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CHAPTER 1
Economics and the Economy
Limited resources
and unlimited
needs create the
scarcity problem

To overcome We can express this as trade-offs

scarcity we must using a production possibilities curve
make choices
according to
opportunity cost

We judge our High and sustained economic growth

progress High employment
according to 5 Price stability
macroeconomic Balance of payments stability
objectives Equitable distribution of income

To make progress Monetary policy

we employ laissez Fiscal policy
faire and Trade and exchange rate policy
economic policies Wage, price and incomes policy
Microeconomic policies

We build economic Using observation, experiments and

models to help in analysis we engage in positive
deciding on the economics and then normative
best economic economics
policies

1. INTRODUCTION
The world is a strange place. On the largest part of this planet people go hungry and thirsty. It
is estimated that about 1 billion (1 000 000 000) people go to bed hungry every night, while
2 billion people usually don’t have enough water. In a smaller part of the world, mainly the rich
countries, much of the population is overweight. Some people have so much that they even suffer

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from illnesses such as bulimia where they would rather throw up their food than digest it, only
to eat again. The average citizens in rich countries have so much water that they use 30 000 litres
of water every year just to flush away their body wastes.

Now some people think that this problem will eventually be solved by progress. They think it is
only a matter of time before poor countries become rich as well. However, this way of thinking
ignores something crucial – we don’t have enough resources on earth to turn every poor person
on this planet (with more than 6 billion people) into a rich person. Rich people consume more
food, water, petrol, paper, meat or just about any other resource you can think of. To make the
millions of cars, electrical appliances and jewellery that rich people want, we need to mine the
earth for iron, gold and oil and so remove its resources – resources that are often gone forever
because we cannot replace them fast enough. In the process of producing the products that rich
people want, producers pollute the air that we breathe, poison our rivers and destroy our forests.

Given this situation, can we afford to make every poor person rich? It is estimated that to give
every person on this planet the same wealth as the average citizen in the USA, we would require
at least 2 12 planets, because we simply don’t have enough resources on earth to achieve this. So
our problem is simply that we do not have enough – and it is this problem of “not enough” that
the subject of Economics tries to address.

2. ECONOMISTS STUDY THE SCARCITY PROBLEM

Every subject looks at the world from a different perspective, and every perspective makes you
understand the world in a different way. The subject of Economics looks at the world as a place
of scarcity. Scarcity happens when there are not enough resources to satisfy all the needs of
people. This problem of scarcity is the basic problem of economics, and we can therefore say that
Economics is the study of how societies use their limited resources to satisfy their unlimited
needs.

In Economics we perceive the world through the glasses of the scarcity problem. The world that
economists study is called the economy, and the economy consists of everyone who has needs
and all the resources that can be used to satisfy these needs. We believe that everyone in the
economy acts rationally and tries to maximise the number of needs they can satisfy given their
limited resources.

These limited resources are called production factors in Economics. Production factors are those
resources that we use in order to produce goods and services that can satisfy needs. We divide
these production factors into four elements:

• Labour – which comes from the physical and intellectual ability of humans to do work. All
working people together are called the labour force;
• Capital – these are goods made by humans, that can be used to produce even more goods and
services. Examples of capital are machinery, buildings, roads or harbours, and such physical
capital is called real capital or capital goods;

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• Natural resources – this includes everything nature offers to humans, for example land, water,
minerals, animals, plants or any other resources that are not changed by labour or capital;
• Entrepreneurship – entrepreneurs are people who identify opportunities and then coordinate
the other production factors in such a way to produce products that others want to buy.

For example, to produce jerseys, a person first needs to identify a need for jerseys. The person
becomes the entrepreneur when she acts on this opportunity. The entrepreneur will buy some
sheep (natural resources) and shear them for their wool. She will buy some machines (capital)
to weave the wool into threads and to knit the threads into jerseys. To shear the sheep and to
operate the machines, the entrepreneur needs workers (labour). She also needs some land (natural
resources) on which to keep the sheep and on which to build her factory.

Production factors are scarce, and anyone who wants to use these factors will have to pay for the
services they deliver. When the owner of a production factor makes his factor available to another
person or firm, the owner of the production factor is entitled to receive a reward from the other
person or firm. Every production factor entitles its owner to a different kind of reward:

• If you work for anyone, you are providing the production factor called labour, and earn income
in the form of wages.
• If you own some land and allow someone to rent it from you, you are providing the production
factor called natural resources and earn income in the form of rent.
• If you own capital goods, you could lend the production factor called capital to others and
earn income in the form of interest.
• If you start your own business, you are providing the production factor called entrepreneurship
and earn income in the form of profit.

3. ECONOMISTS EVALUATE CHOICES

If resources are scarce, we cannot satisfy all our needs. Scarcity means that we have to make
choices. We have to decide which needs to satisfy first. We also have to decide which of our
limited resources to use, which products to produce with the resources we have and who to
provide these resources and products to.

Think about your own life and see how this is true. Most of us have limited money and more
needs than we can satisfy with that money. How do we solve our own scarcity problem? We have
to choose because we don’t have enough money. We choose to satisfy our most important needs
first. If we don’t do this, we may live in a luxury home but die of hunger. We consider all the
opportunities available to us that can earn us money, and we choose those opportunities that earn
us the most money. We have to choose, because we don’t have enough time to pursue all the
opportunities available to us.

A good choice is obviously one that helps us to solve our scarcity problem. But how do we know
whether we have made the best possible choice, or how do firms decide what products to produce?

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This is where the idea of value comes in. If we knew which needs would be most valuable to us
if they were satisfied, we would know which needs to satisfy first. How do we know what is most
valuable? Normally we look at the price or the cost. The more money someone is willing to
sacrifice to buy a product, the more valuable that product is.

So when you choose to satisfy a specific need, you need to sacrifice something. When you pay
R40 to watch a movie, you sacrifice R40’s worth of money. Or in other words, you sacrifice the
opportunity to spend that money on something else. You not only sacrifice money, you also
sacrifice other things like time. The two hours you spend satisfying your need to watch a movie
could have been spent otherwise. So, for example, you also sacrifice the opportunity to spend
those two hours satisfying your need for sleep. There is no way out – whenever you use your
resources to satisfy one need, you sacrifice the opportunity to use those resources to satisfy other
needs.

You know whether you are making the best choice by looking at what you sacrifice when you
satisfy a need. The value of the next best opportunity that you sacrifice when you make a choice
is called opportunity cost. The choice that involves the smallest sacrifice (or smallest opportunity
cost) is the best choice.

Suppose there are two needs that you could satisfy – studying and sleeping. If you could attach
money values to the different needs, you might have said that the satisfaction of your need to
study is worth R50 to you, while satisfying the need to sleep is worth R30 to you at this stage.
So, by studying, you sacrifice something (sleeping) that is worth R30 to you, and sleeping would
involve sacrificing something (studying) that is currently worth R50 to you. The opportunity cost
of studying is therefore R30 and the opportunity cost of sleeping is R50. In this case you would
choose to study because it requires the smallest opportunity cost and ensures that you are making
the most of your limited resources.

Thinking like an economist (in terms of opportunity cost) will make you aware that regardless
of what you do, you are constantly making sacrifices. With this kind of awareness, you are less
likely to waste your limited resources on things that are not important to you. It could also make
you think differently about life. The Dalai Lama summarised the economic view of life when he
said that you should not measure success by what you have achieved, but by what you had to give
up to get there.

4. ECONOMISTS BUILD MODELS OF TRADE-OFFS

If there is scarcity, you are forced to make choices. Since every choice involves a sacrifice, the
scarcity problem means you are faced with trade-offs. A trade-off is an exchange of one thing in
return for another – it normally takes the form of sacrificing one benefit in order to gain another
benefit. For example, if you choose to spend more time playing computer games, you have less
time to spend on studying – so there is a trade-off between entertainment and studying. You are
faced with this trade-off because one of your resources is limited or scarce and you have to make
a choice. In this case you have limited time, so choosing to spend more time on one activity

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means you have to spend less time on another. Due to scarcity, every choice involves a sacrifice,
and these sacrifices can be expressed as trade-offs.

In reality there are an infinite number of trade-offs and an infinite number of factors that influence
those trade-offs. To enable us to make sense of all this complexity, economists build models of
the most important trade-offs created by scarcity.

A model is a simplified version of reality. An economic model is therefore a simplified version of

the real economy. You simplify the real economy by ignoring things that you believe are not
important. So a model will be unrealistic, but this is not necessarily bad. Let’s take the example
of a map. Is a map of a city such as Johannesburg unrealistic? Of course. If a map of Johannesburg
was realistic, it would have to show every person, every dog, every single building, every stone
and every speck of dust that exist in Johannesburg, and it would have to be as big as Johannesburg.
If you had a map that big would it be useful? No, because you want to be able to carry a map in
your pocket and use it to find your way. If you want to find your way, the roads and their names
are important, not the dogs or the stones. So a useful map would be one that only shows the roads
and their names – it is unrealistic, but it is useful.

Suppose we want to build a model of a whole country's economy that shows how well it is solving
the scarcity problem. In this case the most important things to show are the products used to
satisfy needs and the trade-offs involved. One such model is called the production possibilities
curve (PPC). The PPC shows the maximum amount that a country can produce of two products
if it used all of its resources to the fullest. Figure 1.1 shows an example.

Guns

C
50
D
40

A
25

B
10

E
0 Cake
0 15 30 60 70

Figure 1.1: Production possibilities curve

The example of figure 1.1 shows a country that can either produce guns or cakes with its limited
resources. If it uses all of its land and labour as effectively as possible, and puts it all into the
production of guns, it will be able to produce a maximum of 40 guns. In this case, there will be
no resources left to produce any cake (point D). The country could also put all of its resources

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only in the production of cake, and produce 60 cakes and no guns (point E). Or the country could
be anywhere in between. If it put some resources into producing guns and some into producing
cake, this would put the country at point A. Connecting points D, A and E gives us the production
possibilities curve. If this country did not use all of its resources, it would not be on the production
possibilities curve. It would instead be somewhere below the curve (for example point B), producing
a lot less guns and cakes than would be possible if it used its resources as effectively as possible.
Point C on the other hand is impossible, because it lies outside the production possibilities curve.
The country does not have enough resources to produce 50 guns and 70 cakes.

The PPC illustrates choice and opportunity cost. Suppose the country is currently at point D, but
now wants to produce some cakes as well. To produce more cake would require resources, but
what if all the resources were already used for producing guns? Some land and labour will have
to be taken away from the production of guns and moved to the production of cake. If you take
a certain amount of resources away from producing guns, gun production will fall from 40 to 25.
The resources taken from gun production can now be allocated to the production of cake, and
so the number of cakes produced rise from 0 to 30. The country ends up at point A. The choice
to produce more cake involved a sacrifice of 15 guns (40-25). The opportunity cost of the extra
30 cakes produced, is therefore 15 guns. If the country wanted even more cake, it would have to
sacrifice the production of even more guns.

One thing you may notice about the production possibilities curve is its outwardly curved (concave)
shape. As you can see from figure 1.2, if this country starts at point R and wants to increase the
production of guns by 10 (from 10 to 20), it has to sacrifice 10 cakes (from 50 to 40). However,
if it wants to produce a further 10 guns (from 20 to 30), it will have to sacrifice more cakes than
before (40-25=15). The cost or sacrifice of producing guns therefore increases. The cost increases,
because as a country produces more guns, it needs to shift resources (such as workers) from the
cake industry to the gun industry. Unfortunately, workers trained to make cakes will not have
the right skills to make guns, and so they would not be able to contribute as much.

Guns

S
P
30

Q
20

10 R

0 Cake
0 25 40 50

Figure 1.2: Changes on the production possibilities curve

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As a result, as the economy moves from point Q to point P, cake production falls by 15, while gun
production only increases by 10. This increasing cost of production is called the law of increasing
cost. The law of increasing cost states that the production cost per product increases as total
production increases (assuming everything else stays the same).

It is not necessary for a country to accept the given trade-off between cakes and guns. There are
actions that could be taken to move the country to a higher PPC, say from point P to point S.
In doing so, the country will produce more guns and more cakes than before. The trade-off does
not disappear, so the choice between producing guns and cakes remain. However, on the higher
PPC, more guns and cakes will be available for every choice the country makes. When the PPC
shifts outwards, there is more production in the country so that it comes closer to solving the
scarcity problem.

A country could move to a higher PPC if it obtained more resources or if the quality of its resources
increased. In figure 1.2 the country will be able to move to point S if, for example, someone
discovers a new source of iron ore in the country (quantity of resources increases), or if workers
in the country gain better skills (quality of resources increases), or if there is an improvement
in technology (which affects both the quantity and quality of resources).

There is an important condition we have to state - the shift of the PPC will only occur if nothing
else changes. For example, if there is an improvement in technology, but the country is also hit
by a hurricane that destroys great parts of it, the PPC might not shift outwards. So we always
have to add the condition of ceteris paribus, which means that everything else remains the same.
We should therefore change our statement to be: ceteris paribus, if technology improves, the
country will move to a higher PPC.

5. MEASURING ECONOMIC PROGRESS

The scarcity problem can be solved in a number of ways, all of which involve choices. One could
try and increase the resources available, for example by reclaiming land from the ocean or by
improving people’s skills. The choice is in deciding which resources to expand. There is a trade-
off here – for example, the more money we spend on reclaiming land, the less money we have
left to spend on education. We could try to use our resources better so that we can produce more
products, for example through biotechnology that allows us to harvest more maize from a piece
of land. Once again there is a trade-off and the question is which resources we should focus on.
Or we could find ways to spread the resources in such a way that more people’s needs are satisfied.
The choices now are in deciding who should get what.

If we make the right choices, we will come closer to solving the scarcity problem. How do we
know whether we are making progress in solving the scarcity problem? We need to have specific
objectives or targets to work toward and measures that tell us how well we are doing. Economists
have decided on five macroeconomic objectives that countries should pursue if they want to make
economic progress. We shall review these objectives now.

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High and sustained economic growth

Economic growth means that the production of final goods and services in a country is increasing.
For example, if economic growth was 1.9% in South Africa in 2003, it means that 1.9% more
goods and services were produced in 2003 compared to the previous year. Goods and services
must be produced for people to satisfy their needs, so the higher the economic growth rate, the
closer the country comes to solving its scarcity problem. Economic growth is also shown in
figure 1.2 by an outward shift of the PPC.

Although the aim is high economic growth, no country has been able to maintain high economic
growth for long periods. This is because the change in a country’s production follows an up-
down pattern – or a business cycle. When a country’s total production increases (economic
growth is positive), we say the country experiences a boom phase, and when total production falls
(economic growth is negative), the country experiences a recession. Governments should aim
to keep the business cycle as stable as possible, while trying to keep economic growth at least
above the population growth rate.

Price stability
Prices tend to increase in any economy that uses money. Since the price is a rough indicator of
a product's value, we want prices to be an accurate reflection of how scarce a product is compared
to other products. If prices change all the time or increase too fast, it becomes very difficult to
judge the scarcity and value of products.

When the prices of most products in a country increase, we say there is inflation. A country's
inflation rate tells us how fast the prices of most products in a country are increasing. For example,
the inflation rate in South Africa in 2003 was 5.8%. This means that prices of consumer goods
in 2003 were on average 5.8% higher than the prices in 2002. The inflation rate can also tell us
how stable prices are.

The objective is not to have no inflation at all – the objective is price stability, because stability
allows people to plan for the future. Inflation will harm an economy if it is unstable and out of
control. Fast increasing prices reduce the purchasing power of people’s income. Purchasing power
measures how many products people can buy with their income. For example, if your income is
R60, and the price of a loaf of bread is R5, you can buy 12 loaves with that income. If there is a
20% inflation rate, the price of bread may increase to R6. The purchasing power of your fixed
income will fall because you will now only be able to buy 10 loaves. However, if inflation is
moderate and stable, and people’s income increase at the same rate as inflation, inflation will not
necessarily cause people to be in a worse position. Most countries have central banks whose main
purpose is to protect the purchasing power of their countries’ money and this involves controlling
inflation.

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High employment
When someone who is willing and able to work does not have a job and is also not self-employed,
that person is said to be unemployed. A country with many unemployed people faces the danger
of increasing poverty and crime. The unemployment rate tells us what percentage of people who
are willing and able to work cannot find a job or self-employment. For example, the official
unemployment rate in South Africa in 2003 was 28%. This means that 28% of those willing and
able to work were not employed in 2003.

Aiming for high employment is the same as aiming for low unemployment. The ideal is obviously
0% unemployment or full employment, but most economists agree that this is not possible. The
lowest unemployment rate that is possible in an economy is called the natural rate of unemployment.

Economic growth is usually linked to employment. If there is economic growth because firms
produce more, they need more people to work, and so employment increases. The higher the
employment, the more people in the economy will earn an income. If more people earn an income,
they can buy more products to satisfy their needs, and this brings us closer to solving the scarcity
problem.

Balance of payments stability

A country’s transactions with the rest of the world are recorded in a set of accounts that we call
the balance of payments. The transactions that are recorded are exports and imports, and inflows
and outflows of foreign investment. Exports are when foreign countries buy our country’s products,
and imports are when we buy the products of foreign countries.

Other countries’ unit of money (for example the US dollar) is called foreign currency or foreign
exchange. We have to pay for imports with foreign exchange and when we export we receive
foreign exchange. When foreigners invest in South Africa, they also bring foreign exchange into
the country. Foreign currencies can be exchanged for each other at a given exchange rate. For
example, if the R/$ exchange rate is $1=R7, it means that you need to offer R7 if you want to buy
$1.

Exports are good because they earn money (or foreign exchange) for the country; money that we
can use to buy more products to satisfy our needs. Imports are also good because we may be able
to get a wider variety of products, that may be cheaper and of a higher quality from foreign
countries. If people can buy quality products more cheaply from foreign countries, they will have
more money left to spend on even more products, and so satisfy more of their needs. If foreigners
invest money in South Africa (for example by building new factories), it also helps us because
they may need to employ more people to help them (for example to work in their new factories).

However, a problem arises when our exports or imports are not balanced. High exports and low
imports can also be a problem, because it is a waste if you earn lots of foreign exchange but you
don’t use it to buy products that can satisfy needs. Likewise, high imports and low exports can
be a problem – maybe more serious – because imports must be paid for in foreign exchange and

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we earn foreign exchange mainly from exports. Low exports mean that we are not earning enough
foreign currency to pay for crucial imports. It is therefore important that exports and imports
be in balance. We also want our country's foreign investment transactions to be stable and
predictable, for reasons that will be explained in later chapters. We can therefore phrase the
economic objective as: balance of payments stability.

Equitable distribution of income

A country could meet all the previously mentioned objectives and still be economically unsuccessful
unless the income of the country is fairly spread between all members of the population. This
does not mean that income should be spread equally. There is a difference between fair (or
equitable) and equal. If all wealth was spread equally, people would lose their motivation to work
harder or to innovate, since any extra income they earned would be given to others. To be fair
or equitable, income must be spread in such a way that people earn income in relation to their
contribution to society. People who work hardest or innovate the most, deserve to earn more
income than those who don't.

Fairness is not always easy to achieve because people are often poor due to no fault of their own
or because they are exploited by others. For example, if a worker works hard in a firm knitting
jerseys every day, it is not fair if her employer only pays her enough to survive and takes the rest
of the income generated from selling the jerseys for himself. People must get a fair share of the
income from production that reflects the amount of effort and initiative they put in. We therefore
state the last economic objective as follows: equitable distribution of income.

6. MAKING ECONOMIC PROGRESS

There are two main approaches used to make progress toward solving the scarcity problem. One
approach is to do nothing and just allow the economy to follow its natural course, and the other
approach is for the government to interfere in the working of the economy. We shall look at each
one in turn.

Letting the market work

Most of the activity in the economy involves the act of exchange, or in other words – buying and
selling. Buying and selling transactions take place in markets, because markets exist wherever
buyers and sellers meet in order to negotiate possible transactions. Markets can be in shops or
on sidewalks, but it does not always have to be a physical place. Buyers and sellers can also meet
over the telephone or even on the Internet.

Most economists believe that for a country to solve its scarcity problem, we need to let the market
work without any interference by the government. This approach goes by the term laissez faire,
meaning "let people do as they please". The laissez faire approach means that there is no control
over the economy. How can just letting the market work lead to the kind of order that will move
us towards greater wealth in the economy?

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First we need to explain what happens when markets work. When buyers and sellers meet, they
do so to negotiate the price and the quantity of the products or services that they want to buy
and sell. The prices that they negotiate are important to the economy since these prices send
signals to other buyers and sellers about the scarcity of a product. Prices are approximate indicators
of the value of products and services. They help buyers to decide whether a product is worth
buying, and sellers to decide whether a product is worth producing.

If markets work well, they should send accurate price signals to all interested buyers and sellers,
and so help them to make choices that are right for themselves and for the economy as a whole.
For example, why are there more toys in the shops during Christmas time? In the Christmas
season people want to buy more toys to give to their children as gifts, so toys become scarcer. As
a result, toys become more valuable to people and therefore they are willing to pay more for them.
If there are not enough toys available in shops, people will be willing to pay even higher prices.
As toys become more expensive, producers of toys will notice that they can earn more income
at the higher prices. This will encourage them to produce and sell more toys, and so the number
of toys will increase. More toys are available when they are needed most, without anyone controlling
the process! Nobody tells toy producers to produce and sell more toys – it just happens because
of the price signals sent out by the market. After Christmas, there may be many toys left in the
shops that nobody wants to buy anymore. These toys are no longer scarce, so if the market works
well, their prices will fall. Shops will have after-Christmas sales, trying to get rid of the excess
toys. Toy producers will make less money once prices have dropped, and produce fewer toys.
Again, producers do exactly the right thing, not because someone told them to do so, but because
they followed the price signals of the market.

Unfortunately, the market does not always work well. Sometimes a lack of information, coercion,
collusion of firms or exploitation may distort the price signals or prevent buyers and sellers from
acting on these price signals. When this happens we have market failure. We therefore often
need government to interfere in the economy to ensure that a country comes closer to solving
its scarcity problem.

Economic policy
Economic policy are systematic attempts by the government to influence the state of the economy.
Economists distinguish between microeconomic policy (when the government tries to influence
either specific sectors of the economy or the actions of specific role players) and macroeconomic
policy (when the government tries to influence the working of the economy as a whole).

Microeconomic policy includes policies such as competition policy (trying to prevent individual
firms from controlling a market), industrial policy (trying to encourage the development of certain
geographical areas or certain sectors of the economy) or tourism policy (trying to encourage
foreign tourists to visit the country). Microeconomic policy is normally the responsibility of
individual government departments or ministries, for example the Department of Trade and
Industry, Department of Education, Department of Health or Ministry of Tourism.

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Macroeconomic policy tends to get more attention from economists and we divide it into four
kinds of policy: monetary, fiscal, balance of payments and incomes policy. We shall look at each
one briefly:
• Fiscal policy. All adjustments in the level, composition and timing of government spending
and taxation make up fiscal policy. Governments can spend their money on things like salaries,
pensions, building schools or providing water and other services, so a good government can
make a country a better place to live in. Governments get the money they spend mainly from
taxation, that is by taking money from the people and firms that earn income and profit in
the country. Taxation is not bad provided governments don’t constantly spend more money
than they earn through taxation, and provided they use that money to the benefit of the whole
population. The national budget contains a government's plans for spending and taxation and
it is the main tool of fiscal policy.

• Monetary policy. Monetary policy is the management of the money, interest rate and credit
conditions in a country. A country’s central bank manages monetary policy on behalf of the
government. The central bank has the power to change the supply of money in an economy
and the level of interest rates, and their policy influences how well a country solves its scarcity
problem. If a central bank creates more money in the economy, consumers and firms will use
that money by spending more. If firms produce more products to match the increased spending,
more needs can be satisfied. To achieve a similar effect, the central bank could reduce the
interest rate. Lower interest rates make it cheaper to borrow money from banks. With more
money borrowed, people can spend more on products that satisfy their needs. There is a catch,
as we will explain in later chapters. If people spend more, prices of products may increase and
the country is then more likely to experience higher inflation.

• Balance of payments policy. This policy deals with a country’s economic relations with foreign
countries and comprises trade policy and exchange rate policy. Trade policy uses measures
like tariffs and quotas to expand or restrict the imports and exports of a country. A tariff
increases the price of foreign products imported into a country, while quotas restrict the
number of foreign products that may be imported to a country. Governments could encourage
exports by offering technical or financial assistance, or export subsidies to exporters. Since
imports and exports involve the use of foreign countries’ money, trade policy is closely linked
with exchange rates. When a country’s own currency weakens against foreign currencies, it
is called a depreciation. For example, if the R/$ exchange rate goes from $1=R7 to $1=R8, this
is a depreciation of the rand, because now we need more rand to buy one dollar. When a
country’s own currency strengthens against foreign currencies, it is called an appreciation.
With exchange rate policy a central bank tries to influence the level of a country’s exchange
rate.

• Wage and price policy. When a government feels that the prices in a country are increasing
too fast, they will try to bring it under control through indirect measures (like reducing money
supply) or informal measures (like trying to persuade labour unions to accept smaller wage
increases). If these measures fail, the government may resort to incomes policy. With incomes
policy the government uses direct controls and sets legal limits to how high prices and wages

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can go. Also, when the government believes that workers are exploited, it can impose wage
controls by setting legal limits on how low wages can go (this is also called setting the
minimum wage). Or if the government wants to protect producers or consumers, it can impose
price controls. In South Africa the government uses price control in certain products – for
example by setting the price of petrol. Incomes policy is usually ineffective, and should only
be a last resort once everything else has failed to bring the economy under control.

Economic policies can be expansionary or restrictive. Expansionary economic policy aims to

increase spending and production in the economy, while restrictive economic policy aims to
reduce spending in the economy. The government will use expansionary policy when the economy
is in a recession. In a recession, economic growth falls and unemployment increases. By
stimulating more spending and production, the government tries to get the economy out of a
recession. The government will use restrictive economic policy when the economy is experiencing
a boom. In a boom, economic growth is on the increase. Higher economic growth means that
the economy is doing well and there is more income and spending. More spending leads to a
higher demand for goods and services, which in turn will cause prices to increase. By attempting
to reduce spending in the economy, the government hopes to reduce the rate at which prices
increase and so bring inflation under control.

The following actions are tools of expansionary economic policy because they stimulate spending:

• Reducing the interest rate (it may cause companies to invest more or cause consumers to buy
more on credit) or increasing money supply (more money usually leads to more spending).
This is expansionary monetary policy.
• Reducing the tax rate (this leaves more money for consumers and firms to spend) or increasing
government spending (for example, if the government spends more money on building roads,
employing more people or giving poverty relief). This is expansionary fiscal policy.

The following actions are tools of restrictive economic policy because they lead to less spending:

• Tools of restrictive monetary policy which could involve actions like increasing interest rates
or reducing the money supply in the economy.
• Tools of restrictive fiscal policy which could include actions like increasing the tax rate or
reducing government spending.

7. THE CONSTRUCTION AND USE OF ECONOMIC MODELS

Models of how the economy works (like the PPC) help economists to decide on the best way to
solve the scarcity problem. Economic models allow us to make the complex workings of the
economy simple enough for us to grasp. With economic models we can explain what is happening
in the economy and predict what might happen in the economy given certain events and policies.
If we understand what is happening and we can predict what effect certain policies will have, we
can make recommendations on what the best economic policies are for the country.

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To build models of the economy we need to develop an understanding of the most important
objects and role players in the economy and their interactions. We can obtain this understanding
by:

• Observing events and the reactions of role players. By analysing our observations, we can
derive rules of thumb from them, and then use those rules to build models of the economy.
For example, at a flea market we might observe that if a seller increases the selling price of
a product, buyers buy less of that product. Based on that information we could formulate the
law of demand which states that if the price of a product increases, the quantity that buyers
demand will fall. We can then use the law of demand to help us build a model of how markets
work.

• Sometimes it is difficult to rely on observations because so many things can change at the
same time. We may therefore have to revert to controlled experiments where we control the
changes that can take place. For example, we could put 100 people in a room and create an
artificial market. Then we can watch them to see how they act under different conditions (e.g.
when we change their incomes) and derive rules of thumb from their behaviour.

• Should observation or experiments prove difficult, we could use statistical analysis. Economists
constantly create statistical data on many economic indicators like inflation, unemployment,
government spending, exports, economic growth and so on. We could analyse this data to
see if we can derive rules of thumb from them. For example, we may find that if interest rates
rise, the inflation rate falls, and from that we could develop the idea that interest rates can
be used to control inflation.

There are a number of pitfalls we need to avoid when building and using models. Firstly, models
create a picture of the economy at a certain time, but the economy changes all the time. People's
behaviour may change, and models must therefore constantly be revised to take account of changes
that may affect the results produced by these models. Secondly, because models are simplifications,
they will not always produce accurate predictions. There is always an element of uncertainty
related to the results of economic models. Thirdly, if our observations and analysis show that
two events follow each other, this does not necessarily mean that one causes the other. We may,
for example, find that more people die in old-age homes than in student residences, but this does
not mean that old-age homes are dangerous places to live in. Lastly, remember that when using
a model we only change one thing at a time (ceteris paribus). In real life, however, many things
change at the same time.

To construct economic models we rely on positive economics. Positive economics looks at "what
is" and is the analysis of the economy as it exists in reality. A positive economic statement would
be something like "the current R/$ exchange rate is $1=R6.59" or "in January 2004 the inflation
rate in Botswana was 6.2%." We use positive economic statements and the relationships between
them to build economic models. Once an economic model is constructed, we can use it to engage
in normative economics. Normative economics looks at "what should be" and it is concerned with
the design of policies which aim to change the behaviour of people. A normative economic
statement always involves a judgement and could be something like "the government should raise
taxes to reduce income inequality in South Africa" or "the Minister of Finance has done a good
job of managing the economy."

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8. SUMMARY
• The basic economic problem is scarcity i.e. limited resources to satisfy unlimited needs
• To overcome scarcity we must make choices, and using the concept of opportunity cost will help
us make better choices
• Countries that make the correct choices will experience faster economic progress. We measure
economic progress against the achievement of five macroeconomic objectives, namely: high and
sustained economic growth; high employment; price stability; balance of payments stability; and
an equitable distribution of income.
• To make economic progress government can use a combination of laissez faire (letting the market
work freely) and economic policies. The main kinds of economic policies are monetary policy, fiscal
policy, trade and exchange rate policy; incomes policy and various microeconomic policies
• Economists build economic models to understand how the economy works, to predict the effect
of various policies and so decide which policies to recommend to the government

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