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ECO10250 Economics for Decision

Making

Study Guide

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2017.3

Contents

Introduction .................................................................................................................................................................................................. 7

Topic 1 Introduction to economics .................................................................................................................................................... 9 Introduction.......................................................................................................................................................................................... 9 Objectives .............................................................................................................................................................................................. 9 Microeconomics and macroeconomics........................................................................................................................................ 10 Fundamental economic concepts................................................................................................................................................... 10 Opportunity cost................................................................................................................................................................................ 11 Economics in practice ...................................................................................................................................................................... 12 Economic theory................................................................................................................................................................................ 12 Economic models .............................................................................................................................................................................. 12 Markets and trade.............................................................................................................................................................................. 13 Economic systems ............................................................................................................................................................................. 14 Summary ............................................................................................................................................................................................. 14 Review activities................................................................................................................................................................................. 14 Feedback to activities ........................................................................................................................................................................ 15

Topic 2 Markets: Demand and supply ........................................................................................................................................... 16 Introduction........................................................................................................................................................................................ 16 Objectives ............................................................................................................................................................................................ 16 Demand ............................................................................................................................................................................................... 16 Supply ................................................................................................................................................................................................... 17 Equilibrium price............................................................................................................................................................................... 18 The free-market economy ................................................................................................................................................................ 19 Summary ............................................................................................................................................................................................. 19 Review activities................................................................................................................................................................................. 20 Feedback to Activities ....................................................................................................................................................................... 21

Topic 3 Markets: Elasticity.................................................................................................................................................................... 25 Introduction........................................................................................................................................................................................ 25 Objectives ............................................................................................................................................................................................ 25 Price elasticity of demand ................................................................................................................................................................ 26 Calculating price elasticity of demand.......................................................................................................................................... 26 Investigating elasticity along the demand curve......................................................................................................................... 27 Determinants of price elasticity of demand................................................................................................................................. 28 Income elasticity of demand (denoted by ηy) ............................................................................................................................. 29 Cross price elasticity of demand (denoted by ηx) ...................................................................................................................... 30 Price elasticity of supply ................................................................................................................................................................... 30 Short-run and long-run demand ................................................................................................................................................... 31 Markets where prices are controlled ............................................................................................................................................. 31 Consumer surplus, producer surplus & total surplus ............................................................................................................... 31 Summary ............................................................................................................................................................................................. 32 Review activities................................................................................................................................................................................. 33 Feedback to Activities ....................................................................................................................................................................... 33

Topic 4 The supply decision ............................................................................................................................................................... 37 Introduction........................................................................................................................................................................................ 37 Concept review .................................................................................................................................................................................. 38 What is a firm? ................................................................................................................................................................................... 38 Economic profit.................................................................................................................................................................................. 39 Economic efficiency .......................................................................................................................................................................... 39 Markets and the competitive environment .................................................................................................................................. 40 Short-run cost .................................................................................................................................................................................... 40 Long-run production and cost ....................................................................................................................................................... 42 Excess capacity and over-utilisation .............................................................................................................................................. 43 Profit and revenue ............................................................................................................................................................................. 44 The firm’s decisions ........................................................................................................................................................................... 45 Profit-maximising output ................................................................................................................................................................ 46 The firm’s short-run supply curve .................................................................................................................................................. 46 Profit and losses in the short and long-run.................................................................................................................................. 47 Summary ............................................................................................................................................................................................. 48 Review activities................................................................................................................................................................................. 48 Feedback to activities ........................................................................................................................................................................ 48

Topic 5 Market structure: Perfect competition & monopoly ............................................................................................... 56 Introduction........................................................................................................................................................................................ 56 Concept review .................................................................................................................................................................................. 57 Objectives ............................................................................................................................................................................................ 57 What is perfect competition? .......................................................................................................................................................... 58 Short- and long-run equilibrium ................................................................................................................................................... 58 Monopoly ............................................................................................................................................................................................ 59 Summary ............................................................................................................................................................................................. 61 Review activities................................................................................................................................................................................. 62 Feedback to activities ........................................................................................................................................................................ 62

Topic 6 Market failure and government policy ......................................................................................................................... 66 Objectives ............................................................................................................................................................................................ 66 The economic theory of government ............................................................................................................................................ 67 Externalities ........................................................................................................................................................................................ 68 Public goods........................................................................................................................................................................................ 68 Monopoly ............................................................................................................................................................................................ 69 Government intervention ................................................................................................................................................................ 70 Property rights ................................................................................................................................................................................... 70 External costs: The environment.................................................................................................................................................... 70 Progress in microeconomic reform ............................................................................................................................................... 71 Trade practices legislation ............................................................................................................................................................... 72 Summary ............................................................................................................................................................................................. 74 Review activities................................................................................................................................................................................. 74 Feedback to activities ........................................................................................................................................................................ 74

ECO10250 Economics for Decision Making

Contents | 4

Topic 7 Introduction to macroeconomics.................................................................................................................................... 79 Introduction........................................................................................................................................................................................ 79 Objectives ............................................................................................................................................................................................ 80 Economic growth .............................................................................................................................................................................. 81 Jobs and unemployment .................................................................................................................................................................. 82 Inflation ............................................................................................................................................................................................... 83 Governments and deficits ................................................................................................................................................................ 84 The circular flow of economic activity .......................................................................................................................................... 85 Australia’s national accounts ........................................................................................................................................................... 87 The price level and inflation ............................................................................................................................................................ 89 Real GDP and associated limitations ............................................................................................................................................ 91 Labour market indicators and unemployment definitions ...................................................................................................... 91 The labour market ............................................................................................................................................................................. 93 Summary ............................................................................................................................................................................................. 95 Review activities................................................................................................................................................................................. 95 Feedback to activities ........................................................................................................................................................................ 95

Topic 8 Gross domestic product ..................................................................................................................................................... 100 Introduction...................................................................................................................................................................................... 100 Aggregate demand........................................................................................................................................................................... 101 Aggregate supply.............................................................................................................................................................................. 102 Macroeconomic equilibrium ........................................................................................................................................................ 104 The multiplier ................................................................................................................................................................................... 104 Fluctuations in economic activity resulting from shocks ....................................................................................................... 104 Summary ........................................................................................................................................................................................... 105 Review Activities.............................................................................................................................................................................. 105 Feedback to Activities ..................................................................................................................................................................... 105

Topic 9 Money, interest rates & inflation .................................................................................................................................... 108 Introduction...................................................................................................................................................................................... 108 Money markets................................................................................................................................................................................. 109 Types of inflation ............................................................................................................................................................................. 111 Inflation policy ................................................................................................................................................................................. 113 Summary ........................................................................................................................................................................................... 114 Review activities............................................................................................................................................................................... 114 Feedback to activities ...................................................................................................................................................................... 114

Topic 10 The global economy.......................................................................................................................................................... 116 Introduction...................................................................................................................................................................................... 116 Global interdependence and the gains from trade................................................................................................................... 117 Arguments for restricting trade.................................................................................................................................................... 117 Trading blocs .................................................................................................................................................................................... 118 The balance of payments ................................................................................................................................................................ 118 Foreign exchange markets and the dollar .................................................................................................................................. 119 Exchange rate determination: Flexible exchange rates............................................................................................................ 120 Summary ........................................................................................................................................................................................... 121 Review activities............................................................................................................................................................................... 122 Feedback to activities ...................................................................................................................................................................... 122

ECO10250 Economics for Decision Making

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Topic 11 Fiscal and monetary policy ............................................................................................................................................ 123 Introduction...................................................................................................................................................................................... 123 The Commonwealth Government budget ................................................................................................................................. 124 The effectiveness of fiscal policy ................................................................................................................................................... 125 The Reserve Bank and monetary policy ..................................................................................................................................... 125 The relative effectiveness of fiscal and monetary policy ......................................................................................................... 126 Summary ........................................................................................................................................................................................... 127 Review activities............................................................................................................................................................................... 128 Feedback to activities ...................................................................................................................................................................... 128

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Contents | 6

Introduction

This is an introductory course in economics which concentrates on explaining and examining those influences on the level of economic activity in economies such as Australia. It is concerned with the micro and macroeconomic issues which affect us all, such as production decisions, market structures, interest rates, inflation, growth, unemployment and the international sector. Current events are used to illustrate the purposes and conduct of policies by individual companies and governments as they wrestle with some of the micro and macro domestic and international economic problems that confront Australia.

The unit systematically develops an understanding of the main determinants of economic activity in Australia, the problems that face policy makers in regulating the level of economic activity, and the effectiveness of the instruments used by governments in addressing these problems. The order of treatment of topics has been chosen so that the fundamentals of the economy are progressively introduced and new concepts build upon ones previously discussed. It is very important that you have a good understanding of each topic before moving on to the next since each topic builds on the previous topic.

The unit begins by examining the foundation economic principles and then moves to looking at how the microeconomic market is developed through an analysis of product decisions and the various markets which these products are sold in. The next microeconomic step is to investigate why markets fail and offer theories as to how reform can assist. The first macroeconomics topic examines the main indicators of economic performance in the economy and the model which illustrates the impact of changes in these variables. Australia’s international economic relationships complexities are then considered. The unit concludes with some consideration of the complexities of economic management and an evaluation of them in the light of current economic events.

There are eleven topics in this unit. As a guide you should spend about one week on each topic. Your rate of progress in this unit will depend upon your interest in the material, the speed with which you can study, and any outside commitments you might have. You might also find that some topics can be completed much more quickly than others. As a general rule it is suggested that you spend at least 12 hours a week on most topics – 3 hours going through the study learning materials including those on MySCU; 4 hours carefully reading the textbook and taking notes; 2 hours reading the supplied readings and other relevant material; and 3 hours undertaking activities and review activities.

The study guide begins each topic with a brief introduction that outlines broadly what is going to be covered followed by the learning objectives for the topic. The learning objectives should direct your study activity since they identify the expected outcomes from your study of each topic. When you have completed each topic you should check to see that each of the objectives has been achieved.

The leaning objectives are followed by information about the principal reference(s) for the topic. Each topic in the study guide is broken into subsections to make it easier for learning. Follow the directions contained in each section. Throughout the topic you will be given learning activities which test your understanding of the concepts covered. You should try to answer each learning activity before you move on to the next section. Answers to (or feedback on) the learning activities are provided at the end of each topic. We recommend that you attempt the learning activity before consulting the solution. If your answer differs from the one given and you are still confused, then go back through that section again.

At the end of each topic there is a summary which wraps up what we have covered.

The text – Sloman, J, Norris, K ∓ Garratt, D (2014) – follows the topics fairly closely but there will be times when it doesn’t but these will be pointed out in the guide. We recommend that when you have worked through a topic you undertake the MyEconLab activities from the relevant chapter/s. Again you should attempt your own answer before you look up the answer provided. You are also strongly encouraged to keep up to date with the current economic issues by reading newspaper articles regularly.

For additional important information please refer to the Unit Information document associated with this unit. The Unit Information document provides you with material about assessment, study timetable and additional references.

ECO10250 Economics for Decision Making

Introduction | 8

Topic 1

Introduction to economics

Introduction This first topic introduces you to the discipline of economics and discusses some of the main concepts that underpin the economic method of analysis. We begin by considering the nature of microeconomics and how it differs from macroeconomics.

Some fundamental economic concepts are introduced in this topic and they will form an essential foundation to the rest of your work in this unit. The basic economic problem is how best to use scarce resources to meet the needs of human beings and involves concepts such as scarcity, choice and opportunity cost.

In its function in the real world, economics concerns itself with theory, models and the use of graphs to depict and analyse economic data. This topic considers all of these areas and introduces the important assumption of ceteris paribus, which enables economists to focus on individual variables or small models which are abstractions from the total economy.

Building upon the earlier concept of opportunity cost, the next concept examined is the production possibility frontier and the circular flow of the economy.

Many of you will have had previous exposure to a number of these concepts and will be able to refresh your knowledge relatively quickly. Those of you who have never studied economics or graphical analysis may need to take more time with the material. It is very important that you have a good understanding of each topic before moving on to the next since each topic builds on the previous topic.

Objectives On completion of this topic you should be able to:

Study materials The time you need to spend studying Topic 1 will depend upon your previous experience in the study of Economics. Topic 1 sets the foundation for further study in this unit.

distinguish between macroeconomics and microeconomics

describe the basic economic problem and explain why scarcity forces people to make choices

outline the role and uses of economic theory and models and the assumptions underlying their use

describe the operation of markets as coordinating mechanisms

explain opportunity cost and illustrate its use graphically through the production possibility frontier concept.



Textbook Sloman, J., Norris, K. & Garratt, D., 2014, Chapter 1.

Readings

Microeconomics and macroeconomics This unit ECO10250 is a specialisation of the broad discipline of economics. The prefix micro means that we are studying economics at a base level of individual consumers, firms or industries, rather than from the broader view of the total economy which is covered in macroeconomics. The first six topics of this subject focus on microeconomics with Topics 7 to 11 focusing on macroeconomics. Microeconomics focuses on the efficient allocation of scarce resources, between alternative competing uses. Macroeconomics, on the other hand, concentrates on the economy as a whole, for example employment, national income, trade, inflation etc.

In microeconomics we examine how consumers will be trying to maximise the satisfaction they can obtain from consuming products and firms will be trying to maximise profits (total revenue minus total costs). A market is defined as an arrangement that facilitates buying and selling. Note that a market does not have to be visible or occupy a space, for example, an interface between buyers and sellers may be achieved electronically.

Markets do not always allocate resources efficiently. This could mean that consumers are not able to buy products for a price which reflects the true costs of production or society may be incurring additional costs such as pollution of the environment, where producers are not held accountable for their production costs. Costs passed on externally to society are called externalities. Hence we need a market supervisor such as the government, whose role might be to provide some goods and services to households, redistribute income and manage the economy in such a way as to maximise the welfare of the constituents, particularly when the markets fail to share wealth efficiently.

Fundamental economic concepts Economics is based upon some fundamental concepts which govern economic thought, such as scarcity, opportunity cost, choice and marginal cost. The concepts of scarcity, opportunity cost and choice are central to the economic problem which we will now consider.

The economic problem Take a moment to think about your own strategy to study this unit. Economics is about scarcity of resources and making decisions about how to best use those resources. Immediately the study session starts, your time can become a scarce resource for you. However you divide your time there will be a cost, because as soon as we use a scarce resource in one activity such as studying this unit, you are precluding use of your time (the scarce resource) for other activities such as sports or hobbies. Almost every decision we make has some element of choice, and almost every choice we make has some personal economic consequence. Economics is sometimes called the science of choice.

1.1 Lipsey, R. G., Langley, P. C. & Mahoney, D. M., 1981, ‘The economic problems of Australia’s early governors’, in Positive Economics for Australian Students, Weidenfeld and Nicholson, London, pp. 59–63.

ECO10250 Economics for Decision Making

Topic 1 Introduction to economics | 10

Let’s consider the following definitions of economics.

Lipsey, Langley and Mahoney (1981, p. 63) state:

Broadly defined, modern economics concerns:

This unit will touch on all four concerns in this definition.

The economic problem of limited resources and unlimited wants leads to five fundamental questions that must be answered by societies.

These questions are:

The way these questions are answered is dependent on whether a society adopts a command or free-market economy.

Milton Friedman (arguably one of the greatest economists of our time) has said that in practice economics:

The old cliché ‘you can’t have your cake and eat it too’ may be relevant to the dilemma we face when using scarce resources. Whenever choices have to be made there is an opportunity cost, which is the cost of the best alternative forgone. This is the focus of the next section.

Opportunity cost Intimately linked to the study of economics is the concept of opportunity cost. Because we have limited amounts of time, money, resources etc. we cannot have everything that we want. Hence we are continually faced with making choices. The cost of what you choose to do is equal to the best alternative forgone. The opportunity cost of the choice you made is the best alternative passed up. For example, two students doing the same university course may have very different opportunity costs. Industrious Sally may be incurring an opportunity cost of a large salary by becoming a full-time student this year, whilst Larry may be forgoing an overseas trip.

Economics is the study of the choices people make to cope with scarcity and the incentives that influence and reconcile those choices.

— (McTaggart, Findlay & Parkin, 2007, p. 4)

The allocation of a society’s resources among alternative uses and the distribution of a society’s output among individuals and groups

The degree to which society’s resources are used at all2. The ways in which production and distribution change over time, and3. The efficiencies and inefficiencies of economic systems.4.

What goods and services (G & S) should be produced?

How much of each G & S should be produced?

How should these G & S be produced?

Where should these G & S be produced?

Who will consume these produced goods and services?

Always comes down to trying to understand the forces of demand and supply, based on the idea of using scarce resources to achieve alternative goals.

— (McTaggart, Findlay & Parkin, 1992, Economics, p. 89)

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Topic 1 Introduction to economics | 11

Later in this topic we will examine opportunity cost in relation to another concept, that of the production possibility frontier. For an economy to function, decisions have to be made, such as what commodities to produce.

Now we will turn our attention to what economists do and how they use theory, models and graphs.

Economics in practice Economists, in their work on a wide variety of problems, make extensive use of economic theory, economic models and graphs. We will examine all these aspects in this section of the topic.

First we will distinguish between two types of statements often used in economics: positive statements and normative statements.

Positive and normative statements Positive statements deal with facts; they state ‘what is’. Normative statements are based on value judgements and state ‘what ought to be’.

An example of a positive statement would be: ‘NSW spends less money on education per head of population than any other state’. This is a positive statement since it describes reality. An example of a normative statement would be: ‘NSW should spend more money on education’. Normative statements often contain words like ‘ought to’ or ‘should’. Positive statements may be tested against facts or evidence available, whereas normative statements can only be settled by show of preference. In general, economics is the study of ‘what is’ and not ‘what ought to be’.

Economic theory Economic theory is the currently accepted body of generalisations used to explain why economic events happen. For example, the law of demand states that consumers will demand more of a product at lower prices, given other things remaining constant. This is a generalisation saying that a change in price will cause a change in the quantity demanded. It is not difficult to demonstrate with the use of data that a theory such as this one will work in practice. In contrast you will also learn that there will be examples which refute the theory. For example, during the Irish potato famine it was found that when the price of potatoes rose the demand for potatoes also rose, because potatoes being the most affordable staple in the diet, people were left with even less income for substitute staples, forcing them to actually consume more potatoes. You may often find examples contrary to a theory. In this unit you will be exposed to the introductory microeconomic theory necessary to analyse applied economic problems.

Economic models Economic models are abstractions of an economy used to analyse relationships between variables and to make predictions (forecasts) about a complete economy. For example, a simple model of an education market might have three components:

a set of consumers, who are the students

a market place, which is the campus or communication facility

a set of suppliers, who are the teaching staff (or it could be argued that teaching staff are inputs and that schools are the suppliers).



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Topic 1 Introduction to economics | 12

There will be transactions or flows in both directions through the market place. Of course this will only be a simple abstraction (not a complete replica) since the market may not function without other components such as government funding.

To perform the task of observing or predicting economic reactions to stimuli such as changes in wage rates or prices it is often necessary to hold many variables constant so that we can focus attention on a small number of variables at one time. This assumption we refer to as ceteris paribus, meaning other things being equal or remaining constant. For example, if you want to observe any changes in the consumption of ‘Big Macs’ when prices are suddenly raised, you will probably find it necessary to assume that wages have remained constant and the total number of customers has not changed. Otherwise these interferences will hinder us from drawing what should be reasonably accurate conclusions about consumption.

Markets and trade The previous section introduced the fundamental concept of opportunity cost. Building on that concept is the production possibility frontier, which we will consider now.

The production possibility frontier An effective illustration of attainable levels of production is the production possibility frontier (PPF) shown in Figure 1.1 of the text. It is the boundary between attainable and unattainable levels of production for a fixed resource. For example, if an economy has a labour force of, say, 1 million workers who are employed either growing food or making clothes, we can imagine the extremes of production if all the workers are making clothes or all are growing food. In between the extremes different combinations of workers are employed in the two tasks. The path of attainable points forms the frontier. All points under the frontier are attainable, but those above are only reachable if production increases through workforce growth and/or technology gains.

The market economy All the economic decisions that have to be made in an economy need some mechanism to coordinate them in order to ensure that the basic production tasks are carried out. The major coordinating mechanism is the market. Markets if left to operate without interference will address the resource allocation questions of what, how, when, where, and who. However, the resulting decisions might not be fair or please everyone. Alternative mechanisms, such as a command mechanism, have been used to allocate scarce resources, but we will focus on markets and the market economy.

The circular flow model of the economy is a well-known economic model, shown in Figure 1.5 of the textbook. It includes households and firms, households being the consumers and firms being the producers. The transactions between them take place in two markets, the goods market and the factor market. The goods market involves the sale of goods and services and the factor market involves the sale of the factors of production (land, labour capital and entrepreneurship). The flow of goods and services (commodities) from firms to households will produce a counter flow of money from households to firms.

Lipsey, Langley & Mahoney, 1981, pp. 59–63.

Reading 1.1r

ECO10250 Economics for Decision Making

Topic 1 Introduction to economics | 13

The major questions of microeconomics are referred to in the reading:

Study carefully the production possibility boundary (or frontier) given and how the choices are illustrated. Pay particular attention to the statement at the bottom of the second page:

Thus the opportunity cost of getting qs more food is that pr of other goods are sacrificed.

Using Reading 1.1:

Economic systems All societies are faced with the problem of scarcity however the way they tackle the problem differs considerably. One important difference between societies is the degree of government control of the economy. In a command economy the state plans the allocation of resources while in the free-market economy all economic decisions are made by households and firms. The mixed economy refers to one where the state as well as households and firms make the economic decisions.

Summary This topic introduced you to fundamental economic concepts such as the nature of the economic problem, choice and scarcity, opportunity cost, the production possibility frontier, marginal cost, marginal benefit and efficiency. It also considered the differences between positive and normative statements and between microeconomics and macroeconomics. The uses of graphs to depict economic data were discussed. The emphasis in this unit is on applications of economic principles and this topic outlined how economic theories could be used to understand human behaviour. The topic also stressed the need for the coordinating mechanism of a market to regulate the economic decisions that each country needs to make.

Review activities

You are advised to undertake activities in the Sloman, Norris & Garratt, 2014, MyEconLab, Chapter 1.

What commodities are being produced and in what quantities?

By what methods are they being produced?

How is society’s output of goods and services divided among its members?

How efficient is the society’s production and distribution?

Activity 1.1a

Suggest why the frontier is bulging outwards.1. What is the significance of the slope?2. What are some causes of an outward shifting boundary?3. What could have caused an inward shift in the boundary?4.

Review activitiesa

ECO10250 Economics for Decision Making

Topic 1 Introduction to economics | 14

Feedback to activities

Activity 1.1f

At certain combinations there will be efficiency gains, e.g., when half the labour force is working on food production and half on other goods. This may be a more efficient way of using all the tools available. Some resources are better at producing some goods other resources.

The steeper the slope the higher the opportunity cost of obtaining one more unit of foodstuff. Hence as we move from a to b the opportunity cost of obtaining any extra unit of food is increasing in terms of units of other goods forgone. We have to give up more and more other goods to get one more unit of food. | slope of PPF | = opportunity cost of one additional unit of the good on the horizontal axis. It shows how much you must give up to produce a unit more of the other output.

Technology improvement, increase in resources, increased productivity, more favourable weather etc.

Drought, fire, disease, crime, greed of the soldiers.4.

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Topic 1 Introduction to economics | 15

Topic 2

Markets: Demand and supply

Introduction This topic begins by examining the concepts of demand and supply. An understanding of these two concepts and how they interact in markets is the foundation for any study in economics. Most of the topics in this unit are based upon the existence and operations of markets. It is important that you spend time understanding the difference forces that determine demand and supply and be able to use the resulting interaction of demand and supply curves to explain the operation of markets and the determination of equilibrium price levels.

You need to be aware that markets are often inter-related. For example, changes in the prices of houses affects demand and supply in the related market for rental accommodation.

Objectives On completion of this topic you should be able to:

Study materials

Textbook Sloman, J., Norris, K. & Garratt, D., 2014, Chapter 2.

Readings

Demand Buyers and sellers make contact with each other through a market, which uses a medium of exchange such as money or barter to facilitate a transaction. Money is more efficient because it eliminates the ‘double coincidence of wants’ required with barter. A market will not exist without both demand for and supply of a product. Sometimes demand is insufficient to sustain a market.

identify the determinants of demand and supply

explain the market mechanism

distinguish between a shift in a demand or supply curve and movements along a demand or supply curve



explain the significance of equilibrium price.

2.1 Henderson, I. & McKenzie, A., 1999, ‘GST no guarantee of cheaper cars – Tels’, The Weekend Australian, December 4–5, p. 36.

2.2 McTaggart, D., Findlay, C. & Parkin, M., 2003, Economics, 4th edn, Addison Wesley, pp. 66–67.

Demand is more than a want. It is a want backed up by a willingness and ability to pay for the satisfaction of that want. Consumers will have different notions of what they will be prepared to pay for different quantities and qualities of the good in question. The demand curve is the graph of combinations of quantities that consumers are willing to purchase at different price levels. For any given quantity the corresponding price is the price which induced the last unit to be demanded. The demand curve is downward sloping. Price and quantity are said to move in opposite directions to each other, that is, as price rises, quantity demanded falls. Price and quantity have a negative relationship.

It is extremely important to grasp the fundamentals of demand as this material will be assumed knowledge for all subsequent topics.

For the consumer the willingness to exchange is reflected in the demand for different quantities at the different price levels. For the producer the willingness to exchange will be reflected in the supply of different quantities at the different price levels.

Supply For any transaction to take place in a market there will not only have to be a demand for the product, but also a firm (or producer) that is prepared to supply the market.

Supply is the quantity, per unit of time that a firm will place for sale in a market. The supply curve, which is generally upward sloping, shows for any given quantity the price the supplier requires to place the last unit on the market. The law of supply states that the higher the price the greater the quantity supplied to the market. Why does a higher price lead to a greater quantity supplied, and what determines the quantity supplied? The textbook gives you a good insight into the important differences between changes in quantity supplied and changes in supply.

Activity 2.1a

What is the law of demand?1. What is the difference between the demand schedule and the demand curve?2. What is the difference between ‘a change in demand’ and ‘a change in the quantity demanded’?3. A change in demand can be caused by any of:

change in price of other goodsa. change in incomeb. change in populationc. change in tastesd. availability of other goods. Explain how each of these changes (increase or decrease) can have an effect on demand, and note specifically whether the changes in demand are positive (curve shifts to the right) or negative. Use diagrams and/or examples to aid your explanation.

If you were the owner of a clothes shop, how would you set about deciding what prices to charge for each garment at the end-of-season sale?

ECO10250 Economics for Decision Making

Topic 2 Markets: Demand and supply | 17

Explain the effect on supply or on the supply curve of:

Consumers aim to obtain the highest value for their money. Thus after taking into account quality, service, availability etc. they will aim to buy at the lowest price, whilst producers will be aiming to get the highest or best price for their goods. The price at which they actually trade is the equilibrium price which is the best deal available for both buyers and sellers.

Equilibrium price Assuming that the supplier and the prospective buyer have some overlap of price range that they are both prepared to negotiate within, then a point of intersection called an equilibrium price can be found. For example if the Fish Cooperative is prepared to sell king prawns for above $17 per kg and the customer is prepared to pay up to $21 per kg, an equilibrium price will exist for the two since there is a price overlap between $17 and $21. Often the overlap is not reached. Take the case of a house auction where the bids fail to reach the reserve (a minimum price) set by the owners and the house is said to be ‘passed in’ (that is, it is not sold to the highest bidder). In this situation the market has failed to reach an equilibrium price.

Equilibrium price is that price at which the quantity demanded is equal to the quantity supplied. Equilibrium exists at the point of intersection of the demand and supply curves. At any other price other than the equilibrium price there will be an imbalance between demand and supply forces causing price to move towards the equilibrium level.

Changes in demand and supply will have an impact on equilibrium price. These changes can be considered independently or as a simultaneous change in both demand and supply.

In the textbook reading, note in particular the differences between movements along an existing curve and a shift in the curve itself. This essential difference can be one of the most difficult concepts that you have to grasp.

Activity 2.2a

a change in demand1. a rise in the price of a firm’s labour2. more efficient technology introduced3. cheaper raw materials used by the firm.4.

Activity 2.3a

The number of owners of mobile phones has grown rapidly and hence the demand for mobile phones has also grown rapidly. Yet the price of mobile phones has fallen. Why?

Assume that oil begins to run out and that extraction becomes more expensive. Trace through the effects of this on the market for oil and the market for other fuels.

What would be a logical expectation if a store were to set prices too high?3. What if the store were to set prices too low?4.

ECO10250 Economics for Decision Making

Topic 2 Markets: Demand and supply | 18

In this topic we have identified the major factors that influence demand and supply. We have also introduced a model that shows how prices and quantities traded are determined. Now you should try to apply this model to a current economic situation. Keep the model in mind as you undertake the next reading, which discusses a fall in car prices.

Henderson & McKenzie, 1999, p. 36.

McTaggart, Findlay & Parkin, 2003, pp. 66–67.

The replacement of the wholesale sales tax with the 10% GST should result in cheaper car prices. This is because the GST rate is less than the rate of wholesale sales tax.

The free-market economy Our discussions so far have fundamentally focused on the ‘free’ economic market system rather than ‘command’ system – see Chapter 1 of your text. So which one is the better system? Given that both systems have their problems most economies adopt a mixture of the two systems.

Reading 2.1r

Reading 2.2r

Activity 2.4a

Draw demand and supply curves to represent the market for new cars just prior to the announcement of the GST rate. Show on your diagram the effect of the announcement that the GST rate is less than the present rate of wholesale sales tax.

Why would the Federal Chamber of Automotive Industries foresee sales of new cars falling further as the date for the introduction of the GST gets closer?

Reading 2.2 (McTaggart et al., pp. 66–67) discusses the impact of pre and post GST on new car sales. Does the empirical evidence in this article support your analysis in a and b?

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In this topic we learned that consumers and producers meet in a market where exchanges take place. Consumers express their willingness to exchange through demand and producers through supply. When a common price is acceptable to consumers and producers the market has reached equilibrium price. Equilibrium price can vary as there are changes in the demand and supply curves. In building on these demand and supply concepts we will look at quantitative elasticity tools next week and note that:

Review activities

You are advised to undertake activities in the Sloman, Norris & Garratt, 2014, MyEconLab, Chapter 2 and those relevant to pp. 162–164.

elasticity measures demand responsiveness to changes in price and,

changes in price can lead to upward or downward changes in revenue depending on elasticity

Review activitiesa

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Feedback to Activities

Activity 2.1f

The law of demand states that under ceteris paribus conditions the higher the price of a good, the lower the quantity demanded (hence a downward sloping demand curve).

The demand schedule is a table listing the quantity of product consumers are willing to purchase at each price, whilst the demand curve is a graph of the demand schedule which may be linear or curvilinear.

Change in demand is a complete shift of the demand curve and a change in the quantity demanded is represented by movement along the one demand curve (Figure 2.1 and 2.2, Sloman, Norris & Garratt, 2014).

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A change in demand can be caused by any of: change in price of other goods Change in the price of other goods will shift demand to the right in the case of a complement falling in price (e.g., the price of Milo falls, so the demand for milk might shift to the right) and will shift demand to the right in the case of a substitute rising in price (e.g., the price of restaurant meals rises so the demand for home cooked meals might also rise).

change in income A positive change in income will shift demand to the right in the case of a normal good. In the case of an inferior good (which becomes less popular with consumers as their income rises) the shift in the demand curve would be to the left as income rises.

change in population A positive change in population will most likely shift demand for a product to the right, as an increase in consumers who enter the market. A decrease in population will move the demand curve to the left.

change in tastes Changes in tastes will shift demand left or right depending on whether the change is negative or positive. With the introduction of CDs, demand for LP records would have continued to shift to the left until that demand became negligible.

change in availability of other goods. If more substitutes for a good become available then it is likely a decrease in demand for a good will occur.

You would try to reduce the price of each item as little as was necessary to get rid of the remaining stock. The problem for shop owners is that they do not have enough information about consumer demand to make precise calculations here. Many shops try a fairly cautious approach first, and then, if that is not enough to sell all the stock, they make further ’end of sale’ reductions later.

Activity 2.2f

A change in demand will not affect the supply curve as such, but will lead to a new equilibrium market price and hence a different quantity supplied to the market.

Rise in price of labour (wage rise) will shift the firm’s supply curve to the left as costs of production per unit are forced to rise.

More efficient technology will shift the supply curve to the right.3. Cheaper raw materials used by the firm will shift the firm’s supply curve to the right as a greater quantity of product will now be possible for the same cost.

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Activity 2.3f

The price of mobile phones have fallen because: The costs of manufacture have fallen with improvements in technology and mass-production economies.



Competition from increased numbers of manufacturers has increased supply and driven prices down.



The reduction in supply will cause a shortage of oil at current prices. This will cause the price of oil to rise. This will then have a twin effect; it will reduce demand and it will also make it profitable to use more expensive extraction methods, thereby increasing supply. The effect of the higher price, therefore, will be to eliminate the shortage.

Prices set too high would mean that they were set above equilibrium price resulting in an excess quantity supplied. An example would be the floor price for wool in the 1980s which was set above the market equilibrium price.

If prices were set too low they would be below the equilibrium price and there would be excess quantity demanded or shortages of supply. An example would be rent ceilings set below market equilibrium price leading to shortages or sub- letting.

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Activity 2.4f

The change in taxes, when implemented, is expected to result in falling new car prices. Therefore, consumers decide to delay purchases of new cars in anticipation of lower prices in the future. This is an example of a change in demand. A change in demand causes a shift in the demand curve. In this example, demand decreases and the demand curve shifts leftward and results in a new, lower, equilibrium price (P2) and quantity (Q2). So the expected effect of the GST on price starts to actually occur and sales have fallen.

The price of new cars is expected to fall due to the introduction of the GST. As the time of introduction gets closer more and more people will be willing and able to forgo buying a new car until after the introduction. This means that the demand curve (D2 in the diagram in part (a) above) will gradually shift further leftwards as the GST introduction date approaches. Along with this declining demand will be declining prices and quantities traded (and therefore sales).

The answer is Yes. See Economic Analysis (Reading 1.2).c.

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Topic 3

Markets: Elasticity

Introduction Topic 3 examines the concept of elasticity. The concept of elasticity is very important for a firm’s pricing policy and other competitive decisions, and also for the effectiveness and impact of government policy.

Think about this situation – Alex loves to put a thick layer of salt around his daily glass of tequila and Jill takes a packaged holiday to Fiji each year. If the price of salt were to suddenly double would this mean that Alex will change his habit? If the price of packaged holidays to Fiji suddenly jumps, will Jill be likely to alter her plans for next year? Would Alex be more likely to change than Jill? The answers are provided by the concept of elasticity which will enable us to compare different products because elasticity is a uniform measure, independent of the scales used for the measurement of price and quantity.

Barry runs a little take-away on the fast-food strip. Barry’s daughter wants to attend university so he needs to increase business to improve its revenue. His brother Bill tells him to increase his prices whilst his sister Mary suggests he should drop them to increase turnover and revenue. Who has the best advice? Knowledge of price elasticity of demand will help Barry make the correct decision.

Elasticity concepts will help us predict answers to these questions by measuring responsiveness of quantity demanded or supplied to changes in price or income, or the price of another commodity. The most frequently used concepts are price elasticity of demand, cross elasticity of demand, income elasticity of demand and elasticity of supply. With these tools we can investigate normal/inferior goods and substitutes/ complements and the likely revenue implications with price changes.

The topic concludes with an examination of the impacts of price controls and the concepts of consumer surplus, producer surplus and total surplus. Price controls not only affect price, but also the availability of goods and services, consumer surplus and producer surplus, resource allocation and economic efficiency.

Objectives On completion of this topic you should be able to:

define, calculate and interpret price elasticity of demand and supply

distinguish between complements and substitutes using cross price elasticities

explain the variations in demand and supply between the short run and the long run

explain the impacts of price controls on supply and demand

define and illustrate using graphs the concepts of consumer surplus, producer surplus and total surplus

explain and illustrate deadweight loss.

Study materials

Textbook Sloman, J., Norris, K. & Garratt, D., 2014, Chapter 3 and pp. 162–64.

Readings

Price elasticity of demand Governments often respond to falling revenue by raising prices on public transport. Yet the higher prices have the effect of causing fewer people to use public transport. In this situation the higher prices become self-defeating. Product pricing decisions in business need to be made with some knowledge of the responsiveness of demand to changes in the price of a commodity. In economics this involves a study of price elasticity of demand. Price elasticity of demand is a units-free, absolute value measure, giving the percentage change in quantity demanded for a percentage change in price.

In order to determine the price elasticity of demand, we need to make calculations. The following section looks at the method involved.

Calculating price elasticity of demand To find the percentage change in a price, there are two slightly different methods. If the price of commodity A is increased from $10 to $11 and the price of commodity B is increased from $2.50 to $3.50, what are the percentage changes in price for each? Do we measure the change in price from the original price or the new price? Obviously commodity B has increased by a greater percentage (answers 10% vs. 40% or 9.5% vs. 33.3% using average prices as the reference). Note that different answers can be obtained depending on which method we use. For example using the change in price over the original price:

By using average prices we get different answers:

So we now find ourselves with two possible formulas. Price elasticity of demand is often denoted by the Greek letter η (eta), where:

3.1 McTaggart, D., Findlay, C. & Parkin, M., 2012, Economics, 7th edn, Pearson Australia, Frenchs Forest, NSW, pp. 80–87.

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∆ means ‘change in’.

Sometimes E or e may be used instead of η.

Since demand is downward sloping (law of demand) we are not particularly interested in the negative sign generated by the fact that prices and quantities move in opposite directions to each other. Hence absolute value symbols are used or the negative sign is usually disregarded.

The following reading explains, in simple form, the method of calculating price elasticity of demand. The reading also lists the categories of price elasticity of demand. Note the difference between elastic and inelastic demand.

Some important points to note in relation to price elasticity of demand:

Now that you know how to calculate price elasticity of demand, you need to be aware that elasticity changes as you move along the demand curve. This will be examined in the next section.

If the postage rate increases from 55c to 60c per letter and the quantity of letters decreased from 20 million to 18 million per week, calculate the elasticity of demand given that ceteris paribus applies.

Investigating elasticity along the demand curve Demand curves can be made to appear steep or flat depending on the scales chosen on the respective axes. Regardless of the scale chosen, once we locate the point of unit elasticity we will have an indication as to whether the demand is relatively elastic or inelastic.

The following reading explains why elasticity varies along the length of a demand curve and shows how a demand curve can exhibit constant elasticity. A tool kit is also provided to further demonstrate how to calculate elasticity of demand.

McTaggart, Findlay & Parkin, 2012, pp. 80-87.

Draw an elastic and an inelastic demand curve.

elasticity is not the same as slope

if demand for a good is elastic then a 1% drop in price will result in an increase of more than 1% in the quantity demanded (η > 1)



if demand for a good is inelastic a 1% drop in price will result in an increase of less than 1% in quantity demanded (0 < η < 1)



if demand for a good is unit elastic a 1% drop in price will result in a 1% increase in quantity demanded (η = 1)



disregard the negative sign for price elasticity of demand (i.e. use absolute value)

ceteris paribus conditions apply when calculating η.

Activity 3.1a

Reading 3.1r

Activity 3.2a

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The demand schedule for videotape rentals is:

Price (dollars)

Quantity demanded per day

0 150

1 125

2 100

3 75

4 50

5 25

6 0

What is the relationship between total revenue and price elasticity of demand?

Determinants of price elasticity of demand There are three main determinants of the price elasticity of demand:

Each of these factors is discussed in the text.

If consumers believe prices are excessive on commodities which are relatively demand elastic they will quickly change to substitutes or plan their purchases for a different time period.

Activity 3.3a

At what price is the elasticity of demand equal to: 1?i. Infinity?ii. Zero?iii.

What price brings in the most total revenue per day?b. Calculate the elasticity of demand for a rise in price from $4 to $5.c.

Activity 3.4a

substitutability

proportion of income spent on goods

time frame for demand.

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If consumers believe prices are excessive or that firms are trying to take advantage of them by increasing prices on commodities which are relatively demand inelastic they will try over time to find suitable substitutes. Hence we need to consider the difference between short-run and long-run demand. Note also the special cases as described in the text.

In addition to prices resulting in changes to the quantity demanded changes in income and changes in the price of other goods (substitutes and complements) can also result in changes to demand (shift) for a commodity. Income elasticity of demand measures demand responsiveness to changes in income while cross elasticity of demand measures responsiveness to changes in the prices of other goods.

Income elasticity of demand (denoted by ηy) Just as price elasticity of demand measures responsiveness of demand to changes in price, income elasticity measures responsiveness of demand to changes in income. As income rises consumers will tend to buy more of a good. Such a good is known as a normal good. Most goods are normal goods. If the quantity of a good demanded declines when income increases, it is known as an inferior good. Examples are cheap cuts of meat and ‘own’ brand groceries.

Here we are mostly concerned with the distinction between normal and inferior goods. Secondhand computers might be the type of good which is inferior, particularly for business people. If so, when income elasticity of demand is calculated the figure will be negative. This is saying that we would demand fewer secondhand computers if our income were to rise. But for a normal good (say new computers) where the income elasticity of demand turns out to be positive we would conclude that we will demand more of them as our income rises.

Income elasticity of demand (ηy) is simply given by:

Percentage change in quantity demanded divided by the percentage change in income

‘Y’ is used to represent income.

When our income rises (ceteris paribus), how might our demand for these goods and services change:

You need to be aware of the distinction between normal and inferior goods. Another relationship of special interest to economists is that of complements (e.g., bread and butter) and substitutes (e.g., train travel and bus travel). The quantitative method of analysing complementary and substitution is discussed in the next section.

Activity 3.5a

restaurant mealsa. bus travelb. winec. concert tickets and entertainment?d.

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Cross price elasticity of demand (denoted by ηx) Adapting the formula to calculate cross price elasticity simply involves another change in the denominator of the original formula for price elasticity for demand. You need to learn all these formulae. An easy way is to learn the formula for price elasticity of demand and replace the ‘price’ terms with either ‘income’ or the ‘price of another good’.

The cross elasticity of demand is the percentage change in the quantity demanded of a product divided by the percentage change in price of another good.

‘x’ represents cross elasticity. QA is the quantity of good A and PB is the price of good B.

What is the significance of the sign and absolute value of ηx ?

Price elasticity of supply Just as time has a role to play in buyer decision making through demand, it also plays an important role on the production or supply side. The momentary supply curve shows the response of the quantity supplied immediately following a price change. For many goods such as fresh fish, fresh fruit and vegetables the momentary supply curve will be perfectly inelastic. The amount of fresh sea food available to the market today will depend on factors decided earlier, such as last night’s weather. Long-run supply takes into account all long-term adjustments, such as new plant and equipment. In the case of fishing in the long-run new boats may start working if prices have remained high over time. Short-run supply allows time for only some adjustments to the production process such as an increase in labour. In the fishing example this may involve the boats staying at sea longer or working more nights per month.

Activity 3.6a

Activity 3.7a

Explain why: the immediate supply curve might be verticala. the short-run supply should be upward slopingb. the long-run supply should be more horizontal than the other two curves.c.

How could we relate the different supply curves to the supply of residential building allotments in a region? How does the council’s town planner act to regulate the supply?

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Short-run and long-run demand One factor which tends to alter elasticity of demand and supply is time. In general the longer time goes on the more accessible substitutes become and hence the higher is the elasticity of demand and supply. If a loaf of bread suddenly costs 20% more, our demand may not alter much in the week of the sudden price jump, but depending on the level of displeasure of the consumers, over time they will explore substitutes and alternatives in an attempt to reduce costs.

In terms of supply, the longer the time frame the more ability producers have to change their production decisions.

Some important points discussed in the following textbook reading include the differences in consumer behaviour for price rises which are believed to be permanent and those which are believed to be temporary. The short run demand curve describes the initial response of buyers, whilst the long run demand curve describes the buyers response after all adjustments to buying plans have been made. Note also how speculators attempt to stabilise prices.

Markets where prices are controlled So far our studies have presumed that markets were free to operate in response to changes in supply and demand forces. In many instances, however, governments intervene in markets. Market controls can take many forms. There may be controls on the amount of a commodity produced, such as a milk quota system introduced to limit the number of dairy farms so that the industry can become more economically viable. In the wool industry the Australian government used to set a minimum price (floor). Any wool not sold at that price was purchased by the government. This example demonstrates what can happen when the price control is set above equilibrium.

If prices are set too low, for example, in rent ceilings, housing shortages can result and alternative allocated systems such as black markets and political pressure for more public housing will result from the supply shortages. The effect is to reduce the quantity bought and sold below equilibrium quantity. The unmet demand can lead to long queues (e.g., elective surgery), the need for centralised rationing (e.g., logging licences) and the rise of black markets in which goods are sold at prices which bypass the legal restrictions (e.g., ticket scalpers).

Consumer surplus, producer surplus & total surplus The demand curve shows the maximum price consumers are willing to pay for a quantity of good or service. Consumer surplus is the difference between what consumers are willing to pay and what they actually pay (equilibrium price of a G or S).

The supply curve shows the minimum price that must be offered to producers to produce a certain quantity. Producer surplus is the differences between the price (equilibrium price) producers receive and what price they are willing to produce at (their willingness to accept).

The total surplus or net benefit to society is the sum of consumer and producer surplus and in a market this is maximised at equilibrium (MB = MC).

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A new low cost/low price whale watching business enters the Byron whale watching market. What happens to consumer surplus, producer surplus and net benefit to society? Illustrate your answer with a diagram.

Summary Topic 3 introduced the concept of quantitative elasticity tools and discovered that:

The formulae used have a common theme of percentage change in quantity divided by percentage change in price or income, or price of another good.

Though demand may exhibit a full range of elasticity as we move along the demand curve, the general classification of elastic or inelastic is applied. Products can be classified as inferior or normal goods and the sign of the cross elasticity is used to give an indication of substitute or complementary associations between products. The relative strength of the association will be indicated by the absolute value of the cross elasticity.

Finally, we studied the effect of government controls on the price of goods and services and also looked at the concepts of consumer surplus, producer surplus and total surplus. In the next topic, we will examine the theory of the firm by looking at production output and the cost of that output. This will enable an understanding of what underlies the supply curve in our model of markets.

Activity 3.8a

elasticity measures demand responsiveness to changes in price and,

changes in price can lead to upward or downward changes in revenue depending on elasticity

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Review activities

You are advised to undertake activities in the Sloman, Norris & Garratt, 2014, MyEconLab, Chapter 3.

Feedback to Activities

η = 1.2

This means a percentage change in price has brought a greater percentage change in quantity demanded.

Figure 3.2(a) of the Sloman, Norris & Garratt 2014 text demonstrates an elastic demand graph and Figure 3.2(b) demonstrates an inelastic demand graph.

Review activitiesa

Activity 3.1f

Activity 3.2f

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Problem 1

The relationship between elasticity of demand and total revenue can be summarised as follows:

Activity 3.3f

Refer to Figure 4.2 from Reading 3.1. A linear demand curve will have an elasticity of 1 at halfway points to the intercepts on the price and quantity axes.

Price = $3 (This price is halfway between price = 0 and price = 6.)i. Price = $6 (Elasticity is always equal to infinity at the vertical intercept.)ii. Price = $0 (Elasticity is always zero at the horizontal intercept.)iii.

Total Revenue = Price x Quantity, It is easy to verify the maximum will occur when Price = $3 (which is also the unit elastic price).

As price rises from $4 to $5 quantity demanded falls from 50 to 25 per day and using the formula from the previous activity:

Activity 3.4f

If price elasticity of demand is greater than 1 (relatively price elastic) an increase in price will result in a decrease in revenue, and conversely a decrease in price will result in an increase in revenue.



If price elasticity of demand is less than 1 (relatively price inelastic) an increase in price will result in an increase in revenue, and conversely a decrease in price will result in a decrease in revenue.



Hence if prices of beer and cigarettes rise (say by increased taxes), total revenue raised will increase. These goods have a relatively inelastic demand. If prices of foreign travel were to rise the total revenue raised (say by a travel agent) will decline. Foreign travel has a relatively elastic demand.



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Of course we can probably find conflicting arguments in each case; however it may be reasonable to assume that for:

The sign for cross elasticity indicates if the goods or services are complements or substitutes. If the goods are complements then the sign will be negative and if they are substitutes then the sign will be positive. (Make sure you can work out why this is so.) The absolute value of the cross elasticity is a measure of how closely related the two goods are as substitutes or complements. The higher the value of the cross elasticity the stronger the relationship.

Activity 3.5f

restaurant meals, demand would increasea. bus travel, demand would decreaseb. wine, demand would increasec. concert tickets and entertainment, demand would increase.d.

Activity 3.6f

Activity 3.7f

The immediate supply curve might be vertical because the supply at any point in time will be fixed and finite if there are no inventories to call up immediately.

Short-run supply should be upward sloping since supply can be increased in the short run by increasing the amount of labour (e.g., firm might produce for more hours per day). Upward sloping implies that at a higher price the firm is willing to supply greater quantities to the market.

Long-run supply should be more horizontal than the other curves since in the long run all possible adjustments to the production process can be made. This means that new plant, technology, economies of scale or new substitutes become available. Competition may enter the market forcing supply to become more elastic.

The supply of residential building allotments is inelastic or fixed at any point in time. There will be some allotments held but not offered for sale. However a sudden rise in price will still have a time lag before more lots are offered for sale (due to delays in information reaching the entire market).

In the short run the town planner will act to see that some new subdivisions are progressing so that the market supply does not get too low as this will lead to inflated prices and pressure for accelerated subdivisions.

In the long run the town planner will act to ensure the subdivisions of allotments are geographically and environmentally suitable. The plans being studied today might be for the supply to be released in five years’ time.

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The entry of a new low cost/low price whale watching business into the Byron whale watching market will initially move the supply curve to the right. As a consequence there will be a new equilibrium price and quantity (assuming there is no change in demand). Equilibrium price will be lower and people will consume a larger quantity of the product. This means there will be an increase in consumer surplus. It is not so clear what will happen to producer however we can be sure that total surplus increases.

Activity 3.8f

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Topic 4

The supply decision

Introduction We now turn our attention to the production and supply of goods and services. In Topic 2 you studied the principles of supply and learned that the higher the price of a good, the greater will be the quantity supplied by a firm. We now look more closely at the firm, particularly at a firm’s output and costs on the basis of which it decides how much to produce. This topic provides the basis of the perfect competition and monopoly market structures which we study later in this unit. NOTE that there are also other types of market structure that exist, for example, monopolistic competition, oligopoly and duopoly, however they will not be studied in this unit.

The aspects to be covered in this topic include:

Production theory is an essential component of modern economic theory. It can be used to explain why two countries (e.g. Germany and Korea) with very different endowments of the factors of production – land, labour and capital – could both produce motor cars at comparable costs; or why one manufacturer runs its plant profitably 24-hours per day and the manufacturer next door finds it equally profitable to operate only 8 hours per day; or why two farmers in an irrigation area with equal fixed water rights choose to water different areas of land.

Production theory enables us to select the combination of resources which will produce a given output at minimum cost or, put another way, enables us to identify the maximum that could be produced for a given cost outlay.

The short-run is identified by the fact that at least one input is fixed. In your situation inputs include time available to study, existing level of economic knowledge and level of other related knowledge. All of you will have a maximum attainable level of ‘product’ for a given cost. At higher costs you could do better in your studies, not only by incurring direct monetary cost (e.g. paying for private tuition), but also by incurring opportunity costs (e.g. doing less work for other units, the cost being a lower mark in that unit). In the long- run all things except your innate ability would be variable.

The discussion in this topic will also consider revenue and profit maximisation merging cost and revenue curves to assess loss minimisation and shut-down points.

firms and why they exist

the concepts of economic profit and economic efficiency

the economic problems common to all firms

the objective of the firm and the factors which limit profitability

the relationship between a firm’s output and its costs

short-run and long-run cost curves

excess capacity and over utilisation.

Concept review If you are uncertain about the following concepts then you should review them in Topic 2 of this study guide:

The focus of this chapter is on the firm and the firm’s decisions in relation to the production and supply of goods and services. Before you proceed, write down your own definition of a firm. Do you think Southern Cross University is a firm? Why or why not?

Objectives On completion of this topic you should be able to:

Study materials

Textbook Sloman, J., Norris, K. & Garratt, D., 2014, Chapter 4.

Readings

What is a firm? A firm is an institution that hires factors of production (land, labour and capital) and uses these resources to produce and sell goods and services. Our goal in this topic is to predict firm behaviour. To do so we need to know a firm’s goals and constraints.

the determinants of the quantity supplied

the supply curve

the law of supply

differences between changes in supply and changes in quantity supplied.

Activity 4.1a

explain the concept of economic profit and how it differs from an accounting view of profit for a firm

explain the objective of the firm and efficient production when facing particular cost curves

derive a firm’s cost curve and explain the relationship between a firm’s output and its costs in the short and long run



explain how cost may change when a firm’s plant size changes

explain why some firms operate with excess capacity and others over utilise their plant

derive a firm’s total, average and marginal revenue curves

determine the profit maximising price and output in the short and long run for a firm

determine whether a firm should produce or not.

4.1 Hatch, J., Snelling, J. & Cowie, J., 2005, Reading between the lines, Issue 8, Addison Wesley, Sydney, pp. 19–22.

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Economic profit Now that we have discussed some basic aspects about firms, we need to consider the concept of economic profit.

What do you think is meant by the term ‘profit’?

You may have written that profit is revenue less costs. This is correct, but only in part, because this is more of an accounting definition of profit. Accountants and economists differ in how they define profit. In particular, economists have a unique way of looking at costs. For the accountant, the only costs are historical (or explicit) costs. The economist, however, is concerned with the opportunity costs of production. This means that the economist defines economic profit as the difference between total revenue and its total cost of production, including opportunity costs. This means that economic profit is generally less than accounting profit.

An example might serve to illustrate this. Let’s pretend that you own a small manufacturing company and for a $1 million investment in the business you receive $100,000. In contrast, if you put the same $1 million into the bank at an interest rate of 15% you would receive a return of $150,000. Accounting profit in this example is $100,000, but the economic profit is actually an economic loss of $50,000. The economic profit is the $100,000 accounting profit less the opportunity cost (or the cost of the forgone opportunity) of $150,000 which you could get if you put your money in the bank, which is therefore a loss of $50,000.

Economic efficiency We have looked before at the concept of efficiency. Now we will add some new terms that are particularly relevant when we are discussing firms. The first is concerned with production in physical units: technological efficiency. This is where a firm’s production yields the maximum possible output given the combination of resources used. Equally, technological efficiency is where a given amount of product is produced using the least amount of resources.

Economic efficiency (sometimes called productive efficiency) occurs when the firm’s chosen level of output is produced using the least-cost combination of inputs given the available technology.

The achievement of economic efficiency depends on the prices of the inputs used in production and these depend on the physical units used. Therefore to achieve economic efficiency we also have to achieve technological efficiency. In other words, economic efficiency involves achieving technological efficiency (producing the maximum possible output from given inputs) as well as using inputs in their cost- minimising proportions.

Note that these concepts have nothing to say about marginal benefit. When firm production in an industry is economically efficient (therefore, technologically efficient) and the output is that most preferred by consumers, then we have allocative efficiency. This is where marginal benefit equals marginal cost and the sum of consumer and producer surplus is maximised. Therefore, economic efficiency is a necessary but not sufficient condition for allocative efficiency. Generally when the textbook uses the words ‘efficient’ or ‘efficiency’ alone, it is talking about allocative efficiency.

Activity 4.2a

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If a firm has a positive accounting profit but is making an economic loss what will happen?

Markets and the competitive environment The markets in which firms operate vary a great deal. Some are highly competitive and profits are hard to make. Some appear to be almost free from competition and firms earn large profits.

Economists identify four market types:

We will examine how firms operate in the perfect market and monopoly market in Topic 5. At this stage these structures are introduced to provide a backdrop to our cost, revenue and profit maximisation studies in this topic.

The degree of competition in an industry can be estimated in a number of ways.

What is perhaps more important at this stage is the classification of the most common market structures economists study and the characteristics of each of these which is illustrated in Table 5.1 in the text.

Short-run cost So far we have discussed the firm and its modus operandi and the types of market structures it may operate in. We now turn our attention to how a firm’s costs change as it varies its output. Total cost consists of total fixed cost and total variable cost.

Fixed costs are those costs that do not change as the firm’s output changes. For example, you have to pay the same rent on a factory regardless of how much you produce. We can consider fixed costs as either total fixed costs (TFC) or average fixed costs (AFC). Total fixed cost is the cost of the fixed inputs and the total fixed cost curve is a horizontal line. Average fixed cost is the total fixed cost per unit of output. The average fixed cost curve declines continuously. This component of total cost would drive the firm to produce as much as possible.

Variable costs, by contrast, are costs that vary as output changes. For example, as you produce more you have to employ more labour, increasing wage costs. Total variable cost (TVC) is the cost of all the variable inputs. Average variable cost (AVC) is total variable costs per unit of output. The average variable cost curve is U- shaped which means it has a minimum point.

The other important cost relationships are marginal cost (MC) and average total cost (ATC). Average total cost is the total cost per unit of output while marginal cost is the change in total cost resulting from a one unit increase in output. Both the average total cost and marginal cost curves are U-shaped.

Read the textbook material on short-run cost paying particular attention to Figure 4.1.

Activity 4.3a

Perfect competition

Monopolistic competition

Oligopoly

Monopoly.

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Cut Roses: Short-run Costs (dollars per day)

Labour Output TFC TVC TC MC AFC AVC ATC

0 0 200

1 20

2 44

3 60

4 72

5 80

6 84

7 84

Suppose that the cost of employing one worker (the only variable input) is $50 a day and that total fixed cost is $200 a day.

Activity 4.4a

Complete by calculating total fixed cost (TFC), total variable cost (TVC), total cost (TC), marginal cost (MC), average fixed cost (AFC), average variable cost (AVC), and average total cost (ATC).

Graphically represent the TC, TVC, and TFC curves.b. Graphically represent the MC, ATC, AVC, and AFC curves.c. At what level of output is AVC at a minimum? At what level of output does MC intersect AVC?d. At what level of output is ATC at a minimum? At what level of output does MC intersect ATC?e.

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Suppose that the cost of the fixed inputs remains the same, but the cost of employing a worker goes up to $60 a day.

Long-run production and cost The behaviour of long-run costs depends on the firm’s production function. An important feature of production functions is returns to scale. It is important that you be able to explain the cases of increasing, decreasing and constant returns to scale and their link to economies and diseconomies of scale. Constant returns to scale refers to when a given increase in all inputs leads to an equally proportionate increase in output. For example, if all inputs are doubled output will double. The long-run average costs (LRAC) are constant. Under increasing returns to scale for a given increase in all inputs output will increase more than proportionately. For example, if all inputs are doubled the output might triple. Economies of scale occur because the unit cost of production decreases with increases in the scale of production. Decreasing returns to scale occur where a given increase in all inputs leads to a less than proportionate increase in output. If we doubled inputs the output might only increase by 50 percent. Diseconomies of scale occur because unit costs of production rise with increases in the scale of production.

You should note that there is often confusion among the concepts we have been discussing:

The Law of Diminishing Returns is concerned with the returns to a single input, holding all other input quantities unchanged. Returns to scale concerns changes in all inputs. Thus the two concepts deal with distinctly different issues.

In the long-run all inputs are variable. The firm is not committed to using any particular inputs in any particular quantities. This also means that all costs are variable.

Imagine a situation where you manage a factory. At present you have only one machine (your fixed input) but the number of workers you employ is variable. You could examine the output you would produce with different numbers of workers. This is your short-run production function.

In the long-run you don’t have to use just one machine; you could have one, two, three or more. In the long- run the number of machines with which you produce your output is variable. However, if you committed yourself to using a certain number of machines (no matter how many) then you would once again have a fixed input but you would still be able to vary the number of workers. In other words, each possible plant size (the number of machines in this example) that you could choose has its own short-run production function and associated short-run cost curves.

For each level of output there will be at least one plant size which can produce that level of output for the least cost. The long-run average cost (LRAC) curve is derived by tracing the outer envelope of all the short- run average cost curves. It outlines the lowest average costs that the firm will incur over a range of outputs.

Thus the LRAC curve is concerned with evaluating future possible production options; it is concerned with firm planning.

Activity 4.5a

Graphically represent the new MC and ATC curves.a. What is the effect on these curves of an increase in the price of the variable input?b.

Law of Diminishing Returns, also known as Law of Variable Proportions or returns to a variable factor

Returns to scale can be increasing (economies of scale), decreasing (diseconomies of scale) or constant (constant costs).



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LRACs generally initially decrease, then become constant and then increase over a range of output. This is reflected in a U-shaped LRAC curve. Economists have a term for each of these situations, the first with which you may be familiar. A firm is said to be experiencing economies of scale when LRACs are decreasing as output is increasing. Constant costs are being experienced when LRACs are constant as output increases. When LRACs are decreasing as output is increasing, a firm is experiencing diseconomies of scale.

Explain the relationship between the short-run average total cost curve and the long-run average cost curve.

Having discussed costs in the short and long-run it is now worth reading the following to see a student analysis of the cost structures involved in supermarkets turning some resources towards banking.

Hatch, Snelling & Cowie 2005, pp. 19–22.

Excess capacity and over-utilisation It is important to recognise that every firm has a capacity level. The economist’s conception of capacity is not the same as the everyday understanding of the term. To the economist capacity does not refer to the physical limits of the firm (or the maximum level the firm can produce). A firm’s capacity is the output rate at which average total cost is at its lowest. This is the minimum point on the firm’s average total cost curve. If the firm produces less than its capacity it is said to have excess capacity. If its output is greater than its capacity it has over-utilised capacity.

We have already seen that firms can operate at excess capacity. When this occurs the market is characterised by increasing returns to scale. It is often said that excess capacity is common in car manufacturing, telecommunications and electricity generation. It typically occurs in industries where the local market is too small to permit the efficient scale of production. Thus, firms will produce on the downward part of their long-run average cost curves. You should note that despite this the firm is still operating as efficiently as is possible.

Firms that experience frequent periods of peak demand (such as in electricity generation and airline travel) will tend to over-utilise their plant, operating at output levels that exceed capacity. This is because it does not pay the firm to invest in additional capacity. Only when the firm finds itself in a situation where it is continuously exceeding capacity and/or is unable to meet peak demands would it expand its capacity. Firms which experience frequent periods of peak demand tend to adopt a pricing policy called peak load pricing. Under peak load pricing, prices are set higher for periods when demand is at a peak. It is for this reason that electricity charges are lower during the night and why many of us have off-peak hot water systems. It is also why airlines charge higher fares in holiday periods and why train travel is cheaper in Sydney between the times of 10.00 am and 3.00 pm.

Activity 4.6a

Reading 4.1r

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Profit and revenue You already know that profit is total revenue minus total cost. Keep in mind, however, that we are talking about economic profit. It is important that you are able to define and calculate the concepts of total, average and marginal revenue. Total revenue (TR) is the total value of a firm’s sales and is calculated by multiplying the price of the good sold by the amount sold. If you are the owner of a firm selling radios and you sell 10 radios at $10 each then your total revenue is $100.

Average revenue (AR) is revenue per unit of output and is calculated by dividing total revenue by quantity sold. In the example given average revenue is equal to $10. You should therefore be able to see that average revenue equals price.

Finally, marginal revenue (MR) is the change in total revenue resulting from a one unit change in the quantity sold. Under perfect competition marginal revenue is also equal to price. We can see this by calculating marginal revenue, when the number of radios sold increases from 10 to 11. Total revenue then becomes $110. The firm can sell all it wants at the going price thus, since the increase in total revenue is $10 and the increase in quantity sold is 1, marginal revenue is $10 divided by 1, which is $10.

The textbook provides a good example in Figure 4.4.

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Complete the following table by calculating marginal revenue and marginal cost. Plot the TR and TC curves on one graph and plot the MC and MR curves on another graph. Remember to plot the marginal values between the units of output.

Qty TR MR TC MC

0 10

1 10 15

2 20 18

3 30 23

4 40 30

5 50 40

6 60 55

7 70 78

8 80 112

The firm’s decisions Any firm in a perfectly competitive industry has to make four types of decision:

Activity 4.7a

whether to produce or temporarily shut down

how much to produce (if the decision is to produce)

whether to change its plant size

whether to stay or leave the industry.

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The decisions each firm takes depend on the profitability of that firm. You know that the objective of any firm is to maximise profits. For this reason we have to determine the conditions for profit maximisation for a firm under perfect competition.

Profit-maximising output Profit is maximised when the difference between total revenue and total cost is maximised. This can be illustrated diagrammatically, and in a diagram you should be able to identify the point of profit maximisation, the break-even point, and where losses are incurred.

The point at which the distance between total revenue and total cost is maximised is where marginal revenue equals marginal cost. This is the point where the slopes of the total revenue and total cost curves are equal. This produces a simpler and easier method for illustrating profits and the one we will use in this unit is called the marginal approach. Under this method the marginal cost and marginal revenue curves are used to determine the output at which profit is maximised.

Remember: profit is maximised at the output where marginal cost equals marginal revenue.

If you are wondering why profit is maximised where marginal cost equals marginal revenue the answer is really quite simple? If marginal cost is below marginal revenue then profits could be increased by increasing output. For example, if you produced 3 radios then marginal cost is less than marginal revenue and profit is $7. Profit could be increased to $10 by lifting output to 5 radios where marginal cost equals marginal revenue. On the other hand, if marginal cost is above marginal revenue then profits can be increased by reducing output. For example, if you produced 6 radios then marginal cost is greater than marginal revenue and profit is $5. Profit could be increased to $10 by cutting output to 5 radios where marginal cost equals marginal revenue.

The firm’s short-run supply curve The shut-down point for a firm is the point where a firm’s maximum profit is the same regardless of whether it produces or does not produce output. This occurs at the point where the average variable cost curve is at a minimum. When price is less than average variable cost then the firm does not cover its average variable costs. In this situation the firm will temporarily shut-down and wait for price to recover. This does not mean that the firm has gone out of business permanently. What it means is that the firm lies idle until market conditions improve.

In order to understand this, put yourself into the position of the firm owner. If price falls below average variable cost then it is rational for you to produce nothing. Since you still incur fixed costs regardless of whether you produce or not you make a loss equal to your fixed costs. While this is a loss your losses will be greater if you begin to produce and price is less than average variable cost. In this case total revenue will not cover total variable costs and the loss will exceed total fixed costs. Only when price is equal to average variable cost will total revenue equal total variable costs and losses will equal total fixed cost.

The firm will temporarily shut down when price falls below average variable cost. Thus the firm will only produce when price exceeds average variable cost. The implication of this is that under perfect competition the firm’s supply curve is its marginal cost curve above the average variable cost curve.

We will return to this discussion after we look at the more positive outcome for the firm of ‘profit maximisation’.

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Pat’s Pizza kitchen is a price taker. It has the following hourly costs:

Output (pizzas per hour)

Total cost (dollars per hour)

0 10

1 12

2 16

3 22

4 30

5 40

Profit and losses in the short and long-run In the short-run, a profit maximising firm might make an economic profit (supernormal profit), (where price exceeds average total cost), zero (or normal) economic profits (where price is equal to average total cost), or an economic loss (where price is less than average total cost).

In the short-run fixed costs need to be paid. If a firm cannot cover its variable costs then it will shut down. See Figures 4.9 and 4.10 in the text.

In the long-run, however, all costs are variable so if a firm cannot cover its long run average costs it will close down.

The reason for this lies in the assumption we made about firms having freedom of entry and exit in a perfectly competitive market. If positive profits do exist then firms outside the industry will enter the industry. This will drive down price and profits will be eroded. In fact, firms will continue to enter as long as economic profits are to be made.

The textbook reading on long-run equilibrium will consider the entry and exit of firms in detail. It is essential that you are able to describe and use a diagram to illustrate the process by which this result is attained. You must also be able to describe and use a diagram to illustrate what happens when economic losses are being made. In this case firms will exit the industry and price will rise thereby reducing the losses. Firms will continue to exit as long as losses are being incurred.

Activity 4.8a

If pizzas sell for $10 each what is Pat’s profit maximising output?a. What is Pat’s shut-down point?b. Derive Pat’s supply curve.c.

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Summary The main concepts you have covered in this topic are:

Now that you have studied both the consumer and the firm in detail we shall turn our attention to the perfect market and monopoly market structures. In particular we will apply the basic concepts from this topic to see how firms in different market conditions make decisions on how much to produce and what price to charge.

Review activities

You are advised to undertake activities in the Sloman, Norris, & Garratt, MyEconLab, Chapter 4.

Feedback to activities

A firm is an institution or organisation that hires factors of production (namely natural, resources, labour and capital) and uses them to produce and sell goods and services. Firms range in size from the small owner-operator right up to large trans-national corporations employing thousands of workers. Although Southern Cross University is legally a non-profit institution in many ways it might be considered a firm. Southern Cross University hires academic and administrative staff and other factors (such as books, buildings, etc.) to produce the services of education and research.

firms are institutions that hire factors of production and use them to produce and sell goods and services and they exist because they are able to achieve lower transaction costs, and benefit from economies of scale and team production



the economist defines economic profit as the difference between total revenue and total cost of production, including opportunity costs, while the accountant defines profit as total revenue less historical (or explicit) costs



the relationship between a firm’s output and its costs is called a production function

total cost is divided into total fixed cost and total variable cost and as output rises, total cost rises because total variable cost rises



costs depend on how much the firm produces

the average variable cost, average total cost and marginal cost curves are U-shaped and the marginal cost curve crosses the average variable cost and average total cost curves at their minimum point



the firm’s long-run cost curve is the envelope of the firm’s short-run cost curves

a firm’s total revenue is measured by price x output sold, average revenue is revenue per unit of output and marginal revenue is total revenue resulting from one extra unit in quantity sold. The objective of the firm is to maximise profit at marginal revenue = marginal cost



firms that produce a smaller output than their plant capacity have excess capacity while firms that produce more output than their plant capacity have over-utilised capacity



firms will shut down temporarily and lay off workers when price falls below average variable cost

firms will shut down permanently if they cannot cover their long-run average costs.

Review activitiesa

Activity 4.1f

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While the investment is profitable in an accounting sense there will be no incentive to stay in the industry. The owner of the firm will move his/her resources into another industry where returns are greater (assuming that there are no barriers to entry).

Activity 4.3f

Activity 4.4f

Cut Roses: Short-run Costs (Daily)a.

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AVC is at its minimum at a level of output of 35 bunches of roses a day. The MC curve intersects AVC at the minimum point of AVC – that is, at about 35 bunches of roses a day.

ATC is at its minimum at a level of output of 73 bunches of roses a day and MC intersects ATC at the minimum point of the latter – that is, at 73 bunches of roses a day.

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Both curves have shifted up as a result of an increase in the price of the variable factor, labour. The original curves, MC1 and ATC1, are indicated for reference.

The long-run average cost curve shows the lowest average cost of producing each output level when the plant size can be varied. Each plant size represents a short-run; there is a short-run average total cost curve corresponding to each plant size. The long-run average cost curve is derived by taking the lowest possible short run average total cost for each level of output.

Activity 4.5f

Activity 4.6f

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The completed table should look like this:

Qty TR MR TC MC

0 0 10

10 5

1 10 15

10 3

2 20 18

10 5

3 30 23

10 7

4 40 30

10 10

5 50 40

10 15

6 60 55

10 23

7 70 78

10 34

8 80 112

The diagram for TR and TC is:

Activity 4.7f

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The diagram for MR and MC is:

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Activity 4.8f

For Pat’s Pizza Kitchen we have:

Output TC TR(if Price = 10) TR–TC

0 10 – –10

1 12 10 –2

2 16 20 4

3 22 30 8

4 30 40 10

5 40 50 10

So the maximum difference between TR and TC is at output level 4 or 5 therefore 4 or 5 pizzas is the profit-maximising output level. Likewise, you can check what happens if price is 8. You will find that the profit-maximising output level is 3 or 4 pizzas. So, at $9 you will find that the profit- maximising output is 4 pizzas.

Pat’s shut-down point occurs when price is $2 and output is 1 unit. If Pat provides more than one unit, then total revenue is positive.

Pat’s supply curve is shown in Figure 1 (part of MC curve above minimum AVC value). It is the rising section of the MC curve above the point of intersection with the AVC curve.

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Q TC MC ATC VC AVC

0 10 0

1* 12 12 2 2

2 16 8 6 3

3 22 7.3 12 4

4 30 7.5 20 5

5 40 8 30 6

* Minimum

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Topic 5

Market structure: Perfect competition & monopoly

Introduction Why is it that personal computer prices have dropped so much over the last decade? Why are there so many brands of computers on the market these days? Is there any connection between price, the high degree of competition and profits in the computer industry? And why are some industries in both the private and public sector dominated by one large producer? These are the sort of questions you will be able to answer after completing this topic.

In earlier topics we looked at demand and supply and at consumers and firms without considering the market environment they existed in. In this topic we consider two market structures – perfect market and monopoly. The theory of perfect competition provides a benchmark for analysing other forms of market structures including monopolistic competition, oligopoly and monopoly. The study of these markets provides important tools for understanding economic policy making.

The discussion in this topic will consider:

The topic will then consider the opposite extreme to perfect competition which is known as monopoly. We will see that some industries lend themselves to monopoly structure through barriers to entry. We will also consider how a monopoly arises and how prices are set by a monopolist and how a monopoly compares with perfect competition in relation to allocative efficiency.

There are two other market structures – monopolistic competition and oligopoly – however these are not examined as part of this unit. Chapter 5 of the text covers these two market types and it would be good for you to read this material although it will not be tested in this unit. Monopolistic competition is a market structure in which there are a large number of sellers in the market place competing with each other but having a degree of monopoly power because they sell a differentiated product or service.

Oligopoly describes the market type in which a small number of producers compete with each other.

Remember as you work through this topic that perfect competition is considered the ideal market structure and all other market situations should be compared to it.

Why a perfectly competitive firm cannot affect market price

How output in a competitive market changes when price changes

Why firms sometimes shut down temporarily, enter and leave an industry

Whether perfect competition is good for consumers.

Concept review If you are uncertain about the following concepts then you should review them:

Objectives On completion of this topic you should be able to:

Study materials

Textbook Sloman, J., Norris, K. & Garratt, D., 2014, Chapter 5.

Supplied readings

We all have an idea of what competition means and how to recognise it in reality. As a preview exercise you are asked to consider your definition of competition. This will make a useful comparison to the concept of perfect competition developed in this chapter.

Write down an example of an industry you think is highly competitive. Why do you think it is competitive? Do you think you could make large profits if you started up a firm in this industry?

demand and supply curves

price elasticity of demand

average and marginal cost curves

economic profit.

define each of the economic markets

explain why a perfectly competitive firm cannot affect the market price

explain how a competitive market’s output changes when price changes

explain why firms sometimes shut down temporarily and lay off workers

explain why perfect competition is good for consumers

explain how the monopolist sets price and output levels

explain the theory of contestable markets.

5.1 McTaggart, D., Findlay, C. & Parkin, M., 2012, Economics, 7th edn, Addison Wesley, Frenchs Forest, pp. 222–229.

Activity 5.1a

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What is perfect competition? While perfect competition is a hypothetical and idealised model designed by economists it is still a useful starting point for analysing the behaviour of firms in the real world. For this reason it is important that you are able to list and explain the five conditions for a perfectly competitive industry. These are:

One of the key features of perfectly competitive markets is that no individual firm can influence price because there are a large number of firms in the market. This means that firms in a perfectly competitive market are price takers. The main implication of this is that the demand curve for the firm in perfect competition is perfectly elastic.

Short- and long-run equilibrium The price, output and profit of a firm in perfect competition is determined by the price, output and profit of the whole industry.

Due to competition if a firm raises its price above the industry price no sales will be made. To maximise profit a firm needs to operate where marginal cost equals marginal revenue (MR = MC). Note that since the price is not affected by the firm’s output marginal revenue will equal price.

If average costs dip below average revenue then firms can make supernormal profits in the short-run. In the long-run other firms noting these supernormal profits will be attracted into the industry increasing supply, decreasing price and returning firms to normal profits.

In reality perfect competition is rarely achieved due to economies of scale.

many sellers of an identical product1. many buyers2. freedom of entry and exit3. firms already in the industry have no advantage over potential new entrants4. firms and buyers have complete information about prices and all other market conditions.5.

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The following information shows the average cost and average revenue (price) for a firm at each level of output.

Output 1 2 3 4 5 6 7 8 9 10

AC ($) 7.00 5.00 4.00 3.30 3.00 3.10 3.50 4.20 5.00 6.0

AR ($) 10.0 9.50 9.00 8.50 8.00 7.50 7.00 6.50 6.00 5.5

Monopoly At the opposite end of the market structure scale to perfect competition is monopoly, where a single firm is the sole producer or supplier of a good, service or resource for which there are no close substitutes, and barriers to entry prevent other firms from competing. Of course, examples of complete monopoly may be impossible to find, but varying degrees of monopoly structures are readily observable, for example BHP for steel manufacture in Australia and CSR in the production of refined sugar.

You may have heard the phrases such as ‘monopoly prices’, ‘corner the market’ or ‘increase market share’. The profit motive ensures that businesses strive towards the security of a monopoly type market structure. If you have a chance to buy into a business which has no competitors in close proximity or one which is surrounded by similar types of producers it would not be hard to pick a preference for no competition, particularly if you planned to rely on the local market.

The firm under monopoly will be a price maker. The monopolist’s demand curve is the same as the industry demand curve and hence is downward sloping (i.e. the firm has control over price and output but the combination will be determined by the demand curve). Some monopolies such as public utilities (e.g. gas, electricity and water) are known as natural monopolies, since they exist by virtue of the fact that one firm can supply the market more efficiently than numerous suppliers. Hence industries which require very large infrastructure networks such as postal services lend themselves to a natural monopoly market structure. Other types of monopolies exist by virtue of ownership of essential resources, or legal barriers to entry such as patents, franchises and licences.

The textbook covers key aspects in relation to monopoly, such as how monopoly arises and single-price monopoly, and comparisons with perfect competition.

Activity 5.2a

Construct a table to show TC, MC, TR and MR at each level of output. (Put the figures for MC and MR midway between the output figures.)

Using MC and MR figures, find the profit-maximisation output.b. Using TC and TR figures, check your answer to (b).c. Plot the AC, MC, AR and MR figures on a graph.d. Mark the profit-maximising output and the AR and AC at this output.e. Shade in an area to represent the level of profits at this output.f.

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A monopolist would be expected to face an inelastic demand for its product. Yet, to produce where MC = MR it must have an elastic demand. Explain why. Can you solve this puzzle?

Comparing monopoly and perfect competition We have seen in our studies that competitive markets are efficient. Perfect competition, therefore, provides a useful benchmark for analysing other market structures (such as monopoly) and market failure. We have also noted that monopoly is one of the obstacles to efficiency. When studying cost curves we see that monopolists are not minimum cost producers and hence will not be efficient. However, there are some potential gains from monopoly. Your text provides a good comparison between monopoly and competition.

Under what circumstances would you expect a monopoly to charge: a) a higher price; and b) a lower price than if the industry were operating under perfect condition?

(From Sloman, Norris & Garratt 2010, Discussion question 7, p. 128.)

The price discriminating monopolist Under some circumstances, it may be possible for a monopolist to sell the same commodity to different customers for different prices. This is known as price discrimination. The price discriminating monopolist attempts to capture a greater share of the consumer surplus by differentiating between groups of consumers to increase the monopoly profit. The local cinema aims to boost total revenue by charging different ticket prices for different age groups and at different times of the week. Transport services and local councils are examples of entities that discriminate on price. Think about how they practice price discrimination. They do so by charging different rates to different groups such as pensioners and primary producers.

McTaggart et al. 2012, pp. 222–229.

You should have noticed that there are many different forms of price discrimination, for example, age, volume, type of buyer, welfare group, and sex. You should have also noted that the practice of price discrimination increases total revenue for the firm and reduces consumer surplus for the buyers.

Activity 5.3a

Activity 5.4a

Reading 5.1r

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For each of the following practices, state whether it constitutes price discrimination and give a brief explanation for your answer.

Summary In this topic you have learned that:

In the next topic we will look at how markets can fail and how they can be reformed.

Activity 5.5a

A clothing company charges higher prices for large sizes than for small sizes of the same pair of jeans (that is, same style).

Doctors charge a higher consultation fee for after hours surgery consultations than for normal hours surgery consultations.

Some movie theatres charge lower admission fees on Tuesday nights than on Friday nights.c. Australian sugar is sold at a lower price overseas than within Australiad.

perfect competition is a market structure where there are many sellers of an identical product, there are many buyers, there is freedom of entry and exit, firms already in the industry have no advantage over potential new entrants and firms and buyers have complete information about prices and all other market conditions 5.5



a perfectly competitive firm cannot affect the market price

when price increases the perfectly competitive firm’s output rises and when price decreases the perfectly competitive firm’s output falls



firms will shut down temporarily and lay off workers when price falls below average variable cost

firms will enter a perfectly competitive industry when profits are being made and leave the industry when losses are being incurred



firms in a perfectly competitive industry will earn zero economic profits in the long run

for a constant cost industry an increase in demand will increase industry output but will leave price and the firm’s output unchanged in the long run; a decrease in demand will decrease industry output but will leave price and the firm’s output unchanged in the long run



perfect competition is efficient and maximises society’s welfare

the monopolist faces a downward sloping demand curve

the monopolist chooses price and output (as well as the amount of promotion)

the monopolist can charge different prices in different markets

the monopolist restricts output below the level at which P = MC. Hence, excess capacity exists in the industry and the firm is not a minimum cost producer



in a monopoly, economic profits are possible in both the short and long run

the monopolist is less efficient than a perfectly competitive firm.

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Review activities

You are advised to undertake activities in the Sloman, Norris, & Garratt, MyEconLab, Chapter 5.

Feedback to activities

The first important thing to note is that firms that are competitive need not be operating in perfectly competitive markets, e.g. oil companies are competitive but a long way from perfectly competitive. Most of the examples you will think of are likely to be examples of monopolistically competitive market because the firms differentiate their product. Motels, hairdressers, restaurants and the like all differentiate their product. ‘Stars’ for motels are a clear example. ‘Jean-Paul’s’ French restaurant would be horrified to think his meals were identical to ‘Greasy Jack’s’ Australian meals.

By and large the best and closest examples of perfect competition come from the agricultural sector – wheat farmers, banana growers etc. They are competitive because they are in an industry where there are a large number of firms competing against each other. They are unlikely in the long run to make large profits. The farmer can make windfall profits because his/her knowledge is not perfect, e.g. poor banana prices may result in many farmers converting to other crops – leaving those who remain with high prices due to the now short supply. As we will see later in this topic because entry into competitive industries is relatively easy, whenever large profits are being made in a competitive industry other firms will enter until excess profits are eliminated.

Review activitiesa

Activity 5.1f

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Activity 5.2f

See the following table:

Output 1 2 3 4 5 6 7 8 9 10

AC ($) 7.00 5.00 4.00 3.30 3.00 3.10 3.50 4.20 5.00 6.00

TC ($) 7.00 10.00 12.00 13.20 15.00 18.60 24.50 33.60 45.00 60.00

MC ($)

3.00 2.00 1.20 1.80 3.60 5.90 9.10 11.40 15.00

AR ($) 10.00 9.50 9.00 8.50 8.00 7.50 7.00 6.50 6.00 5.50

TR ($) 10.00 19.00 27.00 34.00 40.00 45.00 49.00 52.00 54.00 55.00

MR ($)

9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00

Profit is maximised where MC = MR: at an output of 6.b. Total profit equals TR – TC.

At an output of 5, total profit is $40.00 – $15.00 = $25.00.

At an output of 6, total profit is $45.00 – $18.60 = $26.40.

At an output of 7, total l profit is $49.00 – $24.50 = $24.50.

Profit rises up to 6 units of output and then falls. Profit is thus maximised at 6 units: it is $26.40 per period of time.



See Figured.

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Demand is elastic at the point where MR = MC. The reason is that MC must be positive and therefore MR must also be positive. But if MR is positive, demand must be elastic. Nevertheless, at any given price a monopoly will face a less elastic demand curve than a firm producing the same good under monopolistic competition or oligopoly. This enables it to raise price further before demand becomes elastic (and before the point is reached where MR = MC).

Figure Profit maximisation for a firm facing a downward-sloping demand curve See Figure above. Profit is maximised where MC = MR, at an output of 6. At this output, AR = $7.50 (point a); AC = $3.10 (point d).

This area is shown by the rectangle abcd in the above Figure.f.

Activity 5.3f

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Activity 5.4f

As Figure 5.6 in the text illustrates, the effect of a monopoly producing an output where MC = MR results in a higher price and output than under perfect competition. Even if it operates with lower marginal costs than a firm under perfect competition (as a result of economies of scale or more efficient processes), although this will have the effect of reducing prices somewhat, the price will still be higher than under perfect competition unless marginal costs are substantially lower.

Where the marginal costs are substantially lower, so that they have the effect of pulling the price below that under perfect competition. In Figure 5.6 in the text, this would only occur if the monopolist’s MC curve intersected the MR curve to the right of Q2.

Activity 5.5f

This isn’t price discrimination, because large sizes require more fabric than small sizes.a. This isn’t price discrimination, because after hours consultations involve additional costs of paying staff.

This is price discrimination, because the marginal cost of admitting an extra viewer is equal for Tuesday nights and Friday nights (that is, virtually zero until the theatre is full).

This is price discrimination; selling sugar overseas involves higher transport costs, but because the elasticity of demand for sugar is higher (perfectly elastic for a small exporter such as Australia) in the world market, sugar is sold at a lower price overseas.

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Topic 6

Market failure and government policy

As stated previously the perfect market rarely (if ever) exists and therefore sub-optimal outcomes occur. One of the major reasons for government intervention in the economy is the existence of market failure. For example, in Australia, most roads do not have tolls imposed on them and as a consequence the private sector has shown little interest in road development. In recent times however we have seen the gradual introduction of toll roads in parts of Australia in an attempt by the government and/or private contractors to recoup some of the costs of developing these roads that we travel on. Can you imagine what it would be like if we had to pay a fee every time we drove out onto every public road? Roads have a number of the characteristics of a public good (although they are not a pure public good) and the market system, for the most part, fails to provide them (and other public and merit goods). Hence, the government is expected to provide these essential goods.

In this topic we will begin by examining the types of market failure that exist and then we will turn to look at ways in which government might intervene to prevent or at least minimise the extent of this failure. First we concentrate on externalities and extend on our studies on marginal cost and marginal benefit to include marginal social cost and marginal social benefit. Secondly we look at the provision of public goods and some of their characteristics will be discussed. This topic then revisits monopoly market structure and again discusses how monopolies create deadweight losses.

There are a number of ways governments can act to minimise market failure. The most common policy tools are taxes, subsidies, legislation, regulation, property rights, information, direct provision, reform and opening markets to greater competition.

To get you thinking about this topic consider the following activity.

Why are our defence forces provided by the government rather than by the private sector (ignoring mercenaries)?

Wait until you work through this topic before you look at the full feedback response provided. If you have had difficulty answering this question return to this activity towards the end of the first half of this topic when the answer should be more obvious.

Objectives On completion of this topic you should be able to:

Activity 6.1a

define market failure and give examples of types of market failure

outline the main forms of government intervention in the marketplace

explain the reasons for the government provision of public goods

describe the basis upon which governments choose taxes and tax rates

Study materials

Textbook Sloman, J., Norris, K. & Garratt, D., 2014, Chapter 7.

Supplied readings

The economic theory of government It is often said that the role of government in the economy is:

Regulation refers to those policies of the government designed to influence the level of economic activity. Governments use, for example, fiscal and monetary policies to regulate the level of economic activity. Redistribution refers to those actions of the government designed to bring about a more equal distribution of the nation’s GDP and usually involves differential rates of income taxation and government social welfare supporting mechanisms. Reallocation refers to actions by the government to reallocate resources (e.g. from private use to public use or vice versa) and arises because of the problems of market failure. What do we mean by market failure?

Market prices should reflect the relative costs of production and scarcity of resources. We rely on markets such as those we discussed in Topic 5 to coordinate the independent decisions of many producers and to respond to consumer sovereignty. Some forms of production will not be made accountable for the extra social costs they impose on society above their normal private costs of production. Some other forms of production provide extra benefits to society for which they would not be compensated in an unregulated market. When market prices do not reflect the relative prices of production or when some goods and services are either underprovided or overprovided, we say that market failure is present. One example of this is monopoly where output is restricted. Another example of market failure occurs if external costs or benefits are affecting third parties. The term ‘externalities’ refers to the unintended cost or benefit of production or consumption. Governments are expected to intervene in the economy to rectify such instances of market failure.

explain how natural monopolists and other firms with market power are regulated

explain the nature of external costs and external benefits

describe how property rights address environmental issues

explain how taxes, charges and permits can be used to regulate the exploitation of the environment.

6.1 McTaggart, D., Findlay, C, & Parkin, M., 2012, Economics, 7th edn, Pearson Australia, Frenchs Forest, NSW, pp. 177–180.

6.2 McTaggart, D., Findlay, C, & Parkin, M., 2012, Economics, 7th edn, Pearson Australia, Frenchs Forest, NSW, pp. 364–365.

6.3 Boyle, J., 1999, ‘Rationalisation sends email, Southcorp stocks up sharply’, Australian Financial Review, 6–7 February, p. 11.

6.4 Kavanagh, J., 2006, ‘Bottleneck’, Business Review Weekly, March 30–April 5, pp. 40–43.

regulation

redistribution

reallocation.

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Another form of market failure will encourage governments to provide what are known as public or social goods, for example, roads and highways, a national defence system or the legal system. The peculiar characteristics of public goods are such that the private sector will not produce them (because there is no incentive to produce them) and if the market is unregulated they may not be produced at all. As a result, the government is forced to allocate resources to their production, generally through the taxation system.

Externalities An externality is an effect of production or consumption that is not taken into account by the producer or consumer, and affects other parties. Concerns over the deterioration of the environment arise because of the presence of what economists call externalities. However, it is not only environmental matters that give rise to these externalities. The market system does not take account of economic transactions, either favourable or unfavourable, that have an impact on a third party, that is, someone who is not a direct participant in the transaction. For instance, the market system does not penalise a firm that pollutes a river affecting other people or the environment. The costs that this pollution imposes on others are external costs.

While external costs are readily apparent, the existence of external benefits does not arouse as much attention. For example, society in general gains benefits (which it does not directly pay for) from university research efforts and the resulting accumulated knowledge.

In order to correct this type of market failure the government intervenes because the market fails to recognise or take account of either external costs or benefits. The text examines in some detail how the government acts to achieve a more efficient allocation of resources given the existence of externalities. It does this by first considering the external costs impacting on the environment and then by considering how the external benefits of knowledge can be encouraged.

Public goods There are two characteristics of public goods that distinguish them from private goods: non-excludability and non-rivalry. These characteristics create a free rider problem where people can receive benefits from a good without contributing directly to its production costs. As a result of this governments often provide goods and services which would otherwise not be provided privately.

Classify the following into public and private goods and give a brief explanation for your answer:

Adapted from Bentick, T 2003, Economics, Pearson, Sydney.

There is an almost infinite range of public goods that could be provided by the government. How does it choose which ones to provide?

Activity 6.2a

public librariesa. public beachesb. a cyclone warning systemc. milkshakesd. the crime deterrent effect of a police forcee. tennis rackets.f.

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Determining which public goods (and services) will be produced and which will not is a difficult question for economists to answer. The dimensions of the problem can be seen by the use of benefit–cost analysis, especially by the concepts of marginal benefits and marginal costs. Figure 8.3 in Reading 6.1 illustrates how an economy’s marginal benefit curve for a public good is derived. Note the difference between this curve and the market demand curve for a private good.

The illustration in Figure 8.3 considers an economy with only two people. If we consider an economy with a more realistic population the marginal benefit curve for that economy may look something more like that in Figure 8.4. This figure illustrates how to find the efficient quantity of a public good. The efficient quantity is where marginal (social) benefit equals marginal (social) cost. Equivalently, this is where the net benefit (total benefit less total cost) is maximised. No-one can be made any better off without making someone else worse off. However, the market will not provide the efficient quantity of a public good because of the free rider problem.

McTaggart et al. 2012, pp. 177-180.

The following question relates to a choice as to whether to spray for mosquitoes to cut back on disease or not in a small town of 100 people.

The total cost is $200 per spray per year with a maximum possible sprays being 5 per year. The marginal benefit in $ for each resident is 0 to 1 spray = 12, 1 to 2 sprays = 6, 2 to 3 sprays = 3, 3 to 4 sprays = 1 with the marginal benefit of the 5th spray being 0.

Adapted from Bentick, T 2003, Economics, Pearson, Sydney.

To address market failure governments can act in a number of ways.

Monopoly Whenever markets are imperfect, that is, they are not the ‘perfect’ market they will fail to equate marginal social cost with marginal social benefit even if there are no externalities. To address the price making abilities of monopolies and oligopolies the Australian government has attempted to legislate their behaviour via the Trade Practices Act of 1995. We will return to the mechanisations of the Trade Practices Act later in this topic.

Reading 6.1r

Activity 6.3a

Is a mosquito control program a public good for the residents of this town?a. Calculate the marginal cost and marginal benefit to the whole town of aerial sprays.b. How many aerial sprays will be conducted if each resident has to act independently of the others?c. What is the efficient level of provision of aerial sprays? What is the town’s net benefit from such a level of provision?

How can the town finance the efficient number of aerial sprays? Will voluntary contributions raise the necessary amount?

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Government intervention There has been much discussion in Australia about the need for taxation reform with a major reform being the introduction of a goods and services tax (GST). We are not interested in this unit in the macroeconomic dimensions of taxation but how the government chooses which taxes to impose and at what rates. We find the solution is reached in a similar fashion to that by which the provision of public goods is made. In this case the key person is the median voter.

Political parties wishing to get elected always pay attention to the wishes of the median voter or, in political parlance, the ‘swinging voter’. It is their preferences that are crucial when decisions about taxation rates are being made. All political parties will tend towards the wishes of this median voter since any other stance would be political suicide.

From an economic point of view taxes and subsidies are favoured to provide social efficiency and redistribute income.

Governments may also consider regulation and restricting certain anti-social behaviours.

Property rights Externalities arise because there are no property rights. That is, there is no legal restriction to a resource, good or service. Since there is no legal ownership no one has the obligation to act efficiently in the use of these resources. One way to rectify this situation is to grant a party a property right and then to hold that party responsible for how it uses the good or service for which it was granted the right.

External costs: The environment

Environmental concerns Concerns about the environment have grown as awareness of the seriousness of environmental pollution has become more widespread and also because, with the increase in disposable incomes, consumers have become inclined to spend these incomes on goods and services where the quality of the environment is of greater importance.

The range of environmental concerns encompasses air pollution, water pollution and land pollution. While some groups in society seek to have all activities stopped which lead to an adverse effect on the environment, economists tend to be more cautious and often argue that each environmental question needs to be assessed on its merits and the economic and non-economic factors given balanced treatment.

Dealing with environmental problems There are a number of options available to governments in seeking to address the external costs imposed on the environment. The options may include the granting of property rights and the imposition of charges, trading permits taxes and education.

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Progress in microeconomic reform There has been a concerted effort in the past twenty or so years to bring about reform to the economy through a range of microeconomic endeavours.

Major microeconomic reforms over the past twenty years include:

Developments in competition reform include:

Difficulties with microeconomic reform include:

Despite strong arguments for microeconomic reform the prospects for ongoing reform lay largely in the hands of the States. Governments are loath to make changes where there are significant losses irrespective of potential gains. Industries most likely to be impacted by reform will also resist or slow the pace of reform. Australia however cannot retract from the path of reform that it has this far embarked upon if it wishes to improve its international competitiveness and gain from productivity improvements.

Identify the main benefits generated by microeconomic reform and the main problems such reforms have produced.

deregulation of financial, telecom, aviation, dairy, power, labour and transportation markets

reduction in industry protection

reform to the waterfront, transport and communication systems

new standards of performance for government business enterprises

rationalisation of business regulation

improvements in government sector efficiency

taxation reform including the GST

more flexible labour markets

policies and regulations to promote competition in public and private sectors.

extending competition legislation to government business and unincorporated business

establishing the ACCC to monitor prices, costs and profits

establishing the National Competition Council to oversee the reform process

establishing rights for third parties to access essential facilities such as electricity, rail and gas at commercial rates



reviewing regulations that inhibit competition.

estimating the true benefit

redistribution of the reforms between producers and consumers

unemployment growth in some areas

slow to implement and get outcomes

compensation for losses

cost shifting

GBEs transferring benefits to government.

Activity 6.4a

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The long-held monopoly position of Telstra (previously Telecom) in the telecommunications industry ended when Optus commenced operations in 1992. What do you think have been the major effects of having more telecommunications carriers in Australia?

The banking industry in Australia has been the subject of several major government inquiries over the past twenty years. As a result of these inquiries the industry has been greatly deregulated and the character of the industry is now significantly different from when it was tightly controlled by the government. Do you think this deregulation has been beneficial or not? Why?

The government attempts to bring about microeconomic reform is through legislation. In the final section of this topic we examine how the government influences the behaviour of firms in the economy through the operation of trade practices legislation.

Trade practices legislation One of the major controls over the behaviour of firms in Australia is through the operation of trade practices legislation; the purpose of which is to prevent anti-competitive behaviour among firms. Governments of all political persuasions believe that more competitive markets can be achieved if businesses are prevented from pursuing anti-competitive behaviour.

The original trade practices legislation was enacted in 1974 and was revised in 1995. The major body is now the ACCC and, as the text suggests, it has wide powers.

McTaggart et al. 2012, pp. 364–365.

The approach taken by the ACCC is to make certain activities by businesses illegal outright and to make others subject to a competition test. The let-out clause for businesses is in the form of ‘authorisations’ which is behaviour that limits competition but is considered by the ACCC to provide some offsetting public benefit.

Among the behaviours that may restrict competition are:

Reading 6.2 discusses each of these forms of business behaviour, indicates when authorisations might be possible, and illustrates some actual case histories of firms that have engaged in some of these forms of behaviour. As you read these case histories note the prominence of some of Australia’s best known companies, the approach taken by the ACCC (or its predecessor, the Trade Practices Commission), and the remedies resulting from such behaviour.

Activity 6.5a

Activity 6.6a

Reading 6.2r

collusion

misuses of market power

vertical restraints

price discrimination

mergers.

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The ACCC also has a role in several other areas of market supervision. It is involved in ensuring firm compliance with consumer protection provisions of trade practices legislation such as product safety issues and other non-price dimensions of market conduct. The ACCC is also involved in the process of GTE sector reform and in the monitoring of market prices. Again, the textbook provides an overview of these roles of the ACCC with examples.

State whether each of the following trade practices would be illegal under the Trade Practices Act.

Adapted from Bentick, T 2003, Microeconomics, 4th edn, Addison Wesley, p. 280

Reading 6.3 provides an example of a proposed merger between two Australian whitegoods manufacturers. The ACCC did not oppose this merger, despite high post-merger market concentration ratios and high industry barriers to entry. Your reading includes a summary of the ACCC’s assessment of the competitive effects of the proposed merger. In assessing proposed mergers, the ACCC considers issues such as the extent of market concentration, the level and nature of import competition, the likelihood of new entrants, the countervailing power of buyers, the availability of substitutes, the existence of a vigorous and effective competitor, and the nature and extent of vertical integration in the market.

Boyle, 1999, p. 11.

Boyle & Long, 1999, p. 5.

ACCC, 1999, Online.

Economists debate the importance of various sections of the Trade Practices Act. One view is that so- called competition policy is another example of regulation of markets which actually reduces the efficiency of their performance. The views of those who support the legislation is that the anti- competitive effects of various types of market conduct are significant and would impose serious efficiency losses in the absence of the legislation. Illustrate both points of view by discussing the application of the Act to the acquisition of Southcorp’s whitegoods division by email.

Adapted from McTaggart et al. 1996, Economics, 2nd edn, Addison-Wesley, Sydney, p. 477.

Kavanagh, 2006, pp. 40–43.

Activity 6.7a

A shipping company with a subsidiary company that provides dockside repair facilities refuses to let a rival shipping company use these repair facilities

A fabric manufacturer threatens to cut off fabric supplies to a customer curtain maker unless the latter stops buying fabrics from a rival fabric company

A leather manufacturer sells leather at a lower price to furniture maker A than to furniture maker B because of differences in delivery costs to the two customers.

Reading 6.3r

Activity 6.8a

Reading 6.4r

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Summary Market failure occurs when market prices do not reflect the relative costs of production and scarcity of resources. External costs or benefits affecting third parties occur when there is market failure. The term ‘externality’ refers to the unintended costs or benefits of production or consumption that affect a society. Governments are expected to intervene in the economy to rectify such instances of market failure.

Microeconomic reform involves actions by the government which are designed to make Australian industry more efficient and thus more competitive. This topic concentrated on examining the main ways in which the government intervenes in the operation of markets especially in Australia. The government finds itself providing public goods because their characteristics are such that the market would fail to produce them in sufficient quantities. The government also intervenes because of the presence of externalities. The external costs of private activities can be taken into account in a range of ways including property rights, taxes and charges and permits.

The arguments for and against the deregulation of industry were described and the consequences of regulation and deregulation on consumer surplus and producer surplus were outlined. The regulation of natural monopolies raises difficult questions for government as does the operation of government trading enterprises. There have been substantial microeconomic reforms in the public and private sectors and the benefits and costs of such reforms are still being assessed.

Trade practices legislation can be considered a form of microeconomic reform. The topic finally considered the nature of trade practices legislation in Australia and the attempts by governments to promote a more competitive market economy.

Review activities

You are advised to undertake activities in the Sloman, Norris, & Garratt, MyEconLab, Chapter 7

Feedback to activities

The provision of defence is not a pure public good since it has some characteristics of a private good. However it is unlikely individual citizens would ‘vote’ to have a private defence force but rather they would look to the government to provide this essential service funded through taxation. It is inconceivable that every citizen could be protected by their own privately funded army although some individuals do hire private security people.

Review activitiesa

Activity 6.1f

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Activity 6.2f

Public libraries are not, strictly, public goods. Non-rivalry in consumption applies up to the point of physical congestion and/or the borrowing of all copies of a book at the same time. However, the non-excludability feature doesn’t apply; it is possible to restrict entry and borrowing privileges to cardholders.

Public beaches are not public goods. Like libraries there are issues of congestion and they can be fenced off.

A cyclone warning system is a public good. No one can be excluded from its benefit.c. Milkshakes are private goods. There is rivalry in consumption, and buyers of milkshakes can legally exclude others from drinking them.

The crime deterrent effects of a police force are a public good, because it’s not possible to exclude anybody from its benefits and there is non-rivalry in consumption among the members of the population.

Tennis rackets are private goods.f.

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The main benefits are in the areas of improved efficiency of operation with lower real prices and higher productivity the main indicators. The main problems from these reforms are the loss of jobs and the difficulties of measuring any benefits that the reforms produce.

Activity 6.3f

The control program is a public good for the residents as it has non-rivalry and non-excludability characteristics. All residents enjoy the programs benefits.

(b) sprays/ TC/ MC/ MB each resident/ MB the Town

0 0

200 12 1200

1 200

200 6 600

2 400

200 3 300

3 600

200 1 100

4 800

200 0 0

5 1000

If each individual acted independently no aerial spraying would take place as MC of even the first ($200) exceeds MB for an individual ($12).

Three times a year. Net benefit at 3 per year is equal to total benefit ($1200 + $600 + $300) minus total cost ($600), or $1500 a year.

The town could finance the spray by levying a special tax of $6 per resident for this purpose. Voluntary contributions won’t raise the necessary amount as individuals will be tempted to free ride.

Activity 6.4f

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You might have mentioned some of the following effects:

Note that it is debatable whether some of the above changes in the industry can be attributed to deregulation (e.g. technological change).

Among the beneficial factors you might have mentioned are:

Among the costs you might have mentioned are:

Activity 6.5f

price competition

new product packages

large restructuring and downsizing of Telstra (and associated job losses)

rapid technological change in the industry

reductions in the real costs of telecommunication

costly duplication of infrastructure.

Activity 6.6f

more customer focus

lower interest rates

greater variety of products

access to latest technological developments such as ATMs.

higher bank fees and charges

loss of jobs and careers in the banking industry

closure of banks especially in rural communities.

Activity 6.7f

This is a case of misuse of market power and is illegal under the Trade Practices Act. By denying its rival shipping company access to essential repair facilities, this shipping company is damaging its competitor’s ability to compete and thus reducing competition in the shipping trade.

This would be classified as a vertical restraint on trade, which is prohibited by the Trade Practices Act. Vertical restraints are regarded as anti-competitive because they are regarded as anti- competitive because they are aimed at damaging rivals ability to compete, and in this case a customer’s ability to compete.

Price discrimination is outlawed under the Trade Practices Act because firms may give some customers special prices to block the entry of another firm. However, this firm isn’t really price discriminating because the difference in selling price is based on differences in the cost of supplying the two customers.

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Your discussion may include the following points:

Activity 6.8f

The merger may create benefits through access to economies of scale. This may assist the merged manufacturer to more successfully compete on world markets. This is likely to be used as a major justification for the merger when seeking ACCC approval.



Competition may not be substantially lessened because of the threat of entry from new suppliers, most notably from imports.



The new merged manufacturer will control around 60% of the whitegoods market. There may be some sub-markets in which email will be able to gain and use its market power to increase its own surplus, particularly in the short run.



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Topic 7

Introduction to macroeconomics

Introduction In this unit so far we have examined microeconomic concerns; we now move to an examination of macroeconomic concerns. This topic, as an introduction to macroeconomics, examines the general level of economic activity that takes place in a country. The starting point for this is economic growth and the production possibility model that was considered in Topic 1.

Macroeconomics is that part of economics which studies the operation of the economy as whole. It also studies government efforts to regulate the level of economic activity. It is concerned with understanding such issues as economic growth, inflation, unemployment, business cycles and international trade. Many of these issues directly affect you. For example:

Topic 7 begins with an examination of economic growth. Some questions you may consider include:

The most common measure of standards of living both over time and between countries is that which uses the amount of goods and services available to individuals. Economic growth is the measuring stick of these goods and services. This is the reason for the interest in economic growth.

An assumption that is made throughout most of this unit is that human wellbeing largely depends on a nation providing more and more goods and services to its people. Hence the concept of economic growth dominates our attention for most of the unit since economic growth means additional goods and services are made available to people. However it should be noted that the ‘more is better’ approach is being increasingly questioned with the depletion of non-renewable resources, increasing environmental problems and increasing inequality being associated with increased economic growth.

The main reward we receive for our contributions to economic growth is income. Do you realise that every time you purchase a good or a service, the money that you have spent is received by others in the form of an income? Your spending has resulted in incomes for other people. One of the reasons we are often encouraged to spend locally rather than to travel out of the area to shop is because spending locally is thought to help keep our local businesses alive because the money is continually re-spent within the community. The critical links between our productive efforts, spending decisions and the incomes we receive form the basis of this topic.

This topic is generally descriptive and contains statistical data that you should be able to update by using some of the references given in the introduction to the unit. The first matter examined is the technical terms used by economists to measure growth followed by a discussion of recent economic growth in Australia.

Your ability to find a job will, to a large extent, be influenced by the level of economic growth in the country



Your spending power will be affected by high levels of inflation

Your possible unemployment will have substantial impacts on you and your family.

How would you measure your standard of living?

Has it improved over the past year or two, or has it declined?

How would you compare your standard of living to that of people in other countries?

Since economic growth tends to follow a cyclical rather than smooth path over time, the stages of the business cycle are examined next. The two major indicators of fluctuating economic activity are unemployment and inflation. Their characteristics are introduced in turn. We then review the difficulties of economic management when governments face deficits both at home and overseas. The importance of economic growth in understanding economic activity cannot be understated. Every quarter the Australian Statistician publishes the national accounts for the previous three months. These national accounts are the official estimate of economic growth and the performance of the economy. Many economic decisions are made on the basis of the information revealed in these accounts. Recent accounts show that there has been a slowing in the annual growth rate.

In this topic there is also an examination of how the national accounts are arrived at and some of the assumptions and limitations that underlie their estimation. In addition, the concept of the circular flow of economic activity is revisited in order to illustrate the alternative methods available for measuring economic activity. The alternative ways in which Australia’s economic performance can be determined in the form of national accounts is covered next. The importance of these national accounts over time will be greatly influenced by movements in price levels of the goods and services used. There is also an explanation of how these price variations can be accounted for. The importance of economic growth as a measure of economic welfare is often overstated. It is also important to be aware that there are limitations in using economic growth as a measure of standard of living.

Topic 7 concludes with an examination of the labour market and unemployment.

To get you thinking about the issues in this topic find out the latest official figures for the following three economic indicators:

The three figures are not given to you in the feedback section. Indeed if any figures were included at the time this is being written, the figures would be out of date by the time you read this. If you have no idea of any of these figures then hazard a guess. By the time you finish this unit you should be very familiar with all three rates and trends. But keep your eyes and ears open for regular updates of these statistics in the press. (A good source of current statistics is Friday’s Australian Financial Review.)

Objectives On completion of this topic you should be able to:

Activity 7.1a

official unemployment rate (%)

annual rate of inflation (%)

annual rate of economic growth (%).

explain the importance of economic growth to Australia

evaluate the costs and benefits of economic growth

outline the stages of the business cycle

describe recent trends in unemployment in Australia

calculate the inflation rate

explain circumstances in which inflation becomes a major problem

distinguish between budget deficits and current account deficits

explain the significance of the circular flow of income and expenditure in understanding the national accounts



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Study materials

Textbook Sloman, J., Norris, K. & Garratt, D., 2014, Chapter 9 and pp. 240–246.

Readings

Economic growth Economic growth is the expansion of the whole economy’s production possibilities. It can be pictured as an outward shift in the production possibility curve (PPC). To refresh your memory of the PPC refer to Chapter 1 of the text. We measure economic growth by the increase in real Gross Domestic Product (GDP) which is the value of all the nation’s farms, factories, shops and offices measured in the prices of a single year. Real GDP in Australia is currently measured in the prices of 1999/00 (called 1999/00 dollars). We use the dollar prices of a single year to eliminate the influence of inflation – the increase in the average level of prices – to determine how much production has grown from one year to another. Real GDP measurement will be discussed later in this topic. (Refer to Box 9.1 of the text for a discussion on real versus nominal values.)

Governments spend a lot of time analysing data to ensure that GDP remains within the target range (currently 3%) as serious fluctuations can be detrimental to an economy especially if too low (unemployment) or too high (inflation) While economic growth is the key variable it does not have a sustained and steady path of growth. Rather it tends to fluctuate over time and this has given rise to the concept of the business cycle.

Like true love, the path of economic growth never runs smoothly. Economies seem to lurch from periods of high economic activity to periods of low activity. The economy always seems to be climbing out of some period of recession or we are sliding back into that recession. Economic activity is cyclical. The next provides the names we give to the various stages of the business cycle.

outline the alternative methods of measuring national economic activity

describe the purpose of the Consumer Price Index and the GDP deflator

describe the limitations of GDP as a measure of economic activity

define the labour market indicators

outline competing theories about the causes of unemployment.

7.1 Smith, J., 1999, ‘Could it happen again?’, The Economist, 20 February, pp. 19–23. 7.2 McTaggart, D., Findlay, C. & Parkin, M., 2012, Economics, 7th edn, Pearson Australia, Frenchs Forest,

NSW, pp. 430–435. 7.3 Hamilton, C., 1997, ‘GDP just doesn’t measure up’, Australian Financial Review, 2 July, p. 28. 7.4 Gittins, R., 2005, ‘The future is bright, if one extrapolates’, Sydney Morning Herald, 19 June, p. 44.

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What effects will the following have on trend GDP?

Adapted from Bentick 2003, Economics, Addison Wesley, Sydney, p. 80

Where do you think the economy has moved in more recent years? Do you think it has expanded or contracted? What factors influence your opinion?

You should read a Keynesian analysis of the business cycle to round out your study of the ebb and flows of the cycle. John Maynard Keynes, an eminent 20th century economist, put forward many economic theories including exploring the theory of the business cycle booms and busts.

Not everyone thinks that economic growth is a goal that we should pursue and vigorous debate has taken place especially in the past thirty years or so about the costs and benefits of economic growth. The benefits of growth include increased levels of consumption, an improved ability to redistribute income to the poor, and an improved ability to contribute more funds to improve environmental outcomes. The costs associated with economic growth include the continued use of non-renewable resources and increased environmental damage. In addition growth may generate extra demands and not result in increased happiness levels. It is also argued that the pursuit of excessive growth may lead to a more selfish and less caring society as well as increased income inequality.

Write down three of the costs and three of the benefits of economic growth.

Two of the major indicators of the various stages of the business cycle are unemployment and inflation. The characteristics of each of these are discussed in the next sections of this topic.

Jobs and unemployment Have you ever been unemployed? If so then you would appreciate the impact it has on your standard of living as well as producing other non-economic effects. Unemployment among young people, those living in rural communities and disadvantaged groups in particular, remains one of the most intractable problems facing governments around the world.

Until the effects of the global financial crisis became more apparent, unemployment did not appear to evoke the emotive concerns that it did a few years ago and continues to do so in many countries today. High levels of unemployment seemed to be increasingly accepted without too much concern being placed on addressing the issues that such unemployment creates. While governments won elections in Australia in the mid-1980s on their promises to create jobs and reduce unemployment, such concerns were not voiced as regularly in

Activity 7.2a

The educational attainment of the average citizen is rising steadily over time.a. An increasing soil degradation problem reduces the capacity of more and more farmlands to sustain agricultural crops.

There is an ever growing stock of factories, machinery, and other capital goods.c. There is a rapid pace of technological progress.d.

Activity 7.3a

Activity 7.4a

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the 1990s and beyond. For example, an unemployment rate of over 5% appears to be considered quite acceptable and yet the rate during the 1950s and 19060s was around 2%. Whether an unemployment rate of over 5% paints a true picture of actual unemployment conditions is also a matter of debate since there have been many changes in measurement techniques during the past 30 years. In addition to the unemployment rate, Australia, to some extent, is currently experiencing skills shortages in some industry areas and has gone through major reform of the labour market to address these shortages. As to how these shortages play out over the next few years is yet to be fully realised especially coupled with possible increases in unemployment in some industry categories.

What is the present government attempting to do to reduce unemployment levels?

The textbook provides a definition of unemployment, and explains its measurement and costs. This is an important section since unemployment is an economic indicator which is likely to affect us the most.

Distinguish between the economic and non-economic costs of unemployment.

An economy has a population of 16 million, of which 12 million are of working age – that is, 15 years and older. The employed number 9 million and the unemployed, 1 million. What is the economy’s labour force and unemployment rate?

Inflation Inflation is a sustained rise in the average level of prices. We have all experienced rapid price rises in some of the goods and services we purchase and for most of us the cost of living seems to increase steadily. In the past inflation has been a major problem for many governments including Australia.

Suggest reasons why governments are concerned about high inflation rates.

Before reading the textbook section, think about how inflation might have affected you in the past. Write down several ways in which high rates of inflation affect you.

During the 1970s and 1980s high rates of inflation were a constant cause of concern to economists and to the government. During the past few years the rate of inflation has fallen considerably as a result of a combination of factors. While its severity has diminished the ever-present threat of higher rates of inflation and the adverse consequences of such a development remain a source of concern for policy makers as well as individuals.

Activity 7.5a

Activity 7.6a

Activity 7.7a

Activity 7.8a

Activity 7.9a

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Suggest reasons for the current trend in Australia’s rate of inflation.

In Topic 11 we will discuss inflation in more detail and later in this topic we will look at how inflation is calculated. The following reading discusses inflation from the point of view of why prices rise and the possible costs to the economy of these price rises. In addition to inflation, in some countries, e.g. Japan, the problem of deflation has assumed greater importance in recent years. Reading 7.1 gives an overview of deflation.

Read ‘Could it happen again?’, pp. 19–23.

If everyone’s incomes rose in line with inflation, would it matter if inflation were 100%, or even 1000% per annum?

Business cycle slowdowns, inflation and unemployment all create problems for governments and cause them to incur deficits. This is discussed in the next section.

Governments and deficits One of the most common confusions in economics is the difference between government budget deficits and the current account deficit (CAD). A budget can be:

In recent times there has been considerable debate regarding budget deficits. Despite both major political parties wishing to ensure budget surpluses it appears that deficits will be entrenched for the foreseeable future. There will be further discussion on the budget and government debt in Topic 11. We also hear much discussion about the size of Australia’s trading problems when we pay out more than what we earn in international dealings – recorded as a current account deficit (CAD). Continued current account deficits result in a rise in the level of foreign debt, which is a major source of concern. Note that this is not purely government debt but mostly the debt from trading in imports and exports in goods, services, investment and foreign aid. Obviously the value of Australian exports is less than the value of Australian imports. Again each quarterly CAD leads to a collective overall debt called the Balance of Payments (BOP). This debt will be canvassed in Topic 10.

Governments seek to understand the macroeconomic challenges they face and to identify the various policy tools they can use to meet those challenges. Five challenges to be faced are:

Activity 7.10a

Reading 7.1r

Activity 7.11a

balanced – when spending equals revenue

in surplus – when revenue exceeds spending

in deficit – when governments spend more than they earn.

economic growth

stabilising the business cycle

reducing unemployment

lowering inflation

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These policies are the core of macroeconomic studies for this unit and will be covered in depth in Topic 11.

Spend a moment considering Key Terms you have learnt so far.

So far we have studied the challenges facing governments when attempting to suitably administer a stable economy. No doubt the most important challenge is maintaining appropriate and stable GDP growth. The ensuing discussion will focus on the measurement of GDP from different perspectives.

The circular flow of economic activity You may be both surprised and disappointed to learn that it is not love that makes the world go round but rather the level of economic activity! The starting point for understanding how economic growth is measured in a country is the model of the circular flow of economic activity as outlined in Topic 1. In this topic we use a more detailed model as shown in Figure 9.1 to illustrate flows of economic activity and the markets through which this activity takes place. Indeed the circular flow of economic activity is a very important foundation concept that you will learn in economics this semester so it warrants your close attention.

The simplified circular flow model What the circular flow model does is provide a framework from which an understanding of the measurement of economic activity can be developed. Referring to Figure 9.1 of the text you will see that the essential elements of the model are as follows:

From the simple model of the circular flow you should concentrate first on understanding the nature of savings (that part of income not spent on consumer goods) and investment (that part of production not consumed immediately). The term ‘investment’ can be a difficult term for students of economics to come to grips with because it has a precise economic meaning, which varies considerably from everyday usage. We hear people being told to ‘invest’ their money in this or that account at the bank. To the economist that is not investment but saving. Investment leads to the creation of real wealth and takes place by businesses using the savings that have been accumulated in financial institutions for productive purposes such as building a new factory, shop or office. The notion of investment also includes stocks of goods and services, which have not been sold – what we call unplanned investment.

reducing government deficits.

The means of fighting these challenges are in the main:

fiscal policy

monetary policy.

Activity 7.12a

The economy is depicted as consisting of sectors – in the simple model the only sectors are households and firms.



Between these sectors there are flows of economic activity occurring at all times. These flows are centred on two markets – factor markets and consumption markets.



The flows depicted can be flows of incomes, of consumption spending, of goods and services produced, or of productive effort.



Financial markets also exist to provide a place for savings to be deposited and from which borrowing can occur (e.g. banks).



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What you should also notice in Figure 9.1 is the use of symbols to label the flows between the sectors and markets. These symbols are commonly used in economics:

The key concept and the most difficult to understand is that the flows of economic activity must be equal. What is spent by households and businesses (known as aggregate expenditure) must be exactly equal to the incomes that were generated in the circular flow from economic activity.

What this means is that there are two ways in which we can conceive of GDP which is our measure of economic activity. We can either look at the incomes received by those who produce the goods and services or we can look at the expenditure on the goods and services that are produced. We must get the same result since we are simply measuring the flows at two different points.

You can also see from Figure 9.1 that there is a leakage in the form of saving and an injection in the form of investment. Economists are concerned with these leakages and injections. Leakages reduce the flow of economic activity and injections add to the level of the same activity. However, if what is saved is then used for investment purposes the flow of economic activity will be maintained. The financial sector is the market which brings the savings of individuals together and makes them available for investment purposes (whether business people will always use such savings in reality is another question to be discussed later in this unit).

The real world circular flow model It is an incomplete picture of economic activity to limit the economy to just households and firms. A more complete and realistic depiction is one which takes account of the government and international sectors since both of these contribute significantly to economic activity in Australia. So these extra two sectors and their resulting flows of activity are added to the simple model and depicted in Figure 9.1.

When the government is added to the model we need to take account of:

Government spending can be either on goods or services or in the form of transfer payments. Transfer payments are those expenditures which have not resulted from the contribution of economic activity and are a major item of spending for the government. All forms of social welfare payments such as pensions and unemployment benefits are examples of transfer payments.

Activity 7.13a

An economist would argue that a yard full of bricks at brickworks was an investment good. Can you suggest why?

Would an economist regard the purchase of some shares on the stock exchange as an investment?2.

Y is income G is for Government C is consumption X is for exports I is investment M is for imports S is savings T is for net taxes

its influence on economic activity as a spender

the extra leakage effect of taxation.

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Governments are also borrowers when their spending exceeds their income (budget deficits) and so there are links in the real world circular flow with each of the other sectors. Taxes are a leakage and government spending on the purchases of goods and services is an injection.

We have recently spoken of current account deficits. When we introduce the foreign sector to our model we can see that exports represent an additional injection while imports are an extra leakage. When imports exceed exports a country experiences a trading deficit and needs to borrow to make up the difference. So the financial sector is important for the foreign sector too and we can now complete our circular flow GDP equation as follows.

Y or AE or GDP = C + I + G + X – M

We will further explore and calculate this equation in later readings.

What is most important from Figure 9.1 is that despite the additional sectors aggregate expenditure will still equal aggregate income. The spending taking place in the household, business, government and foreign sectors will be exactly equal to the incomes generated from the productive effort in those sectors.

We can now see that the main leakages from a real world economy are savings (S), net taxation (T) and imports (M). In the same way injections into the economy are investment (I), government purchases (G) and exports (X). In the circular flow model these injections and leakages must be equal, thus:

S + T + M = I + G + X

Close your textbook and draw the model of the circular flow.

Having considered the elements of the circular flow of income model we now turn to reality in the next section and show how these concepts are used for measuring economic activity.

Australia’s national accounts This discussion of the circular flow of income is the starting point for understanding how economic activity is actually measured in Australia. There has to be some way(s) of estimating the total level of economic activity taking place in the economy. What the Statistician produces, usually quarterly, is known as Australia’s National Accounts. And what the Australian Statistician does is adopt an approach that closely mirrors the concepts of the circular flow of income. That is, the Statistician measures total economic activity in three ways:

The text discusses each of these methods in turn and illustrates how (with some technical adjustments) each method must generate the same results.

Activity 7.14a

by measuring production itself (using a concept of value-added)

by measuring incomes received from production

by measuring expenditure by the major sectors.

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The production approach One way to estimate economic activity is to add up the value of the production of each stage of productive effort. This involves using the concept of value-added, which has an important meaning in economics. We hear increasingly that the value of people to an organisation is often determined by the value added by those people to the goals of the organisation. In a similar vein the value of production at any stage of production is calculated by subtracting from the market value of a good or service the cost of other goods and services used in its production (intermediate goods and services). The text contains a clear explanation and illustration of the value-added concept. Remember that the sum of the value added at each stage of production must equal the value of final expenditure. What must be ignored is expenditure on intermediate goods and services or double counting will occur.

The income approach While the principle of measuring economic activity by simply adding up the incomes of those who contributed to its creation is a simple one, the actual mechanics are much more involved.

To measure economic activity by the income approach the statistician adds together the incomes of the factors of production, which are grouped into two categories:

What is included in each of these categories is discussed in the text.

Simply adding together these two categories is not adequate for estimating GDP. It is necessary to make an adjustment for indirect taxes and subsidies.

Part of the income of businesses is put aside in the form of allowances for the depreciation of their capital stock. This provision while not directly shown in the example is nonetheless added to the net operating surpluses if a total picture of their earnings is to be made. This then gives us a measure of GDP at factor cost.

When GDP is calculated by the expenditure method the spending used is that on final goods and services at market price. But market prices are often inflated by the presence of a range of indirect taxes and sometimes reduced by the presence of subsidies. There will thus be a difference between the incomes that factors of production receive for their productive effort (known as factor cost) and the prices that are paid when goods and services are purchased (market prices). To bring these two measures of GDP into line some allowance must be made for these indirect taxes and subsidies.

It is important for you to note the differences in value between domestic factor incomes, GDP at factor cost and GDP as measured by the income method (see Table A2). Also note that for 2011/12 wages and salaries accounted for almost half of all the incomes for productive effort.

Expenditure approach Measuring economic activity by adding together the expenditure of the main sectors in the economy is possibly the most straightforward method and easiest to understand.

In the national accounts the expenditure by the major sectors of the economy are represented by: consumption by households, investment by businesses, government expenditure, and net exports (which is exports less imports) (see Table A3). When we add up these items for any year we get the GDP expenditure figure for economic activity in that year.

wages, salaries and supplements

operating surpluses.

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A definition of GDP has been given in these notes. What that definition highlights is that in measuring economic activity we only count the production of final goods and services, not those goods and services that are used as inputs into the production of other goods and services, since that would involve double counting. Thus the estimate of expenditure in Table A3 for the main sectors is only final expenditure.

You should have noted that in Table A3 there is an item for the increase in stocks since that is also considered to be part of investment, what economists call unintended investment. Note that we defined investment as additions to the capital stock, i.e. additions to productive goods such as plant, machinery, equipment, buildings, or anything produced that in turn will produce other goods or services.

Table A3 also indicates the importance of consumption spending as a component of total economic activity; it accounts for almost two-thirds of economic activity measured by this method. What this suggests is that if consumers have opened their purse strings then the economy should be buoyant but if consumers are not spending then the economy will be depressed. I am sure you can see that this is in fact a realistic snapshot of what actually happens in the economy.

Whichever method of calculating GDP is used, the value of the figures that are calculated will be distorted by the effects of inflation. This is considered in the next section.

The price level and inflation For the past few years the level of inflation has been at a relatively low level in Australia and thus has not been the same concern for governments that it was for most of the 1970s and 1980s. Lately however you may have noticed prices increasing on many of the goods and services you regularly buy. Inflation not only plays havoc with our household budgets but it also distorts measures of economic activity and GDP.

GDP is calculated using current dollars no matter which of the three methods of measuring GDP is used. GDP is a monetary phenomenon. As a result GDP will increase in value whenever inflation occurs even if there has been no increase in the volume of goods and services produced. In order to overcome this problem economists prefer to measure real GDP, which is the monetary value of GDP deflated for the effects of inflation.

Consider the following example. If monetary GDP in Year 1 was $1,000 and in Year 2 was $1,100 we might at first be inclined to say that GDP had grown by $100 or 10%. But if inflation between these two years was 10% then there has been no increase in the real level of GDP at all, only in its monetary value. Consumers have no more goods and services available.

There are two major indices used to measure the inflationary effects on GDP. These are the consumer price index and the GDP deflator. The consumer price index (CPI) is the best known and most published index and appears quarterly.

Read McTaggart et al. 2012, pp. 430–435.

Activity 7.15a

Why is residential housing regarded as investment expenditure rather than consumption?a. Why don’t we consider the sale of established houses as part of investment spending? Surely it adds to economic activity.

Reading 7.2r

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The mechanics of how the CPI is calculated are illustrated in Table 19.1 in the Reading 7.2. The essential point to note is that the CPI measures movements in a select basket of consumer goods and services. The following activity will give you the opportunity to see if you can illustrate how the CPI is calculated.

The following represents the price and quantity for an economy producing three consumption goods. The first $ figure is base period and the second figure is current period.

Vegemite 40 jars $2.00 $1.80

Margarine 60 tubs $1.50 $1.60

Bread 120 rolls $1.20 $1.30

The less well-known but more useful index number is the GDP deflator. The GDP deflator is more useful since it measures movements in the prices of not only consumer goods but also capital goods and government purchases. The mechanics for calculating this index was illustrated in Table 19.2 in Reading 7.2.

The following gives data for an economy producing three final goods: pizza, beer and salad. The first $ figure is current period the second is the total expenditure and the third is base period.

Pizza 10 units $10=$100 $9

Beer 20 bottles $3=$60 $2

Salad 20 serves $4=$80 $5

There are at least four limitations in assuming that a percentage increase in the CPI is the same as a percentage increase in the cost of living. These are the two substitution effects, arrival and disappearance of goods and services, and quality improvements. Each of these is discussed in Reading 7.2 so read up to ‘the limitations of real GDP’.

Activity 7.16a

Calculate expenditure for the base period and the appropriate values of quantities in the current year for calculating CPI.

What is the value of the basket of consumption goods in the base period? In the current period?b. What is the CPI figure for the current period?c.

Activity 7.17a

Complete the above by calculating expenditure on each good valued at base period prices.a. What is the value of nominal GDP in the current period?b. What is the value of real GDP in the current period?c. What is the GDP deflator figure for the current period?d.

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For many years economists have increasingly been criticised for the emphasis they place on using economic growth and GDP as a measure of economic wellbeing. These criticisms are also considered in Reading 7.2.

Real GDP and associated limitations Economic activity is any activity that produces goods and services. The pursuit of high levels of economic activity is considered desirable because it usually improves our standard of living as well as providing high levels of employment. Economic growth is considered to be one of the main goals of governments and economic policies are directed to the pursuit of high levels of growth.

Not all economic activity is measured in the national accounts. This limits the usefulness of such an indicator of economic performance. Moreover it is not generally agreed that emphasising the availability of goods and services is an adequate measure of the welfare or wellbeing of individuals in the economy.

The limitations of using GDP as a measure of economic welfare are carefully explained in the reading. There are some serious deficiencies if we place too much reliance on GDP estimates as the comparator of economic welfare overtime and between people. Note carefully how each of the seven limitations impacts upon the usefulness of the GDP figures that economists are so anxious to measure. Note in particular that the reading introduces GPI as a possible more accurate measure of national wellbeing.

Read Hamilton, p. 28.

To add further fuel to the discrediting of GDP measurement read Reading 7.4.

Read Gittins, 2005, p. 44.

Labour market indicators and unemployment definitions The material covered in this section relates to pages 240–246 of the text. Before we consider how the labour market functions, it is useful to come to a common understanding as to what the various economic terminologies mean. In your readings, take note of the definitions as they become apparent:

Reading 7.3r

Reading 7.4r

an employed person

an unemployed person

the working age population

the labour force

the participation rate

the unemployment rate

equilibrium unemployment

frictional unemployment

structural unemployment

technological unemployment

regional unemployment

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Write down your own definitions for each of the above terms.

Of more interest to us than defining the indicators themselves is their trend over time.

See if you can find current rates for the following on the web:

The discussion so far has looked at the broad labour market indicators. The key indicator is probably the unemployment rate. Defining and understanding the causes of unemployment is where our discussion goes in the next section.

Labour market flows The labour market can be represented with a series of flows somewhat reminiscent of the flows of economic activity in covered in earlier topics. There are flows of workers representing those entering the labour market and flows representing those leaving the market. The final number of unemployed in the economy will be determined by the relative size of these flows. People become unemployed if they 1) lose or leave their job and search for another 2) enter or re-enter the labour force and search for a job. People end a spell of unemployment if they 1) are hired or recalled or 2) withdraw from the labour force. People who become unemployed because they are laid off, either permanently or temporarily, from their job are called job losers. Some job losers become unemployed, but some immediately withdraw from the labour force.

People who become unemployed because they quit their jobs to look for a better one or to retire from the labour force are called job leavers. Job losers depart from their job involuntarily while job leavers voluntarily depart from their jobs.

Entrants are first time job seekers who haven’t previously held a full time job for at least two weeks. Re- entrants are people who become unemployed because they have re-entered the labour force and haven’t yet found a job. New entrants are mainly school leavers and most re-entrants are people who were previously discouraged workers who temporarily withdrew from the labour force.

Some people are unemployed for a week or two and others for a period of a year or more. The average duration of unemployment varies over the business cycle, creating an unemployment cycle, although the timing is a little different. The unemployment cycle is usually about 18 months behind the business cycle. The reason for this is that it is costly for firms to hire and fire workers, so employers don’t rush either to hire or to fire workers when conditions change.

real wage unemployment

participation rate.

Activity 7.18a

Activity 7.19a

participation rate1. unemployment rate2. job growth rate3. wages growth.4.

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At the unemployment cycle peak, there are relatively more very short-term unemployed people and very long-term unemployed people in the pool of unemployed than there are in an unemployment cycle trough. When the overall unemployment rate is low in an unemployment cycle trough, the duration of unemployment is more evenly spread.

The unemployment rate will rise when the growth of the labour force exceeds the growth in the number employed. Why is this so?

Having introduced some of the major concepts and definitions associated with the labour market, we can now analyse it with the familiar demand/supply model.

The labour market The labour market essentially matches the supply of labour to the demand for labour with an equilibrium hopefully occurring at full employment. If this does not occur, the government of the day has a case for policy intervention. Initially we will look at the demand for labour and then the supply of labour.

Labour demand, supply and equilibrium The quantity of labour demanded depends upon the real wage rate, a wage expressed in constant dollars or one indicative of purchasing power. In general, labour is hired while ever the revenues it generates outweigh the costs. The quantity of labour demanded will also depend upon the state of the economy with recessionary conditions leading to demand deficit unemployment.

The quantity of labour supplied also depends upon the real wage rate. As the wage rate increases, people are expected to offer more time for work. The labour supply curve slopes upwards as does a normal supply curve but the labour supply curve can be backward bending, an unusual trait! This is caused by an increase in demand for leisure as incomes from wages increase.

Equilibrium in the labour market is then determined where demand accords with supply.

Take some time here to reflect on your own employment. Consider demand for your skills, your wage rate, what wage rate you wouldn’t accept and how much wages you need before you have enough and start thinking of leisure time.

Unemployment at full employment In this section we focus again on the concept of the natural rate of unemployment or equilibrium unemployment which was introduced earlier. Recall that this refers to that situation in the labour force where the only unemployment is frictional or structural. Much of the natural rate of unemployment is due to matching available jobs to unemployed people.

Activity 7.20a

Activity 7.21a

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Job matching Matching people with jobs involves a search process on the part of the person seeking a job and on the part of the employer seeking a worker. Such a process can be time consuming and costly. Those of you who have sought a job may know the time involved and frustrations you face in the whole job search process. Employers, too, know how difficult it is to find the right people. A lot of unemployment exists because of the difficulty of matching jobs and job seekers. Job matching involves having the right person in the right job at the right time.

The matching process should be looked at from both the employer’s and employee’s perspective. The process for an employer is long and involved and there are three influences on the time taken to find satisfactory employees:

Job search The person seeking a job also has to undergo a search process. Not every job is suitable for every unemployed person and not every unemployed person wants to take the first available job. The main determinants of employee search are unemployment compensation, the stage of the business cycle, demographic changes and technological changes.

One of the most controversial issues of unemployment is the compensation payable to the unemployed. Note that it is suggested by some that the existence of unemployment benefits may act as a deterrent for the unemployed to seek work.

Another way in which unemployment can occur is through job rationing which is discussed in the next section.

Job rationing Job rationing occurs when people are kept out of employment by high wage levels. There are at least two circumstances in which these high wage levels can keep people out of employment. These are:

Policies to reduce unemployment The policies taken to combat unemployment will reflect the understanding as to the causes of unemployment. A number of strategies exist to reduce the problem of job matching and rationing, and they have been employed by different governments at different times.

At this point in time, it would probably be fair to say that the government has largely been focused on the issue of job rationing, given the way spending on unemployment services and retraining has been cut back in federal budgets over the past 15 years.

employment protection laws

the profile of the unemployed

the stage of the business cycle.

efficiency wages where employers pay higher than award to attract good people but in doing so leave less money available to hire more employees



minimum wages if set too high will lead to a decrease in demand for labour (see also Chapter 3 of the text on ‘Price Floors’).



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Read McTaggart et al. 2003, pp. 792–793.

Summary Macroeconomics is concerned with the level of economic activity in the economy as a whole. The performance of economic systems is usually measured by their rate of economic growth. Economic growth does not increase steadily over time but experiences highs and lows of activity which are explained by the business cycle. Two of the main consequences of the business cycle are unemployment and inflation, both of which have adverse effects on the performance of the economy. One of the major consequences of irregular economic performance is the creation of deficits and surpluses for governments who are responsible form attempting to regulate the level of economic activity.

Economists use a number of methods to measure the amount of economic growth occurring in an economy. The circular flow model of economic activity is a simplistic picture of an economy at work. However, from the main flows of economic activity in the model a number of alternative approaches to measuring the level of activity are identified. Economic growth can be measured by the incomes received, expenditure, or value- added approaches. The real value of GDP is only meaningful if the effects of inflation can be allowed for and there are at least two price indices that are used to overcome the effects of inflation. GDP is not a true measure of the level of economic activity since its calculation is subject to a number of limitations.

This topic has been concerned with monitoring and measuring the economy’s macroeconomic performance principally by examining GDP as the indicator of that performance. But what determines the level of GDP in the first place and why does it fluctuate over time? The determination of GDP is discussed in the next topic, using economic models.

Review activities

You are advised to undertake activities in the Sloman, Norris & Garratt, Chapter 9 as well as those relevant to pp. 240–246.

Feedback to activities

a), c) and d) will contribute towards a higher rate of GDP growth while on the other hand b) represents a depletion of the countries land resources and will work to decrease the rate of growth of GDP.

Reading 7.5r

Review activitiesa

Activity 7.2f

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Topic 7 Introduction to macroeconomics | 95

The world economy suffered considerably as a consequence of the Global Financial Crisis (GFC) however Australia managed to register growth during this period due mainly to the buoyancy of its mining sector. The future in Australia is uncertain since it is expected the demand for its resources may reduce.

For the costs you might have mentioned such factors as:

For benefits you might have mentioned:

There are of course many other costs and benefits along these lines that you might have identified.

Until 2008 government attention was focused on maintaining the budget surplus, with policies at that time likely to increase unemployment levels. However in 2009/10 there was a new policy direction, in response to the GFC, with the government willing to go into budget deficit to fund a stimulus package, aimed at keeping unemployment levels as low as possible. This could be considered to be Keynesian theory of fighting recessions. The Abbott government has stated that it wishes to get the budget back to surplus and this may result in increased unemployment.

The main economic cost is the loss of income and earning capacity, as productive resources remain idle, both individually and for the economy as a whole. The non-economic costs include loss of self- esteem, family problems, social dislocation and crime.

Activity 7.3f

Activity 7.4f

depletion of scarce resources

pollution of the environment

massive levels of jobs created and destroyed

undesirable levels of urbanisation and congestion

an unfair distribution of the rewards of economic growth.

improved levels of technology

faster, safer and more convenient forms of transport and communication

more availability of better quality goods and services

improved levels of education and knowledge.

Activity 7.5f

Activity 7.6f

Activity 7.7f

The labour force is equal to the sum of its employed and unemployed adults, or 9+1= 10 million.a. The unemployed rate is the ratio of the unemployed as a percentage of the labour force. The unemployment rate is 1/10 = 10 per cent.

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Topic 7 Introduction to macroeconomics | 96

Inflation, which is unanticipated, is considered a problem because it has a distorting effect on economic transactions. It favours some groups over others, erodes savings, causes consumers to place assets in non-productive uses, and tends to feed upon itself in an upward spiral with prices chasing wages chasing prices etc. It makes rational decision making very difficult.

You might have mentioned such adverse effects of inflation as:

On the other hand you might have mentioned that higher inflation can lead to:

Not all the effects of inflation are negative and their impact affects different people and sectors in different ways.

The reasons you might have suggested could have included:

and reasons why it is currently rising again:

Most of the cost of inflation would disappear. Investment, balance of payments and speculation costs would only disappear if everyone correctly anticipates inflation.

Activity 7.8f

Activity 7.9f

falling real wages

higher prices at the shops

more expensive insurance rates, petrol, interest rates and a rise in the general cost of living.

an increase in the value of assets you own

a rise in property values

big increases in money wages.

Activity 7.10f

high levels of unemployment

effects of the last recession

the Accord arrangements

effective government policies in managing the economy

low levels of unemployment

effects of years of economic growth

wage rises not really an issue

somewhat out of government hands except for fiscal policy.

Activity 7.11f

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Topic 7 Introduction to macroeconomics | 97

Compare your answer with Figure 9.1 on p. 208.

Activity 7.13f

Because the bricks in the yard are unsold stocks which are considered to be part of unplanned investment, but investment nevertheless.

No, since the economist would argue that this is a form of savings not investment since there has been no real wealth created only the purchase of a financial asset.

Activity 7.14f

Activity 7.15f

This is an interesting question. Residential housing is regarded as one of the major forms of investment spending because houses are considered to have a continuing earning capacity (in the form of rents) even if households choose to live in them rather than rent them out. Since they are deemed to produce a continuing service they are regarded as investment. Moreover trends in housing spending are normally considered to be one of the major indicators of the state of the economy.

While the sale of established houses is a major economic activity for the real estate industry and home renovators it is not counted since GDP only measures spending on new investment. Established housing is not new investment.

Activity 7.16f

Vegemite 40 jars $2.00 $80.00 $1.80 $72.00

Margarine 60 tubs $1.50 $90.00 $1.60 $96.00

Bread 120 rolls $1.20 $144.00 $1.30 $156.00

The value of the basket of consumption goods in the base period is the sum of the expenditures in that period: $314.00. The value of the same basket of goods in the current period is the sum of the values of quantities in that period: $324

The CPI figure for the current period is the ratio of the value of the basket in the current period to the base period expenditure, times 100: CPI = (324/314) * 100 = 103.18

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You can find this information from a number of useful websites you may try include the RBA site (http://www.rba.gov.au) and the Australian Bureau of Statistics (http://www.abs.gov.au). Use the Library's database so that you can access the ABS site for free.

Naturally if the workforce available for work increases but actual employment available doesn’t then unemployment rates will increase.

Activity 7.17f

Base period expenditure for each item is obtained by valuing the current period quantity at the base year price.

Pizza 10 units $10.00 $100.00 $9.00 $90.00

Beer 20 bottles $3.00 $60.00 $2.00 $40.00

Salad 20 serves $4.00 $80.00 $5.00 $100.00

The value of nominal GDP in the current period is the sum of expenditures in the current period: $240.00

The value of real GDP in the current period is the sum of the current period quantities evaluated at the base period prices (that is, what the expenditures would have been at base year prices): $230.00

The GDP deflator for the current period is the ratio of nominal GDP to real GDP, times 100: GDP deflator = (240/230) * 100 = $104.35

Activity 7.19f

Activity 7.20f

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http://www.rba.gov.au/

http://www.abs.gov.au/

Topic 8

Gross domestic product

Introduction It is an old joke in economics that if you could teach a parrot to say ‘demand and supply’ you would have an economist. What distinguishes economists from other social scientists is their fascination with the concepts of demand and supply in the operation of markets. A car market needs a buyer and seller if it is to fulfil its purposes. In the same way the market for all the goods and services produced in Australia (as measured by GDP) needs buyers and sellers.

This topic is concerned with an examination of the principles determining the production and selling of an economy’s goods and services. It introduces some new terms and uses graphical tools to explain the interactions that take place in national markets. It is mainly a theoretical topic, which systematically develops a model of economic activity, which is the basis for most of the remaining topics in this unit. Hence it is important that you are able to understand the concepts in this model and how they can be used to explain actual developments in the economy.

When students who have studied economics previously read ‘aggregate demand and aggregate supply’ as the heading for this topic, they have a tendency to think of ‘demand and supply’ which are basic topics in any unit in microeconomics. However the reasoning behind the concepts of aggregate demand and aggregate supply in this topic is very different from that which lies behind demand and supply. Too many students have stumbled in the past with this topic because they think with a ‘demand and supply’ mindset without examining or understanding the principles which underlie the concepts of aggregate demand and aggregate supply.

There are four main sections to work through in this topic. The first section is an introduction to the concept of aggregate demand and its determinants. The aggregate demand curve is derived and reasons for the movement in this curve are explained and illustrated.

The second section of the topic follows a similar procedure in explaining the nature of aggregate supply. The distinction is made between the short-run and long-run aggregate supply curves.

The aggregate demand and aggregate supply curves are brought together in the third section of the topic to explain the notion of macroeconomic equilibrium. The next section of the topic illustrates the concept of the multiplier effect. The multiplier is an effect of an initial increase in aggregate demand leading to an even greater increase in overall GDP.

Objectives On completion of this topic you should be able to:

describe the derivation of the aggregate demand and aggregate supply curves

explain those factors which cause the aggregate demand and aggregate supply curves to shift

distinguish between short-run and long-run aggregate supply

explain the concept of macroeconomic equilibrium

100

Study materials

Textbook Sloman, J., Norris, K. & Garratt, D., 2014, Chapter 10 and pp. 278–282.

Readings

Aggregate demand Aggregate demand is the term which is used to describe the total spending (or demand, since we use the terms to mean the same thing) by the main sectors in the economy. In the previous topic we identified these sectors as:

If we wish to measure how much GDP is being bought then we add up the spending by each of these sectors and this is aggregate spending or aggregate demand (AD).

In order to make some use of this concept, we construct an aggregate demand curve (we call it a curve even though it usually appears as a straight line on diagrams) to show the relationship between inflation and real GDP. We are interested in how aggregate demand might affect economic growth and price levels. This is shown in Figure 12.1 in the textbook. The slope of the AD curve suggests an inverse relationship between movements in prices (on one axis) and growth in GDP (on the other axis). In other words, the higher the level of prices in the economy, the less will be the level of total spending or demand, and vice versa. (The vertical axis is a measure of inflation; the higher up the axis the greater is inflation.)

Since we will be frequently using the type of diagram shown in Figure 12.1 make sure you understand what each axis represents:

Why should there be an inverse relationship between the level of inflation in a country and the level of demand for GDP? The text suggests two reasons:

explain the impact of aggregate demand and aggregate supply shocks on the level of GDP and inflation

explain the concept of the multiplier and how it occurs.

8.1 McTaggart, D., Findlay, C. & Parkin, M., 2003, Economics, 4th edn, Pearson Australia, Frenchs Forest, NSW, pp. 550-561

households or consumers – C

businesses or firms – I

government, and – G

the foreign sector – X-M.

The horizontal axis is what I call the ‘good’ axis since it measures economic growth and economies usually aim at high rates of growth. The further we are along that axis from the origin, the higher the level of growth. But this axis measures more than growth. It also measures employment since higher levels of GDP will mean higher employment levels or, put another way, less unemployment.



The vertical axis is the ‘bad’ axis since inflation is considered to be undesirable and the further we move up that axis from the origin the greater the potential problems with inflation. Most countries aim at getting a long way out on the growth (and employment) axis and to remain as far down the inflation axis as possible.



the income effect

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While the two reasons sound very technical, the explanation is quite simple. If inflation rises then:

When these reasons are combined they explain why the AD curve is shaped inversely.

Can you suggest where there might be a flaw in the ‘income effect’ argument?

In economics we make a crucial distinction between movements along a curve and shifting of a curve. From Figure 12.1 in the text we can see that, as inflation rises and falls, we move along the AD curve but always remain on it. However the AD curve is not static and this is where it becomes a useful tool for analysis. The AD curve will shift to the right whenever there is an increase in spending by any of the economy’s sectors and to the left whenever there is a decrease in spending by any of the sectors.

The shifting of the AD curve (to the left or right) can be affected by a number of factors which were explained in the text. Virtually anything that affects spending decisions will cause AD to shift. The text indicates that the factors which cause a shift can be government policy decisions and international events.

People’s expectations of the future can also affect aggregate demand. If households or businesses suddenly feel less optimistic about the future, then they tend to cut back on or delay spending decisions and this will cause the AD curve to shift to the left. It is interesting that around election time people and businesses often put off spending decisions. But if people and businesses expect a budget decision to increase a tax, then they tend to spend up now. Expectations are thus important influences on behaviour.

Take the time to carefully consider each of these influences on aggregate demand and make sure you can explain and illustrate how they would shift the AD curve. The following activity will assist you to see if you can do this.

Explain the effect of the following events on the AD curve.

Aggregate supply While the concept of aggregate demand is relatively straightforward, students usually have some difficulty understanding the logic behind the aggregate supply curve. The point to remember is that the focus here is on the production of GDP not the demand for it. The notion of aggregate supply requires us to imagine that

the substitution effect.

people have a tendency to save more as the value of their money assets falls (a decline in real money balances)



people delay buying now in the hope prices will fall later

Australia’s goods and services become less price competitive compared to other countries’.

Activity 8.1a

Activity 8.2a

The government cuts its expenditure on final goods and servicesa. The foreign exchange value of the Australian dollar fallsb. Entrepreneurs become more optimistic about future profitsc. The Consumer Price Index increases by 5 per centd. The Japanese economy suffers a recession.e.

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we are producers, and asks us to consider how our production decisions might be affected by inflation rates and GDP growth levels. When we add together the similar decisions of all other producers, then we have a picture of aggregate supply.

Unlike aggregate demand, production (or supply decisions) will be different according to the time period under consideration. In economics we distinguish between the short-run and long-run production periods. The critical difference is that in the short-run the prices of factors of production (such as wage rates) are held constant while in the long-run all prices (including wage rates) can vary. Providing wages are free to vary (both up and down), then in the long-run the economy will be at a level of full employment. So when we draw a long-run aggregate supply curve it will always be at the full employment level.

Long-run aggregate supply The explanation of the long-run supply curve might be brief in the text but it needs working through carefully as it can be an area of confusion. Remember that the long-run supply curve will always be vertical and at the full employment level of GDP. But whether the economy is actually operating at this level will depend on the interaction of aggregate demand and short-run aggregate supply. After reading the textbook read Reading 8.1.

McTaggart et al., 2003, pp. 550-561.

In the same manner that the aggregate demand curve can shift over time, the aggregate supply curves, both short-run and long-run, can shift. The short-run aggregate supply curve will only shift if there are changes in the factor prices. If, for example, wages rise, then businesses faced with higher costs of production would be less willing to make their goods and services available on the market. This effect would be shown as a shift to the left by the short-run aggregate supply curve as in Figure 24.7 of Reading 8.1. Changes in anything else that affects production (such as technology, the stock of capital goods, and the size of the labour force) will have an impact on both the short-run and long-run aggregate supply curves. These effects are illustrated in Figure 24.8 of Reading 8.1.

This section has been solid going since it is introducing new terms and new concepts. To see if you if have understood these terms and concepts, complete the following activity. If you fail to get the correct answers for these questions, then revise this section of work.

Why is the short-run aggregate supply (SAS) curve usually drawn as positively sloped, while the long- run aggregate supply (LAS) curve is drawn as a vertical line?

Short-run aggregate supply The important characteristic of the short-run aggregate supply curve is its positive slope (refer to Figure 24.7 of Reading 8.1), reflecting the reaction by producers to prices. As you read your textbook, remember that the prices of the factors of production remain fixed.

Reading 8.1r

Activity 8.3a

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Topic 8 Gross domestic product | 103

Macroeconomic equilibrium Our interest in the aggregate demand (AD) and aggregate supply (AS) curves is not so much in their shape but what their interaction might explain about the economy. Where the AD curve and short-run aggregate supply curve (SAS) intersect determines the level of GDP and inflation at which the decisions of those wishing to purchase the produced goods and services is in accord with those who wish to produce those same goods and services. This is known as equilibrium. At any other price level and GDP level, the decisions of the producers and consumers will not be in agreement and forces will be set in place that will tend to restore this equilibrium position.

By now you will have made the connection between the circular flow as introduced in Topic 7 and aggregate demand where:

GDP = C + I + G + X – M.

In the circular flow model we introduced withdrawals and injections into the economy. Previously in this topic we explored macroeconomic equilibrium where AD = AS. We discovered that if prices or GDP were not in equilibrium the decisions of producers and consumers will not be in agreement and forces will be set in place that will tend to restore equilibrium. We can however look at macroeconomic disequilibrium from the point of view of injections and withdrawals not equalling each other.

The multiplier When injections rise or withdrawals fall GDP will rise. The question is by how much? The answer is that there will be a multiplied rise in income: that is, GDP will rise by more than the rise in injections or fall in withdrawals. This section also reviews changes to spending and its effect on unemployment and inflation.

What is the relationship between the mpc and the mpw?

So far we have considered the aggregate demand (AD) and aggregate supply (AS) curves separately and then brought them together to illustrate macroeconomic equilibrium. We have discovered that economies will converge towards equilibrium via price, output, withdrawals and injection mechanisms. But economies rarely exist in equilibrium and are frequently subject to major shocks. The impact of these shocks on economic activity is discussed in the following section.

Fluctuations in economic activity resulting from shocks The usefulness of this AD/AS model is that it enables us to see what happens to the level of economic activity when there is some unexpected change in one of the determinants of either aggregate demand or aggregate supply. These unexpected changes are known as shocks. The curves now take on a dynamic nature as we first trace the effect of a shock on the AD curve and the impact this will have on the SAS curve and then trace the effect of a shock on the AS curve and how this can lead to a situation of stagflation which was the experience of many economies in the 1960s and1970s.

The following reading gives an example of how AD/AS analysis is used to explain and analyse government economic policy decisions.

Activity 8.4a

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Topic 8 Gross domestic product | 104

What factors could explain why some countries have a higher multiplier than others?

Estimate where the Australian economy might have moved to in the past few years in terms of in terms of AD/AS and inflation.

Summary This topic has developed a theoretical model for explaining the determination of economic activity. It discussed the nature of aggregate demand, AD, and aggregate supply, AS (both in the long run and the short run) and indicated how a situation of macroeconomic equilibrium was possible, but not guaranteed, in the economy when aggregate demand and aggregate supply intersect. We noted that expenditure in an economy is subject to multiplier effects and the topic also showed the dynamic nature of the AD/AS model and how economic shocks would affect the performance of economic growth.

Review Activities

You are advised to undertake activities in the Sloman, Norris & Garratt, 2014, MyEconLab, Chapter 10.

Feedback to Activities

The real wealth argument suggests that people will be under pressure to save more in times of inflation as the real value of the balance of the savings they hold in banks or elsewhere falls. It could be argued that the very opposite happens. When people see inflation rising they might think that saving is not worth the effort so they go out and spend now!

Activity 8.5a

Activity 8.6a

Reveiw activitesa

Activity 8.1f

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Topic 8 Gross domestic product | 105

In answering the questions in this section, it is worthwhile bearing in mind that

Aggregate demand = C+I+G+X-M

and that the AD curve shows the relationship between the price level and the quantity of real GDP demanded by households, firms, government and foreigners. Thus any change in the price level will lead to a movement along the AD curve, while a change in a factor other than the price level that affects the quantity of real GDP demanded will lead to a shift of the whole AD curve.

The SAS curve shows the relationship between the price level (that is output prices) and the real GDP that firms will supply during a period when factor prices and other supply factors such as technology, the labour force, and the capital stock are remaining constant. The SAS curve is usually drawn as positively sloped because when the price level changes, firms see the prices of their outputs rising while the prices of their inputs remain unchanged. Each firm finds it profitable to increase output and, if all firms do so, aggregate output (GDP) supplied increases. Thus the important assumption underlying the positive slope of the SAS curve is that factor prices remain constant.

The LAS curve shows the relationship between the price level and the quantity of real GDP supplied when there is full employment. For full employment to be maintained, factor prices and output prices must be given time to adjust whenever the economy deviates from the full-employment path. Thus the long-run aggregate supply relates to a period long enough for factor prices and output prices to fully adjust so that full employment is restored. Since there is only one level of real GDP that can be produced when the economy is at full employment, the LAS curve is a vertical line at full employment real GDP. Thus the important assumption behind the vertical LAS curve is that factor prices and output prices adjust to restore full employment whenever the economy deviates from it.

Activity 8.2f

A decrease in government spending will shift the AD curve to the left. It is NOT a price change.a. A decrease in the foreign exchange value of the Australian dollar is NOT a price change. It will make Australian goods for export cheaper and thus demand will rise moving the AD curve to the right.

Future profit expectations are NOT a price change. These expectations should lead to an increase in investment thus moving the AD curve to the right.

An increase in CPI IS a price change and will move the AD curve upwards and along leading to a higher price for less real GDP.

Activity 8.3f

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In Australia in the 1990s through to the 2012, economic growth has been reasonably strong even during the GFC while inflation levels have been low. This would mean that the AD and SAS curves would intersect at ever increasing rightward movements in terms of increased growth on the real GDP axis but with only minor movements upwards on the GDP deflator axis of the Ad/AS graph.

Activity 8.4f

The MPCd is the proportion of the rise in GDP that accrues to domestic firms from consumption (and thus excludes those parts of consumption that goes on imports and is measured in prices that firms actually receive i.e. after the payment of taxes on goods and the receipt of any subsidies on goods) MPCd = change in C/change in GDP The MPW is the proportion of the rise in income that is withdrawn from the circular flow of income i.e. the proportion that does not accrue to domestic firms. Thus MPW = 1- MPCd

The E line is parallel with the Cd line (assuming that the J curve is a horizontal straight line) Thus the slope of the E line is the same as the slope of the Cd line which is given by the MPCd (change Cd/change GDP).

Activity 8.5f

The lower the country’s GDP the higher will be tend to be its MPC and thus the higher will be its multiplier

In some countries there is much more of a savings culture and thus the MPS is higher. Those with less of a savings culture will tend to have a lower MPS and thus a higher multiplier.

In some countries especially large one trade accounts for a relatively small proportion of GDP. In such countries the MPM will be lower and hence the multiplier will be higher than in countries with a higher proportion of trade relative to GDP.

The marginal tax rate, the MPT, differs from country to country. The lower the MPT the higher the multiplier.

Activity 8.6f

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Topic 9

Money, interest rates & inflation

Introduction Bank fees, interest rates and credit cards never seem to be out of the news. Moreover the introduction of EFTPOS facilities, the growing importance of non-banks as major lenders in financial markets and the instantaneous transmission of money globally have changed the whole structure and operation of money and money markets in Australia. Financial systems are undergoing massive transformations as they adjust to new technologies, government policies and increasing international competition. This topic is concerned with these issues of money, interest rates and money markets.

Within that theme we will examine:

Finally in this topic we examine inflation. In recent times it has not been the area of concern for policymakers in Australia however it still remains a potential problem that needs constant monitoring. We briefly looked inflation in Topic 7 and noted that a change in aggregate demand can have an adverse effect on the price level and hence on inflation. In rounding out this topic we turn our attention to a more detailed analysis of inflation in terms of demand-pull, cost-push and the Phillips curve.

Objectives On completion of this topic, you should be able to:

the nature of money

how money is created

the demand for money

how interest rates are determined

the impact of money on GDP and price levels.

describe the main functions and forms of money

explain the process by which financial institutions create money

identify and explain the motives for holding money

outline the influences on the quantity of money held

explain the shape of the money demand curve

describe how money market equilibrium is determined

explain how increases in the money supply affect the price level, GDP and employment

describe the role of the Reserve Bank in the conduct of monetary policy

explain the role of financial intermediaries and the ways in which they are regulated by the Reserve Bank

distinguish between the causes and effects of different types of inflation on economic activity.

108

Study materials

Textbook Sloman, J., Norris, K. & Garratt, D., 2014, Chapters 11 & 12.

Money markets In the model of the circular flow of income reference was made to the existence of a market whereby the savings of households could be made available for borrowing purposes. This market was called the financial market and it plays a critical role in the operation of the economy. In this topic, the term ‘money markets’ will be used in preference to ‘financial markets’. This is because ‘money markets’ is a broader term than ‘financial markets’ and it is the role of money which we want to stress.

What is money? Have you thought about money? The role of money in the economy is critical because it facilitates exchange between people in the economy. Indeed, in order for money to be useful, it must serve three functions, as:

How well would each of the following fulfil the functions of money? Grain, strawberries, strawberry jam, gold, diamonds, a bank share certificate and a savings account requiring one month’s notice of withdrawal?

We are interested in money in this unit, because money is a tool by which the government can regulate the activities of financial intermediaries such as banks. This is the next topic for consideration.

Financial intermediaries and their role Financial intermediary is the common term that covers firms that operate in the money markets. The main types of financial intermediaries are explained in the text along with their vital economic functions in the money sector.

Outline the role of the financial sector.

a medium of exchange

a unit of account, and

a store of value.

Activity 9.1a

Activity 9.2a

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Topic 9 Money, interest rates & inflation | 109

Financial regulation Many powers which were once the exclusive preserve of the Reserve Bank of Australia (RBA) have now passed to the Australian Prudential Regulation Authority (APRA) and the Australian Securities and Investment Commission (ASIC). These powers include both regulation and prudential supervision. However, the RBA is still responsible for the overall stability of the system and monetary policy.

Find the RBA on the Internet and have a brief look through the website. The address is http://www.rba.gov.au.

The supply of money The price of cash (e.g. if we wanted to hold it in our purses/wallets) is the amount of interest we could earn if it was held in a deposit account. Similarly, we can say that the price of money is the interest rate. However, the supply of money is determined, more or less, by intermediaries and the multiplier process, which means it is determined independent of the interest rate. This means our money supply is inelastic in terms of its price, or in other words, vertical as per Figure 11.2 in the text.

The creation of credit Financial institutions are in an interesting position in the financial sector in that they have the ability to create money. They do this by lending most of the money which is deposited with them. If this money is then redeposited by someone else it is available for further lending and this process of lending and redepositing has a multiplier effect in the same fashion as the multiplier we have been discussing in earlier topics.

How does the bank multiplier relate to the expenditure multiplier?

If banks choose to operate a 20% liquidity ratio and receive extra cash deposits of $10 million, assuming that the general public does not wish to hold a larger total amount of cash balances outside the banks:

We are interested in money because there is a market for it. In the next section we consider the demand for money as the first step in understanding the money markets.

Activity 9.3a

Activity 9.4a

Activity 9.5a

How much extra credit will ultimately be created?

By how much will total deposits expand?

What is the size of the bank multiplier?

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http://www.rba.gov.au/

The demand for money As mentioned above, every time we carry money in our pockets, wallets or purses we are incurring an opportunity cost. This opportunity cost is the interest we could earn if we placed the money in a financial institution where it could earn interest.

Interest rates are defined in the text and the inverse relationship that exists between interest rates and asset prices is explained.

If we can earn interest, why hold money in the form of money at all? There are a number of reasons why people hold money and these are described in the text. More important is how much money they will hold and the text discusses four determinants. The most interesting of these influences on holding money is probably ‘financial innovation’, since modern technology has led to a decline in the need to hold money for transaction purposes. In this section also note the difference between nominal money and real money. Real money is the purchasing power of nominal money. Nominal money can increase but if prices rise by the same proportionate amount then real money will be unchanged.

Knowing the determinants of the demand for money, we are in a position to construct a demand curve for money. This curve is depicted in Figure 11.3 in the text and it reflects the inverse relationship that exists between the demand for money and the level of interest rates in the economy. As interest rates rise, people have less desire to hold money since the opportunity cost is high and they would prefer to convert the money into an interest-earning asset. Like most demand curves, if there is a change in one of the determinants of demand then the curve will shift to the left or the right depending on the nature of the change in the determinant. An increase in real GDP, for instance, increases the demand for money.

Why might the relationship between the demand for money and the rate of interest be an unstable one?

We are now in a position to construct a market for money and this is discussed in the next section.

Equilibrium Equilibrium in the money market occurs when the demand for money is equal to the supply of money. This equilibrium is achieved through changes in the rate of interest.

Attempt Discussion Question 8 Sloman, Norris & Garratt 2014, p. 275.

Types of inflation For someone who remembers the 1970s and 1980s, it appears that inflation has disappeared from the economic agenda although the Reserve Bank of Australia (RBA) still uses inflation outcomes as a key indicator when deciding on interest rate (cash rate) movements or non-movements. How monetary policy actually operates will however be the subject of your Topic 11 studies. High rates of inflation are not just a

Activity 9.6a

Activity 9.7a

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problem for governments, but disrupt the economy causing declining standards of living and unemployment. It is for that reason, as students of economics, that we must understand the causes and consequences of inflation.

You may have discovered that the RBA has set a goal of keeping inflation at low levels and that monetary policy is the tool directed to achieving that goal.

To measure the inflation rate we calculate the annual percentage change in the price level. For example if this year’s price level is 126 and last year’s price level was 120 the inflation rate is per cent a year. That is:

Inflation Rate = (126–120)/120 x 100 = 5 percent.

Recall that inflation is a process of rising prices. There are two main causes of inflation, one being from the demand side of the marketplace (demand-pull inflation), and the other coming from the supply side of the market (cost-push inflation). To understand the nature of each of these causes we return to the use of aggregate demand and supply models.

Demand-pull inflation How inflation occurs from an increase in aggregate demand and the resulting effects on the short-run and long-run supply curve are depicted in Figures 12.4 and 12.5 in the text.

Cost-push inflation A similar line of reasoning follows when we look at inflation generated from the supply side of the market. If wages (or the prices of other inputs) rise unexpectedly, then this can set in chain a series of processes which lead to stagflation. This is depicted in Figure 12.7 in the text. An attempt by the RBA to use demand management policies to correct such a situation can be self-defeating as a wage price inflation spiral can occur.

How might you set about analysing whether a particular period of inflation was caused by cost-push or demand-pull inflation?

(From Sloman, Norris & Garratt 2010, p. 291)

By now you should be well experienced in using figures like those in Figures 12.5 and 12.7 in the text. We use the same framework over and over and simply add a little more each time we move further on in the unit.

In the next section we consider the important relationship between inflation and the quantity of money in the economy.

The quantity theory of money Interestingly, some of the earliest notions of a quantity theory of money were constructed by the philosopher David Hume (1711–1776) who was a great influence on that other great economist Adam Smith. Hume’s ideas in logic were astonishingly simple yet extraordinarily provocative in his time. Hume pointed out that if

Activity 9.8a

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you increase the quantity of money (gold or fiat), without increasing the quantity of goods and services available to buy with the money, then we end up with too much money trying to buy too few goods … inflation.

This was called the price-specie-flow mechanism and underpins the later model of the quantity theory of money, which in summary predicts an increase in the supply of money brings with it an equal increase in the price level.

If real GDP is estimated at $400 billion per annum, the quantity of money is estimated at $100 billion, and the average time a dollar is used for transactions is 5, what is the estimated inflation rate?

Another vital aspect of inflation which we need to consider is its relationship to unemployment.

The Phillips curve It may be apparent by now, that the causes of inflation are also inevitably linked to employment. We note, for example, that stagflation starts with cost-push of the economy to a lower level of activity than long run supply. This is unemployment. The government policy response in that case might be expansionary fiscal or monetary policy which eliminates the unemployment but leads to inflation and, indeed, a potential spiral. There is a link between unemployment and inflation.

The New Zealand economist A.W. Phillips investigated the relationship between inflation and unemployment whilst working at the London School of Economics in the late 1950s. He concluded, from empirical evidence, that there was a ‘trade-off ’ between inflation and unemployment.

Deflation For the past 50 years inflation has been seen as a potentially serious problem. This concern peaked in the 1970s when inflation was at historically high levels in most countries. Average inflation for that decade was, for example, 9.8% in Australia and 13.0% in the UK. Inflation rates in most advanced economies have fallen considerably and concern is now being expressed about deflation. In general terms deflation is a continuing fall in the general price level.

Do you think there is a relationship between deflation and a ‘liquidity trap’? You may need to research outside the textbook if you wish to discover what a liquidity trap is.

The final area of inflation to start thinking about is that of policy.

Inflation policy When prices are stable the inflation policy problem is to ensure that they remain so. When we have inflation the policy problem is to reduce its rate and restore stability. The first problem raises some special issues concerning cost-push inflation. As we move into our latter topics you may well consider that non- intervention may be more appropriate, that is, let the economy fix itself. However, such an approach could

Activity 9.9a

Activity 9.10a

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lead to unemployment for a considerable period of time. One must use the most appropriate policy or mix of policies whenever possible. The major player in the fight against inflation in Australia is the RBA. We will turn to policy thoughts in Topic 11.

Summary This topic commenced by discussing the role of money in the economy. We considered the characteristics of money, how banks create money with a multiplier impact, the reasons people demand money, and how the intersection of the demand and supply of money determines an equilibrium level of interest rates. We then discussed the role of the Reserve Bank in the financial markets in Australia and outlined the means by which the money supply is controlled. We also reviewed inflation, its causes and impacts. In the next topic, we will consider the global economy.

Review activities

You are advised to undertake activities in the Sloman, Norris & Garratt 2014, MyEconLab, Chapters 11 and 12.

Feedback to activities

Gold would be acceptable under certain circumstances and, historically was used to constitute the main form of money. The savings account would be included in the definition of broad money and would act as a store of value. It could only be used as a medium of exchange after one month. The others are not currently acceptable as a medium of exchange but could be acceptable if society chose.

Your answer should include expert advice, expertise in channelling funds, maturity transformation, risk transformation and payment transmission.

The ‘change in deposits’ in the deposit multiplier equation is equivalent to the initial change in expenditure in the expenditure multiplier. And the required reserve ratio is the equivalent of the marginal propensity to save in the expenditure multiplier.

Review activitiesa

Activity 9.1f

Activity 9.2f

Activity 9.4f

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This is because the demand for money depends on things other than just the current interest rate. For example expectations about changes in interest rates, exchange rates and inflation will also affect the level of demand for money.

This would be very difficult. One possibility would be to look at the movement in prices and GDP. In demand pull inflation both prices and GDP increase initially. Later in the process prices rise but GDP falls. In a cost push inflation prices rise and GDP falls throughout the inflation process.

Using the equation MV = PY and substituting;

($100billion)(5) = P($400billion);

P=1.25;

The inflation rate is 25%.

Activity 9.5f

$40 million.a. $50 million (i.e. the $10 million extra cash deposits plus the $40 million credit creation).b. 5 (= 1/.0.2).c.

Activity 9.6f

Activity 9.7f

They will increase credit and hence the money supply. MS will shift to the right. The equilibrium rate of interest will therefore fall.

Higher incomes will increase the transactions demand for money. The demand for money curve will shift to the right, causing the equilibrium rate of interest to rise.

If people believe that interest rates will rise, the assets demand for money will rise. Again, the demand for money curve will shift to the right, causing the equilibrium rate of interest to rise.

Activity 9.8f

Activity 9.9f

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Topic 10

The global economy

Introduction The Australian current account deficit, our international trading circumstances and our foreign debt are often the subject of public discussion. Tariff barriers and other forms of industry protection are also a strong source of contention and the gyrations of the Australian dollar have become part and parcel of most regular news services. In this topic we consider aspects of Australia’s international trading relationships.

Australia is a player in the global economy and international trade is a major component of our economic activity. We have already seen in previous topics how the net exports (exports minus imports) constitute one of the main sources of aggregate spending and demand in the economy. Yet, despite the crucial role that the international sector plays in determining the level of economic activity and employment in Australia, we have not examined these overseas impacts in any detail.

Domestic economic policy and international economic events are closely related. Indeed, the success of domestic economic policy decisions is often thwarted by adverse and unexpected developments in the overseas sector. Governments in Australia therefore have to develop policy in the context of their likely impact on the foreign sector.

International trade and finance are big topics and constitute sizeable proportions of most macroeconomics textbooks. There is a range of issues that arise when Australia becomes involved in the international economy. It is not possible to cover all these matters adequately in just one topic. In this topic we have to be selective in what international factors we discuss. We will limit our study to three broad areas:

These are the critical international economics issues with which students of economics should be familiar.

Firstly we will look at the gains from trade and the various arguments for and against trade. We will also view trade from a historical point of view and trading blocs.

The second section of this topic considers the financing of international trade, the composition of the balance of payments and the origins of the current account deficit.

Thirdly we examine the foreign exchange market and how currency values are determined. We look at foreign exchange from a fixed or floating exchange rate policy and the topic finishes with a consideration of the relationship between the rate of exchange and the terms of trade.

This topic will cover various sections of the text. It will range across two chapters and within these chapters it will be selective in the content discussed.

trade

the balance of payments

exchange rates.

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Objectives On completion of this topic, you should be able to:

Study materials

Textbook Sloman, J., Norris, K. & Garratt, D., 2014, Chapters 14 & 15.

Readings

Global interdependence and the gains from trade Companies specialise in producing goods and services which they are good at and which are profitable. Countries also specialise in what they are good at. Often when they produce goods there is a surplus of production so decisions need to be made as to what to produce and buy and what to sell overseas. The next reading will discuss the decision-making process.

Arguments for restricting trade Even though we have seen that trade can bring benefit to all countries, countries throughout the world actually put up barriers to trade.

explain how a country can gain from trade

discuss the history and why countries restrict trade

describe the balance of payments

explain what foreign exchange, foreign exchange markets and foreign exchange rates are

explain what determines exchange rates in a flexible regime

explain how exchange rates are fixed

describe how a country’s international trade is financed

explain what determines a country’s current account balance.

10.1 Kavanagh, J., 2006, ‘Buying Spree’, Business Review Weekly, March 30–April 5, pp. 68–70. 10.2 Richardson, C., 2006, ‘Sucked in, again’, Business Review Weekly, March 30–April 5, pp. 46–47.

Activity 10.1a

To what extent are the arguments for countries specialising and then trading with each other the same as those for individuals specialising in doing the jobs at which they are relatively well suited?

Why do countries attempt to create barriers to trade?2.

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Trading blocs It is likely that you have read in the newspaper or seen on television the trade minister discussing Free Trade Agreements between Australia and other countries. So why do countries develop these agreements known as trading blocs? What happens to countries not invited to join these trading blocs?

The balance of payments Because of the nature of our major exports, our distance from major markets and the structural features of the economy, Australia faces a difficult international situation. Our trading picture is problematic with large and ongoing trade deficits, except for a brief period between 2010 and 2011, and despite the introduction of a wide range of policies to improve the situation, the prognosis remains difficult. We shall see the reasons for this as we examine the balance of payments. Another related legacy of our poor trading performances over many years is an increasing foreign debt.

The current account deficit, or ‘the CAD’ as it is known, has almost become part of the common language of Australians because of the publicity surrounding it in recent years. But the current account deficit has a precise meaning and it is the part of the balance of payments to which we will turn after we first consider the financing of international trade.

Financing international trade The balance of payments is a summary of a country’s international financial relations. It is the difference between what is earned from foreign transactions and what is paid to foreigners. What we earn appears as credits and what we pay for appears as debits in our records of international dealings. There are two major accounts in the record keeping: the current account and the capital and financial account. If you can appreciate what is included in each of these accounts then you are well under way to understanding the nature of Australia’s international trading picture.

The current account In the current account there are three major groups of trading items:

The first of these items, the balance of goods and services (net exports), is one you may well already know about. The term ‘balance on merchandise trade’ refers to goods. Of course, nations also export services as well as goods. One of Australia’s important export earners is now education, which is a service. ‘Net services’ is the balance of the earnings and payments for these services.

Net income is a controversial item for Australia. It is the source of Australia’s current account deficits. Net income is the income earned by foreign individuals and businesses on foreign debt and investments in Australia. Whenever profits and dividends are repatriated overseas, it is in this account that they appear, and it is a growing proportion of Australia’s current account debits.

Transfers include any monies received here or paid abroad without any service being given in return. If a rich uncle overseas sends you some money, not only will you be very pleased (and probably equally surprised) but also the money will appear in our trading accounts under this item. ‘Net transfers’ represents the difference between transfers in and transfers out.

the balance of goods and services

net income

transfers.

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The capital and financial account The capital and financial account is a summary of the borrowings (capital flows) between Australia and the rest of the world. It is a record of how the items in the current account are financed. The balance on the capital and financial account must be identical with the balance on the current account. (The basic logic underpinning this notion is that if a nation is importing more than it is exporting, it must be borrowing to finance the short fall.) Note Table 15.1, page 344 of the text.

The capital account is essentially measuring capital transfers and is a minor item. On the other hand, the financial account, a much more significant account, measures the transactions associated with assets and liabilities.

Kavanagh 2006, pp. 68–70.

Richardson 2006, pp. 46–47.

Attempt Discussion Question 10, Sloman, Norris & Garratt 2014, p. 357.

Foreign exchange markets and the dollar Since countries trade in their own currency, there needs to be a market in which the various currencies can be traded – this is the foreign exchange market. The price at which one currency trades for another is the foreign exchange rate. Foreign exchange dealers make the foreign exchange market highly efficient.

In the end, it is the government which determines the type of foreign exchange regime that a country has. In effect, there are three options:

From the end of World War II until the early 1970s, most countries followed a fixed rate-of-exchange regime. Since that time, however, many countries began to free up their currencies and move towards a flexible, or at least a managed, system. Since 1983, Australia has adopted a managed flexible rate. When one country’s currency rises in value against another’s currency we call that an appreciation and when it declines in value we call it depreciation.

Generally the Australian currency is quoted against the American dollar but there are many currencies against which the Australian dollar is quoted. The trade-weighted index (TWI) measures the value of the Australian dollar against a basket of other currencies. The value of other currencies in this basket is determined by the importance of these currencies in Australia’s international trade.

These matters are discussed in the following section.

Readings 10.1 & 10.2r

Activity 10.2a

a flexible exchange rate, where the value is determined by market forces with no intervention by the Reserve Bank



a fixed exchange rate, where the Reserve Bank fixes a rate at which the Australian dollar will be traded

a managed exchange rate, where the Reserve Bank intervenes to iron out fluctuations in the exchange rate but not to set any specific rate.



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How is the value of the dollar determined in a flexible exchange regime? This is discussed in the next section.

Exchange rate determination: Flexible exchange rates In a flexible market, the rate of exchange for a country’s currency will be determined by the intersection of the forces of demand and supply. To understand what value a currency will have in international markets we need to consider those factors which will cause that currency to be demanded and those factors which will cause that currency to be supplied to foreign exchange markets.

The demand for foreign exchange Three types of transactions which give rise to the demand for foreign exchange:

There are four forces which can cause the demand curve for a domestic currency to either increase or decrease. These forces are:

These shifts are depicted in Figure 15.2 in the text.

The supply of foreign exchange In the same way as there is a demand for foreign currency, there are forces at work to create a supply of this same foreign currency. These forces are:

With these factors in mind, a supply curve for foreign exchange can be constructed, as depicted in Figure 15.2. Domestic currency depreciation will increase the willingness of foreign countries to supply their currency in foreign exchange markets. A foreign currency appreciation will decrease the willingness of foreign countries to supply their currencies in foreign exchange markets. (Remember that a depreciation of the Australian dollar against the American dollar is the equivalent of an appreciation of the American dollar against the Australian dollar.)

The supply curve for foreign currency will shift either to the left or to the right if there is a change in:

the purchase of imports

the transfer of income overseas

the purchase of foreign assets.

the level of domestic GDP

domestic prices relative to foreign prices

domestic interest rates compared to foreign interest rates

expectations about the future value of the currency.

overseas residents purchasing domestic exports

overseas residents transferring income to domestic residents

overseas residents purchasing domestic assets.

the level of foreign GDP

domestic prices relative to foreign prices

differences between domestic and foreign interest rates

the expectations about the future value of the dollar.

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The net effect of changes in these variables is again depicted in Figure 15.2.

When the forces affecting demand and supply are brought together, the equilibrium exchange rate can be determined. The exchange rate value will vary whenever there is a change in the determinants of demand and supply. In a flexible system of exchange rates, the value moves up or down to clear the market and to restore the market to a new equilibrium position.

Attempt Discussion Question 3, Sloman, Norris & Garratt 2014, p. 357.

Managed exchange rates In practice, exchange rates may not be completely free to move but are subject to intervention by the monetary authorities. In Australia, the Reserve Bank pursues a managed exchange rate regime which means that the Reserve Bank frequently intervenes in the foreign exchange market by buying or selling foreign exchange. It does this to prevent the value of the Australian dollar from sharply fluctuating.

There are arguments for and against this interventionist policy. The main arguments for the Reserve Bank intervening are:

The main arguments against intervention are:

Can you find out what RBA intervention in Australia’s exchange rate has taken place recently?

Hint: Try www.rba.gov.au (http://www.rba.gov.au)

Summary The international sector is an important part of any economy. Policy makers need to take account of the determinants of, and movements in, exchange rates. Most nations operate with managed exchange rates, which fall between fixed and flexible exchange rates.

Activity 10.3a

to reduce the undesirable effects of a currency that fluctuates widely in value. Large fluctuations add to the uncertainty faced by exporters



to prevent the inflationary effects of a depreciating domestic currency. As a currency falls in value, the price of imports increases and adds to the inflationary pressures in the economy



sharp appreciations in the currency have an adverse effect on exporters who find themselves being priced out of markets.



the determination of the ‘correct’ level at which the currency value should be set as a result of the intervention. The Reserve Bank has to be certain that it does not set a value, which overvalues or undervalues the true worth of the currency



it removes the ability of the Reserve Bank to operate independent domestic monetary policy. Monetary policy becomes totally focused on the international sector and the maintenance of the exchange rate.



Activity 10.4a

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http://www.rba.gov.au/

The balance of payments is a summary of a country’s international trading transactions. It has two accounts, the current, and the capital and financial sections. Australia has historically been reliant on external borrowings for expenditure on development and infrastructure. Continued borrowing creates a growing level of foreign debt and this has become the subject of much economic debate.

Review activities

You are advised to undertake activities in the Sloman, Norris & Garratt 2014, MyEconLab, Chapters 14 and 15.

Feedback to activities

You should be able to find the answer to this at www.rba.gov.au (http://www.rba.gov.au)

Review activitiesa

Activity 10.1f

The arguments are very similar. Individuals will gain by specialising in jobs in which they have a comparative advantage and using the money they earn to buy items which they could only have produced themselves relatively inefficiently.

This is an example of the prisoners’ dilemma (see Box 6.2 pp. 147–148 of the text). There may be a net gain to all countries from a reduction in trade barriers, but any one individual country may gain if it alone erects a barrier against other countries, and will suffer if it does not erect barriers and other countries do. The effect of this is that countries will all tend to increase their protection unless international agreements (such as the one setting up the WTO) can be signed, binding the signatories to refrain from increasing the protection of their industries.

Activity 10.2f

Activity 10.3f

It may fuel inflation by increasing the price of imported goods and reducing the need for export industries to restrain cost increases.

It may damage export industries and domestic import-competing industries, which would now find it more difficult to remain competitive.

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http://www.rba.gov.au/

Topic 11

Fiscal and monetary policy

Introduction The final topic in this unit examines government policy. Developments in the area of macroeconomics are rapidly changing so you are advised to be aware of changes reported in the press in regard to monetary policy in Australia and interest rates.

The topic begins by providing a description of the role of government in the economy and the part played by the budget and fiscal policy in regulating the level of economic activity.

The topic provides an explanation of fiscal policy as well as the structure and recent history of federal budgets comparative to GDP and the reasons for fluctuations in surpluses and deficits are considered. The important role of automatic stabilisers is also considered, followed by an analysis of how changes in fiscal policy will affect the level of GDP and the price level in the economy.

The next theme is concerned with the operation of monetary policy. Within that theme we will examine:

The government’s involvement in demand and supply management policies via monetary policy (open market operations) and subsequent interest rate setting is reviewed.

We will also review a number of controversial issues in fiscal and monetary policy. The debate continues as to the relative effectiveness of fiscal and monetary policy and whether governments should intervene or not given the long run history of growth anyway.

Objectives On completion of this topic you should be able to:

the Reserve Bank of Australia

financial intermediaries

the regulation of financial institutions

bank multipliers.

define fiscal policy

describe the main trends in federal budgets

distinguish between budget deficits and government debt

outline the nature and operation of automatic stabilisers

outline the impact of fiscal and monetary policy measures on GDP and the price level

describe the rule of the Reserve Bank in the conduct of monetary policy

explain the operation of open market operations in Australia

distinguish between an easing and a tightening of monetary policy

describe recent monetary policy in Australia.

123

Study materials

Textbook Sloman, J., Norris, K. & Garratt, D., 2014, Chapter 13.

The Commonwealth Government budget This topic will have much more meaning for you if you locate some details about the federal budget, which is brought down in parliament in mid-May of each year. What you need to have is the document that sets out the revenue and expenditure estimates. These are usually set out in the major financial papers. Try the website http://www.budget.gov.au or http://www.treasury.gov.au as another alternative.

From the information you have gathered about the budget, summarise:

It is probably fair to say that only economists would find the budget an exciting document to read, and it is also true that it is very important because of the effects that the budget can have on the economy and on our daily lives. The purpose of budgets is to manage the economy. This is referred to as fiscal policy (also known as budgetary policy). Fiscal policy is that arm of government policy which affects the level of economic activity through changes in government spending and taxation.

You also need to know how a budget deficit or budget surplus can arise, and the origin of government debt. These items are discussed in the text.

Deficits and debt If receipts exceed expenditure there will be a fiscal surplus. If expenditure exceeds receipts there will be a fiscal deficit. This is probably like your own budget. Concern is often expressed when budgets go in to deficit especially if these deficits continue year after year. In reality a more meaningful analysis is Australia’s capacity to repay debt which is measured by the debt to GDP ratio (keeping in mind that it is debt that Australians owe to fellow Australians unless the deficit budget is funded overseas).

Note also the situation that occurred in some European countries in 2010 and these countries’ inability to repay their debts.

The government budget fiscal position over time is depicted in Table 14.1 (should be 13.1) on page 297 of the text. Note that the annual budgets are mostly in positive territory up to fiscal year 2007/2008 reflecting budget surpluses during that time but are currently in the negative due in large part to the ongoing impacts of the Global Financial Crisis.

Activity 11.1a

the objectives of the budget

the major revenue initiatives the major expenditure initiatives newspaper editorial comments on the budget.

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http://www.budget.gov.au/

http://www.treasury.gov.au/

Under the Australian federal system, the Federal Government collects income taxes and GST and reimburses the states for the loss of revenue they incur for not having this power. As a result of these taxation arrangements, a major item of Federal Government outlay is grants to the states.

In fact the state governments do have the ability to raise their own income taxes if they so choose. Suggest reasons why they don’t choose this option.

The federal budget can experience fluctuations in its outcomes and is dependent on the state of the economy. Indeed the annual budget has to be framed to meet the economic situation facing the government and this can limit the decisions that governments might want to make in the budget.

What is the size of the current budget surplus or deficit? You may have already discovered this information from Activity 11.1.

We have concentrated on the federal budgetary position but this is only one level of government. We need to broaden the picture by considering the state and local levels of government, and this is done in the next section.

The effectiveness of fiscal policy Can fiscal policy fine tune demand? Can it achieve a desirable level of GDP? Can it achieve employment without inflation? The effectiveness of fiscal policy depends on a number of factors.

Why is it difficult to ‘fine tune’ the economy?

Attempt Discussion Question 5, Sloman, Norris & Garratt, 2014, p. 320.

The Reserve Bank and monetary policy The Reserve Bank of Australia serves a pivotal role in the operation of government monetary policy and in the control of financial institutions. Whenever the Governor of the Bank speaks, financial markets listen. The media seems to wait on every utterance from the Governor hoping that he might give some indication of future developments in interest rate policy.

This section of the topic is concerned with examining the role of the Reserve Bank and the way it manipulates the money supply via the conduct of open market operations.

Activity 11.2a

Activity 11.3a

Activity 11.4a

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Monetary policy Controlling the money supply is a way the government can regulate the level of economic activity. In a way it is similar to varying taxes and government spending as a method of controlling the level of economic activity. Monetary policy is that tool of government which seeks to regulate the availability of money (the money supply) and/or the cost of money (the level of interest rates). It is one of the major tools of government in economic management.

The Reserve Bank controls the supply of money through open market operations.

Open market operations Open market operations involve the buying and selling of government securities by the Reserve Bank in order to influence the money supply. It is this exchange of government securities between banks and the Reserve Bank that lies at the heart of the conduct of open market operations. Government securities are not money; they are a financial asset. If banks buy more of these government securities they will then hold less money and have less money to lend. In such circumstances interest rates start to rise and spending in the economy is cut back.

Is monetary policy in Australia currently expansionary or contractionary?

Log onto the RBA website at http://www.rba.gov.au and see if you can establish the current cash rate and its movement over the past few years.

The relative effectiveness of fiscal and monetary policy In this section we conduct comparative analysis of the use of the two tools of economic management and compare their effectiveness on economic activity. We take each in turn and then summarise the main differences.

Fiscal policy effectiveness How effective a fiscal policy initiative will be in boosting economic activity will depend upon the strength of two relationships:

Diagrammatically, it is the sensitivity of both these curves to interest rates that will determine how much a change in fiscal policy will boost economic growth.

What we can conclude from any analysis is that fiscal policy will be more effective in stimulating the economy when:

Activity 11.5a

Activity 11.6a

the extent to which investment sensitive expenditure will respond to changes in interest rates

the extent to which the demand for money will respond to changes in interest rates.

the more sensitive is the demand curve for money to interest rate variations (the flatter the money

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http://www.rba.gov.au/

Monetary policy effectiveness The same approach may be taken with monetary policy. Again it is the sensitivity of the two demand curves to interest rates that determine the effectiveness of monetary policy. We can conclude that monetary policy will be more effective when:

Demand side policies Having just discussed the relative merits of fiscal and monetary policy the debate today is much more concerned with whether the government should pursue an active demand management policy at all or whether to merely adhere to a set of previously set policy rules.

Long-term economic growth Irrespective of the short-term fiscal and monetary policy decisions of governments if we step back and take a longer term look at the economy we note that while there are short-term fluctuations in growth in the longer term economies grow, not decline. What causes this long-term growth in the economy? The next reading canvasses capital accumulation and technological progress.

Attempt Discussion Question 10, Sloman, Norris & Garratt 2014, p. 320.

Supply side policies Our final discussion in this topic looks at supply side policies (see Box 13.4 in the text).

Summary Issues of government spending and taxation are ever present and this topic has reviewed a number of aspects of government fiscal policy. The state of the economy will be greatly influenced by the stance that the government takes towards fiscal policy and if the government decides to ‘tighten its belt’ then we will feel the impact. So whenever you hear or read about the words ‘fiscal policy’ do not just regard them as just ‘economic speak’. Your standard of living may well be greatly influenced by the decisions governments make about their revenue and their spending.

demand curve) the less sensitive is the investment demand curve to interest rate variations (the steeper the investment demand curve).



the less sensitive is the demand curve for money to variations in interest rates (the steeper is the money demand curve)



the more sensitive is the investment demand curve to variations in interest rates (the flatter is the investment demand curve).



Activity 11.7a

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This topic has been concerned with government involvement in the economy through the use of fiscal policy. But the government also has another policy tool it can use to regulate the economy and that is monetary policy. With this in mind we discussed the role of the Reserve Bank in the financial markets in Australia and outlined the means by which the money supply is controlled through open market operations. Next we considered the effect of changes in monetary policy on the level of economic activity.

Money and interest rates are never long out of the news. If interest rates aren’t moving, economists spend their time predicting the next move and then looking for signals from the Governor of the Reserve Bank. If interest rates are moving then economists get excited about the extent and effects of such moves. Monetary policy remains one of strongest tools of economic policy.

You should undertake Activity 11.8 to add the ‘real world’ to your studies in this topic.

Now that you are a scholar of fiscal and monetary policy it is worth revisiting www.budget.gov.au (http://www.budget.gov.au) and www.rba.gov.au (http://www.rba.gov.au) to review the governments most recent budget direction for policy and the RBA’s monetary policy direction and why.

Review activities

You are advised to undertake activities in the Sloman, Norris & Garratt 2014, MyEconLab, Chapter 13.

Feedback to activities

State governments are always reluctant to introduce any new tax let alone an income tax, which affects people’s income before they receive it. It would almost be political suicide for a state government to announce it was going to introduce an income tax. Moreover, under existing arrangements, the state governments can blame their financial woes on the Federal Government’s taxation arrangements.

Activity 11.8a

Review activitiesa

Activity 11.2f

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http://www.budget.gov.au/

http://www.rba.gov.au/

In general because of the difficulties in forecasting the economy and because of random shocks.

The use of fiscal policy to fine tune encounters problems associated with the substantial time lags involved. It is also difficult to predict the magnitude of the effects of changing government expenditure, and tax and benefit rates.

Monetary policy may be more effective in restraining demand but is of less use in recessions.

(Q5) Changing government expenditure on goods and services has a more predictable multiplier effect; the effect of changes in benefit rates is less predictable as it depends on how much of a change in incomes will be spent. It is not really possible to make downward changes to benefit rates.

Your discussion should centre on the overnight cash rate. The Reserve Bank’s view is that the rate is roughly neutral in its effect when the real cash rate is around 2½ per cent. So what is it currently?

These can be put into two broad categories: an increase in the quantity of factors of production and an increase in their productivity. The quantity of factors can be increased largely through increasing the stock of capital. Higher saving will allow higher investment, a higher stock of capital and a higher level of GDP. But growth will cease once this higher level of GDP has been reached. To achieve sustained economic growth, therefore the productivity of factors must increase over time. This will be brought about largely through technological progress

Activity 11.3f

Activity 11.4f

Activity 11.5f

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ECO10250 Economics for Decision Making Study Guide

Contents
Introduction
Topic 1 Introduction to economics

Introduction
Objectives
Microeconomics and macroeconomics
Fundamental economic concepts
Opportunity cost
Economics in practice
Economic theory
Economic models
Markets and trade
Economic systems
Summary
Review activities
Feedback to activities

Topic 2 Markets: Demand and supply

Introduction
Objectives
Demand
Supply
Equilibrium price
The free-market economy
Summary
Review activities
Feedback to Activities

Topic 3 Markets: Elasticity

Introduction
Objectives
Price elasticity of demand
Calculating price elasticity of demand
Investigating elasticity along the demand curve
Determinants of price elasticity of demand
Income elasticity of demand (denoted by ηy)
Cross price elasticity of demand (denoted by ηx)
Price elasticity of supply
Short-run and long-run demand
Markets where prices are controlled
Consumer surplus, producer surplus & total surplus
Summary
Review activities
Feedback to Activities

Topic 4 The supply decision

Introduction
Concept review
What is a firm?
Economic profit
Economic efficiency
Markets and the competitive environment
Short-run cost
Long-run production and cost
Excess capacity and over-utilisation
Profit and revenue
The firm’s decisions
Profit-maximising output
The firm’s short-run supply curve
Profit and losses in the short and long-run
Summary
Review activities
Feedback to activities

Topic 5 Market structure: Perfect competition & monopoly

Introduction
Concept review
Objectives
What is perfect competition?
Short- and long-run equilibrium
Monopoly
Summary
Review activities
Feedback to activities

Topic 6 Market failure and government policy

Objectives
The economic theory of government
Externalities
Public goods
Monopoly
Government intervention
Property rights
External costs: The environment
Progress in microeconomic reform
Trade practices legislation
Summary
Review activities
Feedback to activities

Topic 7 Introduction to macroeconomics

Introduction
Objectives
Economic growth
Jobs and unemployment
Inflation
Governments and deficits
The circular flow of economic activity
Australia’s national accounts
The price level and inflation
Real GDP and associated limitations
Labour market indicators and unemployment definitions
The labour market
Summary
Review activities
Feedback to activities

Topic 8 Gross domestic product

Introduction
Aggregate demand
Aggregate supply
Macroeconomic equilibrium
The multiplier
Fluctuations in economic activity resulting from shocks
Summary
Review Activities
Feedback to Activities

Topic 9 Money, interest rates & inflation

Introduction
Money markets
Types of inflation
Inflation policy
Summary
Review activities
Feedback to activities

Topic 10 The global economy

Introduction
Global interdependence and the gains from trade
Arguments for restricting trade
Trading blocs
The balance of payments
Foreign exchange markets and the dollar
Exchange rate determination: Flexible exchange rates
Summary
Review activities
Feedback to activities

Topic 11 Fiscal and monetary policy

Introduction
The Commonwealth Government budget
The effectiveness of fiscal policy
The Reserve Bank and monetary policy
The relative effectiveness of fiscal and monetary policy
Summary
Review activities
Feedback to activities