Preliminary Eco Notes 2014 | Johnny Bui

Topic 1: Introduction to Economics

The Nature of Economics

The Economic Problem – Wants, Needs, Scarcity

- Economics is the study of how people choose to use resources

- Economic problem: satisfying unlimited wants with limited resources
o Economic systems must answer these questions:
 What will be produced?  How will we produce it?
 How much will be produced?  How will production be distributed?
o The aim of an economy is to try and solve this problem; but there are different solutions to a
problem and hence there are many types of economies
 Market economy: major economic decisions are made by individuals and firms due to self-
interest
 Planned economy: a central power (government) structures and runs the market, and makes
all economic decisions
 Mixed economy (e.g. Australia): contains elements of the above
- The economic problem affects individuals at home because:
o A currency is introduced in order to prioritise distribution of want satisfiers (goods/services) – if you
have more money, you can pay more to receive a good
o Households now need to priorities which wants should be satisfied first (delaying want satisfaction)
- Wants: a desire that can be fully or partially satisfied with goods and services
o They are unlimited – people always want more
o They change over time
o They can be prioritised over one another (e.g. food over entertainment)
- Needs: wants that are essential to human survival e.g. food, water, clothing, shelter
- Scarcity: the fact that resources are finite and cannot satisfy everyone’s wants
o Scarcity ensures that choices between wants are made
o Scarcity is relative – all societies suffer from scarcity, but some more so than others (some satisfy
more of their wants than others)

Factors of Production (Resources)

- Natural resources (“land”)

o All natural resources e.g. minerals, soil, fishing areas
o Return/reward from natural resources = rent
- Labour
o All forms of human effort used in production process
o Return = wages or salaries
- Capital
o All manufactured goods which are used in the production process e.g. computers, machinery, office
furniture
o Return = interest
- Enterprise (entrepreneurial resources)
o Ability to combine the above 3 factors
o Entrepreneurs take risks to organise production (risks making a loss, but stand to make a profit if
successful)
o Return = profit
- Resources are scarce and can be used in many different ways
 Preliminary Eco Notes 2014 | Johnny Bui
- It is important that resources are used to maximise everyone’s want satisfaction

Choice and Opportunity Cost

- The existence of relative scarcity means that individuals and societies need to choose which wants they want
to satisfy (since they can’t satisfy all of them)
- Choices are made at the expense of other alternatives that could have been chosen
- Opportunity cost: the next best alternative forgone
o Example: You have $20 to buy a shirt or a belt. The opportunity cost of buying a shirt is the belt (NOT
the cost of the belt)
o Opportunity cost does not have to have a physical value
- Opportunity cost exists because of scarcity – people now need to decide how to best use scarce resources

Production Possibility Frontiers (PPFs)

- PPFs illustrate the concept of opportunity cost – a curve shows what CAN be implemented
- Up to four assumptions can be made:
o Only 2 goods are produced by the economy
o All resources are fully employed
o Constant level of technology
o Resources can be switched from one good to another
- Point on the curve:
o Represents how much can be produced of each good in conjunction
- Point below the curve
o The economy is producing at its full potential
 Resources are not fully being utilised
 In the case of labour, this represents unemployment
- Point beyond the curve:
o Unattainable by the economy unless the curve shifts outward enough through:
 Increase of factor resources
 Increase of productivity/efficiency
The PPF is concave to origin to
 Improvement of technology
show diminishing returns
- Often, the PPF is concave to origin due to law of diminishing
returns
o The extra output gained from switching to another good
is initially large
o This extra output gets smaller as we switch more
- A straight line PPF means constant opportunity cost
- Opportunity cost on the PPF
o Rule: draw vertical and horizontal arrows from old point to new point
o From A to B: gain n units of X, sacrifice m units of Y
o From B to A: gain m units of Y, sacrifice N units of X

Future Implications of Current Choices

- Use of a resource in the present can affect how its future use
e.g. use non-renewables today = less available in future
- Choices need to be made about consumption vs. investment
 Preliminary Eco Notes 2014 | Johnny Bui
o More consumption in present = reduced capacity to produce goods and services in the future
o More saving in present = increased productive capacity in future (+ enables increased future
consumption)

Reflecting Choices on PPFs

Changes in Technology

Technology for C Technology for F Technology for

has improved has improved both C and F has
improved

Changinng Productivity OR Resources

(1) Improved productivity OR more resources

(2) Less productivity OR loss of resources (e.g. tsunami)

Capital Goods vs. Consumer Goods

- Capital goods: improve future productive capacity

- Consumer goods: satisfy immediate wants/needs
- Investing more in consumer goods means less
economic development is possible (since less traps
are produced to catch rabbits)
o Forego capital accumulation
- More capital goods means more economic
development is possible – more traps to catch more
rabbits, which means more consumer goods
available in the future
o Forego immediate want satisfaction

Economic Factors Underlying Decision Making

- Individuals:
o Spending and saving: depends on confidence about the future and stability in the present
 Uncertainty = reduction of spending
o Work: unemployed people may not want to take a low-paid job due to loss of health card benefits,
while accruing additional expenses like travel and clothing required for work
o Education: increased education would lead to expected higher salaries, but sacrifices present income
o Retirement: depends on ability to provide for themselves in the future
o Voting and participation in politics: can partially depend on government’s economic performance
- Businesses:
o Pricing: increase due to increased demand, or decrease due to decreased demand
o Production: increase in a booming economy, decrease in a depressed economy
o Resource use: depends on production levels and relative price of resources
 Preliminary Eco Notes 2014 | Johnny Bui
Example: labour costs rise more than capital equipment = employers will switch some labour
resources for capital resources
o Industrial relations: factors include level of unemployment → high unemployment = employers have
more relative power (they will accommodate less needs), low unemployment = employees will pay
more so that they can keep the workers
- Governments: influence the decisions of individuals and businesses
o Example: high unemployment → government lowers interest rates and increases spending
 This encourages businesses and individuals to increase their spending
 This spending will stimulate demand for goods → more people employed in production

The Operation of an Economy

Using Resources to Produce Goods and Services

- Most basic function of an economy – ensure production of want-satisfying goods and services
- Resources must be input to produce these goods
o The resource inputs are the 4 factors of production
- Resource inputs can be used in different combinations
o Combination depends on relative prices of resources (which can change)
 Examples: Australia has high labour costs, so businesses will opt to use capital resources
rather than labour resources

Distribution of Goods and Services

- Scarcity leads to the fact that produced goods must be distributed

- Distribution takes place through operating the economy
- Market economy:
o Does not attempt to distribute output equally
o Income which people can spend on goods is based on the value of their input during production
o Advantage: provides incentive to gain skills and work hard to increase share of output
o Disadvantage: uncertainty for those who cannot contribute as much due to illness, age, disability etc.
 Those with less bargaining power may not be getting a fair return for their labour

Exchange of Goods and Services

- Specialisation: producing what we are best at producing is called specialisation

o Different entities are better suited to produce certain goods/services
o Increased development of economy = increased prevalence of specialisation
- Increased specialisation → increased reliance on others to produce other goods and services
o This means that people need to exchange foods and services so they can satisfy all of their wants
o Exchange takes place via operation of an economy
o Money is used as a medium to unify exchange

Provision of Income

- People earn ‘income’ in two different markets:

o Factor market: people selling factors (usually labour)
o Product market: people selling goods and services
- Income allows people to buy other goods and services or increase savings
- Operating an economy allows people to earn income
 Preliminary Eco Notes 2014 | Johnny Bui
Provision of Employment and Quality of Life

- In an operating market, resources need to be employed in order to produce goods and services
- There are 3 main industries which employ labour and other resources:
o Primary: raw materials (e.g. agriculture, mining, forestry, fishing)
o Secondary: manufacturing – uses the raw materials to produce finished goods
o Tertiary: service – retailing, wholesaling, distribution of finished goods and services
- Quality of life: depends on
o Level of per capita income (income per person)
o Access to a variety of consumer goods and services
o Non-material factors; law and order, quality of environment, health care, education, social welfare

The Business Cycle

1 economic growth cycle = 1 wavelength

- Economic management = reduce amplitude of the economic cycle (try to get dotted line, which is closer to
trend line) → governments aim to have 3-4% growth p.a.
o This is done through counter-cyclical policies
- Upswing: high output, income, expenditure, employment – rising inflation
o Higher tax collections → more government spending → better quality of life
- Boom: maximum output, income, expenditure, employment
o Economic activity peaks → shortages of labour and other resources → price level inflates
o Government will use contractionary policies to reduce economic activity to sustainable levels
- Downswing: lower expenditure, output, income and employment – rising unemployment
o Less economic activity → less demand for labour → some unemployment → decline in quality of life
- Recession: minimum economic activity
o Excess labour supply → unacceptable unemployment
o Government uses expansionary policies to stimulate
spending and economic activity

Equilibrium and the Circular Flow of Income

- Remember: TSM leaks, IGX injects (Spider Man leaks)

- Import = economy buys, export = economy sells
- Equilibrium: 𝑺 + 𝑻 + 𝑴 = 𝑰 + 𝑮 + 𝑿
o Leakages = injections → economic equilibrium
- Disequilibrium: 𝑆 + 𝑇 + 𝑀 ≠ 𝐼 + 𝐺 + 𝑋
o Leakages > Injections → recession/contraction
 Firms employ less resources
 Return to equilibrium by increasing
injections (e.g. government spending) or
decreasing leakages (less savings)
 Preliminary Eco Notes 2014 | Johnny Bui
o Leakages < Injections → boom/expansion
 More resources employed → incomes rise → households will save more until return to
equilibrium (return can also be achieved by increasing taxes and imports)
o These situations are reached when the counter-cyclical policies are not stopped at the right time

Topic 2: Consumers and Business

The Role of Consumers in the Economy

Consumption (and Savings) Functions

- 𝑌 = 𝐶 + 𝑆 (consumer income = consumption + savings)  relates income, consumption, savings

- Consumption function: expresses spending in terms of fixed/autonomous and induced (varies with income)
o 𝐶 = (𝑀𝑃𝐶)𝑌 + 𝐶0
o Total consumption = MPC × disposable income + autonomous consumption
- Savings function: 𝑆 = 𝑀𝑃𝑆(𝑌) − 𝐶0
o Total savings = MPS × disposable income – autonomous consumption
o The constant −𝐶0 is there because there are base costs which must be paid e.g. water
𝐶
- APC – average propensity to consume. 𝐴𝑃𝐶 =
𝑌
o Percentage of income spent on goods and services instead of savings
𝑆
- APS – average propensity to save. 𝐴𝑃𝑆 =
𝑌
o Percentage of income spent on savings rather than goods and services.
- 𝐴𝑃𝐶 + 𝐴𝑃𝑆 = 1 → percentage of income spent + percentage of income saved = 100%
Δ𝐶
- MPC – marginal (additional) propensity to consume. 𝑀𝑃𝐶 = Δ𝑌
o Income can increase → you can choose to save or spend part of this increase
o MPC is the percentage of change of income allocated to consumption
o On a consumption vs. income graph, MPC = gradient
Δ𝑆
- MPS – marginal propensity to save. 𝑀𝑃𝑆 = Δ𝑌
o Percentage of change of income allocated to saving
- 𝑀𝑃𝐶 + 𝑀𝑃𝑆 = 1 → percentage of change in income consumed + saved = 100%
- Consumption functions: C vs Y
o Gradient = MPC
o Breakeven point is when 𝐶 = 𝑌 on the graph (solve simultaneously
with 𝐶 = 𝑌)
 This is because 𝑌 = 𝐶 + 𝑆 → 𝐶 = 𝐶 + 𝑆 → 𝑆 = 0
- Saving functions: S vs Y
o Gradient = MPS
o Breakeven point is horizontal intercept (𝑆 = 0)
o Curve under horizontal axis = dissaving (debt increase), opposite for
above

Consumer Sovereignty

- Consumer is king
o Basic decisions about what to produce are determined by spending decisions of individuals
 Decisions reflected through demand for products
 Pure market – the individual producer takes price or else no sale is made
 Other market structures (e.g. monopoly) have lower consumer sovereignty
 Producer is able to influence price and quantity of produced goods
 Preliminary Eco Notes 2014 | Johnny Bui
- Factors which can deteriorate consumer sovereignty:
o Marketing (manipulate what consumers demand)
o Misleading conduct (false claims about products)
o Planned obsolescence (purposely make goods go “out of fashion” → consumers seek replacements)
o Anti-competitive behaviour (e.g. create a good that only works with one other good)

Spending and Saving/Dissaving Patterns

- In the economy as a whole, as income increases, level of

saving AND consumption increases (different rates)
o As income increases, 𝑀𝑃𝐶 ↓, 𝑀𝑃𝑆 ↑
- Variations of age:
o Younger people spend more than they consume
because they do not work full time
o Middle ages save more because they have capacity
to earn more money. They also save for
retirement/invest e.g. superannuation
o When they retire, they will not be earning income
(except maybe interest off savings). This means that they will be dissaving

Factors Influencing Individual Consumer Choice

- Income: level of disposable income is main factor in spending patterns; usually income ↑ = spending ↑
- Price of product: relative pricing between different brands of same product (ceteris paribus)
- Price of substitutes: assuming preference and level of satisfaction is the same, cheaper = usually chosen
- Price of complements: affect each other
o Complements: used in conjunction e.g. cars and petrol
o Example: petrol price ↑ = car demand ↓, but car price ↓ = petrol demand ↑
- Preferences/tastes: people may intuitively like one item more than alternatives
o Some products may fall out of preference due to being ‘out of season’
o Example: preference for cold drinks in summer but not in winter
- Advertising: dissemination (spreading) of information by firms to consumers through mass media
o Informative advertising: talk about price, quantity, quality, range, features
o Persuasive advertising: tries building loyalty to the brand by linking product to social image
 Example: cologne linked to masculinity; celebrities may be paid to endorse products

Sources of Income

- Income: money received in exchange for providing a good or service

- There are 5 main sources of income: (wages 56%, profit 17.5%, rent/interest/dividends 11.8%, welfare 9.7%)
o Wages and salaries – paid for provision of labour
o Profit – paid for provision of entrepreneurship
o Rent – paid for provision of land/natural resources
o Interest and dividends – paid for provision of capital
o Social welfare payments – Centrelink; paid to non-working people by the government

The Role of Business in the Economy

Firms and Industries

- Firm – business organisation that coordinates use of resources to produce and market goods and services
- Industry – collection of firms which are involved in producing a similar good or service
 Preliminary Eco Notes 2014 | Johnny Bui
- Firms need to make the following decisions about production:
o What will be produced? (determine what the market demands through market research)
o How much will be produced? (enough to satisfy market demand or maximise efficiency)
o How will the product be produced? (attempt to use resources to produce output at minimum cost)
o How will production be distributed? (management structure to oversee production)

Business – Source of Growth of Economy and Increased Productive Capacity

- The main goal of a firm which dictates market behaviour is that it wants to maximise profit
- Hence it will find ways to minimise costs. Some ways include:
o Finding the technical optimum for production
o Developing new technology
- Both of these ways increase productive capacity of the business → satisfy more wants → growth in economy

Goals of the Firm

- Maximising profits – profit = total revenue – total cost

o Total costs = fixed costs (independent of output) + variable costs
o Total revenue = price × quantity sold
- Maximising growth – enables firm to increase productive capacity → survive in the long run
o This often occurs through investing in new plants/equipment or merging and taking over other firms
- Increasing market share – greater market share = profitability in the long run
o Firms may slash prices at expense of larger profit/unit in order to gain a larger consumer base
o Advertising is also used to increase market share
- Meeting shareholder expectations – they expect to earn dividends and also want to see rising share prices
o In small businesses, shareholders may want managers to employ their relatives etc.
- Satisficing – aiming for an adequate result, rather than optimal results (i.e. earning a quota for profit)
o Managers may have other priorities and will do this to maintain job security

Efficiency and the Production Process

- Productivity: an indication of how efficiently production is used

output units
o Productivity = input units
(volume of output produced over volume of inputs used)
output units
o Multifactor productivity (MFP) = all input units
 Generally, make sure all input units are in terms of a common unit (e.g. dollars)
output units
o Single factor productivity (SFP) = single input units
- Entrepreneurs want to gain maximum productivity from factors of production
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Economies and Diseconomies of Scale and the Long Run Average Cost Curve

- LRAC curve: shows average cost for differing levels of output

Fixed costs + Variable costs
o It is average cost as a function of output. Average cost = Output
o It will look like a parabola; minimum = technical optimum (lowest cost/unit to produce)
- Economy of scale: decreasing cost/unit due to increasing output (think decreasing – getting close to min.)
o Slope downward = reaching economy of scale
- Diseconomy of scale: increasing cost/unit as a result of increasing output (think increasing – away from min.)
o Slope upward = diseconomy of scale
o Can be caused when factors become more scarce after technical optimum → factor incomes ↑
 Higher interest rate on loans, overtime, increased rent due to more land owned
o Management issues (e.g. communication problems), or other inefficiencies
- Internal economy/diseconomy of scale: come from growth (or lack of) of the firm
o Examples: investing in specialist machinery, division/specialisation of labour
o Move along the curve
- External economy/diseconomy of scale: outside the firm, within an industry (i.e. affects all firms in industry)
o Examples: better transportation network, development of research facilities, clustering of businesses
o Move the curve – remember, moving the curve down (‘decreasing’ all points) means economy!
 i.e. down = economy, up = diseconomy (cost ↑)

Impact of Investment, Technological Change and Ethical Decision-Making on a Firm

- Production methods e.g. investment in technology (upgrades in equipment, …)

o The firm might become more capital intensive than labour intensive
- Prices: technology improves → production costs may decrease → lower prices passed on to customers
o This means that consumers can now afford a larger range of items
- Employment
o Usually, new technology → firms become more capital intensive → reduced employment
 However, sometimes new technology → new areas of employment
o Example: introduction of computers → less typists needed, more computer specialists needed
- Output: technology increases output, and also increases range of goods and services available
- Profits: introduce new technology → productivity ↑, costs ↓ which → profits ↑
o Introduce new goods and services → new market may be created (more potential to earn profit)
- Types of products
o New capital and technology → new products and services
o Business can widen its reach (more products) or deepen it (more
market share)
o One way: vertical and horizontal integration or diversification of
product base (conglomerate)
 Integration: merging with or taking over other firms
o Remember the plane! O = parent company
o Conglomerate integration: take over firm not related to parent company’s
line of production
 It is in a different plane
- Globalisation: process by which the world becomes a single marketplace
o Globalisation ↑ = faster transfer of technology
o Ensures that firms need to invest in latest technology to remain competitive in global environment
- Environmental sustainability: either improves or deteriorates. Also consider waste management practices
o Usually, new technology = deteriorates, but upgrading/revising current technology = improves