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Solutions for all

Economics
Grade 10
Learner’s Book

Endorsed by the School of Economic and Business Sciences,


Faculty of Commerce, Law and Management, University of the
Witwatersrand, Johannesburg, in the interest of creating future
business and societal leadership, understanding and
knowledge.

J Luiz B Serfontein
Solutions for all Economics Grade 10 Learner’s Book

© M. Eloff, J. Luiz, D. Nel, A. Pretorius, B. Serfontein 2011


© Illustrations and design Macmillan South Africa (Pty) Ltd, 2011

All rights reserved. No part of this publication may be reproduced,


stored in a retrieval system, or transmitted in any form or by any
means, electronic, photocopying, recording, or otherwise, without the
prior written permission of the copyright holder or in accordance with
the provisions of the Copyright Act, 1978 (as amended). Any person
who commits any unauthorised act in relation to this publication may
be liable for criminal prosecution and civil claims for damages.

First published 2011

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Published by
Macmillan South Africa (Pty) Ltd
Private Bag X19
Northlands
2116
Gauteng
South Africa

Cover design by Deevine Design


Typesetting by The Purple Turtle Publishing Services
Illustrations by Michael Souter
Photos from Africa Media Online

The publishers have made every effort to trace the copyright holders.
If they have inadvertently overlooked any, they will be pleased to
make the necessary arrangements at the first opportunity.

ISBN: 978-1-4310-0645-8 
WIP: 3054M000

It is illegal to photocopy any page of this book


without written permission from the publishers.

Acknowledgements
The publisher and author wish to thank the following, in
anticipation for their permission to reprint copyright material:
South African Reserve Bank
Statistics South Africa
Business Day
Financial Mail
South African Mint
Gerald Crawford
Finance Week
Department of Education
www.bbbee.com
Department of Tourism

e-ISBN: 978-1-4310-1737-9
Contents
1 Economics: Basic concepts............................................................. 1

2 Basic economic problem.............................................................. 17

3 Circular flow and quantitative elements....................................... 35

Circular flow.....................................................................................36
Quantitative elements......................................................................57
4 Business cycles............................................................................. 70

5 Dynamics of markets.................................................................... 87

6 Production possibility curve........................................................ 117

7 Public sector intervention........................................................... 137

8 Growth, development and globalisation.................................... 155

9 History of South African economic growth and development..... 176

10 History of money and banking................................................... 200

11 Population and labour force....................................................... 215

12 Unemployment.......................................................................... 232

13 Labour relations......................................................................... 251

14 Economic redress....................................................................... 268

Word list............................................................................................ 290


Bibliography .................................................................................... 292
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1 Economics:
Basic concepts
What will you learn about in this topic?
l Unpacking of economics through describing the concept and
its elements
l The branches and approaches of economics
l The positive and normative statement methods of economics
l The scientific method of economics
l Difficulties faced by the social sciences
l The use of models to explain economics
l The setting of economics within the fields of accounting,
business studies, commercial law and mathematics of finance
l Relationships with other sciences
such as statistics, mathematics,
information technology, law,
politics, sociology and geography
l Career opportunities

Let’s talk about this topic


l Have you ever wondered why you
cannot have everything you need
and want?
l What is studied in economics?
l How does economics relate to other subjects?
l What is it that economists do?

Economics: Basic concepts 1


Economics: Basic concepts
What do I know already?
Needs and wants
All people have needs and wants, but there are only limited resources
available to satisfy them. Needs and wants differ from person to person, and
what one person regards as a need another will see as a want. For example,
you might regard owning a cell phone as a need, but for someone who cannot
afford a cell phone it is a want. Economics is the study of how people use their
limited resources to satisfy their unlimited needs and wants.

k Do you think that being rich means that you have unlimited
Chec f resources?
l
myse Name some resources that you think might be limited even when
you have a lot of money.

Word bank ABC


Needs are those goods and services we need to survive.
Wants are those things other than needs that will give us satisfaction.
Scarcity exists because we have limited resources with which to satisfy
unlimited needs and wants.
Economic efficiency occurs when we make the best use of our resources to
produce goods and services.
Microeconomics studies the individual parts of the economy.
Macroeconomics studies the functioning of the entire economy.
Phenomena are events and patterns that occur, sometimes unusual.
Normative statements are statements that contain value judgements.
Positive statements are statements that can be proven right or wrong.

What do I still need to know?


Description and elements
Economics is about everyday things. It is about the things that affect you, your
family, your town, your country and your planet. Economics is also about the
things that happen in your everyday life. Think about the statements you just
read – what do you think economics is about and how is it part of your
everyday life?

2 • Economics: Basic concepts


Topic 1

Do you know about inflation? Think about how much things cost now
compared with three years ago. Can you still buy the same things with the
same amount of money as three years ago? Why do you think this is?
Questions like these are very important in economics. This is because
economics is also about the study of the causes and effects of and solutions to
inflation.

As a Grade 10 learner, you will soon be reaching the end of your school
career. Are you thinking about your future yet? What you do after you
matriculate is a very important decision because you must start preparing
yourself now for the labour market. In economics, people study the dynamics
of various markets, including the labour market (how it functions, how wages
are determined, etc.).

South Africa unfortunately has a very high unemployment rate. This means
that we have a very large number of people who are looking for jobs but
who cannot find any. Unemployment is one of the biggest challenges facing
South Africa. Economics studies the causes and effects of and solutions for
unemployment.

Economics is about everyday things

Can you now see how economics is about the issues that affect the quality of
life of yourself, your family and friends – all South Africans in fact? So why
are you studying economics?

Economics should be studied by everyone. Some people can use economics to


make a real difference to the building of our economy and society. The study
of economics can help people to become better citizens. As a young South
African, you have a very important role to play in participating in and
contributing to the national debate about the challenges that face South Africa.
To contribute you must be economically literate.

Soon you will be eligible to vote, but voting is not just about choosing a
person or a party to vote for. It is about making well-informed decisions that
affect your own and other people’s futures. It involves understanding your
society and the issues that affect it. So, it means being able to make informed
and critical decisions about economic questions. As a voter, you can influence
which political leaders deal with the problems South Africa faces, and how.

Economics: Basic concepts • 3


Your vote counts – it says which policies you think are good, workable and
right for our situation. To identify the best policies, you will need a good
understanding of economics.

You also need economics to help you develop a better understanding of your
own actions as a human being. You are always making decisions, so you are
always making choices. Sometimes these choices are not easy or popular, and
sometimes the choices you make mean that you have to give up something
else. This means that the choices that you have made, or are still going to
make, involve a cost – something is gained but something is lost.

So now that you know a little about the importance of economics in your own
life, let’s think about what the study of economics is all about – the what, who,
why and how of economics.

Every single human being has needs and


wants. Psychologists (the people who
study the way people think and act) say
that every person in the world has a need
for love, security and social recognition, as
well as a need for necessities such as food,
shelter and water. However, people have a
list of needs and wants that is usually
much longer than this list. As they get
older and change, their list of wants and
needs will also get longer and change. So
we can say that people’s needs and wants
are continually expanding and changing. Limited resources Unlimited needs
and wants
Have you ever noticed how, once a need or
Satisfying unlimited needs and wants with limited resources
want has been satisfied, there is always
something else to take its place? We all would like more food, more love
and more free time, as what we have never seems to be enough. Even in
wealthy societies, you will find that people have wants and needs that are
never fully satisfied.

Economics is not only concerned with needs and wants but also how best to
satisfy these unlimited needs and wants. To do that we must consider how
these goods and services that satisfy our needs and wants will be produced.
It is when dealing with production that we are confronted with the issue of
scarcity. We simply do not have enough resources to produce all the things
we need and want.

4 • Economics: Basic concepts


Topic 1

Because our needs and wants are unlimited and resources are scarce, we as a
society must make some very hard choices. We have to decide which needs
and wants and, importantly, whose needs and wants will be satisfied. We are
therefore not only facing the issue of economic efficiency but also the
problem of ensuring equality.

Economics can therefore be defined as the study of how individuals,


businesses, government and other organisations in our society choose to use
scarce resources to satisfy needs and wants in a manner that is efficient and
equitable.

Classroom activity 1.1


1 Did you make a choice recently for which you had to give up
something? (1)
2 How do you think knowing that choices are a compromise –
a give-and-take situation – has affected the way you view the
world and the choices you make? (2)
3 Why do you think the idea of choices is important in economics? (2)
4 Why do you think it is not possible for people to have all the
things they need and want? (2)

What do I still need to know?


Branches of economics

Macroeconomics
Aggregate price level
Macroeconomics Unemployment
Total level of production
Total level of exports

Economics

Microeconomics
Individual prices
Microeconomics Unemployment in the
agricultural sector
Production of motor cars
Exports of gold

The branches of economics

Economics: Basic concepts • 5


The study of economics can be divided into two main branches called
microeconomics and macroeconomics.
1. Microeconomics (micro means small) looks at the behaviour of the units
of an economy – the businesses (firms), households and individual
consumers. It focuses on how these units make decisions. For example
why households prefer one product over another, or how businesses
choose to produce one product over another. Microeconomics focuses on
individual markets – their products, prices and outputs.
2. Macroeconomics (macro means large), on the other hand, looks at the
behaviour of the economy as a whole, for instance the unemployment rate
or the inflation rate of an economy. Macroeconomics is not concerned with
what the individual units are doing.
Macroeconomics is like an aerial photograph of a landscape where the whole
picture can be seen, but the small details are invisible. But microeconomics is
like a walk through the same landscape – details can be seen up close but the
big picture is hidden.

The relationship between macro- and


microeconomics
It is important to realise that macroeconomics is always supported by micro-
economic processes. In other words, macroeconomics is always the outcome
(the result) of microeconomic behaviour. So care must be taken not to separate
these two branches completely, because they support each other.

Sub-branches of economics

Labour economics Public economics Monetary economics Agricultural economics

Some sub-branches of economics

There are many other sub-branches in economics, but they are normally
classified within the broad categories of micro- or macroeconomics. There are
also many different kinds of specialised or expert fields of economics.
Examples of the sub-branches of economics include the following:
l Development economics focuses on the problems of poorer countries.

6 • Economics: Basic concepts


Topic 1

l Econometrics focuses on statistical techniques in economics.


l Mathematical economics is the use of mathematical techniques in
economics.
l Monetary economics examines the role of money and financial
institutions in the economy.
l Labour economics focuses on labour markets.
l Public finance looks at the role of government.
l Environmental economics studies the impact of the economy on the
environment.
l Agricultural economics focuses on agricultural markets.

Economics is not a static discipline and new sub-branches develop


continuously. For instance, there is the relatively new area of peace
economics, which studies the cost of conflict and the ways in which conflict
can be avoided.

Classroom activity 1.2


1 Do the following statements belong to microeconomics or
macroeconomics?
a) The factors that determine the demand for fried chicken
pieces. (1)
b) The determinants of demand for all goods and services (1)
c) Changes in the inflation rate (1)
d) Changes in the price of cold drinks (1)
e) The reasons why engineers are unemployed (1)
f) The factors that determine the total production of goods
and services of a country (1)
2 Which of the sub-branches of economics do you find the most
interesting? Give reasons for your answer. (2)

Economics: Basic concepts • 7


What do I still need to know?
Approaches and methods of economics

Economics is a social science


Economics is a social science. This means that it studies people and their
behaviour. And, as a social science, it is related to the other social sciences, such
as sociology (the study of societies and social problems), anthropology (the
study of humankind and its customs), political studies (the study of
government) and psychology (the study of the human mind and behaviour).
But, because it is a science, it uses a logical and scientific approach to discovering
how people behave. What do you think a scientific approach means?

Economists study human behaviour

Difficulties faced by the social sciences


Unlike natural sciences that deal with the natural world, social sciences deal
with human beings. Because they deal with humans, with their motivation and
desires, social scientists are faced with a number of problems. Humans are very
complex beings and it is not possible to model or understand every aspect of
being a human.

Economists cannot do experiments in a laboratory

Social scientists therefore simplify things by trying to identify the most


important determinants that affect our behaviour. This may sometimes lead to
oversimplification. Social scientists also cannot experiment and make use of
laboratories to test their theories the way natural scientists do. They are
therefore not able to test their theories and predictions under ideal conditions.

Economists are also human beings with their own preferences and ideas, and
this will have great impact on how an individual economist may view the

8 • Economics: Basic concepts


Topic 1

world. Facts do not speak for themselves; they require interpretation. We may
have the same facts but they will mean different things to different people.

Economics uses the scientific method


Economists construct (make) theories based on assumptions so as to reach
certain conclusions. For example, economists have studied human behaviour
and have observed that when the price of a good rises, the quantity demanded
by consumers will fall. In understanding a scientific approach, it is important
to first recognise a few steps:
l Human behaviour is first observed.
l On the basis of this observation, a pattern is recognised.
l The pattern of behaviour is then stated as a theory, i.e. ‘as the price of a
good rises so the quantity demanded thereof will fall’.

But, this theory is also based on two key assumptions. Firstly, that humans
behave rationally. Secondly, that all other things remain the same or constant.
The assumption that other things remain constant is called the ceteris paribus
condition. It is an important assumption and tool in economics because it
allows economists to make generalisations or theories based on what they
have observed.

Compare this to what happens in a science laboratory where one chemical at a


time can be observed under controlled conditions. The ceteris paribus condition
allows economists to do something similar – to look at one thing at a time and
to assume that everything else stays the same.

Positive and normative statements


Economics can also be categorised into positive and normative economics.
They both have their place in economics and they are each used to accomplish
different objectives.
1. Positive economics deals with positive statements and facts and does
not make value judgements (what is right or wrong). It is concerned
with making scientific statements about economic behaviour. Positive
economists investigate phenomena and are concerned with how the
world really works. Positive economic statements can be proven either
right or wrong.
2. Normative economics, on the other hand, deals with normative
statements and makes judgements about what an economy should or
should not be like, and so it is more concerned with policies.

The main difference between positive and normative economics is that


positive economics deals with what is, and normative economics deals with
what should be.

Economics: Basic concepts • 9


Whenever you see the words ‘should’ or ‘ought’, you are probably looking at a
normative statement. And whenever economists move from facts or theories to
the policy level, they are probably moving from positive to normative economics.

Note that a positive statement can be wrong. A statement such as ’the


unemployment rate for South Africa was 3,5% in 2004‘ is a positive statement,
but it is wrong. The unemployment rate was much higher.

Economics uses models


Economists observe and theorise about human behaviour to explain the
world, predict outcomes and make policies based on their models. Through
careful observation, economists can recognise patterns that are either caused
by behaviour itself, or by the results of such behaviour. It is this skill of
knowing about patterns that allows economists to make policies that will
bring about certain outcomes – if we do this, then that will happen.

Classroom activity 1.3


1 Are the following statements normative or positive?
a) The economy grew by 2,5% in 2002. (1)
b) Bafana Bafana should be the most popular soccer team in Africa. (1)
c) Mr Trevor Manuel was the Minister of Finance in South
Africa in 2003. (1)
d) Wages should be increased in South Africa. (1)
e) This economics textbook is written for Grade 10. (1)
f) The unemployment rate for South Africa was 0% in 2004. (1)
2 Why is it easier to test the prediction of a theory in the natural
sciences than in the social sciences? (2)

What do I still need to know?


Relationship with other fields of study
Economics is an interesting and crucial discipline because it deals with issues
that are very important to society – it deals with our quality of life, poverty
and wealth, and the opportunities of the present and future. It is through the
study of economics that we are able to see how the world and our actions are
all related and interdependent.

Our social, economic and political problems cannot be solved in isolation from
one another. They require an integrated approach. Economics is one of the
keys to a better future for all humankind.

10 • Economics: Basic concepts


Topic 1

Mathematics of finance Accounting

Economics

Commercial law Business studies

Economics and other fields of study

Economics also forms part of the economic sciences that deal with commercial
subjects, such as accounting, business studies, commercial law and
mathematics of finance. A qualification in commerce usually requires you to
study these subjects, as well as economics.

The field of study for economics is much broader than that of the other
commercial subjects. This is because it involves the functioning of the
economic system, while other subjects deal with specific components of the
economic system.

Accounting involves recording financial transactions and reporting this


information according to certain standards in financial statements. Financial
statements are there to provide information on how well a business is doing
financially.

While an accountant is interested in the profits that the business makes, an


economist will consider issues such as the role of profits in the economy or
whether it is possible to produce the same amount of goods with less costs.
While an accountant will record the actual costs of the business, the economist
will be concerned with the forces that determine the cost of production, as
well as other factors such as pollution, which the accountant would not take
into account.

Much of the financial information provided by accountants is very useful for


economists, and many of the techniques developed by accountants are used
by economists too.

Business studies is concerned with the functioning of a business enterprise


and focuses on topics such as marketing, product development, management,
production methods and labour relations. Business studies teaches how a
business should be run and how the business world works.

Economics: Basic concepts • 11


The economy has an important impact on any business. For this reason
business studies learners would do well to study economics and understand
how the economy affects the survival of a business.

In economics, business enterprises play an important role in solving the


scarcity problem. This is because they produce the goods and services that we
use to satisfy our needs and wants. Economists therefore pay very close
attention to the behaviour of businesses in the economy. They analyse
elements such as the impact of tax policies on business, business confidence
and the competition between businesses.

Commercial law concerns the rules and regulations that govern commercial
or business transactions in the economy. These laws are part of the
environment in which an economy functions. For an economy to work well,
business contracts must be legally binding and honoured by both parties.

Economists are also interested in the effects and unintended results that laws
and regulations may have on the functioning of the economy. Competition
law, for example, is an area where economists are very active.

Mathematics of finance involves the use of applied mathematics to study and


solve problems relevant to the finance sector. The techniques developed in
this field are very important to economists. Not only because they study
financial markets extensively, but also because they use applied mathematics
in many other branches of economics.

Classroom activity 1.4


Are the following statements true or false?
1 Economics is not part of the commercial subjects. (1)
2 The study field of economics is broader than other commercial
subjects. (1)
3 Economists pay close attention to the behaviour of businesses. (1)
4 Commercial law involves studying the functioning of financial
markets. (1)
5 For an economy to work well, transactions must be legally
binding. (1)

12 • Economics: Basic concepts


Topic 1

What do I still need to know?


Relationship with other sciences and career
opportunities

Relationship of economics with other sciences


Statistics helps us to organise numerical information and draw conclusions
from the data. We do this with tables, graphs and charts and by using
statistical techniques such as regression analysis, sampling and probabilities.
An important branch of economics is econometrics, which is using
mathematics and statistics to analyse economic data. It is through these
statistical techniques that economists test many of their economic theories.

Mathematics is the study of numbers, shapes, structure and change and the
relationships between these concepts. In economics extensive use is made of
mathematics when economic models are developed.

Information technology deals with the development, implementation and


support of computer-based information systems, as well as software and
hardware issues. Economists use various software packages to collect, analyse
and present economic theories and data.

Law is a body of rules and regulations that we use to bind us together as a


society and according to which we should behave. The study of law also has
different branches: private law, commercial law, criminal law and customary
law, etc. For an economist this is an important field of study, as it determines
the environment in which economic activity and transactions take place.

Politics is the study of governments and political parties. A very close


relationship exists between politics and economics. The one cannot be studied
without taking the other into account. An important study field in economics
is public sector economics, which deals with the role of government in the
economy. Economic policy-making is also closely linked to government. There
is even a political business cycle where the action of government causes
economic activity to increase or decrease.

Sociology is part of the social sciences and so is economics. Both subjects


involved the study of human society – not of only individual actions but also
of groups and institutions and the interaction of individuals and groups.

Geography deals with the study of the earth's physical environment and
human habitat. An overlap exists with the study of economics, especially

Economics: Basic concepts • 13


when dealing with population, environmental issues and the use of natural
resources.

Career opportunities
Economics is a skill and discipline that is used in many different jobs. It can
open doors in business and finance – you could work as an economist at one
of the big South African or international banks, or for any of our large
companies in tourism, mining, agriculture, pharmaceutics, insurance, etc. You
could even work in government to make public policy decisions or become
the future Minister of Finance. What about a career with one of the large
international development agencies, such as the United Nations, the World
Bank or the International Monetary Fund? Or you could teach economics at
school or university. What about becoming a financial journalist?

Economists advise businesses


Economics is the foundation of many career options in many different fields:
l Economists are used in the formulation of all government policy and
hence you could end up formulating South Africa’s tax or expenditure
policy at national, provincial or local level.
l You could work in the banking industry where they use economists to
predict future economic outcomes, inflation and exchange rate changes,
for instance.
l You could work for various non-governmental organisations (NGOs) that
work in the field of promoting economic development and alleviating
poverty.
l All newspapers have an economics section, so you can also work as a
journalist.

There are many other career opportunities. Government departments use the
advice of economists to understand how the economy may affect them and
how they affect the economy in return. Likewise, major corporations rely on
economists to determine how local and global economics will affect them.

Classroom activity 1.5


1 Describe the relationship between politics and economics. (3)
2 What are the different career opportunities available to
economists? (3)

14 • Economics: Basic concepts


Topic 1

Homework activities
1 Why do you think the study of economics is important? (2)
2 Define the study of economics. (4)
3 What is the difference between efficiency and equality? (2)
4 Distinguish between macroeconomics and microeconomics. (2)
5 Give an example of a positive statement and a normative
statement in economics. (2)
6 Describe the relationship between economics and statistics. (2)

Extra practice
1 Why are needs and wants unlimited? (2)
2 Why do we say resources are scarce? (2)
3 Is the following statement true or false:
In macroeconomics we study the price level of all goods, while
in microeconomics we study the price of a specific good or
service. (2)
4 Can the following statement be proven correct or incorrect?
The economic growth of South Africa has declined during 2010
compared to 2009.
Is this a positive or normative statement? (2)
5 How does the work that accountants do differ from what
economists do? (4)
6 Is it possible to give everybody in our society the same things?
Should we try to give everybody the same goods and services? (2)

Economics: Basic concepts • 15


Summary
l We study economics to better understand how we as a society
can best deal with the economic problem of satisfying unlimited
needs and wants with limited resources. We must therefore not
only decide what we are going to produce, but also how we are
going to produce it and for whom. The study of economics is
therefore not only about efficiency but also about equality.
l Economics is divided into the two main branches of
macroeconomics and microeconomics. While macroeconomics
gives us an overview of the functioning of the economy,
microeconomics gives us a more detailed view. Economics is
both a social and an economic science and has strong
relationships with other sciences and subjects.

16 • Economics: Basic concepts


Topic 1
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Basic
economic problem
What will you learn about in this topic?
l Problems that all economies try to solve
l The problem of scarcity, both absolute and relative scarcity
l Alternatives, choices and opportunity cost
l Economic and free goods
l The basic economic processes of production, exchange and
consumption
l The promotion or
violation of
human rights and
the environment

Let’s talk about this topic


l What do you think it means when we say something is
scarce?
l Have you ever had to choose one thing over another because
you could not afford both?
l Have you ever wondered how we deal with the problem of
scarcity?

Basic economic problem • 17


Basic economic problem
What do I know already?
The study field of economics
Economics is the study of how we as a society (households, businesses,
government and other organisations) use our scarce resources to satisfy our
unlimited needs and wants.

k
Chec f Why is it so difficult for us to satisfy all of our needs and wants?
l Who are the important decision makers in the economy?
myse

Word bank ABC


Scarcity exists because we have insufficient resources to satisfy our needs
and wants.
Relative scarcity exists when something is relatively scarce compared to
something else.
Absolute scarcity exists when it is not possible to produce more of
something.
Opportunity cost is the best alternative you give up when you make a
choice.
Capital goods are things of value, such as machines and tools, that are
used to produce other goods.
Factors of production are used to produce goods and services.
Primary sector has to do with natural resources.
Secondary sector is where manufacturing takes place.
Tertiary sector has to do with services.
Factor market is where the factors of production are bought and sold.
Goods and services markets are where goods and services are bought
and sold.
Markets bring buyers and sellers together.
Market economy is an economy that uses markets to solve the problems
of what to produce, how to produce and for whom to produce.

18 • Basic economic problem


Topic 2

What do I still need to know?


Scarcity problem
For people to satisfy their needs and wants, they need resources to produce
the goods and services to satisfy them. However, there will never be enough
resources to meet everyone’s needs and wants. As a result, there will be a
scarcity of certain goods and services.

There are over seven billion people on our planet. Imagine the long list of
needs and wants for everyone. Now imagine trying to satisfy everyone’s needs
and wants with the resources available. For example, consider how much food
seven billion people need. On earth there is only so much land available that
can be used to cultivate the crops to feed everyone. And, to make matters
worse, what land is available is getting smaller all the time as it is increasingly
being used for other things, such as industry, cities or biofuel crops.

Scarcity forces us to make choices


It is because of the scarcity of resources that societies are forced to make
choices. We cannot produce and consume everything we want. Any society
therefore needs to answer the following fundamental economic questions:
l What goods and services will we produce?
l How will we produce these goods and services?
l Who are we going to produce these goods and services for?

Who are we
What goods How will we going to produce
and services will produce these goods these goods and
we produce? and services? services for?

Every society must answer the three fundamental economic questions

Economics gives us the tools and knowledge necessary to make these kinds of
choices. It is about deciding how best to use the available resources to satisfy
as many needs and wants as possible. Economics is therefore concerned with
the study of choices and decision-making in a world that has very real limits.
Since we live in a world of scarcity, we have to make choices all the time.
Unfortunately, these choices are not always popular or easy to make.

Basic economic problem • 19


Absolute and relative scarcity
Economics is mainly concerned with the issue of relative scarcity. When you
decide to have one thing instead of another, you are dealing with the issue of
relative scarcity. If we decide to use our resources for the production of bread,
for example, they are not available anymore to increase the production of
milk. Milk is therefore relatively scarce in relation to bread.
Absolute scarcity exists when it is not possible to increase the supply of a
good or service. It is not an issue of choice. It usually applies to goods and
services that are essential for human survival, such as water and food.
The concepts of relative and absolute are also used to describe poverty.
Absolute poverty is a measure of the level of poverty against a certain
minimum level of income that is regarded as essential to get basic goods and
services. Relative poverty is a measure of the level of poverty against another
group in society or the average income of the country. This deals with the
distribution of the wealth of a country among its population. For instance, in
rich societies a person can be regarded as poor even if the person has more
than enough to satisfy basic needs and wants, but might not have a television
or a two-bedroom house. While a measure of absolute poverty might be
earning less than $1 a day, relative poverty in the USA might be regarded as
earning less than $30 a day.

Classroom activity 2.1


1 What are the three fundamental economic questions that every
society must answer? (3)
2 Why does scarcity force us to make choices? (2)

What do I still need to know?


Opportunity cost
Because our needs and wants are greater than our resources, we must choose
which needs and wants to satisfy. Once we have chosen to satisfy a particular
need or want, we have made a choice. We have chosen to satisfy that
particular need or want instead of some alternative need or want.

We are constantly confronted by the opportunity cost of our choices

20 • Basic economic problem


Topic 2

For instance, imagine that you want a soccer ball and soccer boots, but you do
not have enough income to purchase both. If you choose to buy the soccer ball
instead of the soccer boots, then the cost of your choice is the soccer boots that
you gave up. Every choice we make involves giving something up, and this
something else or alternative is the cost of our choice. In economics this cost is
called the opportunity cost.
Because of the choices we are forced to make, we are always trading off
options and alternatives. For example, imagine that you have a test tomorrow,
and that you only have this afternoon to study. However, you would really
like to play soccer this afternoon, as you are trying to get on the school team.
You therefore face a choice – if you choose to play soccer, you will have less
time to study, and you will probably get a lower grade for your test. If you
miss playing soccer you will have more time to study and will probably get a
higher grade, but you may not get a place on the soccer team. Your limited
resource of time therefore puts a constraint on what you can and cannot do.

Everyone faces an opportunity cost


Everyone faces an opportunity cost when they make choices and decisions –
even the richest people in the world. Being rich may mean that you can have
as much of anything as you want, but you still have to make choices, e.g. are
you going to drive your new sports car or fly your helicopter to work? You
cannot do both at the same time.

Everyone faces an opportunity cost

Can you now see that you have to make decisions and choices all the time as
you try to manage your limited resources to satisfy your unlimited wants?
Economics takes this one step further by looking at how a society manages its
resources to satisfy its unlimited needs and wants.

Government must also make choices, as it has limited resources

Let’s look at how these questions affect government. Government has to decide
all the time how to spend limited resources (the revenue that has been raised
through taxation). Decisions must be made on how to allocate this revenue

Basic economic problem • 21


between competing needs, for example housing and education. They also have
to consider how it will influence how much is available for defence or health
care. As you know, the state cannot increase its spending on everything,
because there are limited resources available. This is what economics studies.
Economists can help government officials make these decisions because
economics provide the tools to quantify (measure) the costs and benefits of an
action, thereby making informed decisions about the best way forward.
A business also faces opportunity cost. Should it produce fried chicken pieces or
fried chicken burgers? How should it produce the goods and services? Should it
make use of more labour or more capital? If the business decides to produce
fried chicken pieces, the cost of doing that is not producing fried chicken burgers.

Opportunity cost is the cost of the best alternative


To emphasise the point that all resources are scarce and that the use of resources
is never without a cost, even if it is free, economists use the TANSTAAFL
principle. TANSTAAFL stands for There Ain’t No Such Thing As A Free Lunch.

Accounting costs vs opportunity cost

In economics the opportunity cost of any decision is the value of the best
alternative that is given up because of that decision.
It is not all the alternatives that are given up, but only that thing you really wanted
but chose not to have. Even if you are given something for free it does not mean it
did not cost something. We could have produced something else instead – it is this
something else that is the cost of the goods or service you have received for free.
Can you see that opportunity cost differs from accounting costs? While the
accountant calculates what something actually costs in rand, the economist
estimates it in terms of the best alternative that was given up.

Classroom activity 2.2


1 What is your opportunity cost for being in the classroom? (1)
2 Provide a definition of opportunity cost. (2)
3 Give an example of an opportunity cost that a business faces. (2)
4 Why do we say in economics that nothing is free? (2)

22 • Basic economic problem


Topic 2

What do I still need to know?


Free goods and economic goods
Goods refer to tangible things – the things that you can see and touch, such as
food, radios, gold, tractors and this book. But there are also many different
types of goods. Services on the other hand are intangible – you cannot see or
touch them. Examples include financial services, medical services, catering
services and teaching services.

Free goods are useful to people and they satisfy important needs and wants,
but they are not scarce. They are usually gifts of nature and there is an
abundant supply, such as fresh air, sunshine and sea water. These goods do
not belong to anybody and as long as there is an abundant supply of them,
people will not be prepared to pay for them.

Economic goods are goods that are produced using scarce resources. They can
command a price in the market and are usually owned by somebody.
Economic goods are also called scarce goods and we can distinguish between
different kinds of goods.

Consumer goods

Capital goods Consumer goods


Capital goods and consumer goods
Consumer goods are the goods used by households to satisfy their wants,
such as food, cars, clothing and appliances. There are three main categories of
consumer goods:
l Non-durable goods are goods that can only be used once, such as food,
drink and petrol.
l Semi-durable goods are goods that can be used more than once but last
for a limited period, such as clothing and car tyres.
l Durable goods are goods that last for many years and include fridges,
stoves, furniture and cars.

Capital goods
Capital goods are used for the production of other goods. Capital goods are
not consumed to satisfy wants, but are used to produce other goods, e.g. the

Basic economic problem • 23


machinery used for manufacturing or farming and the buildings used for
offices. They are very important goods because they allow people to produce
those goods that satisfy consumer wants and needs.

Private goods and public goods


Private goods are consumed and owned by households. For example, if a
household buys a chair, they then own it and can stop other people from
using it. Can you think of some other goods that you own and can stop other
people from using?

Public goods are the goods that are collectively consumed and owned by
communities. These goods are supplied by the government. Examples of
public goods are roads and street lights.

Classroom activity 2.3


1 Differentiate between free and economic goods and give an
example of each. (4)
2 Distinguish between durable, semi-durable and non-durable
goods and give an example of each. (6)
3 Give examples of a consumer good, a capital good and a public good. (3)

What do I still need to know?


Production
Goods and services must be produced to satisfy needs and wants. The ultimate
aim of production is to provide society with goods and services so that they can
satisfy their needs and wants. It is mainly businesses that are responsible for the
production of goods and services in our country, and they must make a number of
important decisions. One decision is how the goods and services will be produced.

Resources Production Consumer goods Consumers

The ultimate aim of production is to satisfy needs and wants

24 • Basic economic problem


Topic 2

All goods and service need resources to be produced. These resources are
called the factors of production. Through the process of production, the factors
of production (the resources) are combined to produce goods and services. It is
possible to produce the same product by using different combinations of
factors of production. For example, a house can be built with bricks, wood,
straw, concrete or even glass. Different kinds of tools can also be used to build
this house; the mortar can be mixed by hand or by machines, for instance.

Sometimes a decision on how to produce something is easy – it is not a good


idea to build a house with gold bars. But most of the time these decisions are
more complicated. Should the house be built with bricks, wood or concrete
blocks? Because the factors of production are scarce, these decisions are
important – production must be efficient and use these resources effectively.
As you know, the more effectively and efficiently resources are used, the more
goods and services can be produced, and the more needs and wants can be
satisfied. So the efficient and effective use of the factors of production
contributes to economic growth and the wealth of an economy.

Factors of production
There are four main factors of production: natural resources, labour, capital
and entrepreneurial ability.

Natural resources include land, water, mineral deposits and the environment.
In other words, they are all the resources that exist naturally. Most natural
resources are limited, but with the aid of technology natural resources can be
made more efficient. For example, fertilisers have improved the quality of
land, making more land available for agriculture. Better drilling technology
has opened up oil deposits in frozen areas such as Alaska. Nevertheless, as
natural resources are limited (in fixed supply), the exploitation of natural
resources must be carefully considered. Over-exploitation can cause
environmental damage as well as long-term economic and human suffering.

Labour is the human effort that is put into the production of goods and
services, and includes both physical and mental work. For example, the
writing of this book took both physical work – typing – and mental effort –
using the brain for research and creativity. When we talk about labour, we
need to separate it into the quality and the quantity of labour:

Labour is any mental or physical effort

Basic economic problem • 25


l The quantity of labour is the size of a population or the number of people
who are of a working age (15–64 years old), and who are willing and able
to work.
l The quality of labour refers to the skills, knowledge and health of workers.
The quality of labour is also often called human capital. Human capital is
becoming increasingly important in modern production processes. Why
do you think this is?

Capital is items like factory buildings, machines and tools that are used in
producing other goods and services. The characteristic of a capital good that
makes it different from other goods is that it is created with the specific aim of
producing goods and services. Note that this is different from financial
capital, which is the money needed to purchase these real capital goods. It is
not money that is directly used in the production of goods and services, but
these buildings, machines and tools.

Entrepreneurial ability is linked to labour. Entrepreneurs are people who


take calculated (planned) risks and seize opportunities as they arise. They are
the people who have foresight (judgement to think and plan before an event),
and so invest in new things (products, services, markets). Entrepreneurs are
the people who open up new doors for humankind. They do not do this
because they like to do good deeds; they do this to make profits. However, the
chances they take are risky, because they can lose a lot of money by investing
in untested things. The company that first developed a fax machine gave up
their rights to the technology because they were unwilling to take the risk of
further development – they weren’t sure if there was a market for their
product. Today we know what a mistake this company made. But the point is
that at the time, the company had no evidence that people would buy fax
machines. So an entrepreneur stepped in and the rest, as they say, is history.

One of the fundamental problems in the South African economy is the lack of
entrepreneurs. Only about 7% of South African adults are engaged in
entrepreneurial activity and working for themselves. Given the high levels of
unemployment in South Africa, we will need many more entrepreneurs in the
economy.

Now that you know what the factors of production are, let’s think about how
production should occur. To do this, we must consider which factors of
production are available. For example, if there is an abundance of labour but a
shortage of capital, then it would be best to focus on labour-intensive rather
than capital-intensive techniques. If a country has little land available for
growing crops, then they would have to make sure that this land is used as
intensively as possible.

26 • Basic economic problem


Topic 2

This is why different countries in the world specialise in producing certain


goods and services – they try to use the factors of production available to
them as efficiently and effectively as possible. The aim of using available
resources efficiently is very important in any economy – the more efficient an
economy is in using its factors of production, the more goods and services it
will be able to produce, and the more it will be able to satisfy the needs and
wants of its citizens.

What are we producing?


Our production can be divided according to the sector of the economy it
originates from:

Primary sector Secondary sector Tertiary sector

Activities extracting Resources from the primary Activities related to the


natural resources from sector are processed into a supply of services
nature more acceptable form for
human use

Examples: Examples: Examples:


Agriculture The manufacturing sector Trade
Forestry Electricity, gas and water Transport
Fisheries Construction Storage and
Mining communication
Stone quarries Finances and insurance
Community welfare and
local authority services

By comparing the production in the different sectors over the years, we can
see how production in South Africa has changed:
l Primary sector – The contribution of this sector declined from 49% in
1911 to 8% in 2009. The decline in the contribution of agriculture is
particularly noticeable. The contribution of mining also shows a marked
decline from 1911 to now. However, in contrast to many other countries,
mining continues to play a major role in the South African economy
today.
l Secondary sector – This sector’s contribution increased significantly from
5% in 1911 to 22% in 2009. The contribution of the manufacturing industry
in particular shows a marked increase.
l Tertiary sector – The contribution of this sector increased from 46% in
1911 to 69% in 2009.

Basic economic problem • 27


Classroom activity 2.4
1 Name the four factors of production and give an example of each. (8)
2 Give an example of the production that occurs in the primary
sector, secondary sector and tertiary sector of the economy. (3)
3 Why is it important that we make efficient use of the factors of
production? (4)

What do I still need to know?


Exchange
Our economy is mainly an exchange economy. Exchange is the phase between
production and consumption and involves voluntary transactions between
producers and consumers.

Workers exchange their labour for income. Income is then exchanged for
goods and services to satisfy needs and wants. All these exchanges take place
in markets. We exchange our labour for income on the factor market and our
income for goods and services on the goods and services market.

A market brings buyers and sellers together to establish a price. For a market
to exist there must be at least a seller who has something to sell and a buyer
who wants and can afford to buy this good or service.

As societies have become more sophisticated, markets too have become more
complex. Markets today are linked globally. A market in Johannesburg can be
linked to a market in New York. Technology now allows people to exchange
goods without ever meeting or being physically present. Exchange now
happens through technology or economic agents. For example, a rooibos
farmer in Citrusdal sells his rooibos to an agent in Johannesburg. This agent
then exports the rooibos to a wholesaler in the USA who sells the rooibos to a
tea shop in New York. The tea shop sells the rooibos to customers, which is
the final market, unless one of the customers runs a restaurant. Then the
rooibos will be served in the restaurant – and this is yet another market.

Another example of a modern market is the internet. There are some auction
(public sale) sites that allow sellers to auction goods and services to the
highest bidder. Again, in this market buyers and sellers do not meet, but the
truly interesting thing is that a market does not even have to be a physical
place – it can just be an abstract space such as the internet.

28 • Basic economic problem


Topic 2

Technology has changed the way people buy and sell

Not only goods are sold in markets and the service sector now makes up a
large part of many economies worldwide. In some countries the value of the
trade in services is more than that of goods. Examples of service sector
industries are tourism, banking and insurance. Can you think of any others?

A market economy is an economy dominated by buying and selling with little


interference from government. It uses markets to solve the economic problem
of what, how and for whom to produce. It is through the prices of goods and
services that the message of what to produce, how to produce and for whom
to produce is sent through the markets. And as you will see later, prices are
determined by demand and supply in a market.

Price changes are an important way that businesses decide on how much or
how little of a product they should produce. An increase in the price of a
product usually tells businesses to produce more of a product, but a decrease
in the price tells businesses to produce less. Likewise, price changes also tell
individuals and households if they should use more or less of a product.
Usually, an increase in the price of a product tells consumers that the product
is now scarcer, and that they should use less of it. A decrease in the price will
tell consumers to use more of a product.

Classroom activity 2.5


1 What is the role of markets in an economy such as South Africa? (2)
2 What will producers do if the price of a product increases in a
market? What will consumers do if the price increases? (4)
3 How does the market for goods differ from the market for
services? (2)

Basic economic problem • 29


What do I still need to know?
Consumption
The aim of all production is to supply households with goods and services
that they can use to satisfy their needs and wants. The process of satisfying
our needs and wants is called consumption. This is why members of
households are often referred to as consumers.

If one looks at the statistics for household spending in South Africa for 2009,
it gives us a picture of how households spend their income:
l 7,1 % of our income was spent on durable goods.
l 9,1% of our income was spent on semi-durable goods.
l 39,5% of our income was spent on non-durable goods.
l 44,3% of our income was spent on services.

It is through our spending that the question of what to produce is answered.


Producers produce according to what households spend their income on.
As we change our spending habits, this changes the production of goods and
services. Production follows the spending of income.

For whom to produce


A question related to consumption is how the goods and services produced
are distributed among households. Another way of asking this question is to
ask whose wants should be satisfied. As you can imagine, this is a sensitive
issue and actually a question of normative economics. It is about how we
think things should be.

In a market system, people get an income by taking part in the process of


production, for example by selling the factors of production to producers.
So people who sell more of a resource, or who sell a resource that is more
valuable, will earn a very good income. The better people’s income is, the
more goods and services they will be able to afford, and the more they will
be able to satisfy their needs and wants.

Classroom activity 2.6


1 What do we mean if we say ‘Production follows the spending
of income’? (3)
2 To satisfy their needs and wants a household needs an income.
In South Africa there are many poor households. How can we
help them to satisfy their needs and wants? (4)

30 • Basic economic problem


Topic 2

What do I still need to know?


Human rights and the environment
Because economics is a social science that studies human needs and wants, it
is not only about choices, production systems and constraints but also about
people. The human side of economics is very important because all economic
outcomes affect the quality of life for people and their ability to feed and
educate themselves. Economics is therefore also about the dignity of all human
beings.

Is this sustainable?

Economics can create or limit opportunities for people, and for this reason
many believe that it should also be about promoting development. The overall
goal of development is to create a sustainable (continuing) living standard for
all. But development is slightly different from economics. Development
stresses a form of economics in which production is geared towards giving
people more choices and opportunities. It is about creating jobs, ensuring
good health and access to quality education, guaranteeing good nutrition and
thus restoring the dignity of all people.

Fundamental human rights


Economic development is based upon three core human rights:
1. Basic needs – all people have a basic need for food, shelter and health.
Without these, they cannot live. The main purpose of all economic activity
must therefore be to provide as many people as possible with the means to
meet these basic survival needs.
2. Self-esteem – all people have the right to respect, recognition, dignity and
a future.
3. Freedom – all people have a basic, human right to be free from poverty,
ignorance and ownership by another (slavery).

How can economics be part of ensuring these fundamental human rights? The
most important thing that economics can do is to contribute towards creating
a better life for all by providing more opportunities. It can do so by expanding

Basic economic problem • 31


economic wealth, thereby increasing the range of choices that people have.
Economics cannot make everything equal, but it can try to make sure that
everyone has access to resources to satisfy their basic needs.

Economics and the environment


Humankind has disregarded and exploited the earth for far too long. We have
taken the environment for granted, using up resources without considering
the consequences. Earlier you learned about land and natural resources as a
factor of production, and how natural resources are limited and non-
renewable. For example, the supply of oil is limited and once it is used up
there will be no oil left. We may be able to find alternatives for many natural
resources, such as alternative sources of energy, but we usually only start
doing this when our planet’s natural resources are almost all gone.

World leaders have committed themselves to the principle of sustainable


development. This means that they will ensure that progress meets the needs
of the present generation without compromising the ability of future
generations to meet their own needs (World Bank, 2002: 14). It recognises that
all resources are limited and that if people use resources at a rate that is not
sustainable, the future of our world, its people and the environment will be
destroyed. The economic necessity of satisfying human wants and needs
cannot and must not be done by ignoring the impact of economic activity on
future generations and their ability to make and have choices.

The key question that we are now confronted with is whether we are able to
increase prosperity for all people without destabilising the environment. This
is an enormous challenge, but one that must be faced. All economies must
adopt a win-win strategy – a strategy that allows us to preserve natural assets
while increasing the opportunities and living standards of all people. Our
choices do not have to be a case of either/or. In fact, the best way to deal with
poverty is to look after the environment, because it is the only long-term
sustainable solution.

Classroom activity 2.7


1 What does the following statement mean? ‘Economic development
is not just about the production of goods and services.’ (2)
2 Do you think the world is taking sustainable development
seriously? Motivate your answer. (4)

32 • Basic economic problem


Topic 2

Homework activities
1 Are the following statements true or false?
a) Scarcity is a problem experienced only by poor countries. (1)
b) Opportunity cost is the cost of the best alternative that is
given up. (1)
c) If government provides free education to its citizens, there
is still an opportunity cost associated with the provision of
education. (1)
d) Capital goods are goods that are consumed by households. (1)
e) A market must be in a specific place. (1)
f) An ice cream is an example of a non-durable good. (1)
2 How does opportunity cost differ from accounting cost? (2)
3 What are the three fundamental economic questions? (3)
4 Differentiate between the production, exchange and consumption
processes. (5)
5 What is meant by sustainable development? (4)

Extra practice
1 Briefly describe how a market economy deals with the question:
‘For whom do we produce?’ (2)
2 a) Did you make a choice recently for which you had to give
something up?
b) What was it that you had to give up?
c) What is the opportunity cost of the choice you made? (2)
3 To produce a wooden table you need the following: wood, saw,
carpenter, hammer, nails and a person who decides to produce
and sell the table. Name the factors of production these items
represent. (4)
4 Discuss the consequences for future generations if we do not
take sustainable development seriously. (4)

Basic economic problem • 33


Summary
l All societies, poor and wealthy, face the problem of scarcity.
This forces us to make choices about what to produce, how
to produce and for whom to produce. Every choice we make
involves a cost, the opportunity cost, which is the best alternative
we give up. It is this opportunity cost that we study in
economics.
l Economics also concentrates on the study of economic goods
(also called scarce goods). Examples of economic goods are
consumer goods, capital goods and public goods.
l In a market economy we can differentiate between three
processes: production, exchange and consumption. The
production of goods and services requires the factors of
production and it is during this process that the question of
how to produce is answered. During the exchange process the
goods that were produced are consumed by households. This
happens through markets. During the process of consumption,
households exchange their income for goods and services,
and the questions of what to produce and for whom to produce
are answered.
l During this cycle of production, exchange and consumption the
quality of life, human rights and the environment are all affected
and it is important to take these effects into account.

34 • Basic economic problem


opi
T
c
3 Circular flow and
quantitative elements
What will you learn about in this topic?
l Who the main participants in the circular flow are
l Product and factor markets
l How real and monetary flows influence the circular flow
l Diagram and interactions of the circular flow model
l How leakages and injections influence the circular flow
l How the variable flows of spending, production and income
influence the circular
flow
l Definitions of gross
domestic product (GDP)
and gross national
income (GNI)
l Composition,
importance and
comparison of GDP
and GNI

Let’s talk about this topic


l Who do you think are the major role players in the economy
(i.e. who makes important decisions in the economy)?
l How do you think the decisions by the major role players
impact on the economy?
l Why do you think it is important to measure the performance
of the economy?
l Who do you think is responsible for measuring economic
activity?

Circular flow and quantitative elements • 35


Circular flow
What do I know already?
The basic economic problem
The basic economic question that all societies must answer is how to use their
scarce resources to satisfy their unlimited needs and wants. In a market
economy this answer is provided by making use of different markets in which
various participants play an important role.

k What are the three economic questions that must be answered by


Chec f all societies?
l
myse Name the four factors of production in a market economy.

Word bank ABC


Circular flow is the flow of production, income and spending that take
place in an economy.
Households are groups of people that live together and make economic
decisions.
Business enterprises are the producers of goods and services.
The public sector consists of all levels of government and state-owned
enterprises.
Foreign sector are all the other countries in the world.
Savings is the difference between income and spending.
Investment is the creation of capital goods.
Income taxes are the taxes paid by households and business enterprises on
their income.
Exports are goods and services we produce and sell to the rest of the
world.
Imports are goods and services we buy from the rest of the world.
Factor market is the market where the factors of production are bought
and sold.
Real flows are the flows of physical goods, services and factors of
production.
Nominal flow is a flow of money.
Goods market is the market where goods and services are bought and
sold.
Aggregation is adding things together.
Financial market is the market where savings and loans occur.
Surplus units are the savers in the economy.
Deficit units are the borrowers in the economy.

36 • Circular flow and quantitative elements


Topic 3

Flow of factors of production is the flow of labour, capital, land and


entrepreneurship in the economy.
Flow of income is the flow of payment in the form of wages and salaries,
rent, interest and profits.
Flow of spending is the flow of spending on goods and services.
Flow of production is the flow of goods and services that are produced.
Leakages are any factors that decrease the flow of spending.
Injections are any factors that increase the flow of spending.

What do I still need to know?


The main participants in the circular flow
An economy is a complex system and it is impossible to model or even
describe all the different forces that impact on the level of economic activity.
To understand what determines the level of economic activity we must
simplify things by concentrating on the most important forces that shape our
economy. The circular flow model is such a simplification.

In this model the interaction and interdependence between the major


participants (households, business enterprises, government and foreign
sector) in the various markets (factor, goods and financial) are captured and
explained.

You will learn how the decisions that these participants make and the way in
which they interact with one another impact on the economic life of every
individual in our society. You will also see how the decision of one participant
in the economy will impact on and cause a reaction in the behaviour of
another participant, and the influence it has on the level of economic activity.

The main participants


The main participants in the circular flow model are households, business
enterprises (also called firms), the public sector and the foreign sector:
l Households are all the people who live together and who make joint
economic decisions. Your family is a household; a person who lives on
his/her own is a household. A commune of friends who live in one house
and who share their expenses is also a household.
l Business enterprises or firms are the units that employ the factors of
production to produce the goods and services that are sold on the goods
market. An important aim of a business is to make a profit through selling
goods and services. There are many different forms of businesses, such as
sole proprietors, partnerships and private and public companies.

Circular flow and quantitative elements • 37


l Public sector is a broad
term that includes all
aspects of local, regional (or
provincial) and national
government and everything
that is owned by
government as the
representative of the people.
l The foreign sector consists
of all the countries in the Businesses
Households
rest of the world. It includes
the international institutions
that govern the flow of
goods and services and the
flow of funds between
different countries. Public sector

It is the decisions made by the Foreign sector


main participants that will have The important decision makers in the economy are households, businesses,
a major impact on the economy the public sector and the foreign sector
and we must take a closer look
at them.

Classroom activity 3.1


Name the four major participants in the economy and give an example
of each. (8)

What do I still need to know?


The role of households in the circular flow

Households own the factors of production


In a market economy, households are the biggest owners of the factors of
production. They own all the labour and entrepreneurship and most of the
capital and natural resources (land).

Even though businesses own the capital goods (the buildings, factories, tools
and machines), these businesses are in return owned by households through
the shares they have in them. Some households may own only a few hundred
rands’ worth of shares, while others may own thousands or millions of rands’
worth of shares in a company. The point is that businesses are legal entities

38 • Circular flow and quantitative elements


Topic 3

that are owned by people (households). These households own a firm’s capital
goods and have a right to its profit in the form of dividends.

Households make these factors of production available to the economy where


it is used to produce goods and services. In exchange for the use of the factors
of production, households receive an income in the following forms:
l Salaries or wages for their labour
l Interest on their capital
l Rent for natural resources such as agricultural land
l Profit from entrepreneurial activities.

The most important source of income for households in South Africa is the
wages and salaries they receive in return for their labour services. To earn an
income, households must therefore take part in the production of goods and
services. This is an important decision that households must make. The more
factors of production a household owns, and the more valuable the factors of
production, the higher the income of the household.

Households use their income to buy goods


and services
In an economy, the primary or main aim of households is to maximise their
satisfaction. Households try to maximise their satisfaction by using their
income to buy consumer goods and services that satisfy their needs and
wants. They are therefore not only the owners of the factors of production but
also the consumers in our society.

If one looks at the statistics for household spending in South Africa for 2009 it
tells us that households spend:
l 7,1 % of their income on durable goods
l 9,1% of their income on semi-durable goods
l 39,5% of their income on non-durable goods
l 44,3% of their income on services.

If you think back to the basic economic questions of what, for whom and how
to produce, you will immediately recognise the importance of households. It
is the households, through their income and spending, that determine what is
produced and for whom these goods and services are produced. What
households (consumers) want and can afford (their demand) determines what
businesses will produce.

Circular flow and quantitative elements • 39


Households save
Savings is the difference between income and spending. The part of income
that a household does not spend is its savings.

There are different reasons why households save. Some households save for a
rainy day – that is for those unforeseen events such as the car breaking down
or medical expenses. Sometimes households save for specific events –
birthdays, graduations, holidays or for a deposit to buy a house. Another
important reason why households save, and should save, is to provide for an
income when working members retire.

Classroom activity 3.2


Consider the following example:
Asanda is a single woman living on her own and is employed by ABC
Manufacturers as an accountant. Every month she is paid R10 000, of
which she spends R9 000 on goods and services and saves R1 000.
1 Is Asanda part of a household? Motivate your answer. (2)
2 What factor of production does Asanda sell to the firm? (2)
3 What kind of income does she receive from the firm? (2)
4 How much does it cost the firm to employ her? (2)
5 What does Asanda do with the income she receives from ABC
Manufacturers? (2)
6 If Asanda buys a television, is it an example of durable goods,
semi-durable goods or non-durable goods? (2)

What do I still need to know?


The role of business enterprises

Business enterprises produce goods and services


Business enterprises or firms are responsible for the production of goods and
services. The bulk of the goods and services in South Africa are produced by
privately owned businesses and they are therefore important decision-makers
in our economy.

Businesses do not only produce the consumer goods and services that
households want. They also produce the capital goods (factories, machines
and tools) that are used in the production of consumer goods and services.
This creation of capital goods is known as investment.

40 • Circular flow and quantitative elements


Topic 3

In 2009, 61,39% of gross fixed capital formation (investment) in South Africa


originated from private business enterprises, which makes this a very
important sector of the South African economy. One may therefore expect
changes in the investment behaviour of private businesses to have a major
impact on the economy.

Looking back at our economic problem of what, how and for whom to
produce, businesses are responsible for the ‘how to produce’ and they are
continuously searching for ways to make the production of goods and
services more efficient. This is important, because our resources are scarce
and we cannot afford to waste them.

Business enterprises pay for the use of the factors


of production
Businesses need factors of production to produce goods and services. These
factors of production are owned by households. In return for the use of the
factors of production, businesses pay households wages and salaries for
labour, interest for capital, rent for land and profits for the entrepreneur. This
is part of the cost of production for the businesses.

Classroom activity 3.3


Consider the following example:
ABC Manufacturers produces clothes and Boab Industries produces
machines.

Are the following statements true or false?


1 Both ABC Manufacturers and Boab Industries are part of the
businesses in the economy. (1)
2 ABC Manufacturers produces capital goods while Boab
Industries produces consumer goods. (1)
3 If ABC Manufacturers increases its production of clothes it
will employ more factors of production. (1)
4 When ABC Manufacturers employs more factors of production,
the income paid to the factors of production increases. (1)

Circular flow and quantitative elements • 41


What do I still need to know?
The role of government and the foreign sector

Government is an important spender in the


economy
Government provides goods and services to households and businesses in the
form of protection services, social services and economic services.
l Protection services consist of spending on defence and intelligence, police,
prisons and justice to promote social order and stability.
l Social services include spending on education, health, social security and
welfare, housing and community development to promote the quality of
life in South Africa.
l Economic services include spending on infrastructure such as roads and
railways to improve the productive capacity of the economy.

Social services Protection services Economic services

The government is a big spender in the economy

In 2009 government accounted for approximately 21,10 % of the total


spending in South Africa, which amounted to R1 473 490 million.

Government taxes households and businesses


To finance its spending, government needs revenue, and the most important
source of revenue for government is taxes. These taxes are paid by households
and businesses and we can distinguish between the following taxes:
l Income taxes are taxes on the income and wealth of households and
businesses. Personal income taxes paid by households are a very
important source of revenue for government.
l Taxes on goods and services are usually paid by the consumers of these
goods and services. Value added tax is an example of this tax.

42 • Circular flow and quantitative elements


Topic 3

Foreign sector
Over the past few years the economies of different countries have become
much more integrated and dependent on each other and we see a much
higher level of interaction between countries. It can be said that the world is
increasingly becoming a global village where a change in one part of the
village affects many other parts of the village. Fundamental changes in trade
flows (the flow of goods and services between countries), financial flows (the
flow of money between countries), the exchange of technology and
information, and the movement of people between countries have led to this
increased level of integration and interdependence. The term ‘globalisation’
is used to describe this higher level of integration between countries.

South Africa is an open economy. This means that it does a lot of business
with the rest of the world, and international trade therefore has a very
important impact on the South African economy.

We sell goods and services to the rest of the world


Many goods and services produced by businesses in South Africa are sold to
other countries. These goods that we sell to the rest of the world are called
exports and they include minerals, cars, food and chemicals.

We buy goods and services from the rest of the world


Households, businesses and government also buy many goods and services
from other countries. These goods that are produced in the rest of the world
are called imports. South Africa’s imports consist mainly of capital and
intermediate (semi-final) goods, which are used to produce goods and
services.

Classroom activity 3.4


1 Give an example of the protection, social and economic services
that government provides to households and businesses. (2)
2 Distinguish between income taxes and taxes on goods and
services. (2)
3 Explain why South Africa is regarded as an open economy. (2)
4 Distinguish between exports and imports. (2)

Circular flow and quantitative elements • 43


What do I still need to know?
The major markets in the economy
The major markets that play an important role in our circular flow model are:
l the factor market
l the goods and services or product market
l the financial market.

The factor market


The factor market is the market where the factors of production are
exchanged for income. It is through this market that households supply
businesses with the factors of production in exchange for an income in the
form of wages and salaries, interest, rent and profits.

Real and monetary flows in the factor market


Two flows occur through the factor market – a real flow and a monetary or
nominal flow.

The real flow is the flow of the factors of production – the quantity of labour,
capital, land and entrepreneurship. The monetary flow is the flow of income
in terms of money. In other words, the amount that is paid in wages and
salaries, interest, rent and profits. Another thing to notice is that these flows
are in opposite directions. If the real flows increase (more factors of
production are flowing to businesses), the monetary flow increases as well
(more income is flowing to households).

Goods or product market


There are literally thousands of different producers of goods and services and
millions of different consumers of these goods and services in the economy. In
macroeconomics all these different markets for goods and services, which
include both the producers and the consumers, are grouped together under
the heading of the goods market. In economics this grouping together is
called aggregation.

Do you remember the main difference between macroeconomics and


microeconomics? Macroeconomics studies the aggregate of all these markets –
the goods markets. Microeconomics studies each of the markets individually.

It is in the goods market that households (consumers) buy their goods and
services and the producers supply their goods and services.

44 • Circular flow and quantitative elements


Topic 3

Real and monetary flows in the goods market


Two flows occur through the goods market – a real flow and a monetary flow.

The real flow is the flow of goods and services from businesses to households,
while the monetary flow, in the opposite direction, is the spending by
households on the goods and services supplied by businesses.

Something interesting to note is that the spending by households on goods


and services becomes the revenue of the businesses (their income). Businesses
then use this revenue to pay for the factors of production.

The financial market


This market consists of institutions such as banks, insurance companies and
the Johannesburg Securities Exchange. The financial market or sector is not
directly involved in the production of goods. Rather, its role is to channel
(direct) funds from surplus units to deficit units in an economy.

Savers Financial institution Borrowers

Financial institutions channel funds from surplus units to deficit units

l Surplus units are those households and businesses in an economy that


do not spend all their income. They are also called the savers in an
economy.
l Deficit units are households, businesses and government in an economy
that are looking for more funds, e.g. because they have overspent or
because they need more money to invest. They are also the borrowers in
an economy.

Surplus units or savers deposit their surplus funds with institutions in the
financial markets, such as banks. The institution then uses this surplus to lend
money to those deficit units that qualify for credit or a loan.

Circular flow and quantitative elements • 45


Classroom activity 3.5
Indicate in which market the following takes place and whether it is a real
or monetary flow:
1 Mr Dlamini decides to accept a job offer from ABC Manufacturers. (1)
2 ABC Manufacturers pays rent of R50 000 per month to Ms Naidoo. (1)
3 Mr de Klerk decides to save R150. (1)
4 ABC Manufacturers produce a new range of clothing, which
they supply to the market. (1)
5 Mrs Tshaka buys clothes for her family. (1)

What do I still need to know?


A simple circular flow model between households
and businesses

Factors of production
Income

Businesses

Figure 3.1: Flows between households and businesses

From households to businesses there is a flow of factors of production in the


economy, as illustrated by the top dotted purple line in Figure 3.1. Between
the business and the household a flow of income occurs, as shown by the
purple line in the diagram. These flows occur through the factor market,
indicated by the purple circle.

Note that the flow of income is in the opposite direction of the flow of the
factors of production and that the flow of the factors of production is a real
flow and the flow of income is a monetary flow.

Between the household and the business a flow of spending occurs, as


indicated by the bottom purple line in the diagram. This flow of spending by

46 • Circular flow and quantitative elements


Topic 3

households is called consumption spending. Businesses supply households


with goods and services. This is shown by the bottom dotted purple line in
the diagram. Businesses are therefore part of the flow of production.

This flow of spending by households and flow of production by businesses


take place in the goods market, which is the black circle in the diagram.
Note that the flow of spending is in the opposite direction of the flow of
production. The flow of spending is a monetary flow and the flow of
production is a real flow.

Simplifying the model


To build a manageable circular flow model that shows the interaction between
all the different participants, we must simplify things a bit further by
concentrating only on the monetary flows. This involves presenting Figure 3.1,
which shows the real and monetary flows and the different markets, as a
model showing only the monetary flows, as indicated in Figure 3.2.
Remember that behind the monetary flows there is a real flow in the opposite
direction and these flows occur in the factor market and the goods market.

Income

Households Businesses

Consumption spending
Figure 3.2: Monetary flow between households and businesses

Classroom activity 3.6


1 Draw the simplified circular flow model and show what happens
with the flow of income and flow of spending if:
a) business enterprises increase their production
b) households increase their spending. (4)
2 What happens to the real flows in the goods market and the
factor market if:
a) business enterprises increase their production
b) households increase their spending. (4)

Circular flow and quantitative elements • 47


What do I still need to know?
Leakages and injections

Income

Households Businesses
Leakage

Injection
Consumption spending

Savings Investment

Figure 3.3: Leakages and injections

Savings are a leakage


You have learned previously that households not only spend but also save
some part of their income. The part that households save is therefore a
leakage, as it decreases the spending flow.

For example, if the income that households receive from businesses is


R100 million and they save R20 million, then their spending is R80 million.
The R20 million is a leakage, because all of their income does not return as
expenditure to the spending flow. These savings by households flow to the
financial market.

Investment is an injection
Investment is an injection and the financial market plays an important role
concerning this. The financial market channels the savings from households
(which are considered a leakage) to businesses in the form of loans, which
they then use to finance their investment spending. Investment spending is
the production of capital goods. As these goods are produced, more factors of
production are employed and the income flow to households increases.
Investment spending is therefore an injection into the circular flow, as it
increases the spending flow.

48 • Circular flow and quantitative elements


Topic 3

Classroom activity 3.7


1 Given the following information, draw a circular flow model to
show these flows:
a) Income flow is R100 million.
b) Spending flow by households is R80 million.
c) Investment spending is R20 million. (6)
2 Use your circular flow model to illustrate what happens if
investment spending increases by R10 million. (4)

What do I still need to know?


Changes in the flow of spending, production and
income

Business enterprises increase their production


As business enterprises produce more goods and services, the flow of
production in the economy increases. To increase their production, businesses
will need more factors of production. Where are the businesses going to get
more factors of production? They are going to buy it from the households who
own the factors of production. As businesses buy more factors of production,
income flows from businesses to households increase. This increase in the
incomes of households will cause an increase in their spending and so the
spending flow from households to businesses will increase in return.
Remember that the spending of households is also the income of the
businesses, which then becomes spending again – to produce more goods and
services. So the circular flow continues.

Households increase their spending


As households increase their spending, they demand more goods and
services. In our diagram the spending flow increases. What do you think
businesses are going to do given this increase in the demand for goods and
services? They will respond by increasing the production of goods and
services so that the production flow to households increases. To increase the
production of goods and services, businesses will employ more factors of
production. There is therefore also an increase in the flow of income from
businesses to households.

Circular flow and quantitative elements • 49


Labour decides to go on a strike
Labour is now withdrawing their services and consequently the level of
production falls and the flow of production declines. If the principle ‘no work
no pay’ applies, then the flow of income to households decreases. And as we
know, a decrease in the income flow leads to a decrease in the spending flow.

These three examples illustrate the interaction and interdependence between


businesses and households in the economy.

Classroom activity 3.8


Explain why the flow of income and spending decreases if businesses
produce fewer goods and services. (4)

What do I still need to know?


Adding government to the circular flow

Disposable income Income


Leakage
Taxes

Government spending
Households Injection Businesses

Injection
Leakage

Government

Consumption spending
Savings Investment

Figure 3.4: Circular flow between households, businesses and government

Government spending is an injection


Government has to supply households and businesses with goods and
services, such as education, health services, defence, law and order, roads and
dams. To provide these goods and services, government buys other goods and
services from businesses and the spending flow in the economy increases. As
a result, businesses will produce more goods and services. For businesses to
produce these goods and services, they must employ more factors of
production. So the income flow to households increases because they are the
owners of the factors of production. As the income flow of households
increases, they in turn increase their spending flow. Government spending is
therefore an injection into the circular flow.

50 • Circular flow and quantitative elements


Topic 3

Taxation is a leakage
Government needs revenue to finance its spending. It gets this revenue from
taxation. There are different kinds of taxes, of which income tax is the most
important. Before households can spend their income they must first pay their
taxes. The income that is left after they have paid their taxes is called their
disposable income.

Taxation decreases the income available for households to spend. In other


words, their disposable income decreases. So, there will be less income
available in the circular flow. And the lower the income flow, the lower the
spending flow and production flow. Taxation is therefore a leakage because it
decreases the income and spending flows in the economy.

Classroom activity 3.9


1 Explain what happens to the circular flow of spending, production
and income if government spending increases by R50 million. (4)
2 Explain what happens to the circular flow of spending, production
and income if government collects R30 million more in taxes. (4)

What do I still need to know?


Adding the foreign sector to the circular flow

Businesses

Figure 3.5: Circular flow between households, government and the foreign sector

Circular flow and quantitative elements • 51


Up until now, our circular model represented a closed economy, i.e. an
economy that is not part of or influenced by the international economy or
the foreign sector. In the real world there are no closed economies.
It is mainly through exports and imports that the foreign sector influences
the circular flow of spending and income.

Exports are an injection


Exports are an injection into the circular spending and income flows – when
we sell more goods and services to the rest of the world, the spending on the
goods and services that we produce increases. As more is spent on producing
goods and services, businesses employ more factors of production, and the
income of households increases.
In Figure 3.5 this is indicated by the purple line that links the foreign sector
with businesses (it is part of the spending flows) and is shown as exports.

Imports are a leakage


Imports, however, are a leakage from the circular flow. As households,
businesses and government increase their spending on imported goods and
services, less is spent on goods and services produced inside the country.
Our spending on our own goods and services therefore declines, and so does
the income flow to households.
Look at Figure 3.5 to see how this can be illustrated by the broken purple lines
linking the foreign sector to the households and businesses.

Classroom activity 3.10


1 Explain what happens to the circular flow of spending, production
and income if exports increase. (4)
2 Explain what happens to the circular flow of spending, production
and income if imports increase. (4)

What do I still need to know?


Complete circular flow model
In our complete model presented in the following diagram there are four main
participants:
l Households
l Businesses

52 • Circular flow and quantitative elements


Topic 3

l Government
l Foreign sector

There are three markets:


l Factor market
l Goods market
l Financial market

There are two kinds of flows:


l Monetary flows
l Real flows in the opposite direction

There are three leakages:


l Savings
l Taxation
l Imports

There are three injections:


l Investment
l Government spending
l Exports

Households provide factors of production (a real flow) through the factor


market to businesses. These factors of production are bought on the factor
market and businesses use these factors of production to produce goods and
services. In return they pay households an income (nominal flow) in the form
of wages and salaries for labour, rent for natural resources, interest on capital
and profits for entrepreneurship. The more factors of production the business
uses, the higher the production is. There are subsequent increases in the
income that households receive and in the income flows in the economy.
Households use their income to buy goods and services on the goods market,
which is part of the spending in the economy. This is called consumption
spending and it is a monetary flow. The higher the income flow to
households, the higher their spending on goods and services will be and the
higher the spending flow will be. Households save part of their income and
these savings flow to the financial sectors as a leakage.
Businesses supply goods and services (a real flow) on the goods market to
households, the government and the foreign sector in the form of exports. This
is represented by a flow of goods and services to the goods market from the
businesses. In return, businesses receive payment for these goods and services
(monetary flow). The more they produce and the more they sell, the higher
the production and income flows in the economy will be.

Circular flow and quantitative elements • 53


Businesses also use the savings of households for investment spending, which
is an injection. This happens through the financial market. The higher the
investment, the higher the spending and income flows in the economy will be.

The government buys goods and services (textbooks, medicine and bricks for
instance) on the goods market. This buying of goods and services is part of the
flow of spending. Government then supplies households and businesses with
goods and services. These include police services, education, the defence
force, roads, etc. The more goods and services government buys, the higher
the spending, income and production flows in the economy. To pay for these
goods and services the government imposes taxes on households and
businesses. Taxation is therefore part of the flow of payments to government
and it is a leakage. The more taxes the government collects, the lower the flow
of spending, income and production in the economy.

The foreign sector buys goods and services on the goods market and it is part
of the spending flow of goods and services called exports. If foreign countries
buy more goods and services from South Africa, our exports increase and
consequently the flows of spending, production and income in the economy
increase. Exports are therefore an injection into the spending, production and
income flow.

Businesses

Figure 3.6: The circular flow model

54 • Circular flow and quantitative elements