2011

Microeconomics
By Wilmon Steyn

Student No. 116753 Mancosa CM Year 1 9/12/2011

Table of Content Introduction Question 1 Is cigarette smoking in poorer nations highly sensitive to price? 1.1 1.2 Define price elasticity Cigarettes in Russia and China are researched to have a price elasticity of -0.1q5. Explain what this means? 1.3 Will an increase in price of cigarettes in Russia and China increase or decrease the quality bought? 1.4 1.5 Define income elasticity of Demand? Explain using a diagram what would happen to the demand for cigarettes if the consumer in Russia and China increased. 1.6 Are cigarettes a normal or inferior good? Justify your answer. ....9 ....4 ....4

Question 2

Oligopolists are the most common market form in modern economies. When people talk about big business and market power, they are usually referring to oligopolists.
Microeconomics Study Guide, Certificate in Management Studies, Page 137

2.1 2.2 2.3 2.4

Explain the main features of an oligolpolist. Explain the theory of the kinked demand curve of an oligolpolist. Highlight the shortcomings of the kinked demand curve model. Research the internet or newspaper and find an organization which operates as an

oligolpolist. Provide an overview of this business and explain why the organization you have meets the requirements of an operating oligopolists in the economy at present.

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Question 3 Maize shortage linked to push prices up

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Japie Grobler, chairman of the National Maize Producers Organisation says with the lower area planted a critical shortage of both white and yellow maize can be expected this season and it will be necessary to import. As a result domestic prices will rise and remain at the higher levels. Extract from the Sunday Business Times, 25 January 1998 3.1 Using a diagram, explain the difference between a movement along a demand curve

and a shift of the demand curve 3.2 Using a diagram explain the difference between a movement along a supply curve and

a shift of the supply curve. 3.3 3.4 Define market equilibrium and explain how it arises. Explain how the lower quantity of maize supplied led in the above article, affected

market equilibrium. Question 4 ..19

With the aid of a diagram, discuss the relationship between government, firms and households.

Conclusion

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Bibliography

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Introduction The study of Microeconomics is the focus on the individual parts of the economy. Mikros means small in the Greek language. In this assignment we will provide greater understanding of the principles that govern the rules of demand and supply and the effect that they have on an economy in the microenvironment. We will also discuss the role of Oligopolistic firms and the rules that define how they conduct themselves in the market place. We will then discuss the cycle of income and the relationship between the various role players in that cycle.

Question 1 Is cigarette smoking in poorer nations highly sensitive to price? 1.1 Define price elasticity of demand. The law of demand states that as the price off a good increase the demand for the quantity of those goods will decrease. The law of demand further states that the price elasticity of demand will always be greater than zero. Price elasticity is used to measure the sensitivity of demand for a good when the price changes. The higher the price elasticity is the more responsive consumers are to price changes. PEoD > 1 the demand is Price Elastic PEoD < 1 the demand is Price Inelastic PEoD=0 the demand is Perfectly Inelastic A number of factors affect price elasticity of demand; 1.1.1 Number of close substitutes in the market 1.1.2 Luxury goods vs. Necessity goods 1.1.3 The percentage of income spent on a particular good 1.1.4 Considerations over a period of time. 1.1.5 Goods that are habit forming

1.2 Cigarettes in Russia and China are researched to have a price elasticity of -0.15 Explain what this means? The PEoD is less than one which indicates that the price of cigarettes in China and Russia is price inelastic. This means that the increase in price is very unlikely to cause a large drop in the demand for the quantity of cigarettes.

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Price elasticity can best be expressed in the equation Price Elasticity (Ep) = (% change in Quantity Demand / % change in price).

(Figure 1.2: Illustrates Price Inelasticity)

The inelastic demand of a good is denoted by a much more vertical curve as the quantity changes little with a movement on the price axel. 1.3 Will an increase in price of cigarettes in Russia and China increase or decrease the quality bought? Cigarette is a habit forming inelastic good that people find very difficult to do without, very much unlike an elastic good that will force consumers to buy less of. A price increase will cause a movement along the demand curve I will substantively show that the quantity of cigarettes will remain fairly constant and should not result in a lower quantity demanded for that good. In an inter-office correspondence from Phillip Morris published in 1982 it depicts the relationship in the United States of America between price increases and per capita consumption measured between 1966 and 1981.[ This was prior to the introduction of strict Anti-Smoking legislation. We have seen a market decline in The United States over the past 2 decades due to health concerns and various economic reasons.[ Both China and Russia are developing economies with greater numbers of consumers entering the middle working class. In a growing economy where income continues to increase and the lure of brand appeal and disposable income makes for a scenario where the demand will not be dampened by price increases. There currently is no or little enforcement of Anti-Smoking Legislation in China and Russia and consumers continue to smoke in public areas.

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Equilibrium

Ep<1

(Figure 1.3.1: Illustrates a shift in the demand curve)

Figure 1.3.1 Illustrate a shift in the demand curve at the point of equilibrium. The low inelasticity of cigarettes will remain at 40 even should the price increase to $2.80. It must be noted that with the increase in the disposable income the demand curve will shift to the right as more people have a demand for cigarettes.

1.4 Define income elasticity of Demand? This measures the sensitivity of the quality demanded to changes in income as a proportion of the percentage change in the quality demanded and a percentage change in the consumers income. The result of Income Elasticity can be both positive and negative. Positive income elasticity is referred to as normal goods while Negative income elasticity is called inferior goods. It is best expressed in the formula; ey = (% change in Quantity demanded / % change in income)

1.5 Explain using a diagram what would happen to the demand for cigarettes if the consumer in Russia and China increased.

Ep < 1

(Figure 1.5.1 illustrates the shift in the demand curve)

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As Russia and China become more industrialized and more consumers enter the middle class there will be an increase in disposable income. As a result of new entrants into the market new demand will be created. The demand curve shifts to the right due to the positive income shift. At a constant price level (P1), more demand could be created through increases in disposable income. A new demand curve (D2) will be set based on the market size and need of the consumers. This is illustrated through a shift in the demand curve from P1Q1 to P2Q2. Therefore, for the same price level, a greater quantity of the product could be demanded (Q1 to Q2). 1.6 Are cigarettes a normal or inferior good? Justify your answer. Normal goods can be defined as a shift either to the left or right in the demand curve as a result of an increase or decrease in income. The income elasticity of demand is positive however it is less than one. (www.Businessdictionary.com) An Inferior good is defined as a decrease in demand for a particular item when their income increases because they can now afford a higher priced substitute. The income elasticity of demand is less than zero. (www.Businessdictionary.com) Cigarettes classification as being a normal or inferior good should first be regionalised based on the geographic spread of its consumers. Cigarettes are classified as a habit forming good. In Russia and China which is a developing economy cigarettes can be defined as a normal good based on the fact that as income has risen demand for this particular good continues to increase. Chinas State Tobacco Monopoly Administration sets policies and enforces them, while also overseeing the worlds largest cigarette maker the China National Tobacco Corporation. Additionally it is culturally entrenched in China that smoking makes you a man. (Smoking: China's new SARS? By Daniel Mark Carr, 2010/08/19)

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In the more developed economies of Europe and North America we can classify cigarettes as inferior goods because as incomes and education continues to rise the demand for this good continues to decrease. Smoking cigarettes are no longer accepted as socially acceptable behaviour and the focus over the past decades on the health risks associated with smoking has seen the quantities demanded decreasing considerably.

Figure 1.6.3

Percent of U.S. Adults Who Smoke by Education, 2009

Source: National Centre for Health Statistics, "Summary Health Statistics for U.S. Adults: National Health Interview Survey, 2009," Vital and Health Statistics 10, no. 249 (2010).

Russian Females

Russian Men

Russian Females Russian Men

Figure 1.6.4 Illustrates the habit forming of smoking in relation to Men & Women in Russia

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Question 2 Oligopolists are the most common market form in modern economies. When people talk about big business and market power, they are usually referring to oligopolists. Microeconomics Study Guide, Certificate in Management Studies, Page 137 2.1 Explain the main features of an oligolpolist.

Oligopoly is one type of imperfect competition as there are only a few sellers in that market. There are two types of oligopolistic firms that differentiate themselves on price competition and non-price competition. Additionally pure oligopoly or perfect oligopoly is the production of identical products while imperfect or differentiated oligopoly is the production of similar but not identical products. According to Prof. G.J. Stigler, Oligopoly is the situation in which a firm bases its market policy in part on the expected behaviour of a few close rivals There are a number of main features of an Oligopolist. 1 Number of firms: There are only a few sellers in that market with a high market concentration. These firms produce branded products and they closely consider the others actions and reactions. 2 Nature of the products: Perfect/ pure oligopoly produces and sells homogeneous products while Imperfect/ differentiated oligopoly produces and sells

heterogeneous products. 3 Barriers to Entry: Barriers to entry does exist and these can range from free to restrictive. 4 5 Information: Organisations operate under conditions of incomplete information. Interdependentness: The actions of one firm will have an effect on others in that market. The pricing and investment decisions take into account the likely reactions of other firms in the market. This creates the opportunity for price collusion. 6 Oligopoly Pricing: They are price makers and price setters and they compete on price and profits that will be the same as in a competitive market. These firms could collaborate to charge the monopoly price and hence benefit from the monopoly profit because of the interdepent modelling of price and output decisions.

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Demand Curve: The price elasticity of their product demand can vary significantly. The exact behavioural patterns of customers are unknown and hence the demand curve of an oligopolistic is indeterminable due to the interdependence of other oligopolistic firms in the market.

2.2

Explain the theory of the kinked demand curve of an oligolpolist.

A bend in a standard demand curve that is a result of competitors decreasing their prices to match each others, but not raising them to achieve the same effect. The thought is that once a business has reduced their price to a certain level any fluctuation that raises the price will cause the firm to lose customers. (www.Businessdictionary.com) It explains price rigidity in an oligopolistic market where once thought to be unresponsive to changes in costs or demands. The kinked demand curve model which is downward sloping model of oligopoly pricing illustrates oligopolistic prices as a natural result of non-collusive behaviour. The reaction of rivals firms in the market to a price change depends on whether price is raised or lowered. Increases in the price of its product could result in losing customers to its rivals. As a result of this the upper part of demand curve has greater elasticity than the part of the curve lying below the kink which is more inelastic. The demand curve will be kinked, at the current price. A decrease in the price of its product will see an increase in the demand for its product. However it must be noted that it cannot push up its sales very much because the rival firms will follow suit with a corresponding price cut. The risk in engaging in a market strategy of price differentiation it that the competing firms could out price you on that same product which will result in decreased sales. Therefore oligopolistic firms avoid competing on price but rather try selling their products at the current market price. These firms compete far more sustainably with one another on the basis of quality, product design, after-sales services, advertising, discounts, gifts, warrantees and special offers. At point a, the price is currently P and Q units of the good that are sold by this firm in this oligopoly. Demand curve D0 represents a relatively elastic demand should the other firms in the market chose to ignore these price changes. This will result in a lower demand of the quantity of product P1 and Q1. If other firms did not follow suit it could lead to its customers shifting to their competitors products. Demand curve D1 represents a relatively inelastic demand should the firm lower its price. Unchallenged the sales revenues and quantity demanded would increase P2 and Q2. Profit is maximized at the existing quantity Q and price P, The importance of the kinked demand curve is that Marginal Cost can increase or decrease
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significantly without affecting the Equilibrium output and price. This is as a result of the interdependence among oligopolists and the resulting uncertainty about how competitors will react to price changes. The more fiercely oligopolists compete the closer these firms will come to a perfectly competitive output and price.

D0

D1 a

(Figure 2.2.1 Illustrates a Kinked Demand Curve)

2.3

Highlight the shortcomings of the kinked demand curve model. The Kinked Demand curve is only applicable to an oligopolistic market. It is not predictive in nature. It denies price and also output fluctuations in response to cost changes. The theory offers no explanation for how current price (at which the demand curve is kinked) arrived at. The overriding factor for industries operating in this market is price and hence profit will be the overriding factor.

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2.4

Research the internet or newspaper and find an organization which operates as

an oligolpolist. Provide an overview of this business and explain why the organization you have meets the requirements of an operating oligopolists in the economy at present. Coffee shops are strewn across the country. This has made drinking coffee an important part of social gathering. There is a wide variety of coffee offerings in the South African market that differentiate on size, flavour, gourmet meals and value added services.

Barriers to entry are a key factor that makes it difficult for new firms to enter an industry which lead to imperfect competition. The most commonly known barriers of entry are economies of scale, legal restrictions, high cost of entry, advertising and product differentiation. The larger role players in the South African market for coffee consumption are Mugg & Bean and Wimpy that has the highest market concentration. They offer essentially identical core products namely coffee. These firms will compete for market share and the demand from consumers in a number of unique of ways. We have to make a distinction between price competition and non-price competition. Price competition can involve discounting the price of coffee. Non-price competition focuses on other strategies for increasing market share. Herewith are some market differentiating strategies.

Mass media advertising and marketing Store Loyalty cards Banking and other Financial Services In-store book stores Extension of trading hours Internet or Wi-Fi access

However the price of a basic cup of coffee remains relatively static across both these firms. Instead they have opted to differentiate on the variety of supplementary goods that they sell and the hours of trading.

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Wimpy business overview: The Wimpy brand was created in the 1930s. The name was inspired by the character of J. Wellington Wimpy from the Popeye cartoons created by E. C. Segar. The company is owned by Famous Brands South Africa and it operates a franchise model. Wimpy is a casual dining family restaurant that has become famous over the year for its breakfasts and coffee. Mugg & bean Business overview: Mugg & Bean is a coffee themed franchise restaurant that is primarily located in busy shopping centers throughout South Africa that will offer you a welcome reprieve from your busy shopping. The Mugg & Bean franchise has been very successful in creating a store identity around the fictional characters of George Bean and Edmund Mugg that grew up in 1874. Mugg & bean is also owned by Famous Brands. Interesting Coffee facts: Both restaurants are famous for their coffee and both serve 100% Arabica coffee. The cost of a small Wimpy coffee is R9.95 and at Mugg & Bean that same size coffee will cost you R13.50, however it must be noted that this is a bottomless cup. The average South African according to the Coffee Company consumed 0.6kg of coffee annually that effectively equates to less than one cup of coffee per day. Mugg & Bean creates the very effective case that you can have more than one cup. The reality however is that most people will drink only one. About Famous Brands: It has already been stated that they own both franchises, however additional facts must be shared is that Famous Brands also owns and controls the manufacturing of many of the products that these firms use in their business. Additionally they also control the distribution network ranging from warehousing to export. The franchises agreements also bind the buyer of this business to purchase most of their raw goods for production from the franchisor. The marketing/ brand identity and leasing approval for both firms is also controlled by Famous Brands.
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Conclusion: Both Mugg & Bean and Wimpy operates as oligopolists. Famous Brand could also been seen as an oligopolist should it be stacked up against Pioneer Foods. However in the space of the franchisee Famous Brand could be construed as a Monopolist. Question 3 Maize shortage linked to push prices up Japie Grobler, chairman of the National Maize Producers Organisation says with the lower area planted a critical shortage of both white and yellow maize can be expected this season and it will be necessary to import. As a result domestic prices will rise and remain at the higher levels. Extract from the Sunday Business Times, 25 January 1998 3.1 Using a diagram explain the difference between a movement along a demand curve

and a shift of the demand curve. The quantity demanded is directly influenced by a change in the price.

Figure 3.1.1 Illustrates a movement along the Demand Curve

The movement along the downward sloping demand curve from P1Q1 to P2Q2 reflects a change in the quantity of a particular good demanded. There is a single demand curve for the market (D1), and the quantity demanded is greatly influenced by the price of that good. As the price decreases point a, (P1 to P2) the demand of that particular good will increases Q1 to Q2. This is reflected as a movement along the demand curve (D1) to point b reflecting the new demand.

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Shift in the Demand Curve

b a

Figure 3.1.1 Illustrates a Shift in the Demand Curve

As a result of changes to a particular market new demand is created. At a constant price level (P1), more demand could be created through increases in disposable income. A new demand curve (D2), can be drawn. This is illustrated through a shift in the demand curve from P1Q1 to P2Q2. The equilibrium point shifts from a to the new market balance position of b. Therefore, a new market price level is set with greater quantity of the good being demanded on the demand curve D2. 3.2 Using a diagram explain the difference between a movement along a supply

curve and a shift of the supply curve. The law of supply states that as the price of a good increases, so the quantity supplied will increase, and as prices fall so will the quantity supplied. Supply refers to the planned quantities that producers or sellers plan at each price.

Movement Along Supply Curve

Figure 3.2.1 Illustrates the movement along the Supply Curve

A movement along the supply curve is a direct result of a change in price.

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Shift in Supply: Decrease

Shift in Supply: Increase

Fig 3.2.2 Illustrates a Decrease shift in Supply

Figure 3.2.3 Illustrates an Increase shift in Supply

A change in supply results in a change in the non-price factors of supply. These are the factors that we assumed were constant when we used the ceteris paribus assumption in developing the supply curve. An increase in supply will result in a shift to the right at the same price; however the quantities supplied will be greater. 3.3 Define market equilibrium and explain how it arises.

Equilibrium in the market occurs when quantities demanded exactly balance the quantities supplied for those goods and services. This is where the demand and the supply curves intersect to determine the equilibrium price and equilibrium quantities that are bought and sold in this particular market. When the market price is set above or below the equilibrium price, the market will be in disequilibrium. This will either result in a market surplus or market shortage. To overcome a surplus or shortage, buyers and sellers will change their behaviour and the market will tend towards equilibrium where no further adjustments will be required. Price acts as an important factor in determining market equilibrium. (www.Businessdictionary.com) Quantity Demanded = Quantity Supplied

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4 Forces of disequilibrium Consumer surplus: This is the difference between what consumers pay and the value that they receive. Producer surplus: This is idea that producers will be willing to supply goods at less than the market price. Excess supply: This is when the quantities of good supplied are greater than the quantity demanded. Excess demand: This is when the quantities of goods demanded are greater than the quantity supplied.
Demand, supply and market equilibrium

Figure 3.3.1 Illustrates Demand, supply and market equilibrium

3.4

Explain how the lower quantity of maize supplied led in the above article,

affected market equilibrium. The lower quantity of both white and yellow maize has resulted in a severe drop in the supply. This drop in supply is represented by a shift from S1 to S2. S1 represents the supply of maize at normal planting levels. D1 represents the countrys demand for maize. As can been seen, the supply and demand for maize in the country is equal prior to the lower planting levels. This is represented by the fact that Q1, the quantity of maize being supplied, is located along in the intersection of both S1 and D1. This is called equilibrium, or the point at which both the supply and demand are satisfied.

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Shift in Supply of Maize

Price

Shortage

Quantity of Maize

Figure 3.4.1 Illustrates the shift in Supply of Maize as result of shortage

However, due to the lower yield as a result of lower planting in the country the maximum quantity of maize supply the farmers are able to supply has decreases. This decrease is represented by a shift from S1 to S2. This has affected the quantity supplied. The result is a shift from Q1 to Q2 along the supply axis. Throughout the shift the price is initially maintained at P1. Q2 however represents a point along the supply curve that does not create equilibrium as it does not fall along the D1 line as well. Instead the new quantity falls below the demand curve, resulting in a shortage. A shortage is when the quantity of an item supplied is less than the quantity that the item is demanded. On a diagram this is represented by having a point falling below the point of equilibrium. The market will try to find equilibrium in order to satisfy the needs of both the consumers and producers. In this situation, it can be expected that the price of maize will rise in order to create a movement along the supply curve to meet the demand of the market. Q2 falls below its point of equilibrium. Assuming the market is functioning normally the price of maize will increase until it reaches a new equilibrium. There are yet no discussions of introducing a price ceiling resulting in the maximum price maize can be sold for. The situation is not ideal as it will cause inflationary pressures.

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Question 4 With the aid of a diagram, discuss the relationship between government, firms and households. The circular-flow diagram presents a visual model of the different groups that participate in the economy. These major markets coordinate macroeconomic activities.

The circular flow of Money

Resource market

Government

Government Borrowing

Businesses

Households

Financial Institutions Imports

Exports Product Market

Foreign Economies

The governments, firms, households and financial institutions actively engage in the marketplace by offering to buy or sell goods and services or resources of production. Participation in this market is primarily motivated by the desire to maximise the utility (consumers), profits (business firms) and the general welfare (government) from each participants general resources. All these engagements involve the exchange of either resources of production or finished products. These exchanges can occur anywhere and take place in product markets or resource markets, depending on the goods being exchanged. The marketplace is made up of primarily two basic markets; the Resource market and the Product market. The resource market is where the factors of production are exchanged. Market participants buy or sell land, labour, or capital that can be used in the production process. When someone is looking for a job they are contributing a resource of production
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(labour) available to the producers. The producers will hire the workers and pay them at a rate that they will be willing to work for. In the product markets, consumers continuously interact with business firms where they purchase goods and services. Businesses sell goods and households buy from them. The product market coordinates the demand (consumption, investment, government purchases, and net exports) for and supply of domestic production (real GDP). Foreigners also actively participate in this product market by bringing purchases (imports) from foreigners into balance with sales (exports plus net inflow of capital). The South African market place can be considered an open economy as it allows foreigners to participate in our market. A closed economy does not consider international trade while an open economy takes imports and exports into consideration. The firms place a demand on the resources market in order to produce goods. The demand curve slopes downward due to the fact as resource prices like labour increase the firm will demand less. The supply curve will be sloped upward because of higher wages meaning an increase in the supply of labour. Businesses pay taxes to government who again make payments for goods received. The households supply the labour to the resource markets that allow for the production of resources that will again enable firms to produce goods. The households will again acquire these goods and services through the product market for consumption. Households pay taxes to government and also supplies labour. Households supply the loanable funds to the financial institutions in the form of investments. Government interacts with all the market participants and set the macroeconomic policies that will influence the overall efficiency of the circular flow of income in a market.

Conclusion By having a greater understanding of the factors that define the micro economy and how they interact with each other and their impact on the market we now understand the inner workings of the macro economy. We have provided greater insight into the mikros parts of the economy through our explanations of demand and supply and the relationship they have in ensuring that the market continues to function at equilibrium.

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Bibliography 1 Philip Mohr, Louis Fourie and associates (2008) Economics for South African students Fourth Edition. 2 Cecilia van Zyl, Ziets Botha, Peter Skerritt (2006) Understanding South African Financial Markets Second Edition. 3 4 Jain, T.R and Khanna, O.P. (2009) Business Economics First Edition Richard G Lipsey, Colin Harbury (1992) First Principles of Economics Second Edition 5 6 7 8 9 10 11 12 13 14 15 16 17 18 N Gregory Mankiw, Mark P. Taylor (2006) Microeconomics First Edition www.BusinessDictionary.com www.investorpedia.com www.ernestmorgan.com www.flatworldknowledge.com www.economicsonline.co.uk www.edu.uoh.edu.cn www.population.reference.burea.com www.choices_health_concerns_or_price.html www.tobaccodocument.org/pm/2043565313-5328.htm www.shangaiist.com/2010/08/19/smoking_-_the_new_sars_php www.wimpy.co.za www.themugg.com www.famousbrands.co.za

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