February 2007, the stock reached a record $86.18, giving Lehman a market capitalisation of close to $60 billion. However, by the first quarter of 2007, cracks in the U.S. housing market were already becoming apparent as defaults on subprime mortgages rose to a seven-year high. On March 14, 2007, a day after the stock had its biggest one-day drop in five years on concerns that rising defaults would affect Lehman's profitability, the firm reported record revenues and profit for its fiscal first quarter. In the post-earnings conference call, Lehman's chief financial officer (CFO) said that the risks posed by rising home delinquencies were well contained and would have little impact on the firm's earnings. He also said that he did not foresee problems in the subprime market spreading to the rest of the housing market or hurting the U.S. economy. The Beginning of the End As the credit crisis erupted in August 2007 with the failure of two Bear Stearns hedge funds, Lehman's stock fell sharply. During that month, the company eliminated 2,500 mortgage-related jobs and shut down its BNC unit. In addition, it also closed offices of Alt-A lender Aurora in three states. Even as the correction in the U.S. housing market gained momentum, Lehman continued to be a major player in the mortgage market. In 2007, Lehman underwrote more mortgage-backed securities than any other firm, accumulating an $85-billion portfolio, or four times its shareholders' equity. In the fourth quarter of 2007, Lehman's stock rebounded, as global equity markets reached new highs and prices for fixed-income assets staged a temporary rebound. However, the firm did not take the opportunity to trim its massive mortgage portfolio, which in retrospect, would turn out to be its last chance. Hurtling Toward Failure Lehman's high degree of leverage – the ratio of total assets to shareholders equity – was 31 in 2007, and its huge portfolio of mortgage securities made it increasingly vulnerable to deteriorating market conditions. On March 17, 2008, following the near-collapse of Bear Stearns – the second-largest underwriter of mortgage-backed securities – Lehman shares fell as much as 48% on concern it would be the next Wall Street firm to fail. Confidence in the company returned to some extent in April, after it raised $4 billion through an issue of preferred stock that was convertible into Lehman shares at a 32% premium to its price at the time. However, the stock resumed its decline as hedge fund managers began questioning the valuation of Lehman's mortgage portfolio.

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On June 9, Lehman announced a second-quarter loss of $2.8 billion, its first loss since being spun off by American Express, and reported that it had raised another $6 billion from investors. The firm also said that it had boosted its liquidity pool to an estimated $45 billion, decreased gross assets by $147 billion, reduced its exposure to residential and commercial mortgages by 20%, and cut down leverage from a factor of 32 to about 25. Too Little, Too Late However, these measures were perceived as being too little, too late. Over the summer, Lehman's management made unsuccessful overtures to a number of potential partners. The stock plunged 77% in the first week of September 2008, amid plummeting equity markets worldwide, as investors questioned CEO Richard Fuld's plan to keep the firm independent by selling part of its asset management unit and spinning off commercial real estate assets. Hopes that the Korea Development Bank would take a stake in Lehman were dashed on September 9, as the state-owned South Korean bank put talks on hold. The news was a deathblow to Lehman, leading to a 45% plunge in the stock and a 66% spike in credit-default swaps on the company's debt. The company's hedge fund clients began pulling out, while its short-term creditors cut credit lines. On September 10, Lehman pre-announced dismal fiscal third-quarter results that underscored the fragility of its financial position. The firm reported a loss of $3.9 billion, including a write-down of $5.6 billion, and also announced a sweeping strategic restructuring of its businesses. The same day, Moody's Investor Service announced that it was reviewing Lehman's credit ratings, and also said that Lehman would have to sell a majority stake to a strategic partner in order to avoid a rating downgrade. These developments led to a 42% plunge in the stock on September 11. With only $1 billion left in cash by the end of that week, Lehman was quickly running out of time. Last-ditch efforts over the weekend of September 13 between Lehman, Barclays PLC and Bank of America, aimed at facilitating a takeover of Lehman, were unsuccessful. On Monday September 15, Lehman declared bankruptcy, resulting in the stock plunging 93% from its previous close on September 12. Conclusion Lehman's collapse roiled global financial markets for weeks, given the size of the company and its status as a major player in the U.S. and internationally. Many questioned the U.S. government's decision to let Lehman fail, as compared to its tacit support for Bear Stearns (which was acquired by JPMorgan Chase) in March 2008. Lehman's bankruptcy led to more than $46 billion of its market value being wiped out. Its collapse also served as the catalyst for the purchase of Merrill Lynch by Bank of America in an emergency deal that was also announced on September 15. (Investopedia, 2012a)

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Task Questions 1. Assume you were the chief economist advising CEO Richard Fuld in August 2007. What advice would you have given him, taking into consideration the given economic system, the company’s financial position and the investment portfolios?

7.1.6

Introduction to Economic Theories

The table below presents well-known economic theories established over time. TABLE 1: WELL-KNOWN ECONOMIC THEORIES

Modern Schools of Thought (since late 18th century) • Classical (Adam Smith) • Marxism (Karl Marx and Friedrich Engels) • Keynesian (John Maynard Keynes) • Neoclassical (William Jevons, Carl Menger and Leon Walras) • New classical (Robert Lucas) Economic Cycles • Keynesian • Monetarism • The Phillips curve • Permanent income hypothesis • Rational expectations • Time consistency • Financial accelerator • Financial instability hypothesis • Lender of last resort Economic Systems • Capitalism (and state capitalism) • Communism • Socialism • Mixed economy • Shock therapy Tax and Spend Policies • Tax incidence • Excess burden • Supply-side economic • Crowding out

Global Trade • Comparative advantage • Heckscher-Ohlin trade model • New Trade theory • Optimal currency area • The impossible trinity (Trilemma) • Purchasing power parity Markets • The invisible hand • Marginalism • The tragedy of the commons • Property rights • Polluter pays principle • Adverse selection • Moral hazard • Efficient market hypothesis • Rent seeking Choice • Rational choice theory • Game theory • Public choice • Expected utility theory • Prospect theory Growth • Neoclassical growth • New growth theory • Creative destruction • Human capital • The rule of law • Limits of growth (Adapted from Marron, 2010) © Regenesys Business School

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Whilst an explanation of each of the above is beyond the scope of this study guide, students are encouraged to use reputable sources to expand their knowledge of these important theories. For discussion purposes we have included a synopsis of the modern schools of thought. TABLE 2: COMPARISON OF THE VARIOUS ECONOMIC SCHOOLS OF THOUGHT

Adam Smith, who is known as the father of economics, made the most important contribution to the classical school of thought. The classical school of thought influenced the scientific and industrial revolutions. The following are characteristics of the classical school: • • The Classical School

•

The forces of the free market should organise the economy and government’s interference should be minimal Self-interest leads to collective interest, profits, development and natural harmony of interests in the society The development of laws and economic principles: o o o o o

The law of diminishing returns Role of capital accumulation in economic growth Consumer freedom and autonomy Market as a platform for harmonising individual and societal interests and needs Theory of comparative advantage

Marx believed that class exploitation, class privilege and class monopoly were morally unacceptable. He believed in a natural law of “social evolution”, which involved the growing “socialisation” of the process of production. This, he believed, carried with it a corresponding evolution in the field of human relations, destined to result in a complete democratisation of economic affairs and the achievement of a classless society. The main contributions of Marx and characteristics of Marxism are presented below: • Marxism • • • • •

Contribution towards the Theory of Value in economics – although the idea of workers being the source of all value is disputed by contemporary economists; Business cycles and economic fluctuations Growth of monopolies Theory of exploitation – arguing that the conditions of workforce continues to deteriorate, resulting in workers overthrowing capitalism because of exploitation Analysis of capital accumulation – arguing that accumulation leads to decreasing profits and unemployment due to improved technology Theory of class conflict – based on the notion of class conflict and capital accumulation

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The main characteristics of the Keynesian school of thought: • Keynesian School of Thought

• • • •

The macro-economic approach, considering factors such as employment, consumption, savings, income, investment and outputs It promotes government’s fiscal intervention to improve employment, price stability and economic growth Government spending (and deficit) should be increased to stimulate the economy; Money supply should be increased to reduce interest rates and promote investment Taxes should be reduced to encourage people to work, produce, save and invest

The proponents of the neoclassical school argue that the value of goods is not determined by the production cost (as argued by the classical school) but by their usefulness to the consumer or end-buyer. The main characteristics of neoclassical school of thought are: • • • Neoclassical School • •

The minimalist role of government in economy The assumption that people act rationally, balancing present and future needs Economic forces strive for equilibrium and, after disturbances, a new equilibrium is found The role of an individual (or a firm) as a focal point in economic decision-making The application of analytical, abstract, deductive methods in economic analysis

The main contribution was related to interpreting value in terms of both demand and supply and not just focusing on one of these aspects. A contribution was also made in the area of business competition and monopolies. One of the most famous books from this school is Alfred Marshall’s Principles of Economics (1890).

New Classical School

Built largely on the Neoclassical School, the New Classical School emphasises the importance of microeconomics and models based on behaviour. Proponents of this school assume that all agents try to maximise their utility and have rational expectations. They also believe that the market clears at all times. Mainly, these economists believe that unemployment is largely voluntary and that discretionary fiscal policy is destabilising, while inflation can be controlled with monetary policy. (Economics Online, 2014)

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Task Questions 1.

Explain the following terms: • Scarcity • Choice • Opportunity cost Explain how the following economic systems can be used to answer the three central economic questions: • Market economic system • Command system • Traditional system

2.

7.1.7

Economic Aggregates

Gross Domestic Product Defined To understand the concept of GDP, and its relationship with economic growth, ensure that you read the following chapter in your prescribed textbook:

Chapter 21 in Parkin, M. 2014, Economics, Global Edition, 11th ed., England: Pearson Education Limited.

Economists measure a country’s wealth by measuring the gross domestic product (GDP).

GDP is "the market value of the final goods and services produced within a country in a given time period." (Parkin, 2014:490)

This definition suggests that GDP includes four parts (see Figure 2 below and extended description): • • • •

Market value Final goods and services Produced within a country In any given time period

Consider the following figure and the connections it depicts.

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FIGURE 2: CIRCULAR FLOWS IN A MARKET ECONOMY

(Parkin, 2014:491) The definition can be unpacked as follows: • • • • • • •

GDP is “the market value”: The prices people are willing to pay for the relevant goods or services; “Of the”: GDP attempts to measure the aggregate value of all output. It only “counts” legal activities; “Final”: GDP only measures final goods. (If a car is produced in South Africa, economists measure the value of the car as part of GDP and not the component parts of the car); “Goods and services”: GDP includes both tangible goods, e.g. food, clothing and cars; and intangible services, such as haircuts, house-cleaning and doctor visits; “Produced”: GDP includes only goods and services currently produced. Does not include re-sales and transactions produced in the past; “Within a country”: GDP measures the value of production within the geographic confines of a country. This is regardless of the nationality of the producer; and “In a given period of time”: GDP is usually measured for a year but is also recorded quarterly; i.e. every three months.

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Components of GDP To understand how the economy uses its scarce resources, economists measure GDP by the spending in an economy. To do this, GDP (which we denote as Y) is divided into four components: consumption (C), investment (I), government purchases (G) and net exports (NX) (which is the difference between exports and imports). We can derive the identity as follows:

Y = C + I + G + (X-M) Where: Chapter 1 Y is GDP Chapter 2 C is the spending by households on goods and services, with the exception of purchases of new housing Chapter 3 I is spending on capital equipment, inventories and structures; including household purchases of new housing Chapter 4 G is spending on goods and services by National, Provincial and Local government • NX, or net exports (X-M), is the spending on domestically produced goods by foreigners (exports) minus spending on foreign goods by domestic residents (imports)

Calculating GDP Growth “The GDP Growth Rate shows a percentage change in the seasonally adjusted GDP value in the certain quarter, compared to the previous quarter. Because of climatic conditions and holidays, the intensity of the production varies throughout the year. This makes a direct comparison of two consecutive quarters difficult. In order to adjust for these conditions, many countries calculate the quarterly GDP using so called seasonally adjusted method. The Gross Domestic Product can be determined using three different approaches: the product, the income, and the expenditure technique, which should give the same result. In sum, the product technique sums the outputs of every class of enterprise. The expenditure technique works on the principle that every product must be bought by somebody, therefore the value of the total product must be equal to people's total expenditures in buying products and services. The income technique works on the principle that the incomes of the productive factors must be equal to the value of their product, and determines GDP by finding the sum of all producers' incomes.” (Trading Economics, 2013a)

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Real versus Nominal GDP Economists note that, if total spending rises from one year to the next, one of two things must be true: (1) The economy is producing a larger output of goods and services, or (2) goods and services are being sold at higher prices. When studying changes in the economy over time, economists want to separate these two effects. In particular, they want a measure of the total quantity of goods and services the economy is producing not affected by changes in the prices of those goods and services. To do this, we use a measure called real GDP, which answers a hypothetical question: What would be the value of the goods and services produced this year if we valued these goods and services at the prices that prevailed in some specific year in the past?

Nominal GDP is "the value of final goods and services produced in a given year when valued at the prices of that year. Nominal GDP is just a more precise name for GDP." Whereas: Real GDP is "the value of final goods and services produced in a given year when valued at the prices of a reference base year. By comparing the value of production in the two years at the same prices, we reveal the change in production." (Parkin, 2014:495)

Consider the following example (Parkin, 2014:495). Calculation of Nominal GDP and Real GDP PRICE (dollars)

EXPENDITURE (millions of dollars)

(a) In 2005 C T-shirts 10 I Computer chips 3 G Security services 1 Y Real and nominal GDP in 2005

5 10 20

50 30 20 100

(b) In 2012 C T-shirts I Computer chips G Security services Y Nominal GDP in 2012

5 20 40

20 40 240 300

5 10 20

20 20 120 160

ITEM

QUANTITY (millions)

4 2 6

(c) Quantities of 2012 valued at prices of 2005 C T-shirts 4 I Computer chips 2 G Security services 6 Y Real GDP in 2012

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From the example we can see that in 2005 (the reference base year) real GDP equals nominal GDP and was $100 million. Then in 2012, the nominal GDP increased to $300 million. However the real GDP is shown in part (c), which is calculated by using the quantities of 2012 in part (b) but the prices of 2005 in part (a). Real GDP is therefore only $160 million. As Parkin (2014:496) points out, economists use estimates of real GDP for two main purposes: • •

To compare the standard of living over time To compare the standard of living across countries

Task Questions Read the limitations of GDP in your prescribed textbook (pp. 499-500 in Parkin, M. 2014, Economics, Global Edition, 11th ed., England: Pearson Education Limited) and then discuss the argument proposed by Joseph Stiglitz, "that GDP is dangerously misleading and needs to be replaced by a measure that he calls Green Net National Product (or GNNP)." Use the two views given in the table below to support your argument: Joe Stiglitz maintains … • GDP has passed its sell by date • A gross measure is wrong because it ignores the depreciation of assets • A domestic measure is wrong because it ignores the incomes paid to foreigners who exploit a nation's resources • A green measure is needed to take account of the environmental damage that arises from production • GNNP subtracts from GDP incomes paid to foreigners, depreciation, the value of depleted natural resources, and the cost of a degraded environment • The existence of a market price for carbon emissions makes it possible to measure the cost of these emissions and subtract them from GDP • A bad accounting framework is likely to lead to bad decisions • America's "drain America first" energy policy is an example of a bad decision. It increases GDP but decreases GNNP and makes us poorer.

The mainstream view … • As a measure of the value of market production in an economy, GDP does a good job. • GDP is used to track the ups and downs of economic activity and it is a useful indicator for making macroeconomic stabilisation policy decisions • GDP is not used to measure net national economic well-being nor to guide microeconomic resource allocation decisions • There is no disagreement that a net national measure is appropriate for measuring national economic well-being • There is no disagreement that "negative externalities" arising from carbon emissions and other pollution detract from economic well-being • The omissions from GDP of household production and underground production are bigger problems than those emphasised by Stiglitz • It isn't clear that depleting oil and coal resources is costly and misguided because advanced in green energy technology will eventually make oil and coal of little value. The stone-age didn't end because we ran out of stone, and the carbon-age won't end because we run out of oil and coal! (Parkin, 2014:500)

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Conclude this section by reading the following journal article by Trainer (2014) and by completing the tasks that follow.

Trainer, F. 2014, 'Ethics and the Economy', Humanomics, 30 (1), 41-58.

Task Questions

1. Reflect critically on the journal article. Do you agree with Trainer's view that there is a lack of social responsibility on the part of economists? Substantiate your position. 2. Training (2014:51) states that the supreme goal of economics is to increase sales as much as possible (and without limits) as opposed to a satisfactory quality of life for all. What evidence is there of this in your country – cite examples? Do you support this assertion? 3. Critically evaluate the following statement (Training, 2014:51) "It [economics] legitimises the market as the supremely effective and efficient way of allocating things and of determining what will be done or developed. This gives those who are rich and powerful the freedom to produce and to take what they want, by outbidding others." How might the views of Trainer (and other proponents of sustainability) impact on current thinking about the market system and growth economies? Refer to Trainer's "The Simple Way" and explore the economic validity of his argument.

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7.2 T HE S OUTH A FRICAN E CONOMY Timeframe: Learning Outcome: Recommended Book:

Recommended Articles:

Section Overview:

Minimum of 8 hours • Explain and evaluate the impact of macroeconomic and microeconomic policies on a country • Chapters 6, 16 and 17 in Parkin, M. 2014, Economics, Global Edition, 11th ed., England: Pearson Education Limited. • Department of Trade and Industry, 2013, 'South Africa's Trade Agreements' http://www.thedti.gov.za/parliament/ITED.pdf (accessed 19 March 2014). • Ghosh, J. 2013, 'The Global Economic Chessboard and the Role of the BRICS: Brazil, Russia, India, China, South Africa', http://www.globalresearch.ca/the-global-economicchessboard-and-the-role-of-the-brics-brazil-russia-india-china-south-africa/5357502 (accessed 19 March 2014). • Trading Economics, 2014, www.tradingeconomics.com (accessed 18 March 2014). (Note: Selections available include countries, indicators, and markets) • Weiss, L. 2013, 'The myth of free-market capitalism versus the rest', http://speri.dept.shef.ac.uk/2013/01/15/myth-free-market-capitalism-rest/ (accessed 18 March 2014). • Indexmundi, 2012, 'South Africa Economy Overview', http://www.indexmundi.com/south_africa/economy_overview.html (accessed 18 March 2014) (Note: Go to the website main page and select a country of your choice) • Third World Planet, 2014, 'Third World Planet: The Third World Economies' http://www.thirdworldplanet.com (accessed 18 March 2014) (Note: Click on the side bar to view the different economies, e.g. The Indian Economy) This section deals with the South African economy; in particular, the recent growth, employment and inflation records, the position of the balance of payments, its international economic position, factor endowment and economic links with the rest of the world. The section also examines the microeconomic and macroeconomic policies governing economic activities in the country.

7.2.1

Performance of the South African Economy

Reflect on South Africa's economic performance before and after it gained independence in 1994.

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Between 1990 and 1993, the South African economy performed poorly and recorded negative economic growth, a decrease in the standard of living, a rise in unemployment and inflation, and had serious balance of payment problems. The situation has improved significantly after political reform in 1994. When measuring the performance of the economy, it is important that comparisons are made between a wide range of indicators. To achieve this go to the following websites and select the countries and economic indicators as required:

• •

•

Trading Economics, 2014, www.tradingeconomics.com (accessed 18 March 2014). (Note: Selections available include countries, indicators, and markets) Indexmundi, 2012, 'South Africa Economy Overview', http://www.indexmundi.com/south_africa/economy_overview.html (accessed 18 March 2014) (Note: Go to the website main page and select a country of your choice) Third World Planet, 2014, 'Third World Planet: The Third World Economies' http://www.thirdworldplanet.com (accessed 18 March 2014) (Note: Click on the side bar to view the different economies, e.g. The Indian Economy)

Task Questions

1. Using the above resources, discuss how South Africa’s economy compares with other economies – emerging and developed?

7.2.2

South Africa’s International Economic Position

Certain criteria are used by international organisations, such as the World Bank and the United Nations, to rank countries’ economies in the world. South Africa is categorised as “emerging/developing” with a population of 52m (Global rank No. 23). South Africa climbed one place to 14th in terms of global rankings in the Emerging Economies survey, maintaining its position as the highest ranked African economy, ahead of Nigeria (who climbed to 17th) (Grant Thornton, 2013a). However, a recent Grant Thornton survey (2013b) has revealed that South Africa urgently needs to become more attractive to foreign investors if it wants to be a viable contender as a global ‘hotspot’.

“Overall 57% of international business leaders considering global expansion are looking at the five biggest emerging economies – China, India, Russia, Brazil and Mexico – compared with 38% looking at Western Europe and 33% at North America. In contrast, privately held businesses ranked the African continent at 13% with South Africa achieving a 12% response as a potential investment hotspot for 2013.” (Grant Thornton, 2013b) © Regenesys Business School

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South Africa’s growth rate is expected to reach 5.7% (up from 5%) for 2013. anticipated that rising prices and wage bills will fuel inflation.

However, it is

Grant Thornton’s survey (2013b) indicates that SA businesses will continue to be constrained by the perennial shortage of skilled workers (mismatch of talent to job requirements). Figure 3 reflects a comparison between hiring practices and the availability of skilled workers worldwide. South Africa is located in the quadrant of “more hiring and lacking skilled workers”. The following indicators show a negative trend (Lloyds, 2013): • • •

Ease of doing business: 39th (down from 2012: 35th) Competitiveness: 52nd (down from 2012: 50th) Freedom from corruption: 62nd (down from 2012: 55th) FIGURE 3: HIRING VS. SKILLED LABOUR 2012 (WORLDWIDE)

(Grant Thornton, 2012b)

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Task Questions

It is argued that the South African government is committed to a ‘mixed economy,’ but much speculation and pressure exists over the precise implications of this for South Africa and international business. It is fuelled by the fact that the ‘mixed economy’ is a loose concept rather than a rigorous economic model. For example, the term itself could be applied to the economic arrangements of countries as different as India, South Korea, Nicaragua, Zimbabwe, Sweden, Britain and Germany. 1.

2.

In light of the above, how would you describe the ‘mixed economy’ in South Africa today? Is it, for example a mixed economy oriented toward capitalism or socialism? What are the implications of this? Use economic terms to substantiate your argument. Some economists believe that the act of nationalisation is so difficult and costly that the same ends could be achieved through taxing the private sector, controlling key prices, and regulating firms’ operations. Others have noted that it only changes the ownership of firms but does not necessarily change the way they operate or ensure that they meet national goals. Discuss these assertions.

7.2.3

Banking Stability in South Africa

South Africa’s banking sector has been rated among the top 10 globally, and its financial system continues to grow. South Africa has moved to a so-called “twin peaks” model of regulation by the South African National Treasury involving the separate prudential regulator (housed at SARB) and the market conduct regulator (Financial Services Board) aimed at creating a more resilient and stable financial system.

“Macroprudential and microprudential: The term “macroprudential” regulation or supervision refers to the analysis of strengths and vulnerabilities of financial systems as a whole (systemic risk). Macroprudential assessments cover a wide range of economic and financial circumstances and information, such as gross domestic product growth and inflation, the structure of a financial system, and qualitative information on the institutional and regulatory framework. The term “microprudential” refers to the safety and soundness of individual financial institutions.” (Treasury, 2013)

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7.2.4

South Africa’s Factor Endowment

This section gives a brief overview of South Africa’s position regarding natural resources, labour, capital and entrepreneurship. South Africa is well endowed with certain factors of production and poorly endowed with others, as outlined below:

Natural Resources South Africa is part of Sub-Saharan Africa, which is poor in agricultural activity. The climate is a major problem as it is characterised by droughts, hail-damage, floods etc. However, South Arica is endowed with significant natural resources, which include rivers, lakes, fertile soils, precious minerals, etc. These natural factor endowments have given the country a significant comparative and competitive advantage over the last 5-10 decades. The future policy imperatives of government and industry are to fully beneficiate all natural resources such as precious minerals as part of their export strategy. South Africa has beautiful forests that attract tourists, a small fishing industry and a large variety of minerals. The minerals form the backbone of its economy.

Capital This refers to all man-made (manufactured) assets that are used in the production of other goods and services such as machines, power plants, buildings, roads, bridges, dams etc. South Africa has a poor capital base; hence, most of its capital goods are imported.

Labour People are every organisation’s most prized resource and, even at national level, the importance of the human resource or human capital can never be overemphasised. South Africa’s main challenge, as we have seen, is a lack of skilled labour, which has been worsened by the high prevalence of HIV/AIDS. The greatest challenge facing the South African economy is the need to increase its supply of skilled labour, thereby increasing the productive capacity of the country.

Entrepreneurship An entrepreneur is a person who identifies opportunities and takes calculated risks by combining the factors of production in order to develop new markets in the pursuit of profit. Entrepreneurial activity is vital for economic development and South Africa is not particularly well endowed with entrepreneurship (Global Entrepreneurship Monitor, 2012).

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7.2.5

South Africa’s Links with the Rest of the World

The South African economy is open to the rest of the world; that is, it has strong links with other economies of the world. Mining products dominate the composition of South Africa’s imports and exports because of the rich endowment of natural minerals in the country (Mohr and Fourie, 2008:85). South Africa’s major trading partners are Germany, the USA, the UK, Japan and, more recently, Brazil, Russia, India, and China. BRICS is a unique grouping with shared opportunities and common challenges (formalized with the first meeting of the Foreign Ministers of Brazil, Russia, India and China in New York on the margins of the United Nations General Assembly in September 2006). In a short span of time, the grouping has come a long way in developing a number of mechanisms for consultation and cooperation in a number of sectors. South Africa joined the Grouping at the third Summit in Sanya, China in April 2011. (BRICS, 2012)

The South African Trade Policy Customs tariff investigations, trade remedies and import and export control fall within the domain of the International Trade Administration Commission of South Africa (ITAC). The aim of ITAC (as stated in the International Administration Act 71 of 2002) is:

“To foster economic growth and development in order to raise incomes and promote investment and employment in South Africa and within the Common Customs Union Area by establishing an efficient and effective system for the administration of international trade subject to this Act and the Southern African Customs Union (SACU) Agreement.” (ITAC, 2014)

Read the following documents, which set out South Africa's Trade Agreements and discuss South Africa's participation in BRICS.

• •

Department of Trade and Industry, 2013, 'South Africa's Trade Agreements' http://www.thedti.gov.za/parliament/ITED.pdf (accessed 19 March 2014). Ghosh, J. 2013, 'The Global Economic Chessboard and the Role of the BRICS: Brazil, Russia, India, China, South Africa', http://www.globalresearch.ca/the-global-economic-chessboard-andthe-role-of-the-brics-brazil-russia-india-china-south-africa/5357502 (accessed 19 March 2014).

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Task Questions

1. Debate the impact of South Africa’s trade agreements and BRICS membership on aggregate macro-economic indicators as well as on firms and households.

Balance of payments All countries measure domestic transactions with the rest of the world through the balance of payments. A country’s balance of payments records its international trading, borrowing, and lending in three accounts: • • •

Current account Capital and financial account Official settlements account

The sum of the balances of these three accounts always equals zero. That is to pay for a current account deficit, a country must either borrow more from abroad than it lends abroad or use its official reserves to cover the shortfall. (Parkin, 2014:633) As an example, consider the U.S. Balance of Payments Account in 2011 (Parkin, 2014:633). Current Account Exports of goods and services Imports of goods and services Net interest income Net transfers Current account balance

Billions of dollars +2 103 -2 663 +227 -133 -466

Capital and financial account Foreign investment in the U.S. U.S. investment abroad Statistical discrepancy Capital and financial account balance

+1 040 -501 -89 +450

Official settlements account Official settlements account balance

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The Organisation for Economic Co-operation and Development provides statistical data on each country (www.stats.oecd.org) as well as Trading Economics (www.tradingeconomics.com). For the purposes of discussion we have included the latest current account data for South Africa below. FIGURE 4: SOUTH AFRICAN CURRENT ACCOUNT (2008 TO 2014)

(Trading Economics, 2014b)

Task Questions

Read the following article and then debate the validity of the argument in the context of South African economic policy and the 2008 economic crisis. Weiss, L. 2013, 'The myth of free-market capitalism versus the rest', http://speri.dept.shef.ac.uk/2013/01/15/myth-freemarket-capitalism-rest/ (accessed 18 March 2014). Successful development strategies have always involved proactive state intervention; mainstream thinking needs to start acknowledging this. As governments rushed in to prop up collapsing economies in response to the 2008 financial meltdown, the myth of freemarket capitalism was suddenly put to the test and found wanting. But it’s been the rapid rise of China and other emerging giants, India and Brazil – the so-called BICs – that has done more to challenge the Washington Consensus idea that state activism is always inimical to economic prosperity. While some economists and political scientists fall back on labels like ‘state capitalism’ to make sense of the alliance of free markets and unfree politics in China, others have revived the idea of state ‘guided’ capitalism, a model once associated with Japan at the height of its economic prosperity. © Regenesys Business School

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These labelling efforts are based on the assumption that the developmental experience of the emerging giants is somehow wholly different from the earlier industrialisation of the advanced countries. Yet nothing could be further from the truth. In spite of some obvious differences that arise from history and international context, both developing and developed countries share at least one major feature in common – namely, state efforts to protect and promote industrial development. State ‘guidance’ of the economy, in the broadest sense, is the shared history of all countries that have successfully industrialised. When climbing the ladder of development, even Britain and the United States used tariffs to protect infant industry, copied or appropriated foreign intellectual property wherever possible, and placed a variety of controls on capital and technology markets. At various times, for example, Britain banned the transfer of technology – including the migration and overseas recruitment of skilled workers, as well as the export of all tools and machines and implements related to the textile industries. Since these and other industry protecting policies are precisely the ones developing countries are told they must avoid or abandon, they have evoked the image of ‘kicking away the ladder’. So what is different today? One difference of course is the greater technological complexity of the modern economy, encapsulated in the notion of knowledge-intensive or high-tech industry. Another is the emergence of global value chains. Contrary to the belief that these changes make state activism less relevant to economic advancement (a belief that policymakers take more or less seriously across different parts of the developed world), globalisation has helped to reinforce and valorise the state’s economic role. One striking – and historically repetitious – example of the state’s valorisation can be seen in the way the destabilisation of national economies by financial globalisation has provoked a vast panoply [display] of state responses. Another example is the boom in sovereign wealth funds as resource rich nations hedge against vulnerability to global fluctuations in commodities markets. And still a third important example is the state’s race to secure high-technology and ensure a place in the growth sectors of the future. Thus the knowledge-intensive sectors (in particular, IT, biotech, nanotechnology, and clean energy) have become the new arena of (a high-tech) infant industry policy – but this time instituted by and for the advanced countries. Although free-market orthodoxy may seem to reign, the reality is that these sectors do not need the simple tariff protection against imports of yesteryear; rather, the knowledge-rich sectors need more costly and complex support, including investment subsidies at the high-risk end of development. It should come as no surprise, then, that it’s the advanced countries that are currently the frontrunners in this particular race. So it would be hard to maintain that the use of state tools by the BICs – such as China’s state-guided investment and five-year plans, or Brazil’s state-owned oil corporation Petrobras as an instrument for developing a national oil industry – is in some way inconsistent with the experience of the now-developed countries; or indeed that it is at odds with the practice of advanced countries in seeking to maintain their technological lead. It is not that one set of countries practise ‘free market capitalism’ while another set practise ‘state guided capitalism’. It’s closer to the truth to point to the differing ways in which all economies – whether emerging or advanced – draw on state involvement in guiding and shaping development. And it’s recognition of this point that is long overdue in mainstream economic and political thinking.

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7.3 D EMAND AND S UPPLY Timeframe: Learning Outcome: Recommended Book:

Minimum of 14 hours • Explain how prices are established in the market as well as the restrictions on the market mechanism • Chapters 3, 8 and 9 in Parkin, M. 2014, Economics, Global Edition, 11th ed., England: Pearson Education Limited.

Recommended Articles:

•

Section Overview:

This section looks at the establishment of prices in the market and restrictions on the market mechanism. It also examines the theories of demand and supply and how the forces of demand and supply influence prices.

7.3.1

Abboushi, S. 2014, 'Solar trade tariffs', Competitiveness Review, 24 (1), 59-65.

Demand

What are the laws of demand and supply and how do we illustrate them?

Demand is the outcome of decisions regarding wants and affordability (Parkin, 2010:61). If you intend to buy something, you need to have the means to purchase it. When we talk of demand, we refer to the quantity of goods or services that the potential buyers are willing and able to buy at various given prices. It is a flow concept that is measured over time. Demand can be expressed in words, schedules, curves and equations.

Individual Demand Individual demand refers to demand for a household. A household is all the people who live together and who make joint economic decisions or who are subjected to others who make such decisions for them (Mohr & Fourie, 2008:43).

Determinants of Individual Demand The quantity of a good demanded by an individual, in a particular period, depends on the price of the good, the prices of related goods, the income of the individual, taste and the number of people in the household.

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The Law of Demand Other things being equal (i.e. ceteris paribus), the higher the price of a good, the lower the quantity of the good demanded. A demand curve shows the relationship between the quantity demanded of a good and its price when all other influences on consumers’ planned purchases remain the same. The figure below illustrates the demand curve resulting from the demand schedule using tomatoes per kilogram as the unit of demand. FIGURE 5: AN INDIVIDUAL’S WEEKLY DEMAND FOR TOMATOES

(Mohr and Fourie, 2008:113)

Market Demand This is the sum of all individual demands; i.e. in a market system, the plans of all consumers and producers of a good or service have to be taken into account.

Movements and Shifts A movement occurs along the same curve. The fall in the price of goods leads to a movement along the demand curve for that good. A shift results in a new curve. Shifts are caused by factors other than the price of the good; e.g. income, taste, prices of related goods, etc. A decrease in income will result in the demand curve shifting to the left and an increase in income will shift the demand curve to the right. Therefore, more quantities will be demanded at new reduced prices. In figure 6 below, the movement along demand curve D0 from point a to point b as a result of the price rising from $2 to $4 is a change in the quantity demanded. The shift of the demand curve from D0 to the new demand curve D1 is a change in demand.

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FIGURE 6: CHANGE IN DEMAND

(Mohr and Fourie, 2008:116)

Change in the Price of a Related Good Substitute A substitute is a good that can be used in place of another good to satisfy a certain want; e.g. butter and margarine, beef and mutton, or tea and coffee. An increase in the price of a substitute will cause an increase in the demand for the product in question, ceteris paribus. For example, 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 than before. Consider the figures below.

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FIGURE 7: TWO SUBSTITUTES – BUTTER AND MARGARINE

(Mohr and Fourie, 2008:117)

Complements Two complements: Videocassette recorders (VCRs) and videocassettes, or tennis balls and tennis rackets. FIGURE 8: TWO COMPLEMENTS – CASSETTES AND VCRS

(Mohr and Fourie, 2008:118) A decrease in the price of VCR will cause an increase in the demand for videocassettes. © Regenesys Business School

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Task Questions

1. Identify other examples of substitutes and complements. 2. Why is it important to understand this concept? Justify your assertion with examples from your workplace.

7.3.2

Supply

Supply can be defined as the quantity of a good or service that producers plan to sell at each possible price during a certain period (Mohr and Fourie, 2008:121). Supply refers to planned quantities; i.e. the quantities that producers plan to sell at each price. A supply is more than just having the resources and technology to produce something. Supply is a flow concept like demand and it can be expressed in words, numbers, graphs and symbols. Individual supply refers to supply by a single firm. A firm is a unit that employs factors of production to produce goods and services that are sold in the market. The quantity of a good supplied by a single firm in a particular period depends on the price of the product, the prices of alternative products, the prices of factors of production, and other inputs and expected future prices.

The Law of Supply Other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller is the quantity supplied. Why does a higher price increase the quantity supplied? Suppliers are motivated to supply more because they will receive more from each unit of good supplied. The relationship between price and quantity supplied can be explained by using the supply schedule and supply curve below.

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FIGURE 9: RELATIONSHIP BETWEEN PRICE AND QUANTITY SUPPLIED

(Mohr and Fourie, 2008:124)

Market Supply Market supply is the sum of all individual quantities supplied.

Movements and Shifts A change in price results in a movement along the supply curve, which is a change in the quantity supplied. A change in other factors shifts the supply curve, which means a change in supply. The movement along supply curve S0 from point a to point b as a result of the price rising from $2 to $4 is a change in the quantity supplied. The shift of the supply curve from S0 to the new supply curve S1 is a change in supply.

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FIGURE 10: THE EFFECT OF RISING PRICES

(Mohr and Fourie, 2008)

Task Questions

1. 2.

Explain what is meant by excess demand and excess supply in a goods market. Explain how market forces eliminate excess demand and excess supply.

7.3.3

Market Equilibrium Equilibrium is "a situation in which opposing forces balance each other. Equilibrium in a market occurs when the price balances buying plans and selling plans." (Parkin, 2014:66).

Parkin (2014:66) points out that a market moves toward its equilibrium because: • •

Price regulates buying and selling plans Price adjusts when plans don't match.

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FIGURE 11: DEMAND, SUPPLY AND MARKET EQUILIBRIUM

(Mohr and Fourie, 2008:128)

Task Questions

1. Explain what you understand by consumer surplus and producer surplus.

7.3.4

Consumer Surplus and Producer Surplus

The consumer surplus is the difference between the prices a consumer is willing to pay and the price he/she actually pays (Economics Help, 2013). For example, if you were willing to pay R8 000 for an iPad, but you can buy it for R6 000, the consumer surplus is R2 000. Therefore, we can say that the consumer surplus is the difference between the demand curve and the market price. Likewise, the producer surplus is the difference between the prices the firm receives and the price it would be willing to sell it at (i.e. the difference between the supply curve and the market price).

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FIGURE 12: CONSUMER SURPLUS AND PRODUCER SURPLUS AT MARKET EQUILIBRIUM

(Mohr and Fourie, 2008:130)

Task Questions

1. 2.

Use examples to distinguish between a change in demand and a change in quantity demanded. What is the significance of the consumer surplus and the demand surplus?

7.3.5

Change in Demand

If the demand for a good or service increases, the demand curve shifts to the right. As a result, the equilibrium price rises and the equilibrium quantity increases. If the demand for a good or service decreases, the demand curve shifts leftward. As a result, the equilibrium price falls and the equilibrium quantity decreases. Supply does not change and the supply curve does not shift. Instead, there is a change in the quantity supplied and a movement along the supply curve.

Task Question

1. Use examples to distinguish between a change in supply and a change in quantity supplied.

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7.3.6

Change in Supply

If the supply of a good or service increases, the supply curve shifts to the right. As a result, the equilibrium price falls and the equilibrium quantity increases. If the supply of good, or service, decreases, the supply curve shifts. Consequently, the equilibrium price rises and the equilibrium quantity decreases. Demand does not change and the demand curve does not shift. Instead, there is a change in the quantity demanded and a movement along the demand curve.

7.3.7

Simultaneous Changes in Demand and Supply

It is possible to predict what will happen to equilibrium prices and quantities in the market if we deal with change in demand and change in supply. However, if demand and supply change simultaneously, the precise outcome cannot be predicted. This is a special case of a more general problem in economic theory. TABLE 3: SIMULTANEOUS CHANGES IN DEMAND AND SUPPLY

Change in Demand

Change in Supply

Change in Price

Change in Quantity

Increase

Increase

Uncertain

Increase

Increase

Decrease

Increase

Uncertain

Decrease

Increase

Decrease

Uncertain

Decrease

Decrease

Uncertain

Decrease (Mohr and Fourie, 2008:139)

Task Question

1. Explain, with the aid of a diagram, the effect of setting a maximum price below the equilibrium point of a particular good.

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7.3.8

Government Intervention

The changes explained in the previous section will occur only if the market forces of supply and demand are free to establish the equilibrium prices and quantities of goods and services. Consumers, trade unions, farmers, business people, and politicians are often not satisfied with the prices and quantities determined by market demand and supply. Therefore, government intervenes to influence the prices and quantities in the market. Government intervention can take different forms, including: • • • •

Setting maximum prices (price ceilings) Setting minimum prices (price floors) Subsidising certain products or activities Taxing certain product or activities

Refer to the following journal article which discusses the U.S. government's generous support programmes and subsidies to the U.S. solar industry. "Accordingly, U.S. punitive tariffs against Chin's solar industry on grounds of government subsidies are of questionable merit" (Abboushi, 2014).

Abboushi, S. 2014, 'Solar trade tariffs', Competitiveness Review, 24 (1), 59-65.

Task Questions

After reading the journal article provided above, answer the following questions: 1. Discuss the dynamics between demand, supply, and price in the journal article. 2. What are implications on markets as a result of the U.S.'s solar trade tariffs? 3. What examples are there in your own country of price ceilings, price floors, and subsidies? What impact to these have on supply and demand?

Ensure you have a working knowledge of ‘price ceilings’, ‘price floors’, and ‘subsidies’ as these concepts occur repeatedly in economic discussions.

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7.4 E LASTICITY AND T OTAL I NCOME Timeframe:

Minimum of 14 hours

Learning Outcome:

•

Explore the relationship between elasticity and total income

Recommended Book:

•

Chapters 4, 5, 10, 11, 12, 13, 14 and 15 in Parkin, M. 2014, Economics, Global Edition, 11th ed., England: Pearson Education Limited.

Recommended Articles:

•

Buder, F., Feldman, C., and Hamm, U. 2012, 'Why regular buyers of organic food still buy many conventional products', British Food Journal, 116 (3) 390-404.

Section Overview:

This section examines the relationship between elasticity and total income and discusses the differences between perfect competition, monopolistic competition, and oligopoly and monopoly.

“Warm up” Question 1. Suppose that you are appointed as the chief executive officer of Transnet (South African State Owned Company) at a time when it is making a loss on passenger transport. You are informed that the price elasticity of passenger rail services is 1.4. What pricing strategy would you follow in your attempt to restore profitability at Transnet?

7.4.1

The Price Elasticity of Demand

In general, elasticity measures responsiveness. The price elasticity of demand measures how responsive demanders are to a change in the price of the good. This information is useful for both businesses and governments.

Calculating the Price Elasticity of Demand The price elasticity of demand is a units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on a buyer’s plans remain unchanged. The price elasticity of demand is equal to the absolute value of:

Percentage change in quantity demanded Percentage change in price

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Inelastic and Elastic Demand If the price of demand is less than 1.0, the good is said to have an inelastic demand. In this case, the percentage change in the quantity demanded is less than the percentage change in price. If the quantity demanded remains constant when the price changes, then the good is said to have perfectly inelastic demand. The price elasticity of demand is 0 and the good’s demand curve is a vertical line. If the price elasticity of demand is equal to 1.0, the good is said to have a unit elastic demand. In this case, the percentage change in the quantity demanded equals the percentage change in price. If the price elasticity of demand is greater than 1.0, the good is said to have an elastic demand. In this case, the percentage change in the quantity demanded exceeds the percentage change in price. If the quantity demanded changes by an infinitely large percentage in response to a tiny price change, then the good is said to have perfectly elastic demand. The price elasticity of demand is infinite. The table below shows some “real-life” elasticity: TABLE 4: REAL-LIFE ELASTICITY

Furniture

1.26

Motor Vehicles

1.14

Clothing

0.64

Oil

0.05

Elasticity along a Straight-Line Demand Curve With the exception of a vertical demand curve and a horizontal demand curve (along which the elasticity is 0 and infinite, respectively), the price elasticity of demand changes when moving along a linear demand curve. At points on the demand curve above the midpoint, the price elasticity of demand is elastic; while, at points below the midpoint, the price elasticity of demand is inelastic. At the midpoint, the price elasticity of demand is unit elastic.

Total Revenue and Elasticity The total revenue from the sale of a good equals the price of the good multiplied by the quantity sold. If demand is elastic, a one percent price cut increases the quantity sold by more than one percent and total revenue increases. If demand is unit elastic, a one percent price cut increases the quantity sold by one percent and total revenue does not change. If demand is inelastic, a one percent price cut increases the quantity sold by less than one percent and total revenue decreases. © Regenesys Business School

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7.4.2

Income Elasticity of Demand

The income elasticity of demand is a measure of the responsiveness of the demand for a good to a change in the income, other things remaining the same. The income elasticity of demand is equal to:

Percentage change in quantity demanded Percentage change in income

7.4.3

Cross Elasticity of Demand

The cross elasticity of demand is a measure of the responsiveness of the demand for a good to a change in the price of a substitute or complement, other things remaining the same. The cross elasticity of demand is equal to:

Percentage change in quantity demanded Percentage change in price of a substitute or complement

The changes in the quantity demanded and the price are percentages of the average price and quantity demanded over the range of change. The cross elasticity of demand is positive for substitutes and negative for complements.

7.4.4

The Price Elasticity of Supply

The elasticity of supply measures how responsive suppliers are to a change in the price of the good. The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price of a good when all other influences on selling plans remain unchanged. The elasticity of supply is equal to:

Percentage change in quantity supplied Percentage change in price

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Three Cases of Elasticity of Supply Supply is perfectly inelastic if the elasticity of supply equals 0. In this case, the supply curve is vertical. Supply is unit elastic if the elasticity of supply equals 1. In this case, the supply curve is linear and passes through the origin. If any supply curve is linear and passes through the origin, the supply is unit elastic; the slope of the supply curve is irrelevant. Supply is perfectly elastic if the elasticity of supply is infinite. In this case, the supply curve is horizontal. The key for perfectly elastic supply is if the particular good has a very large number of close substitutes.

Task Questions

Consider the following values for price elasticity of demand and supply for newspapers: Price elasticity of demand

Price elasticity of supply

–0,5

+2,0

1. Briefly define and interpret the value given for the price elasticity of demand for newspapers. State some of the most important factors influencing this value. 2. Given the above price elasticity information, and if you were concerned with maximising total revenue from newspaper sales, what pricing strategy would you recommend for newspapers and why? 3. Briefly state what we can infer about the price elasticity of supply for newspapers.

Read the following journal article and then answer the questions that follow.

Buder, F., Feldman, C., and Hamm, U. 2012, 'Why regular buyers of organic food still buy many conventional products', British Food Journal, 116 (3) 390-404.

Task Questions

1. Assume that your organisation is a leading supermarket chain. You are considering increasing the supply of organic food products. Discuss, in economic terms, what you should consider before implementing this strategy.

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Monopoly Monopoly, derived from the Greek word meaning ‘sole seller’, is an indication of imperfect competition in the market. Monopolies exist for various reasons, which may include: • • • •

Entry to the market might require large investment, e.g. energy and transport sectors State intervention, e.g. Eskom, Transnet, and South African Reserve Bank Patent rights given by the state to certain companies (e.g. particular drug produced by a pharmaceutical company) Control of a certain important resource in a certain niche market (e.g. exclusive ownership of raw materials) A monopoly is a firm that is the sole provider of a good or service. The monopoly's self-interest is to maximise its profits and because the monopoly has no competitors it can set the price to achieve its self-interested goal. (Parkin, 2014:115)

Task Questions

Discuss the validity of the following statements: 1. Monopolies have no close substitutes. 2. Monopolies have high barriers to entry.

Monopolistic Competition From your reading thus far, you will now be familiar with perfect competition (a large number of firms produce at the lowest possible cost, make zero economic profit and are efficient). And now you have been introduced to the concept of a monopoly in which a single firm restricts output, produces at a higher cost and price than in perfect competition and is inefficient. Most real-world markets are competitive but not perfectly competitive because firms in these markets possess some power to set their prices as monopolies do – we call this type of market monopolistic competition (Parkin, 2010:299). Monopolistic competition is characterised by: • • • •

A large number of competing firms Each firm producing similar but slightly different products (product differentiation) Competition based on quality, price, and marketing Unrestricted entry and exit (Parkin, 2014:233)

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Oligopoly An oligopoly, like monopolistic competition lies between perfect competition and monopoly competition. An oligopoly is characterised by: •

A market structure in which a small number of firms compete (Parkin, 2014:233)

Task Questions

1.

2.

3.

Using an airline as the basis for discussion, consider that Airline A has a monopoly on internal routes in Country A. Show the demand for travel on a route for which Airline A has a monopoly (i.e. the airline will maximise profit by carrying the number of travellers at which marginal revenue equals marginal cost and charging the highest price that travellers will pay for that quantity). Now suppose that internal routes in Country A were opened to various low-cost airlines. Show the effects on the traditional Airline A (this competition from other airlines would decrease the demand for high-priced travel and the travellers’ willingness to pay these prices). Discuss why demand would become more elastic and why the demand curve would shift to the left.

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7.5 T HE S OUTH A FRICAN L ABOUR M ARKET Timeframe:

Minimum of 12 hours

Learning Outcome:

•

Recommended Book: Recommended Articles:

Chapters 18, 19, 20 and 22 in Parkin, M. 2014, Economics, Global Edition, 11th ed., England: Pearson Education Limited. • Dowlah, C. 2014, 'Cross-border labor mobility', Journal of International Trade Law and Policy, 13 (1), 2-18. This section examines the labour market in the South African economy. Unemployment is generally regarded as the most important economic problem in South Africa and the creation of employment opportunities is thus an important macroeconomic objective. Increases in wages and salaries are often blamed for increases in costs and prices. Wage disputes and strikes are often in the headlines. A clear understanding of labour issues is important for the management of organisations.

Section Overview:

Explore critically a country's labour market and its key development challenges

•

“Warm-Up” Question

1. Using examples, outline the main differences between a labour market and a goods market.

7.5.1

The Labour Market versus the Goods Markets

Like any other market, the labour market provides a link between potential sellers (the suppliers of labour) and potential purchasers (those who demand labour). There are a number of differences between the labour market and other markets – mostly relating to the fact that the labour market is concerned with human beings rather than inanimate objects such as consumer goods. The table below lists the main differences between the labour and goods markets:

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TABLE 5: LABOUR VERSUS GOODS MARKET

Labour Market

Goods Market

Link between potential sellers (households) and potential purchasers (firms) Physical presence is necessary

Link between sellers (firms) and potential purchasers (households) Physical presence not necessary

Labour services not transferable

Goods are fully transferable

Labour is always rented

Goods can be sold

Characterised by trade unions

These are absent from the goods market

Labour is heterogeneous

Goods can be homogeneous

Non-economic considerations are important

Non-economic considerations are not important

Remuneration is affected by a number of factors e.g. taxation, standard of living, etc.

Prices of goods are determined by costs and demand (Mohr and Fourie, 2008:278-279)

Task Questions

1. Explain the relationship between the market supply of labour in a perfectly competitive labour market and supply curve facing an individual employer in such a market.

7.5.2

A Perfectly Competitive Labour Market

Some of the characteristics of a perfectly competitive labour market are listed below: • • • • • •

A large number of buyers (employers) and a large number of sellers (employees) in the market: all participants are price takers (wage) Homogeneous labour; i.e. identical skills Workers must be completely mobile (free entry/exit) No government intervention Perfect knowledge exists (on jobs, wages etc.) There must be perfect competition in the goods market (firms must be price takers)

Individual Supply of Labour A competitive labour market is one in which many firms demand labour and many households supply labour (Parkin, 2014:422). However, this supply of labour derives from decisions made by individual households, which is explained in the example below.

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Jill – one of the workers at Angelo's Bakery Jill enjoys her leisure time, and she would be pleased if she didn't have to spend her time working at Angelo's Bakery. But Jill wants to earn an income, and as long as she can earn a wage rate of at least $5 an hour she's willing to work. This wage is called her reservation wage. At any wage rate above her reservation wage, Jill supplies some labour. The wage rate at Angelo's is $10 an hour, and at that wage rate Jill chooses to work 30 hours a week. At a wage rate of $10 an hour Jill regards this use of her time as the best available as shown in the diagram below. If Jill were offered a way rate between $5 and $10 an hour she would want to work fewer hours. If she were offered a wage rate above $10 an hour she would want to work more hours, but only up to a point. If Jill could earn $25 an hour she would be willing to work 40 hours a week (and earn $1000 a week). But at a wage rate above $25 an hour with the goods and services that Jill can buy for $1000 her priority would be a bit more leisure time. So if the wage rate increased above $25 an hour, Jill would cut back on her work hours and take more leisure. Jill's labour supply curve eventually bends backward. Therefore, we can say that Jill's labour supply decisions are influenced by a substitution effect and an income effect.

(Parkin, 2014:422-423) Read the following case study, including questions and answers. Consider that this is the type of question you must be able to answer in your examination.

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Task Questions

College Major and Job Prospects Which college major is most likely to land you a well-paying job right out of school? Katie Bardaro, an economist at PayScale, a compensation research firm, says biomedical engineering is your best bet. The median salary starts at $53,800 and by mid-career reaches $84,700 and keeps rising. The median salary for all biomedical engineers in 2012 was $88,000. Some other science and engineering jobs pay more but don't have as good an outlook for jobs growth. The Bureau of Labour Statistics projects that the number of jobs for biomedical engineers will increase from today's 20,000 to 32,000 in 2020 – an increase of more than 60%. In contrast, the working age population will increase by only 8% by 2020. (Forbes in Parkin, 2014:425) Questions: 1. 2. 3. 4. 5.

Why is the number of jobs for biomedical engineering graduates increasing? What determines the demand for biomedical engineers and why might it be increasing? What determines the supply of biomedical engineers and why might it be increasing? What determines whether the wage rate of biomedical engineers will rise? Provide a graphical illustration of the market for biomedical engineers in 2012 and 2020.

Answers: 1. The number of jobs for biomedical engineers is growing because both demand for and supply of biomedical engineers are increasing. 2. The demand for biomedical engineers is derived from the demand for biomedical products. The demand for replacement parts for the human body is increasing because technological advances are creating new and improved products. 3. The working age population and the number of people who decide to major in the subject determine the supply of biomedical engineers. The supply is increasing because the working age population is increasing and good job prospects are attracting a larger percentage of people to study biomedical engineering. 4. The wage rate of biomedical engineers will rise if the demand for their services increases faster than supply. 5. The figure illustrates the market for biomedical engineers in 2012 and in 2020: a. Demand is expected to increase from D12 to D20 b. Supply is expected to increase from S12 to S20 c. The increase in demand is much greater than the increase in supply d. The equilibrium quantity (the number of jobs) increases from 20,000 in 2012 to 32,000 in 2020 e. Because demand increases by more than supply the equilibrium wage rate rises (the 2020 wage rate is an assumption)

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(Parkin, 2014:425)

Task Question

1. Discuss the likely impact of a labour union on labour demand and supply.

7.5.3

Imperfect Labour Markets

In most economies, labour markets are not perfect. Below are some of the reasons why some labour markets are not perfect (Mohr and Fourie, 2008:288): • • • • • •

Workers in a particular market are organised in a trade union, which then acts as a monopolistic supplier of labour There is only one buyer of labour (major employer) in a particular market; i.e. monopsony (opposite of monopoly) Labour is heterogeneous, not homogeneous, and each worker has particular abilities, attributes, education, training or experience that differentiates him/ her from other workers Labour is not completely mobile, in the sense that workers cannot move freely from one occupation to another, from one employer to another, or from one region to another Government intervenes in the labour market Employers and employees have imperfect knowledge © Regenesys Business School

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In South Africa, the labour market has undergone major transformation, for example, through labour legislation such as AA and EE – government intervention has had a profound impact on the labour market.

Task Questions

“If the national average wage for men exceeds the national average wage for women, there is definitely sexual discrimination in the labour market.” 1. Do you agree with this statement? Substantiate your view.

7.5.4

Wage Differentials

Wage differentials exist when different workers earn different wages even if all wage markets are in equilibrium. These wage differentials are permanent phenomena. Some of the determinants of wage differentials (Mohr and Fourie, 2008:298-301): • • • • •

Job-related differences Worker-related differences Differences related to market structure Differences as a result of discrimination Differences in productivity

Task Question

1. “Minimum wages inevitably result in an increase in unemployment.” Do you agree with this statement? Why (not)?

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Case Study

Read the case study and then answer the question that follows. Minimum Wages, Employment and Household Poverty: Investigating the Impact of Sectoral Determinations South African minimum wages are stipulated in several sectoral determinations published by the Department of Labour. The aim of minimum wages is to redistribute earnings and lift the working poor out of poverty by raising wages of workers in designated occupation categories or economic sectors. The downside of mandated wage increases is that they may cause employment levels to decline. The extent of the employment loss depends on the responsiveness of employment levels to wage changes or the wage elasticity of demand for labour. Higher wages also impact on the rest of the economy by raising production costs and hence consumer prices. Such inflation erodes income gains associated with minimum wages, while causing aggregate demand levels in the economy to decline. There is no easy answer to the question about the impact of minimum wages on poverty; the overall outcome depends on the level of the minimum wage relative to market wages, the wage elasticity, the poverty line and the type of income sharing that takes place at the household level. This study explores these possible effects of minimum wages under a variety of assumptions about how the economy functions. Sectoral determinations covering retail and wholesale trade workers, domestic workers, farm and forestry workers, taxi operators, security workers, hospitality sector workers and contract cleaners are included in the analysis. Two modelling approaches are used. The first is a partial equilibrium analysis, which focuses on income and poverty effects at a micro (survey) level and uses micro-simulation techniques to identify potential gainers and losers of a minimum wage policy. The second is a general equilibrium approach that loses some of the specificity of the partial equilibrium model, but considers all indirect economic effects such as price increases and indirect demand effects. Simulations in both these models are based on the actual minimum wage shocks introduced in South Africa during the last six years. The study finds that the poverty effects of minimum wages are generally small but positive. The partial equilibrium model shows, however, that the decline in poverty is statistically insignificant at high wage elasticity levels when employment losses are large and therefore offset gains from higher wages. When accounting for indirect effects in the general equilibrium model, the poverty-reducing effect of minimum wages is statistically insignificant at all wage elasticity levels. This important result suggests that when firms are unable to reduce employment levels of minimum wage workers due to substitutability constraints (low wage elasticities) they tend to raise prices, which offset gains. Alternatively, when wage elasticities are high, prices do not rise by as much, but higher employment losses are observed (as in the partial equilibrium model). The statistical insignificance of the poverty results also relates to the fact that the poor are largely removed from the labour market due to low participation rates and high unemployment rates, which means that labour market policies such as minimum wages only affect the poor to a limited extent. In addition to this, poor households tend to be larger in size than non-poor household, implying that more family members in poor households are dependent on the wages of employed members. Any income gain in a poor household is shared among many family members, thus reducing per capita gains. (Ramutloa, 2009) Task question: 1. Evaluate the theoretical impact of imposing minimum wages in a market economy and contrast this with the aforementioned case study findings.

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Read the following journal article and then answer the questions that follow.

Dowlah, C. 2014, 'Cross-border labor mobility', Journal of International Trade Law and Policy, 13 (1), 2-18.

Task Questions

1. In a perfectly competitive labour market, what would be the effect of an increase in labour supply on employment and wages? 2. If labour supply increased but wages could not be adjusted downwards, what would be the effect of an increase in labour supply on wages and employment? 3. What is the effect on migrant workers on the economies of the respective countries? 4. Explain the following statement in economic terms, "Recent economic research makes a robust case in favour of cross-border labor mobility from less developed to developed countries on the basis of widening income and wage gaps between these countries, abundant supply of medium and less-skilled workers in developing countries, aging population and declining fertility rate in developed countries, and potential economic gains from efficient allocation of labor resources across national borders." (Dowlah, 2014:4)

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7.6 I NTRODUCTION TO E CONOMIC P OLICY A NALYSIS Timeframe: Learning Outcome: Recommended Book: Recommended Articles:

Section Overview:

Minimum of 10 hours • Understand public policy and economic analysis used to evaluate policies, projects or programmes. • Chapters 23, 30 and 31 in Parkin, M. 2014, Economics, Global Edition, 11th ed., England: Pearson Education Limited. • Ali, S., Rabbi, F., Hayat, U., and Ali, N. 2013, 'The composition of public expenditures and economic growth: evidence from Pakistan', International Journal of Social Economics, 40 (11), 1010-1022. This section provides an introduction to economic policy analysis. It highlights the relationship between economics and public policy making; the evaluation of alternative policy options; and tools that can be used for this evaluation. Governments as well as corporations have to choose between various projects, which may derive the same or similar outcomes. As previously discussed, there is an opportunity cost in selecting one project over another. Decision-makers must therefore optimise their choices based on the available information and on both qualitative and quantitative economic analysis. This section highlights: • • •

7.6.1

The need for government intervention Economic tools used for evaluation Other factors to consider in conjunction with economic analysis

The Need for Government Intervention

According to our earlier discussions on economic systems and theories, most modern economies are mixed and operate largely in line with free market principles. Many economic players prefer little or no government intervention and believe that markets will operate efficiently if left alone. However, the effects of the 2008 economic downturn and other instances where there have been significant market imperfections that require government intervention have been noted. Listed below are some market failures that could warrant government intervention: • • • • • •

Externalities Information asymmetry Monopolies Public goods Moral hazard Transactional costs

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Note: Learners must research the above market failures and consider practical and current examples.

When free markets fail to allocate resources efficiently, a loss of economic and social welfare results. This phenomenon is referred to as ‘a market failure’ and often merits government intervention in order to redress potential perverse incentives or regulate when the market does not have enough incentive to produce certain public goods.

Task Questions

Read the following excerpt (Riley, 2012) and then debate: 1. Whether it might be more cost effective for governments to switch from pollution taxation to direct subsidies to encourage greater innovation in designing cleaner production technologies 2. That the impact of green taxes depends crucially on what is done with the revenues – if they are balanced by reducing other taxes through ‘revenue re-cycling’ the green taxes could result in an overall economic improvement. Government intervention to reduce market failure from negative externalities “Traditionally, policy towards the environment has concentrated on two main areas: • •

Intervention in the price mechanism – for example environmental taxes and subsidies; and Command and control measures – for example through regulations and directives.

These policies are designed to: • • •

Achieve a more efficient use of resources; Promote substitution between resources (e.g. abundant for scarce, renewable for non-renewable); and Provide incentives for lower or a change from harmful to benign emissions.

Environmental taxation: In 2008 Economist Robert Frank wrote that, “When market prices convey accurate signals of cost and value, the invisible hand promotes the common good. But prices often diverge from cost and value and, in those cases, taxes can actually help steer resources toward more highly valued uses.” An environmental tax is a tax on a good or service, which is judged to be detrimental to the environment. It may also be a tax on a factor input used to produce (supply) that final product. The main aim of green taxation is to: •

•

Increase the private cost of producing goods and services so that the producer/consumer is paying for some of the negative externalities that their actions are creating (i.e. the externality is internalised) – this promotes allocative efficiency; Raise the final cost/price of the product so that demand contracts -there is normally a direct link between the level of output / consumption and the total pollution created; © Regenesys Business School

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• •

• •

Reduce output levels towards the estimated social optimum level of production; Well-designed environmental taxes can encourage innovation and the development of new technologies, which reduces our dependency on pollution-inefficient forms of energy. This can help to promote dynamic efficiency; Revenue derived from these taxes can be earmarked for lower taxes elsewhere in the economy so that a new environmental tax is ‘revenue neutral’ or to fund increased spending on environmental projects; and Inter-generational equity justification: Achieving improved sustainability in our resource use now helps to protect the resources available for future generations.

Examples of environmental taxes include: fuel duty, vehicle excise duty, air passenger duty, the aggregates tax, the landfill tax and the London Congestion Charge. The Irish Government also introduced a tax on plastic bags in a bid to reduce consumption and encourage recycling. The main aim of an environmental tax is to increase the firm’s private marginal cost (PMC) until it equates with the social marginal cost curve (SMC). Problems with environmental taxation: There is a growing body of economists who argue that reliance on environmental taxation is an ineffective way of promoting environmental improvement, and that some taxes are prone to government failure. The main criticisms of environmental taxes are discussed below: •

•

•

• •

Valuing the environment: There are problems in setting taxes so that marginal private costs will equate with the marginal social costs. Frequent adjustments of tax levels may be required and this involves substantial organisational costs; Consumer welfare effects: Taxes reduce output and raise prices, and this might have an adverse effect on consumer welfare. Producers may be able to pass on the tax to the consumers if the demand for the good is inelastic and, as result, the tax may only have a marginal effect in reducing demand and final output; Achieving a target quantity of pollution reduction: Taxes do not lend themselves to the government achieving an accurate reduction in total pollution. This is because no government can ever predict how consumers and or producers will respond to higher costs and prices. The price elasticity of demand will vary over time; Income distribution: Taxes on some de-merit goods may have a regressive effect on low-income consumers and lead to greater inequalities in the distribution of income; and Employment and investment consequences: If pollution taxes are raised in one country, producers may shift production to countries with lower taxes. This will not reduce global pollution, and may create problems such as structural unemployment and a loss of international competitiveness.” (Excerpt from Riley, 2012)

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7.6.2

Economic Tools used in Economic Policy Analysis

Government, as well as corporations, use various tools to evaluate public policy, projects or programmes. More often than not, more than one approach is adopted to ensure that financial, socio-economic as well as environmental feasibility is measured. Below are some tools that are often used: • • • • • •

Cost benefit analysis Cost effectiveness analysis Financial Analysis/Feasibility Fiscal Impact Analysis Economic Impact Analysis Social/Environmental Impact Analysis

Note: Students must research the above evaluation tools and consider practical and current examples.

Cost benefit analysis include the following key considerations: • • • • • •

It measures economic efficiency as a ratio of benefits to costs It is used in evaluating alternative actions It measures the stream of benefits and costs over time resulting from a project It values these benefits and costs (B/C) in Dollars/Rand It includes discounting, and Net Present Value (NPV) to handle time It measures non-market benefits via willing to pay (WTP)

It is argued that the issue of a possible relationship between fiscal policy and economic growth is of vital importance for policy making (Ali, Rabbi, Hayat, and Ali, 2013). Read the following journal article and then answer the questions that follow.

Ali, S., Rabbi, F., Hayat, U., and Ali, N. 2013, 'The composition of public expenditures and economic growth: evidence from Pakistan', International Journal of Social Economics, 40 (11), 1010-1022.

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Task Questions

1. There are several views on fiscal policy including that fiscal policy leads to lower economic growth due to the crowding out of private investment. Explore the different views given in the journal article above and then reflect on these in the context of your own country. 2. "The better composition of government expenditures has a large impact upon society". Discuss this statement in light of developed and developing economies.

7.6.3

Further Considerations of Economic Policy Analysis

The outputs of economic policy analysis provide useful information to decision-makers who evaluate different projects. They provide an informed benchmark to compare the feasibility of projects’ NPV, Benefit Cost Ratio (BCR), Internal Rate of Return (IRR), etc. However, not all decisions can be made according to financial indicators. Decision-makers often have to consider several other factors that may influence the selection of a particular policy, project or programme. Below are some examples of other considerations: • • •

Urgency to act: A policy option with a lower NPV (or other decision-making criteria) may be considered if it can be mobilised more expediently than other projects Political imperatives: Often the most economically feasible project is not selected because of political sensitivities and voter needs Socio-economic benefits: Decision-makers may place a higher value on the socioeconomic benefits of some projects

Task Questions

1. How do you determine the need for government intervention? 2. Highlight the steps in conducting a specific economic analysis. 3. What additional factors influence decision-making (in addition to economic analysis)?

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7.7 T HE M ONETARY S ECTOR Timeframe: Learning Outcome: Recommended Book: Recommended Articles:

Section Overview:

Minimum of 16 hours • Discuss and critique the various financial institutions, their functions and the nature of their business • Chapters 24, 25, 26, 27 and 28 in Parkin, M. 2014, Economics, Global Edition, 11th ed., England: Pearson Education Limited. • Marcus, G, 2014, 'Quarterly Economic Review', South African Reserve Bank, Quarterly Bulletin March 2014, https://www.resbank.co.za/Lists/News%20and%20Publications/Attachments/6140/01Full%20 Quarterly%20Bulletin%20%E2%80%93%20March%202014.pdf (accessed 20 March 2014). This section examines the various financial institutions in the economy, their functions and the nature of their business. The monetary policy is also examined under this section.

“Warm up” Question

1. Describe the main functions of money and explain the role of each function in your personal life.

7.7.1

The Functions of Money

The table below summarises the broad functions of money. TABLE 6: FUNCTIONS OF MONEY

Medium of Exchange Unit of Account

Store of Value

Standard of Deferred Payment

Money is anything that is generally accepted as payment for goods and services or that is accepted in settlement of debt. It serves as a lubricant or intermediary to smooth the process of exchange and to make it more efficient. Through money, double coincidence of wants is avoided (barter economy). It is an agreed measure for stating the prices of goods and services; i.e. expressing everything in monetary terms (e.g. Gross Domestic Product). Any other commodity/product can be used as a unit of account. Money can lose some of its usefulness as a unit of account during inflation. The use of money to hold wealth. This is so because money can be exchanged for other goods and services at a later (more convenient) date. It is the most liquid form in which wealth can be kept. In hyperinflation situations, money is not a good store of value because it loses its purchasing power. Money serves as a standard of deferred payment. N.B. Money is not income or wealth. Income is reward earned in the production process; e.g. natural resources, labour, capital and entrepreneurship. Wealth is assets that have been accumulated overtime; e.g. fixed property, shares, oriental carpets or paintings etc. Money is a unit in which debt is denominated and an acceptable way through which debt is settled. The real value of the debt may change due to inflation and for international debt via devaluation of the currency in which the debt is held. (Parkin, 2010:543-546) © Regenesys Business School

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7.7.2

Different Kinds of Money

Money takes and has taken several forms: •

• • • • • •

7.7.3

Commodities: The intrinsic value of the commodity was equal to the exchange value assigned to it. Properties such as uniformity, durability, divisibility and ability to be carried were used to choose the commodities. Over the years, coins replaced commodities. The coins were made of various kinds of metal. Paper money replaced coins as trade transactions increased. It started as certificates of deposits, which were fully covered by the metal they represented. Fiduciary/credit money is a type of paper money for which the value was greater than the value of gold backing it (partial). The modern banknote is legal tender that is based solely on confidence in the government or monetary authorities. A cheque is paper that can be used as legal tender. Other technological developments include credit cards, debit cards and electronic payment.

Money Supply in South Africa

South African Money Supply M0 Money Supply M0 is the most liquid measure of the money supply, including coins and notes in circulation and other assets that are easily convertible into cash. Money Supply M0 and M1 are also known as narrow money. The figure below includes the historical data for South African Money Supply M0. FIGURE 13: SOUTH AFRICA MONEY SUPPLY M0 (2004 TO 2014)

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South African Money Supply M1

M=C+D Where:

M is Quantity of Money C is Cash D is Demand Deposits

M1 is currency plus demand deposits. It includes coins and notes (in circulation outside the monetary sector), and all demand deposits (including cheque and transmission deposits) of the domestic private sector with monetary institutions. Demand Deposits are deposits that can be withdrawn immediately by means of a cheque. It includes any form of payment. D is larger than C (D is 90%). M1 mainly functions as medium of exchange. FIGURE 14: SOUTH AFRICA MONEY SUPPLY M1 (2004 TO 2014)

(Trading Economics, 2014c)

Broader Definition of Money (M2) M2 is equal to M1, plus all other short-term and medium-term deposits of the domestic private sector with monetary institutions. Short-term: 30 days; medium-term: 6 months – similar to M1 (Quasi-money) i.e. M2 = Money + Quasi money. M2 mainly functions as medium of exchange.

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FIGURE 15: SOUTH AFRICA MONEY SUPPLY M2 (2004 TO 2014)

(Trading Economics, 2014c)

Comprehensive Measure of Money (M3) M3 = M2 plus all long-term deposits of the domestic private sector with monetary institutions (longterm being greater than six months’ maturity). It is the most reliable indicator of developments in the monetary sector of the economy. It reflects the store of value function of money in addition to medium of exchange. FIGURE 16: SOUTH AFRICA MONEY SUPPLY M3 (JAN 2000 TO MAR 2013)

(Trading Economics, 2014c)

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Task Questions

1. Compare the data in the four charts provided above. 2. If you expect that interest rates are going to fall, will you hold cash or buy bonds? Explain your answer.

7.7.4

Financial Institutions Financial institutions are "establishments that focus on dealing with financial transactions such as investments, loans, and deposits. Conventionally, financial institutions are composed of organisations such as banks, trust companies, insurance companies, and investment dealers. Everything from depositing money to taking out loans and exchanging of currencies must be done through financial institutions." (Investopedia, 2014)

The South African Reserve Bank (SARB) The South African Reserve Bank (SARB) was established in 1920 with the primary mandate of protecting the value of the currency in the interest of balanced and sustainable economic growth in the Republic. It must perform its functions independently and without fear of favour or prejudice – there must be regular consultation between the bank and the cabinet member responsible for national financial matters. The main functions of the South African Reserve Bank are listed below: Issuer of Banknotes and Coins It has the sole right to issue banknotes and coins and it circulates money through the purchase of assets (financial) by the bank (guided by public requirements for cash). Banker of other Banks The SARB holds the minimum cash reserves that banks are required to hold, i.e. part of the monetary base that can be used by banks to create the demand deposits (D). It controls the quantity of money in the country and acts as a clearing agent – for banks’ claims and obligations. It is the lender of last resort – it gives credit to banks.

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Methods used: • • •

Rediscounting of approved financial assets Extension of overnight loans against collateral of high quality financial assets at bank rate Repurchase (repo) tender system: o Banks tender weekly for SARB funds through repurchase agreements o Repo rate – the interest rate at which banks are charged.

Banker for the Government • • • •

Handles most of the financial receipts and payments of the State Government has other accounts with private banks (tax and loan accounts) Acts as adviser to government with regard to monetary matters Responsible for the administration of all exchange control regulations

Custodian of Gold and other Foreign Exchange Reserves • • •

Keeps all the country’s gold and foreign exchange reserves, except balances held by banks and the treasury Gold coins and gold billion are added to the reserves at a market-related price NB: level of reserves indicates state of the economy and future growth prospects

Formulation and Implementation of Monetary Policy • •

Fulfilment of bank’s other functions is done through monetary policy; e.g. keeping inflation rates at low levels Financial stability (mainly price stability) is its most important objective

Task Questions – Own Research

1. What are the main functions of the Reserve Bank (or an equivalent bank) in your country? 2. Identify a trust company in your country and determine the role that it plays. 3. Explain the function of insurance companies in terms of individuals and companies.

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7.7.5

The Supply of Money

Before reading this section it is useful to reflect on Basel III. TABLE 7: BASEL III

Basel III (Regulation relating to banks)

The Base III framework was born out of the financial crisis of 2007-2008. It is a comprehensive set of reform measures developed by the Basel Committee on Banking Supervision to strengthen the regulation, supervision and risk management of the banking sector. The aim is to: • Improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source • Improve risk management and governance • Strengthen banks' transparency and disclosures (Bank of International Settlements, 2013) For a more extensive overview go to: http://www.bis.org/bcbs/basel3.htm (A summary table is also available at this website.)

Banks create money by accepting deposits from the public and lending funds to borrowers; i.e. the difference between deposit rates and lending rates equals income for banks. The South African Revenue Bank (SARB) closely monitors bank activities. Cheque accounts are part of M1 (clients can access their money/demand deposits by writing cheques). Since cheques are a form of money, banks pay little interest on cheque accounts (i.e. they charge bank charges).

Creation of Demand Deposits (M=C+D) Money Supply (M) = sum of currency (C) + demand deposits (D) C = currency (cash) held by the public and currency held by banks D = deposits at banks which the public can withdraw on demand (e.g. through a checking account)

Demand deposits are influenced by the fact that the bank is obliged to pay out the deposit in cash (bank notes) or to transfer it immediately on demand to another bank or account holder. Reputable people with reasonable amounts of money at their disposal can be given demand deposit in exchange for cash deposited at that bank. For example, if someone has R10 000 in banknotes, a bank can open a cheque account for that person, allowing the person to write cheques to the value of R10 000:

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Passive role: •

Change in M = change in C + change in D = -R10 000 + R10 000 = 0.

D can also be created by lending some of the funds deposited to deficit units; i.e. overdraft facilities (creditworthiness): Active role: •

Change in M = change in C + change in D = 0 + R10 000 = R10 000 (Credit Creation)

Reserve Asset Position and the Credit Multiplier • • • • •

Credit creation is limited, because D may be withdrawn anytime Each bank must ensure that it has sufficient cash reserves available to cater for cash withdrawals Each bank must provide for the claims of other banks for its clients The issue of cash reserves should not be left in the hands of individual banks alone (e.g. SARB should be involved) Reason: confidence of creditors in a bank is crucial because if it is eroded it could lead to a rush on withdrawals leading to collapse of the bank and disruption of the entire financial system, (e.g. collapse of Saambou in 2002) can result

Monetary authorities (e.g. SARB) maintain confidence in the financial sector by stipulating the amount of cash reserves to be held against the total liabilities (demand deposits) of a bank; i.e. 2.5% of total liabilities in cash reserves should be kept in a non-interest bearing account with the reserve bank. This money is used to compensate investors in the case of the bank collapsing. Reserve Maintenance Manual (Board of Governors of the Federal Reserve System) "Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities. Within limits specified by law, the Board of Governors has sole authority over changes in reserve requirements. Depository institutions must hold reserves in the form of vault cash or deposits with Federal Reserve Banks." (Federal Reserve, 2014) Each time the bank increases its demand deposits there should be a corresponding increase in cash reserves (R) as illustrated below: Change in R = b * Change in D e.g. Change in D = 2 000, b = 0.025 (2.5%) Change in R = 0.025 * 2 000 = 50 (Additional Cash Reserve) Change in R = b * Change in D, b = cash reserve requirement (%) Change in D = 1/b * Change in R, where 1/b = Credit Multiplier i.e. 40 = 1/0.025

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Note: • • • • • •

•

•

Variation in the cash reserve requirement is not an essential part of the present monetary control system in South Africa The present system of monetary control in South Africa controls the amount of demand deposits by influencing the cost of additional cash reserves (classical cash reserve system) Banks borrow additional reserves (Change in R) from SARB at the repo rate (the higher the repo rate the more expensive credit becomes) Creation of demand deposits is determined by the demand for credit at the interest rates quoted by the banks; i.e. money supply is a function of the demand for money Exports and inflows increase the money supply; and imports and outflows decrease the money supply Government deposits – money supply decreases; government withdrawal – increases money supply (injection of money into circulation). Net impact of government depends on the difference of deposits/ withdrawals Government can now keep accounts with private banks – this makes it easy because it reduces the disruptive impact on the monetary system of large government receipts and payments; i.e. funds remain in circulation If government borrows from the Reserve Bank to finance expenditure, this is called inflationary financing (which is undesirable)

Task Questions

1. What are the main determinants of the demand for money?

7.7.6

The Demand for Money

Wealth can be held in the following forms: • •

Assets (real) – fixed property, valuable items (paintings, stamps) etc. Financial assets – money and interest bearing assets (bonds)

Demand for money is the amount that the various participants in the economy plan to hold in the form of money balances. N.B. Demand has to do with choices between money and bonds. Opportunity cost, of holding any money balance, is the interest that could have been earned had the money that could have been used to purchase bonds instead. The demand for money is related to the functions that it performs.

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Components of the Demand for Money • •

Transactions demand – arises from the medium of exchange function Demand for money as an asset – arises from the store of value function

According to Keynes, money is the most liquid of all assets (liquidity preference).

Reasons for holding money Transactions Motive Money is used as a medium of exchange (active balance). Without money, it is impossible to perform transactions in a money economy. Participants' payments and receipts of money do not coincide; e.g. salaries/ wages are paid every month/ week. At macro-level, the transactions demand for money is therefore a function of national income. Precautionary Motive Money is sometimes held for unpredictable expenditures. At macro-level, it is a function of national income (active balances). Speculative Motive This is related to the function of money as a store of value (complicated). The opportunity cost of holding money is the interest that is foregone by not holding bonds. There is a negative relationship between the quantity of money demanded for speculative purposes and the level of interest rate.

7.7.7

Equilibrium in the Money Market

The idea of independent money supply does not exist. Money supply is determined by the interaction of demand for money and the interest rate level.

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FIGURE 17: THE MONEY MARKET

(Mohr and Fourie, 2008:329)

Ensure that you complete the exercises provided in your textbook. This is the most effective way to test your understanding.

7.7.8

The Instruments of Monetary Policy

Accommodation Policy The classical cash reserve system requires a holding of 2.5% cash reserve with the SARB. Where shortages are experienced, banks can borrow from other banks or the SARB to finance the shortages; i.e. interbank rate or repo rate. The accommodation system is only effective if the repo rate changes are reflected in the changes in interbank overnight rate; i.e. Repo rate > Interbank rate.

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In 2001, to address the shortcomings of the accommodation policy, SARB introduced the following measures: • • • • •

Fixing the repo rate (to prevent uncertainty about bank’s policy stance) Reducing the spread between repo rate and interbank overnight rate to enhance participation and competition Replacing daily auctions with weekly repo auctions (one-week maturity) to encourage interbank market transactions Discontinuing the announcement of the market’s daily liquidity shortage prior to repo auctions (to encourage interbank market transactions) Calculating a weighted average overnight lending rate and put on the market: Providing a benchmark reference rate for interbank and enhance its effective functioning

The accommodation policy of SARB is mainly comprised of changes in repo rate and other conditions on which cash is made available to banks; i.e. regulation of the Q of money through variations in the cost of credit.

Open-Market policy This involves the sale/purchase of domestic financial assets (treasury bills and government bonds) by SARB to influence interest rates and quantity of money. When money supply increases – SARB buys government bonds on the open market. When supply decreases – SARB sells government bonds on the open market. N.B: Increase/decrease of cash reserves of banks. Other players are influenced to participate by attractive (low) prices. The transactions can be used to support the accommodation policy.

Other Instruments This refers to on-market oriented measures; e.g. credit ceilings and deposit rate control, terms of hire purchase agreements changes, reserve bank intervention in foreign exchange markets and public debt management. Other instruments involve “moral suasion”– through consultation and persuasion.

Task Question 1. What do you mean when you say the South African Reserve Bank or an equivalent bank in your country is ‘independent’?

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7.7.9

Bank Supervision

Banks are supposed to meet the following terms: • •

Capital Requirements: Higher of R50 million Liquid Asset Requirement: 5% of total liabilities to the public in form of: o Cash reserve deposits with SARB, banknotes and coins, gold con and bullion, short-term treasury bills, short-term land bank bills, securities of the reserve bank, and government bonds.

Case Study

Read the case study below. Inflation and Monetary Policy in Israel: A Case Study In 1977, several years after the Yom Kippur War, the Labour party lost the elections and the Likud party took power. During this time, Israel faced massive inflation, balance of payments deficit, and a growing budget and declining income. In order to stabilise the economy, the government created a crawling peg exchange mechanism and slowly devalued its currency. This made Israeli exports cheaper and imports more expensive. In 1979, the Iranian Revolution limited oil exports and drove up the prices of oil imports even further. Moreover, the Israeli government also increased defence spending during this time and inflation kept rising. The Minister of Finance, Yoram Aridor, introduced the Aridor Package in 1981 in order to decrease inflation. This included a reduction on taxation for luxuries, an increase of subsidies on basics and a restriction on currency devaluation to 5% a month. Unfortunately, this plan made the economy worse as it made products cheaper, which encouraged people to keep buying, leading to increased inflation. Finally, in 1985 the government introduced its Stabilisation Programme. This plan included the following key components: shrinking the deficit, devaluating currency by 18%, cutting subsidies, increasing real interest rates, restricting currency linked deposit and temporarily freezing wages. In addition, Israel received 1.5 billion dollars in aid from the U.S over two years. When the government introduced these measures simultaneously, the initial months were very difficult. However, soon the demand for dollars went down and people started to save. The increased interest rates helped convince Israelis to save their money and put in into the banks. According to “Inflation Worries Spread,” the Chinese government is instituting new policies like Israel did in 1985 in order to keep inflation down. Obviously, China and Israel are extremely different countries and the monetary policies reflect this, but the People’s Bank of China (PBOC) has also instituted higher interest rates, as Israel did in 1985. As you can see in the below chart, the 1985 programme dramatically decreased inflation rates and put the Israeli economy back on course. Hopefully, PBOC’s new policies will do the same for China.

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(Schilit, 2011a & b) Task question: 1. Based on the case study, what is the relationship between inflation, interest rates and exchange rates?

Task Questions

1. Discuss the three main motives for holding money. 2. Explain the relationship between the interest rate and the quantity of money demanded.

Conclude this section by reading the latest Quarterly Economic Review (September 2013) by the South African Reserve Bank. Key topics include: • • • •

Domestic economic developments Foreign trade and payments Monetary developments, interest rates and financial markets Public finance Marcus, G, 2014, 'Quarterly Economic Review', South African Reserve Bank, Quarterly Bulletin March 2014, https://www.resbank.co.za/Lists/News%20and%20Publications/Attachments/6140/01Full%20Quart erly%20Bulletin%20%E2%80%93%20March%202014.pdf (accessed 20 March 2014).

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7.8 T HE F OREIGN S ECTOR Timeframe: Learning Outcome: Recommended Book:

Minimum of 16 hours • Identify and evaluate reasons why international trade takes place, and the advantages of international trade • Chapter 26 in Parkin, M. 2014, Economics, Global Edition, 11th ed., England: Pearson Education Limited.

Recommended Articles:

•

Section Overview:

This section examines the reasons for international trade and the advantages of it. As a result of globalisation, countries (just like individuals) have become economically interdependent. The extent of a country’s involvement in international trade is referred to as its openness or the degree of its integration.

7.8.1

Ezeani, E. 2013, 'WTO post Doha: trade deadlocks and protectionism', Journal of International Trade Law and Policy, 12 (3), 272-288.

Why Countries Trade

Countries trade to gain self-sufficiency (or autarky) and therefore aim to produce everything themselves. However, this is practically impossible; hence, countries only specialise in the activities they are best at, exporting the surplus and importing what they cannot produce. As a result of limitations on factors of production, countries choose what to produce based on the following factors:

Absolute Advantage Countries only focus on the products they can produce more efficiently and economically in comparison with their trading partners. For example, if one South African worker can produce 100 kg of cement and 24 bricks per week, while a Zimbabwean worker produces 50 kg of cement and 100 bricks per week, South Africa will specialise in the production of cement only where they have absolute advantage over Zimbabwe and will import bricks from Zimbabwe.

Comparative Advantage Comparative advantage is based on opportunity cost. The theory of comparative advantage suggests that each country will tend to specialise in and export those goods for which it has a low opportunity cost of production. Comparative advantage can come from many sources and these include: technology, resource endowments, and differences in tastes between the trading partners.

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New Trade Theory (NTT) New Trade Theory (Krugman in Pettinger, 2013) suggests that a critical factor in determining international patterns of trade are the very substantial economies of scale and network effects that can occur in key industries. “Economies of scale and network effects can be so significant that they outweigh the more traditional theory of comparative advantage. In some industries, two countries may have no discernible differences in opportunity cost at a particular point in time. But, if one country specialises in a particular industry then it may gain economies of scale and other network benefits from its specialisation.” (Pettinger, 2013).

Pettinger (2013) also argues that an early entrant can become a dominant firm in the market (the firm achieves economies of scale against which new entrants can’t compete – some say an unfair advantage). This leads to a form of monopolistic competition.

Consider that poorer; developing economies may struggle to develop industries because they lag too far behind the economies of scale enjoyed in the developed world. This is not due to any inherent comparative advantage – but has more to do with the economies of scale and potential networks developed by the early entrant. This may suggest that governments have a role to play in supporting new industries (tariff protection and domestic subsidy especially when large capital outlays are required). If the industry gets support for a period of time it will be able to exploit economies of scale and networks and go on to be competitive without government support (e.g. infant industry). In your opinion, is free trade and laissez faire government intervention much less desirable for developing economies, which might find themselves unable to compete with established multinationals?

Task Question

1. Suppose you are hired by a group of South African clothing manufacturers to prepare a case for the introduction of new barriers to international trade in the clothing industry. List the arguments that you would use.

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7.8.2

Trade Policy

A trade policy outlines the protection measures a country uses to protect its domestic firms from foreign competition. These protection measures may take the following forms:

Import Tariffs These are duties or taxes imposed on imports. They are used to protect domestic firms from international competition or to raise revenue for the government. The types of tariffs include specific tariffs (fixed amount levied per import unit) and ad valorem (tariff levied as a percentage of import value).

Quantitative Restrictions These include the imposition of import quotas – explicit limits (or quotas) on the physical amounts of particular commodities that can be imported or exported during a specified time period (measured either by volume or value). In some cases, a quota may be applied on a selective basis, with varying limits set according to the country of origin or destination.

Subsidies These help to make domestic products cheaper and thus give them the competitive edge over cheap imports. It is argued, however, that subsidies encourage the preservation of inefficient producers.

Exchange Controls These involve reducing the amount of foreign currency available to import goods. Whether the country is developing or developed, foreign exchange control measures are used to encourage export and impose limitations on specific goods in order to promote foreign trade and keep in equilibrium the balance of payments.

Exchange Rate Policy This involves depreciating the domestic currency to make imports more expensive.

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Non-Tariff Barriers This refers to administrative discrimination practices such as channelling government contracts to domestic firms; e.g. BEE Policy. Read the following journal article to gain a perspective on current arguments.

Ezeani, E. 2013, 'WTO post Doha: trade deadlocks and protectionism', Journal of International Trade Law and Policy, 12 (3), 272-288.

Task Questions

1. Discuss the key findings from the journal article provided above. 2. The balance of payments must always balance. Does this mean that policymakers need not be concerned about balance of payments? Explain your answer. 3. Explain how exchange rate changes can affect exports and imports.

7.8.3

The Exchange Rates

An exchange rate is the price of one currency in terms of another currency; e.g. R9/USD (Direct quote) or USD/R7 (Indirect quote). An increase in the value of a currency is called appreciation and a decrease is called depreciation.

The Foreign Exchange Market This is a market where foreign currency is traded.

Exchange Rate Policy There are three options that can be used: • • •

Determination of exchange rate through market forces Determination of exchange rates through managed float Determination of exchange rates through use of interest rates

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Task Questions

1. Define ‘terms of trade’ and explain its significance (refer to your textbook pp. 734 in Parkin, M. (2010). Economics: Global and Southern African Perspectives. Cape Town: Pearson Education South Africa (Pty) Ltd.

7.8.4

The Terms of Trade (TOT)

The terms of trade (TOT) is the ratio between export prices (expressed as an index) and import prices (expressed as an index):

TOT

=

Export Price Index x 100 Import Price Index

An improvement in TOT means that the welfare of the nation has increased, ceteris paribus. A fall in TOT indicates a welfare loss, ceteris paribus.

Case Study

Read the case study below. Internationalization of the Swedish food industry: challenges and opportunities Abstract: Economic globalisation has brought up both opportunities and challenges for the world trade. An increased flow of capital, labour and production factors across the boundaries, increased opportunities for off-shore production and outsourcing in manufacturing and even service sector are only a part of the "opportunities" that has been brought up by economic globalisation. On the other hand cultural barriers, managerial complexity, and environmental uncertainty are among the challenges of economic globalisation. Internationalisation (international expansion) has been defined as an important strategy for businesses to exploit the opportunities in the globalised world of trade. A trend toward a more internationalised structure has been evident within the Swedish food industry. Although the export of food products by Swedish enterprises has increased dramatically during the last decade, more than 70 per cent of the export goes only to the EU member states. Consequently, by considering the phenomenon of economic globalisation, the potential opportunities placed in other parts of the world are not satisfactorily exploited by Swedish food enterprises. The purpose of this study is to investigate the Swedish food enterprises’ internationalisation decisions regarding the choice of international markets; what factors might have crucial impact on the choice of a foreign market and how these factors may affect the firm’s performance. © Regenesys Business School

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The study focuses on the case of "Lantmännen Cerealia" a company within the Lantmännen Group, one the largest Nordic groups within food. Accordingly, knowledge about business and cultural issues in a market has a crucial role in the firm’s internationalisation decisions regarding the choice of a foreign market. Furthermore, conducting market research will help the firm to acquire knowledge about business and cultural issues within a foreign market, which also enhance its performance in that market. (Goudarz, 2010) Task Question: 1. Based on the case study, what are Lantmännen Cerealia’s comparative and competitive advantages for entering foreign markets?

Recap Questions 1. Why do countries trade? 2. What are the arguments for and against trade? 3. What does it mean to ‘peg’ an exchange rate? Use examples to support your explanation.

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7.9 A N I NTRODUCTION T O A PPLIED E CONOMETRICS Timeframe: Learning Outcome:

Minimum of 14 hours

Recommended Articles:

•

Understand the application of econometrics to economic phenomenon

•

Naidoo, J. (n.d.). 'The impact of HIV/AIDS on crime in South Africa', http://www.sarpn.org/documents/d0001964/HIVAIDS_crime_SA_Naidoo.pdf (accessed 18 March 2014).

The ability to analyse data in order to determine specific relationships; calculate levels of economic convergence; or to forecast future events is very important to a variety of audiences. Complex analysis using credible data can be used to inform important decisions in different sectors, organisations, projects, policies, etc.

Section Overview:

Econometrics is the application of mathematical and statistical methods to analyse economic data. The two main purposes of econometrics are to give empirical content to economic theory by formulating economic models in testable form and to estimate those models and test them to determine acceptability or rejection. This section provides an overview of econometrics: the key methodological problems encountered, the econometrics techniques often used by econometricians, and considerations for the practical application of econometrics.

7.9.1

Econometric Techniques

Econometrics uses various statistical techniques to test real world phenomenon. Econometricians usually develop theoretical constructs, which they test empirically. The types of econometric techniques that are used are determined by: the types of estimates that need to be generated; the relationships that are being estimated, and the methodological problems encountered. Below are some key econometrics techniques: •

•

•

Regression Analysis: Focuses on the relationship between the dependent variable and independent or explanatory variables; i.e. how the typical value of the dependent variable changes when one independent variable is changed and the other explanatory variables are held fixed; Ordinary Least Squares (OLS): OLS fits a line through a set of data points, which minimises the sum of the squared vertical distances between observed variables and the predicted linear approximation (please research the properties of unbiased OLS estimates); Two Stage Least Squares: Used when some of the OLS assumptions are violated. In the first stage, the endogenous covariate is regressed on all exogenous variables and the predicted values are captured. In the second stage, the OLS regression is run with the predicted variables;

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•

•

Fixed and Random Effects Models: Random effects models are used in panel data analysis in which one assumes that there are no individual effects. Fixed effects models, by contrast, assume that the magnitude of the explanatory variables is non-random; and Difference in Difference Analysis (DiD): Calculates the average rate of change in estimates between two time periods.

7.9.2

Econometric Concepts

The following table provides a summary of econometric concepts. TABLE 8: ECONOMETRIC CONCEPTS

Multicollinearity

Occurs when two or more explanatory variables in a regression are highly correlated.

Variance

A measure of how the data distributes itself around the expected value or mean.

Heteroskedasticity

Occurs when the standard deviations of a variable, evaluated over a period of time, are nonconstant.

Endogeneity

Usually occurs when there is causality between the independent and dependent variable (correlation between the error term and the given variable). It can be caused by measurement errors, simultaneity, omitted variables, sample selection errors, etc.

Level of significance

In hypothesis testing, the level of significance is the criterion used to reject the null hypothesis (the result is unlikely to have occurred by chance).

Extreme bounds analysis

Focuses on the largest and smallest values of an estimate of a given variable coefficient.

Descriptive statistics

Quantitatively describe the main features of a dataset (e.g. means, standard deviations, range, etc.). (Regenesys in-house Research, 2012)

7.9.3

Practical Application of Econometrics

The application of econometrics has evolved over time. Econometrics is currently used in varied applications from international trade (calculating the rate of economic convergence between countries) to the analysis of complex applied socio-economic phenomena.

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Task Questions

Read the article: Naidoo, J. (n.d.). 'The impact of HIV/AIDS on crime in South Africa', http://www.sarpn.org/documents/d0001964/HIVAIDS_crime_SA_Naidoo.pdf (accessed 18 March 2014) and answer the following questions: 1. 2. 3. 4.

What economic theory underpinned the analysis? What was the major methodological problem? How did the author overcome the above problem? What are the policy applications of the study?

Recap Questions

1. What is regression analysis? 2. What are some of the most common methodological problems econometricians encounter? 3. Describe a practical real life phenomenon that could be analysed using econometric techniques.

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7.10

I NFLATION AND C APITAL B UDGETING

Timeframe: Learning Outcome: Recommended Book: Recommended Articles: Section Overview:

Minimum of 16 hours • Understand and analyse the effects of inflation on capital budgeting decisions and the cost of debt • Chapter 29 in Parkin, M. 2014, Economics, Global Edition, 11th ed., England: Pearson Education Limited. • Financial Times, 2013, 'Inflation Targeting', http://lexicon.ft.com/Term?term=inflationtargeting (accessed 18 March 2014). This section examines the effects of inflation on capital budgeting decisions and the cost of debt. Inflation is often described as “public enemy number one”, because it affects the whole economy.

7.10.1 Definition of Inflation Inflation is defined as a continuous and considerable rise in prices in general. This definition is neutral because it does not include the causes of inflation; it is a continuous process and it involves considerable increase in prices. As such it also refers to price increase in general.

Task Questions

1. What are the causes and effects of inflation in your home country?

7.10.2 The Measurement of Inflation Several methods are used to measure inflation, two of which are: • •

Consumer Price Index Production Price Index

Consumer Price Index (CPI) “The CPI is a current social and economic indicator that is constructed to measure changes over time in the general level of prices of consumer goods and services that households acquire, use, or pay for. The index aims to measure the change in consumer prices over time. This is done by measuring the cost of purchasing a fixed basket of consumer goods and services of constant quality and similar characteristics, with the products in the basket being selected to be representative of households’ expenditure during a year or other specified period. Such an index is called a fixed-basket price index. The index also aims to measure the effects of price changes on the cost of achieving a constant standard of living (i.e. level of utility or welfare). This concept is called a cost-of-living index (COLI).” (Statsa, 2013a) © Regenesys Business School

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The South African CPI has two equally important objectives (Statsa, 2013a): •

•

To measure inflation in the economy so that macroeconomic policy is based on comprehensive and up-to-date price information and to provide a deflator of consumer expenditure in the expenditure national accounts To measure changes in the cost of living of South African households to ensure equity in the measures taken to adjust wages, grants, service agreements and contracts

Consumer Price Index excluding mortgage interest rates (CPIX) CPIX was discontinued in 2009 and the CPI for all urban areas was announced as a headline inflation measure and also used as an inflation target measure (Statssa, 2013a). Alignment with international best practice in CPI formulation: “The International Labour Organisation (ILO) is the authoritative body on the methodology for price statistics and the compilation of CPIs. The ILO is supported by other organisations including the United Nations Statistics Division (UNSD), International Monetary Fund (IMF) and the World Bank. The ILO manual for CPIs is the main reference for statistical offices for CPI concepts and definitions. The manual provides the theory and conceptual framework of the CPI and aims to give methodological and practical guidelines for the compilation of CPIs. Statistics SA follows the methodology guidelines in the ILO manual when compiling the South African CPI.” (Statssa, 2013a)

The Production Price Index (PPI) The production price index is a measure of the change in the prices of goods either as they leave their place of production or as they enter the production process. “The Producer Price Index (PPI) measures changes in the prices of locally produced commodities. A sample of producers is surveyed each month and the results of this survey are used to compile the producer price indices for final manufactured goods, intermediate manufactured goods, electricity and water, mining, and agriculture, forestry and fishing. The PPI can be used as an economic indicator of inflation, as an escalator in contracts and as a deflator in the calculation of the national accounts. Further information on the weighting structure, sources of information and methods of compilation of the PPI can be found in the PPI sources and methods document, available on the Stats SA website.” (Statssa, 2013b)

Task Questions

1. Should the Reserve Bank of South Africa do everything in its power to combat inflation? Justify your response.

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7.10.3 The Effects of Inflation Distribution Effects Inflation benefits borrowers at the expense of creditors (lenders). The purchasing power (real value) of money is eroded as prices increase.

Economic Effects Inflation results in decreased economic growth and high unemployment. Productive investment is replaced by speculative practices as people try to maintain the real value of their wealth.

Social and Political Effects Price increases cause different groups of people in society to blame each other; this might lead to political unrest as standards of living deteriorate to unprecedented low levels.

Task Questions

1. Why is it difficult to distinguish between cost-push and demand-pull inflation in practice?

7.10.4 The Causes of Inflation Consider the following approaches to and causes of inflation:

The Monetarist Approach to Inflation This is based on the belief that sustained high rates of monetary growth cause high inflation. This view is based on the quantity theory of money, which, in turn, is based on the equation of exchange.

Demand-Pull and Cost-Push Inflation Demand-pull inflation occurs when demand for goods and services increases while supply remains unchanged. This creates a scenario where too much money chases too few goods. Cost-push inflation occurs when increases in production costs push up price levels. Cost-push inflation causes stagflation as increases in prices (inflation) are accompanied by increased unemployment (stagnation).

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The Structural Approach to Inflation According to this approach, the inflation process is a result of interaction between three sets of factors, namely: underlying factors, initiating factors, and propagating factors.

The Conflict Approach to Inflation According to this approach, inflation is a symptom of a fundamental disharmony in society, which results in a continuous imbalance between the rate of growth in the real national income and the rate of growth of the total effective claims on this income.

Task Questions

1. What are the most important advantages of inflation targeting as a monetary policy framework?

7.10.5 Anti-Inflation Policy

Inflation targeting is "a monetary policy strategy used by central banks for maintaining prices at a certain level or within a specific range." (Financial Times, 2013)

Inflation targeting is designed to assure price stability and as the Financial Times (2013) point out "countries adopting inflation targets have tended to have lower and more stable inflation and the framework has proved durable." For more on ‘Inflation Targeting’, refer to the following:

Financial Times, 2013, 'Inflation Targeting', http://lexicon.ft.com/Term?term=inflation-targeting (accessed 18 March 2014).

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Task Questions

1. What are the benefits of inflation targeting? Think about the planning/forecasting function in your organisation with particular consideration of wage negotiations. 2. Would you say that inflation targeting is self-reinforcing – low inflation expectations lead to low inflation. Why (not)? 3. Why should organisations take time to budget their capital?

7.10.6 Capital Budgeting Capital budgeting (or investment appraisal) is the planning process used to determine whether an organisation's long-term investments (such as new machinery, replacement machinery, new plants, new products, and research development projects) are worth pursuing. It is the budget for major capital (or investment) expenditures. Many formal methods are used in capital budgeting, including the techniques discussed below:

Accounting Rate of Return (ARR) This is also known as the average rate of return, or ARR. It is a financial ratio used in capital budgeting. The ratio does not take into account the concept of time value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. For example, if ARR = 7%, the project is expected to earn seven cents out of each dollar invested. If the ARR is equal to, or greater than, the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. Over one-half of large firms calculate ARR when appraising projects.

Net Present Value (NPV) Net present value measures the difference between present value of future cash inflows generated by a project and cash outflows during a specific period of time. With the help of net present value we can figure out an investment that is expected to generate positive cash flows.

Profitability Index Profitability index (PI) is the ratio of investment to payoff of a suggested project. It is a useful capital budgeting technique for grading projects because it measures the value created per unit of investment made by the investor. This technique is also known as profit investment ratio (PIR), benefit-cost ratio and value investment ratio (VIR).

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Internal Rate of Return (IRR) Internal rate of return is another important technique used in Capital Budgeting Analysis to access the viability of an investment proposal. This is considered to be most important alternative to Net Present Value (NPV). IRR is the discount rate at which the costs of investment are equal to the benefits of the investment; or, in other words, IRR is the Required Rate that equates the NPV of an investment zero.

Modified Internal Rate of Return The modified internal rate of return (MIRR) is a financial measure of an investment’s attractiveness. It is used in capital budgeting to rank alternative investments of equal size. As the name implies, MIRR is a modification of the internal rate of return (IRR) and, as such, aims to resolve some problems with the IRR.

Equivalent Annuity The equivalent annuity method expresses the NPV as an annualised cash flow by dividing it by the present value of the annuity factor. It is often used when assessing only the costs of specific projects that have the same cash inflows. In this form it is known as the equivalent annual cost (EAC) method and is the cost per year of owning and operating an asset over its entire lifespan. It is often used in the comparison of investment projects of unequal life spans. For example, if Project A has an expected lifetime of seven years, and Project B has an expected lifetime of eleven years, it would be improper to simply compare the net present values (NPVs) of the two projects, unless the projects could not be repeated.

Task Questions

1. 2.

Do you think that inflation is a serious problem that should be accorded a high priority by policymakers? Discuss the various costs of inflation. In your opinion, which approach to the diagnosis of inflation provides the most useful analysis of inflation in your country? Why

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7.11

T HE I MPACT OF G LOBALISATION

Timeframe: Learning Outcome: Recommended Book: Recommended Articles: Recommended Multimedia:

Section Overview:

Minimum of 10 hours • Understand and critically examine the impact of globalisation • Describe and evaluate the benefits of international portfolio diversification • Chapter 7 in Parkin, M. 2014, Economics, Global Edition, 11th ed., England: Pearson Education Limited. • Andrew, T., and Alex, F. n.d. 'A Teaching Note on Offshore Financial Centers', Journal of Advancements in Business Education. https://www.sbrconferences.com/uploads/Vol1Faseruk_Alex.pdf (accessed 20 March 2014). •

Ernst &Young, 2012, 'Globalization', [video clip] http://www.youtube.com/watch?v=JvCyRoY6azk (accessed 18 March 2014).

This section examines the impact of globalisation on the economies of the world in general and on the South African economy in particular. At the start of the new millennium, the world’s economies appear to be becoming more integrated. Integration here is understood in the sense that trade is expanding, capital markets have sprung up in developing and transition economies, tourism is increasing, and new technologies have linked the farthest corners of the world together.

7.11.1 The Definition of Globalisation Globalisation can be defined as the integration of the world economy. In most of the definitions of globalisation found in the literature, the process of globalisation is seen as the breakdown of borders between countries, governments, the economy and communities. In the financial markets, it is also the blurring of borders between different markets. Global competition is characterised by: Networks of international linkages that bind countries, institutions, and people in an interdependent global economy. Economic integration results from the lessening of trade barriers and the increased flow of goods and services, capital, labour, and technology around the world. (Deresky, 2011:18) The above definitions suggest that globalisation is the intensification of economic, political, social and cultural relations across international boundaries. It is principally aimed at the transcendental homogenisation of political and socio-economic theory across the globe. Business media (e.g. http://www.globalpost.com/business-news) demonstrate the increasing speed at which we receive news, thereby enabling businesses, institutions, and governments to quickly assimilate and react to new information. It can be argued that technology is one of the most aggressive drivers of globalisation.

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Watch the following video clip, which explores current trends and how businesses can respond to them in order to succeed.

Ernst &Young, 2012, 'Globalization', [video clip] http://www.youtube.com/watch?v=JvCyRoY6azk (accessed 18 March 2014).

7.11.2 The Impact of Globalisation on South Africa From cross-sectional empirical analyses of trade, financial openness and liberalisation, it is evident that not all countries/regions have benefited from globalisation to the same extent. It is imperative to establish what the impact of globalisation is on the South African economy. South Africa reentered the international economic arena in the early 90s when the forces of globalisation became more prominent. A general analysis indicates that the expansion in the South African economy only started to take off in 1994. The trade pattern since 1990 shows that, after a period of stagnation during the early 90s, international trade started to increase from the latter part of 1994. Financial flows in the form of foreign direct investment (FDI), portfolio and other investment flows created a dramatic turnaround from dominantly negative flows to mostly positive inflows from the third quarter in 1994. In contrast with the long-term upward trend in trade since 1994, the investment flows are still extremely volatile. The volatility can be explained, firstly, by the fact that South African companies and individuals – due to exchange rate restrictions and international sanctions – did not have the opportunity to invest abroad. Since 1994, a large number of South African companies expanded to become transnational companies. The gradual relaxation of exchange control also permitted companies and individuals to invest abroad. A second explanation for the volatility in capital flows is the relative openness of the capital market to foreign speculative attacks against the Rand. The inevitable phenomenon of globalisation has impacted powerfully on events all over the world. South Africa has been no exception. Economic, political, and social developments in other parts of the world have impacted on South Africa’s propensity to provide viable economic benefits for its citizens. Blame for failure to provide good service delivery has been partially placed on the shoulders of the apartheid administration, even years after the attainment of political independence. Furthermore, the new political dispensation has failed to meet the post-apartheid expectations of its populace, given that people had high hopes for themselves. It begs the question: Can South Africans still point an accusing finger at the vagaries of apartheid for the country’s failure to deliver the goods to an increasingly restive population; especially in the post-Mbeki era. The global recession has not spared South Africa’s economic performance either (Mapuva, 2010).

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Task Questions

1. How would you define “International Portfolio Diversification”? 2. What are the benefits of international portfolio diversification?

7.11.3 Benefits of International Portfolio Diversification The old adage, “do not put all your eggs in one basket” resonates with international portfolio diversification. In simple terms, if one invests in different countries or economies and something adverse happens in any of the countries, the total investment will not suffer as much as it would have if it had all been invested in one country. Globalisation has made it easy for countries and individuals alike to diversify their investment portfolios by increasing access to international markets.

CAPM and MPT Theories of Finance Two well-known theories in the finance literature, the Capital Asset Pricing Model (CAPM) and the Modern Portfolio Theory (MPT), suggest that individual and institutional investors should hold a well-diversified portfolio to reduce risk. An institutional investor can achieve a well-diversified portfolio because the amount of funds in the portfolio is large enough for in-house diversification. Individual investors with limited wealth will have to find another way that does not require substantial funds to diversify their portfolios. Mutual funds offer a quick and relatively inexpensive way for small investors and others to diversify. It is also argued that since differences exist in levels of economic growth and in the timing of business cycles among various countries, international portfolio diversification can be used as a means of reducing risk. In fact, the 1990s witnessed an explosion of international portfolio investment, especially among emerging markets. Mutual fund companies such as Janus and Templeton achieved phenomenal rates of return on their investments during the mid to late 1990s. It should be made clear that, while performances of these mutual funds over the long haul vary, it is still true that diversification reduces risk at a given level of return.

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7.11.4 Offshore Financing Offshore finance is, at its simplest, the provision of financial services by banks and other agents to non-residents. These services include the borrowing of money from non-residents and lending to non-residents. This can take the form of lending to corporates and other financial institutions, funded by liabilities to offices of the lending bank elsewhere, or to market participants. It can also take the form of the taking of deposits from individuals, and investing the proceeds in financial markets elsewhere. Some of these activities are captured in the statistics published by the Bank for International Settlements (BIS). Probably rather more significant are funds managed by financial institutions at the risk of the customer. Such off-balance sheet, or fiduciary, activity is not generally reported in available statistics. Furthermore, it is believed that significant funds are held in offshore financial centres (OFCs) by mutual funds and trusts, so-called International Business Companies (IBCs), or other intermediaries not associated with financial institutions. The definition of an OFC is far less straightforward. At its broadest, an OFC can be defined as any financial centre where offshore activity takes place. This definition would include all the major financial centres in the world. In such centres, there may be little distinction between on- and offshore business; that is, a loan to a non-resident may be funded in the centre’s own market, where the suppliers of funds can be residents or non-residents. Similarly, a fund manager may well not distinguish between funds of resident customers and those of non-residents. Such centres (e.g. London, New York, and Tokyo) could more usefully be described as "International Financial Centres" (IFCs). In some cases (e.g. New York and Tokyo) some of this activity, but by no means all of it, is carried on in institutions which are favourably treated for tax and other purposes; e.g. the U.S. International Banking Facilities (IBFs) and the Japanese Offshore Market (JOM). A more practical definition of an Offshore Financial Centre (OFC) is:

A centre where the bulk of financial sector activity is offshore on both sides of the balance sheet (that is, the counterparties of the majority of financial institutions liabilities and assets are non-residents), where the transactions are initiated elsewhere, and where non-residents control the majority of the institutions involved. (Andrew and Alex, n.d.)

Thus, OFCs are usually referred to as (Andrew and Alex, n.d.): • • •

"Jurisdictions that have relatively large numbers of financial institutions engaged primarily in business with non-residents Financial systems with external assets and liabilities out of proportion to domestic financial intermediation designed to finance domestic economies More popularly, centres which provide some or all of the following services: low or zero taxation; moderate or light financial regulation; and banking secrecy and anonymity"

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However, the distinction is by no means so clear-cut. OFCs range from centres (such as Hong Kong and Singapore) with well-developed financial markets and infrastructure, and where a considerable amount of value is added to transactions undertaken for non-residents; to centres with smaller populations (such as some of the Caribbean centres) where value added is limited to the provision of professional infrastructure. In some very small centres, where the financial institutions have little or no physical presence, the value added may be limited to the booking of the transaction. However, in all centres, specific transactions may be more or less of an "offshore" type; that is, in all jurisdictions it is possible to find transactions where only the "booking" has taken place in the OFC while, at the same time, business involving much more added value may also take place. To read the full journal article go to:

Andrew, T., and Alex, F. n.d. 'A Teaching Note on Offshore Financial Centers', Journal of Advancements in Business Education. https://www.sbrconferences.com/uploads/Vol1Faseruk_Alex.pdf (accessed 20 March 2014).

Recap Questions 1. What is the impact of globalisation on your country’s market for goods and services?

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