Economics 1000 Tutorial PDF

ECO1000 Economics
Faculty of Business and Law
Study book
Published by University of Southern Queensland Toowoomba Queensland 4350 Australia http://www us! edu au " #ni$e%sity of Southe%n &ueensland' (01) (
Copy%i*hted mate%ials %ep%oduced he%ein a%e used unde% the p%o$isions of the Copyright Act 1+,- as amended' o% as a %esult of application to the copy%i*ht owne% .o pa%t of this publication may be %ep%oduced' sto%ed in a %et%ie$al system o% t%ansmitted in any fo%m o% by any means elect%onic' mechanical' photocopyin*' %eco%din* o% othe%wise without p%io% pe%mission /%oduced by Lea%nin* 0esou%ces 1e$elopment usin* the 2CE /ublishin* System
3able of contents
/a*e
Module 1 !ntrodu"tion to e"onomi"s
Lea%nin* ob4ecti$es Lea%nin* %esou%ces
3e5t Essential
1
1 1
1 1
1 1 2nt%oduction
1 1 1 3he economic way of thinkin* 1 1 ( 3he lan*ua*e of economics
1
( )
1 ( 3hinkin* like an economist

1 ( 1 Economic models
)
6
1 ) #sin* *%aphs in economics 1 6 /%oduction economics

1 6 1 Sca%city and oppo%tunity cost
7 ,
,
Summa%y
Module # $ow the mar%et wor%s

3e5t Essential
11
11 11
11 11
( 1 2nt%oduction ( ( 3ools of analysis: demand

( ( 1 3he concept of demand ( ( ( 3he demand cu%$e ( ( ) 3he downwa%d8slopin* demand cu%$e ( ( 6 9o$ements alon* and shifts of the demand cu%$e ( ( 7 0easons fo% the demand cu%$e to shift
11 1(
1( 1( 16 16 17
( ) 3ools of analysis: supply

( ) 1 3he concept of supply ( ) ( : sin*le fi%m;s supply ( ) ) 9a%ket supply ( ) 6 9o$ements alon* and shifts of the supply cu%$e ( ) 7 0easons fo% the supply cu%$e to shift
17
17 1, 1< 11-
( 6 3ools of analysis: ma%ket e!uilib%ium ( 7 Elasticity

( 7 1 2nt%oduction ( 7 ( 3he concept of elasticity ( 7 ) /%ice elasticity of demand ( 7 6 C%oss8p%ice elasticity of demand ( 7 7 2ncome elasticity of demand ( 7 , /%ice elasticity of supply
1(0
(0 (1 (1 (1 (1 ((
( , Economic efficiency and ma%ket failu%e

( , 1 Consume% and p%oduce% su%plus and economic efficiency ( , ( /%ice floo%s and p%ice ceilin*s ( , ) 3he economic impact of ta5es
()
() (6 (6
Summa%y
(7
Module 3 &irms and mar%et stru"ture

3e5t Essential
#'
(< (<
(< (<
) 1 2nt%oduction ) ( 3he concept of cost %e$isited ) ) 3he sho%t %un p%oduction function ) 6 Sho%t %un cost functions ) 7 Lon* %un a$e%a*e cost ) , 3he model of pe%fect competition
) , 1 2nt%oduction ) , ( 3he pe%fecti$ely competiti$e model: in the sho%t %un ) , ) 3he ent%y and e5it of fi%ms in the lon* %un and efficiencies in pe%fect competition
(< ((+ )0 )0 )(
)( )( )(
) < 9onopoly ma%kets

) < 1 9onopoly model ) < ( Economic efficiency and *o$e%nment %e*ulation in monopoly ma%ket
)7
)7 ),
Summa%y
)<
Module 4 Ma"roe"onomi" &oundations

3e5t Essential
3(
)+ )+
)+ )+
6 1 2nt%oduction 6 ( =1/ measu%es total p%oduction

6 ( 1 9easu%in* the si>e of the total p%oduction 6 ( ( 3he ci%cula% flow model of an economy 6 ( ) Economic *%owth
60 60
60 61 6(
6 ) #nemployment and inflation

6 ) 1 #nemployment 6 ) ( 2nflation
6)
6) 66
6 6 3he business cycle 6 7 :**%e*ate demand and a**%e*ate supply Summa%y
67 67 6<
Module 5 Monetary and &is"al )oli"y

3e5t Essential
4(
6+ 6+
6+ 6+
7 1 2nt%oduction 7 ( 9oney' banks and the 0ese%$e Bank of :ust%alian 7 ) 9oneta%y policy 7 6 Fiscal policy Summa%y :ppendi5 7 1 ?optional %eadin*' and not e5aminable@
Epilo*ue: b%ief %e$iew of selected schools of thou*ht in economics
70 71 7( 76 77 7+
7+
ECO1000 Economics
9odule 1 A 2nt%oduction to economics

Lea%nin* ob4ecti$es
On successful completion of this module, you should be able to:

discuss the three important ideas: people are rational; people respond to incentives; optimal decisions are made at the margin understand the issues of scarcity, and trade-offs understand the concepts of opportunity cost, the difference between centrally planned economy and market economy, and the issues associated with efficiency and equity understand the role of models in economic analysis understand normative and positive analysis, and distinguish between microeconomics and macroeconomics apply graphical techniques in economic analysis and understand their interpretations apply the model of the production possibilities frontier to illustrate the concepts of opportunity cost and economic growth understand comparative advantage and explain how it is the basis for trade explain the basic idea of how a market system works
Lea%nin* %esou%ces
3e5t
!ubbard, "arnett, #ewis, and O$%rien, &'(), Economics, chapters ( and & ; appendix to chapter (
Essential
Study book: module (
1 1 2nt%oduction
*his module introduces you to the study of the social science of economics +s a social science, economics provides an orderly approach to theory development, to the construction and testing of models, and to the analysis of economic policy Practical economics seeks to focus the power of reason on the economic issues of our times
University of Southern Queensland
ECO1000 Economics
,hen starting the study of economics, you have to learn the assumptions and language of this new way of thinking One of the difficulties with learning economics is that it can take some time to get used to this approach to everyday life -ome people are fortunate, in that they grasp the principles quite quickly; however, for most, it takes some time *herefore, the course team believes that it is best to start slowly with a few concepts and then add to them as you work through the course +s with learning another language, you first learn very basic words, then you move to phrases, and then you .learn sentences/ 0inally, you learn how to be .grammatically accurate/; but this can take many years 1ue to time constraints, this course can only take you to the very early stage of .learning sentences/ or, in this case, applying concepts
1 1 1 3he economic way of thinkin*

2conomics provides a set of analytical tools, but it is also a way of thinking 3n this course we are showing you some of those basic tools and trying to encourage you to understand the .economic way of thinking/ *his way of thinking is characterised by a .language/ in which words have a meaning specific to economics +s with any language, you need to understand the terms and their definitions !owever, economics is most importantly a particular way of looking at individual, group and national behaviour 3n other words, economics provides another way of looking at our domestic lives, our working lives and national and international politics -ome economists have argued that even marriage, crime and human life can be analysed in terms of economic choices 3t may help you to understand the main concepts in this course if you keep posing the question .how would an economist interpret this4/ 3t may also help to relate the concepts to everyday situations; indeed, newspaper discussions on economics can provide some good material for consideration !owever, remember that this is an introductory course, and we use a lot of assumptions to simplify the concepts for teaching purposes *herefore, you cannot always get the ideas and examples to exactly conform to real-world situations *ry to think of the concepts presented at this level as being limited to the illustration of general tendencies +n important part of the language of economics is maths *his course has been designed to de-emphasise the maths 5believe it or not6, but some knowledge of maths is useful +part from the use of simple algebraic formulae in economics, there are various .tools/ to show data and to illustrate or represent concepts 2conomic data is presented in three main ways:

descriptive prose 5written work6 2conomics, as with any social science, relies heavily on descriptions of what has happened and what is happening tables of numbers that can be used to identify trends or points of note *ables are used throughout the text and it is important that you learn to interpret information from them graphs of key indicators and measures, usually over time or in relation to each other *hese are usually based on tables and are really a variation of the above
7ost of the course is based on written explanation, as you would expect when learning a social science ,hile there are other ways of representing economic ideas, this remains one of the most fundamental %eing able to explain an idea or concept is still a real test of understanding *hat is why we use assessment, such as the written assignment and the extended response questions, in the exam
ECO1000 Economics
*here are also algebraic equations, where symbols are used to represent variables *hese are occasionally used to calculate real numbers, for example calculating the si8e of an economy, but they are often symbolic *hat is, the equation is 9ust a shorthand way of explaining a relationship ,hile the obvious focus of the course is on content, we also want you to develop skills in description and interpretation *herefore, it is very important that you take the opportunity to develop the capacities to interpret data and to identify concepts as they are variously expressed
1 1 ( 3he lan*ua*e of economics

:ou will come across many terms used throughout this course and also in your career 2conomics is the language used in politics, the media, and in business 3t will be everywhere in your daily lives *he level of wages you receive, your 9ob security and the interest you pay on a home loan are all indicators of economic activity and they will all be discussed in economic terms 3f you want to interpret what is happening to you, you must be able to speak the language :ou may find it useful to refer frequently to the glossary of terms at the back of the text
1 ( 3hinkin* like an economist

2conomists get .bad press/ +t best they are often portrayed as people who deal entirely with the abstract, having little or no experience of the real world +t worst, they are portrayed as hard-hearted, narrow people, seeking to reduce human activities to monetary values, and proposing policies that add to human misery !owever, many economists are engaged with questions of poverty, development, fairness, distribution, the environment and so on and they do wish to make the world a better place, though often disagreeing with each other about how that might be achieved +t the heart of the activity of the economist lies the development of theories and models 3n developing these theories and models, economists have sought to bring a particular way of thinking, which is really common sense plus careful reasoning and the use of data, to make the world a better place 3t is a difficult task ;eople must make choices as they try to attain their goals *hese choices reflect trade-offs people make because we live in a world of scarcity; although our wants are unlimited, the resources available to satisfy our wants are limited 2conomic models are simplified versions of some aspects of economic life 2conomists construct models and use them to analyse economic issues 2conomics focuses on the decisions buyers and sellers make through markets 2conomists assume people 5(6 are rational, 5&6 respond to economic incentives, and 5)6 make optimal decisions at the margin 2conomists often focus on decision-making .at the margin/ on the grounds that when making choices, economic agents 5be they consumers, firms or governments6 focus on the benefits and costs associated with the extra, or marginal, activity 0or example, when considering whether or not to buy another pi88a, a consumer would calculate 5however roughly6 the marginal cost and the marginal consumption benefit; a business when considering whether or not to hire another saleswoman would calculate the marginal cost of employing the worker and the marginal revenue to be gained from her services; and a government when considering whether or not to build another hospital, would consider the extra costs and extra benefits
ECO1000 Economics
from constructing and running another hospital 0or economists, economic agents will only make decisions to undertake the extra activity if the marginal benefit is equal to, or greater than, the marginal cost *ry a little introspection on this point; ask yourself if this what .goes through your mind/ when you make consumption choices 5for example, to have another drink; to buy another loaf of bread; or to spend an extra week on holiday6 2ach society faces the economic problem of having a limited amount of resources, and so can produce a limited amount of goods and services 2ach society faces trade-offs, particularly when answering three questions: 5(6 ,hat goods and services will be produced4 5&6 !ow will the goods and services be produced4 5)6 ,ho will receive the goods and services produced4 -ocieties organise their economies in two main ways to answer these questions + society can have a centrally planned economy characterised by extensive government decision making Or a society can have a market economy in which the decisions of households and firms interacting in markets allocate resources 7ost developed countries have predominately market economies with some central government regulation or control 7arket economies tend to allocate resources more efficiently than do centrally planned economies, but efficient outcomes may not be perceived as fair 1etermining what is a fair or equitable outcome calls for the application of normative economic analysis < what ought to be ;ositive economic analysis is concerned with what is ,hile most or all economists can agree on the results of positive economic analysis, they may disagree widely on normative economic issues 7icroeconomics is the study of how individual choices are made by households, business firms, and government 7acroeconomics is the study of the economy as a whole
1 ( 1 Economic models
3t is important to realise that economics is a social science, not a natural science 3n other words, the .economy/ is not like a mechanical system, even though some economists and politicians speak as if it were 2conomics is about the study of human activity in relation to the production, distribution and exchange of goods and services *he behaviour of humans is not always, or perhaps ever, scientifically predictable; however, economists have developed a range of techniques for trying to make sense of economic activity *he .real/ world, that is, the world in which you live, is very complicated =onsequently, economists have to use .pretend economies/ to simplify it *hese pretend economies, or models, are simplifications of the real world 0rom the models, you can derive general propositions about the relationships and the behaviour of groups of individuals -uch propositions are developed using economic theories >emember, you are taking an introductory course and simplification is required; don/t try to make everything fit neatly into real world situations *heoretical reasoning, followed by data analysis, helps economists to explain the operation of the economy and to develop solutions to economic problems +n economic model cannot be so simple that it is completely unrealistic, but neither must it be so complex that important interrelationships are lost in the detail 0inally, while the models and graphs might seem scientific and ob9ective, it is important to note that they are very much based on certain assumptions about how people do, or will, behave in particular circumstances ,hen studying a model, always look for the assumptions, be they explicit or implicit, the logical reasoning used, and the conclusions reached
ECO1000 Economics
0eadin* acti$ity 1 1
-tudy chapter ( of the text 5!ubbard et al 6 7ake sure that you can:

1iscuss the three important economic ideas: people are rational; people respond to incentives; optimal decisions are made at the margin explain the social science of economics as the study of scarcity and choice understand the role of models in economic analysis distinguish between positive and normative economics distinguish between microeconomics and macroeconomics
Lea%nin* acti$ity 1 1
?%: *his is the essential set of exercises 3f you have additional time, you should practise the qui88es and tests in 7y2conlab 5=heck the -tudy1esk on how to access 7y2conlab6 ((( +nswer >eview @uestions (-(' and ;roblems and +pplications &, ), A, B, ((, (&, (A, (B, (C, (D, &' at the end of chapter ( 5check your answers with those from the -tudy1esk6
1 ) #sin* *%aphs in economics

3t is common practice in economics to use graphs to illustrate relationships among economic variables and to work out the effects of changes in economic circumstances +ccordingly, it is necessary that we pause to ensure that the essential aspects of graphical analysis are understood
0eadin* acti$ity 1 (
-tudy +ppendix to chapter ( of the text 5!ubbard et al 6 7ake sure that you can:

plot graphs of economic data to show the relationship between two variables use graphs to illustrate positive and negative relationships between economic variables calculate the slopes of a straight line and a curved line
ECO1000 Economics
Lea%nin* acti$ity 1 (
?%: *his is the essential set of exercises 3f you have additional time, you should practise the qui88es and tests in 7y2conlab (&( +nswer all questions in $;roblems and +pplications$ for the appendix to chapter ( 5check your answers with those from the -tudy1esk6
1 6 /%oduction economics
1 6 1 Sca%city and oppo%tunity cost
3n our previous study, we introduced economics as the science of scarcity and choice *he problem of scarcity is often developed in terms of the three fundamental economic questions: .what to produce/, .how to produce it/, and .for whom to produce it/4 3n this presentation of the problem of scarcity, two very important economic concepts emerge: .opportunity cost/ and .marginal analysis/
Oppo%tunity cost
One of the most important concepts in economics is that of opportunity cost *his is a concept that has application in many aspects of our lives 3ndeed, for every action we undertake, there is an opportunity cost (or something foregone) 2very time you spend time or money, you make a choice and you forego all other opportunities 0or example, if you go out in the evening to socialise, you forego the opportunity to watch television, or to study or to spend time with your family :ou cannot claim you will catch up on those things later, because of the time factor 3n economics, there is always scarcity 0or humans, time is limited and the hours used cannot be recaptured 3t is the same with spending 3f you buy movie tickets, you cannot use that money for a meal, savings or for the purchase of 1E1 :ou are making choices all the time and the cost is to be thought of in terms of what has been foregone +ccordingly, opportunity cost may be defined as: The value of that which must be given up to acquire or achieve something. Opportunity cost is therefore expressed in the terms of what is .given up/ -trictly speaking, opportunity cost is to be thought of in terms of the next best option that has been given up !ere is an example:
+ visit to the movies :ou go to the movies instead of studying *he financial cost is the entry fee 5say F('6 but an additional opportunity cost of going to the movies is the foregone & hours of study *hus, the opportunity cost of going to the movies is F(' G the value of & hours of study
ECO1000 Economics
/%oduction possibilities f%ontie% ?//F@

3llustrating the concept of opportunity cost, the production possibility frontier is a valuable tool used to examine the consequences of production initiatives, changes in the resource mix and developments in technology 3t is our first example of an economic model ;roduction possibility frontiers may be used to graphically demonstrate the impact of inefficiency within the economy 3n +ustralia, during the (HI's and the (HH's, an appreciation of this inefficiency led to the introduction of widespread industrial reform measures designed to deliver better work practices and, consequently, improvements to net community welfare *hese changes, taken together, became known as microeconomic reform *he ;;0 delineates what it is possible to produce from what it is not possible to produce 3ndividuals have ;;0s in relation to particular goods that they can produce *hat is, each of you has a limit to what you could produce, within a particular time frame, whether that is pages of typing, sales of goods or house painting 3n similar fashion, we can think of the ;;0 for any economy "iven a number of assumptions, the ;;0 for an economy shows the combinations of goods that can be produced with full and efficient use of available resources *he ;;0 is an example of an economic model that has been constructed to show the key relationships that underlie production in any economy 3t is usually represented in terms of a graph with two goods shown on the axes, and is shown as a .bowed outwards/ curve 2ssentially, it shows the production .boundary/ for an economy and the fact that, if the economy is producing efficiently, it can only produce more of one good by giving up increasing amounts of the other good 5the .law of increasing opportunity costs/6 ?ote that, conceptually, we can apply the ;;0 to many resource-use questions 5for example, the production of .defence/ or .peacetime/ goods; the production of a .clean environment/ or .ordinary/ industrial output; and the production of .health goods/ or ordinary consumer goods6 ?ote, also, that we may consider a change 5such as an increase in the output of one good at the expense of the output of another6 that is modelled by a movement along a given ;;0, or a change that is modelled by a shift of the ;;0 5such as a change in technology that enables more of all goods to be produced from a given quantity of resources
Specialisation and the *ains f%om t%ade

*he logic that flows from the concept of opportunity cost is that if we, as individuals, business, people and citi8ens, want economic efficiency and to maximise the outcomes of our economic efforts, then both individuals and nations should .specialise/ Specialisation is the cornerstone of the modern economy *he principle is that it is theoretically more efficient to specialise in production and then exchange or trade, than to try and be fully self-sufficient *he argument that nations gain by specialising in production and trading is based on the theory of comparative advantage 2ssentially, this says that a country with a comparative advantage in the production of a good or service should specialise in the production of that good or service and exchange it for goods and services from other countries + country is
ECO1000 Economics
said to have a comparative advantage when it has a lower opportunity cost of production than do its trading partners 3t is important to distinguish between .comparative advantage/ and .absolute advantage/ ,hereas comparative advantage exists when a country has a lower opportunity cost of production, absolute advantage refers to the situation in which a country has a lower absolute cost of production in terms of resources used
3he ma%ket system

!ubbard et al 5&'(), pp A'<AB6 have a good discussion of the following basic concepts 3t is essential to understand them before we move on to modules & and ) + market is a group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade ;roduct markets are markets for goods < such as computers < and services < such as medical treatment 0actor markets are markets for the factors of production, such as labour, capital, natural resources, and entrepreneurial ability + free market is a market with few government-imposed restrictions on how a good or service can be produced or sold, or on how a factor of production can be employed *he market mechanism refers to the inherent forces in the market that will allocate resources in a way that maximises consumer satisfaction *he assumption is that individuals are rational and self-interested *herefore producers will produce and sell what consumers want to buy, so that the producers can maximise their own profits *hese inherent forces are what +dam -mith referred to as the .invisible hand/ of the market *he price mechanism is the signalling device between consumers and producers; if consumers are willing to pay a higher price due to strong demand, this will signal producers to supply more; if demand for a product is low at the current price, the product won/t sell and producers will need to lower the price 2ntrepreneurs are an essential part of a market economy +n entrepreneur is someone who operates a business, bringing together the factors of production < labour, capital, and natural resources < in order to produce goods and services 2ntrepreneurs often risk their own funds to start businesses and organise factors of production to produce those goods and services consumers want
0eadin* acti$ity 1 )
-tudy chapter & of the text 5!ubbard et al 6 7ake sure that you can:

define the term .opportunity cost/ explain and apply the concept of the .production possibilities frontier/ distinguish between the concepts of .absolute/ and .comparative/ advantage use the concept of the production possibilities frontier, and theory of comparative advantage, to explain the gains from trade 2xplain the basic idea of how a market system works
ECO1000 Economics
Lea%nin* acti$ity 1 )
?%: *his is the essential set of exercises 3f you have additional time, you should practise the qui88es and tests in 7y2conlab ()( +nswer >eview @uestions (-(' and ;roblems and +pplications (, &, ), A, B, C, I, H, (', ((, (&, (A, (B, (C, (D, (H at the end of chapter & 5check your answers with those from the -tudy1esk6
Summa%y
*his module introduced the study of economics and explored briefly some of the essential concepts and methods used by economists in their professional work 2conomists seek to use the economic way of thinking to develop answers to a wide range of questions arising from the general problem of relative scarcity 3ts methods are applicable to the analysis of the choices of households, businesses and governments *hey are applicable, also, at the level of a region, a nation, or the world 3n this module, we explored the economic way of thinking, the use by economists of graphical analysis, a number of key concepts, and the model of the production possibilities frontier ,e saw how this model enabled us to consider the decision problem faced by a country 5or a person or business at the micro level6 as it sought to use its resources efficiently ,e saw also that the model can be used to explain the gains that a country may capture by engaging in specialisation and trade ,e also acknowledged that 2ntrepreneurs, those who own and operate businesses, are critical to the working of a market system *hey produce goods and services consumers want and decide how these goods and services should be produced to yield the most profit ,e will introduce a number of additional concepts and models in subsequent modules as we develop our understanding of the importance of economics for the welfare of people
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ECO1000 Economics
ECO1000 Economics
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9odule ( A Bow the ma%ket wo%ks

Lea%nin* ob4ecti$es

explain the concepts of demand, supply, and market equilibrium explain the concept of elasticity calculate and interpret price, income and cross price elasticity of demand calculate and interpret price elasticity of supply understand the concepts of consumer surplus and producer surplus use demand and supply graphs to analyse the economic impact of price ceiling and price floors use demand and supply graphs to analyse the economic impact of taxes
Lea%nin* %esou%ces
3e5t
!ubbard et al , &'(), Economics, chapters ), A and B
Essential
Study book: module &
( 1 2nt%oduction
*his module introduces the well-known economic concepts 5tools6 of supply and demand, and their use in market analysis *he .supply-demand/ model of a market provides us with important insights into the use of resources in a market economy, largely a response to the signals conveyed to decision-makers by prices in an economy Jsing this model, we are able to predict the general direction of changes in prices and quantities resulting from changes in the market-place 5for example, those arising from the imposition of a sales tax on goods purchased by consumers, or from the payment of a subsidy to producers6 %efore the .market/ model can be used, it is necessary to have a sound grasp of the concepts of supply and demand and of a measure of responsiveness to a given change in the market, known as elasticity
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ECO1000 Economics
Once the mechanics of the model have been mastered, you will find that you can use it to analyse contemporary economic issues, for example, the move to deregulate the +ustralian labour market Our focus in this module is on the operation of particular markets 5such as the market for unleaded petrol6; this is the field of microeconomics as distinct from macroeconomics 3n the previous module, we introduced a number of concepts used by economists and also spent some time looking at what is means to .think like an economist/ 3n this module, we continue that pattern when we turn our attention to the economic analysis of markets ,e are aware, of course, that markets and trading in markets are as old as human history -ome markets are readily observable, such as those for fruit and vegetables, while others are quite obscure, such as those for futures and share options 1espite the legality, or otherwise, of markets, we should be able to apply our tools of market analysis to any market situation Our aim is to understand how markets work and to predict the direction of change in market prices and quantities traded that are likely to follow some change in the economy 0or example, in +ustralia at the moment, many people are very concerned about the rising price of fuel for motor vehicles +s economists, we would like to use the tools of market analysis to predict the likely change in the price of fuel over the next month, or year 3n this module, we will see how economists develop their predictions
( ( 3ools of analysis: demand

( ( 1 3he concept of demand
2conomists define market demand as the set of possible prices per unit of the good and the quantities that would be demanded at each of those prices 5other things remaining the same; the .ceteris paribus/ assumption6 3f we knew the set of prices and associated quantities, we could show this information in a table, or plot it to represent a market demand curve 5more specifically, the price demand curve6 *his is usually drawn as a downward-sloping curve !ndividual demand is defined in the same way 3t is the set of possible prices and the associated quantities demanded by a consumer 5other things remaining equal: that is, ceteris paribus6 +s for market demand, we an represent individual demand in a table of data or by a plot of the price-quantity information contained in the table
( ( ( 3he demand cu%$e

-uppose we have the following price and quantity demanded information for a consumer *able & ( is ;eter/s demand for hamburgers 5ceteris paribus6 Table #*1+ /ete%;s demand fo% hambu%*e%s ;rice per hamburger 5F6 @uantity demandedKwk ( B' H & I & B' D ) C ) B' B A A A B' ) B & B B' (
ECO1000 Economics
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*his table shows the quantity demanded by ;eter at each and every possible price *hat is, if the price were F( B', he would buy nine hamburgers per week and so on ?ote that this information tells us what ;eter would purchase if the price were, F( B', F& '' etc , and that the ceteris paribus assumption applies *he data in the table can be plotted as a graph to show ;eter/s demand in the form of a demand curve 5you could use a spreadsheet programme, such as 2xcel, to plot demand curves6 ;eter/s demand curve is shown in figure & ( ?ote that it is downward-sloping, telling us that ;eter would purchase more at lower prices 2conomists often use such graphical tools 3t is very important to interpret them correctly &i,ure #*1+ /ete%;s ?indi$idual consume%;s@ demand fo% hambu%*e%s
3nteractive presentation 3f we were to add together all of the individual demand curves for people who eat hamburgers, we could construct a market demand curve >emember, markets may have geographical limits Table #*#+ 3he demand fo% hambu%*e%s ?in one city@ ;rice 5F6 @uantityKwk ( B' (C'' & (B'' & B' (A'' ) ()'' ) B' (&'' A (('' A B' (''' B H'' B B' I''
*his data could then be plotted to show the market demand curve for hamburgers *he associated market demand curve is shown in figure & & ?ote that it is also downwardsloping and that the ceteris paribus assumption applies
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ECO1000 Economics
&i,ure #*#+ 3he ma%ket demand fo% hambu%*e%s
3nteractive presentation
( ( ) 3he downwa%d8slopin* demand cu%$e

*he law of demand is explained by the substitution and income effects *he substitution effect is the change in quantity demanded of a good that results from a change in price, making the good more or less expensive relative to other goods that are substitutes *he income effect is the change in the quantity demanded of a good that results from the effect of a change in the good/s price on consumer purchasing power *herefore, the demand curve is downward sloping, representing an inverse relationship between price and quantity demanded
( ( 6 9o$ements alon* and shifts of the demand cu%$e

:ou will have noticed that we assumed other things remained equal 5the ceteris paribus assumption6 as we looked at the quantity demanded at each of a set of possible prices 3f the price were to change, we would move to a new cell in the table or to a new point on the demand curve -uch a movement along the curve, or a change from one price to the next, is known as a change in the quantity demanded
ECO1000 Economics
15
3f, however, the price remained the same and some other economic variable that affects demand changed 5for example, income6, we would get a whole new set of price-quantity data *his would be shown by a shift of the demand curve, to the left or the right + rightward shift represents an increase in demand 5more is demanded at each and every price6; a leftward shift represents a decrease in demand 5less is demanded at each and every price6
( ( 7 0easons fo% the demand cu%$e to shift

,hen the demand curve is drawn, we assume that only the price of the good changes; all the other demand determining variables remain unchanged 5this is what the ceteris paribus assumption means6 3f we subsequently let any of these other economic variables change, we show the effect by a shift of the demand curve *he economic variables .captured/ in the ceteris paribus pond are:

the price of related goods the income the tastes population and demographics expected future prices
0or example, consider the effect on the demand for fuel efficient dual-engine motor vehicles of an increase in consumer incomes +ssuming these are normal goods 5more are purchased at higher income levels6, more vehicles would be purchased at each and every price *hus, we would show this by a rightward movement of the market demand curve :ou should make sure that you can reason through the effect of changes in the other variables on the demand for a good or service ,hen undertaking such analysis, however, it is best to begin by changing one variable at a time Otherwise, things become rather complex
( ) 3ools of analysis: supply

( ) 1 3he concept of supply
2conomists define market supply as the quantity that would be supplied to the market at each and every price, other things remaining equal 5the ceteris paribus assumption6 +s for demand, if we knew the set of prices and associated quantities, we could show this in a table or plot the data on a graph -uch a plot would give us what is known as the supply curve 3t is usually drawn as upward-sloping, although there are some special cases
16
ECO1000 Economics
2ssentially, market supply is an aggregation of the supply of single firms in that marketplace ,e can think of single firms supply in the same way as we do market supply 3t is the quantities the firm would be willing to supply at each of a possible set of prices, other things remaining equal 5the ceteris paribus assumption6 + single firm/s supply may be shown in a table or graph
( ) ( : sin*le fi%m;s supply

!ypothetical data for a hamburger cafL are shown in table & ) Table #*3+ /ete%;s demand fo% hambu%*e%s ;rice per unit 5F6 *omaine/s quantityKwk ( B' &'' & &&' & B' &A' ) &C' ) B' &I' A )'' A B' )&' B )A' B B' )C'
*his table shows the quantity supplied of hamburgers by *omaine =afe at each of the possible price levels #ogically, if the price goes up, this firm is likely to produce more *hat is, if the price were F( B', *omaine would produce &'' hamburgers per week and so on *his can then be represented as a graph to show the supply curve &i,ure #*3+ 3omaine;s supply cu%$e
ECO1000 Economics
17
3nteractive presentation
( ) ) 9a%ket supply
3f we were to add all of the individual supply curves together, we could construct a market supply curve -uppose the aggregate data is as shown in table & A Table #*4+ 3he demand fo% hambu%*e%s ?in one city@ ;rice per unit 5F6 @uantityKwk ( B' D'' & I'' & B' H'' ) (''' ) B' (('' A (&'' A B' ()'' B (A'' B B' (B''
*his information can be plotted on a graph and the supply curve formed by 9oining the points &i,ure #*4+
3nteractive presentation +s we would expect, the higher the price, the greater the quantity supplied to the market +t higher prices, a firm is able to cover the increased costs of higher production levels
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ECO1000 Economics
( ) 6 9o$ements alon* and shifts of the supply cu%$e

+s for the treatment of demand curves, we need to distinguish between a movement along a given supply curve and a shift of that curve 3f we allow price of the good to vary, and keep all other determining economic variables constant 5the ceteris paribus assumption6, as price changes we move along the supply curve *his is known as a change in quantity supplied 3f we hold price constant and let any of the other determining economic variables change 5such as input prices6, we have a new set of price-quantity data *his change is known as a change in supply 3f there is an increase in supply 5more would be supplied at each and every price6 the supply curve shifts to the right 3f there is a decrease in supply 5less would be supplied at each and every price6 the supply curve shifts to the left
( ) 7 0easons fo% the supply cu%$e to shift

+s for the treatment of demand, there are a number of .non-price/ determining variables of supply ,hen we construct the supply curve, these are held constant 5the ceteris paribus assumption6 3f we relax that assumption and allow one of them to change, we have a change in supply 5show by a shift of the curve6 3t is important that we can explain the effect of a change in these variables on supply *he variables include:

prices of inputs technology prices of substitutes in production number of firms in the market
( 6 3ools of analysis: ma%ket e!uilib%ium

3n a competitive, or freely operating market, the market equilibrium price is the price at which the quantity demanded equals the quantity supplied 5ceteris paribus6 *hat is, buyers and sellers, by a process of trial and error are .agreeing/ on a price and quantity that .clears/ the market 5the equilibrium price and quantity6 ;roducers are prepared to sell that amount at the particular price and buyers are prepared to buy that same amount +t a price higher than the equilibrium price, there will be an excess supply in the market +t a price less than the equilibrium price, there will be excess demand in the market -uch prices are not sustainable and eventually the price will ad9ust to the equilibrium price *o illustrate the point, let us return to the market for hamburgers and put market supply and demand together *able & B shows the relevant market data Table #*5+ 3he ma%ket supply and demand of hambu%*e%s ?in one city@ ;rice per unit5F6 @uantity demandedKwk ( B' (C'' & (B'' & B' (A'' ) ()'' ) B' (&'' A (('' A B' (''' B H'' B B' I''
ECO1000 Economics
19
@uantity suppliedKwk
D''
I''
H''
('''
((''
(&''
()''
(A''
(B''
*his can be shown on an appropriate graph &i,ure #*5+
3nteractive presentation ?ote how the equilibrium price and quantity were not actually given in the table, but we can deduce them from the graph 2quilibrium price M F) DB 2quilibrium quantity M ((B' 7ake sure you understand how this was deduced #ook carefully at the graph, as this is the sort of thing you need to be able to do in practice
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ECO1000 Economics
0eadin* acti$ity ( 1
-tudy chapter ) of the text 5!ubbard et al 6 7ake sure that you can:

explain the law of demand explain why the demand curve is downward-sloping distinguish between a movement along and a shift of a demand curve explain and illustrate the effect on demand of changes in non price determinants of demand illustrate the concept of demand using either a table or a demand curve explain the law of supply distinguish between a movement along and a shift of a supply curve explain and illustrate the effect on supply of changes in non price determinants of supply illustrate the concept of supply using either a table or a supply curve explain the concepts of equilibrium price and quantity explain the concepts of market .surplus/ and market .shortage/ explain and illustrate the effect of a market shortage on market price explain and illustrate the effect of a market surplus on market price
Lea%nin* acti$ity ( 1
?%: *his is the essential set of exercises 3f you have additional time, you should practise the qui88es and tests in 7y2conlab &)( &)& +nswer >eview @uestions (-(' at the end of chapter ) 5check your answers with those from the -tudy1esk6 +nswer ;roblems and +pplications (, &, ), A, C, H, (', ((, (&, (), (A, (B, (C, (D, (I, (H, &' at the end of chapter ) 5check your answers with those from the -tudy1esk6
( 7 Elasticity
( 7 1 2nt%oduction
3n our development of the tools of analysis above, we have used a downward-sloping demand curve and an upward-sloping supply curve ,hen changes in price or other economic variables occurred, we focussed on the direction of the resulting effect on prices and
ECO1000 Economics
21
quantities, rather than on the responsiveness of the dependent economic variable 3f we had a measure of responsiveness of one economic variable to a change in another 5for example, the responsiveness of quantity demanded to a price change6, we could take out analysis to the next level and reach more useful conclusions "lasticity is a measure of responsiveness 3n this section of the module, we introduce the concept of elasticity, study the calculation and interpretation of various elasticity measures, and see how knowledge of elasticity can be used in market analysis
( 7 ( 3he concept of elasticity

2lasticity is a measure of responsiveness 3t is a measure of the responsiveness in one economic variable 5the dependent variable6 to a change in another economic variable 5the independent variable6 0or example, consider the .own-price/ elasticity of demand; this is a measure of the responsiveness in the quantity demanded of a good to a change in its price Or, consider the price elasticity of supply; this is a measure of the responsiveness in quantity supplied of a good to a change in the price of the good =learly, the responsiveness in either case could be high or low *he measure that we calculate for the elasticity indicates to us the relative si8e of the responsiveness *here are many measures of elasticity that we could calculate using appropriate economic variable !ere we focus on some of the most common ones
( 7 ) /%ice elasticity of demand

Price elasticity of demand is a measure of the responsiveness in quantity demanded of a good to a change in the price of that good *he calculation is straightforward, but the resultant elasticity does require correct interpretation
( 7 6 C%oss8p%ice elasticity of demand

=ross-price elasticity of demand is defined as the responsiveness in the quantity demanded of a good to a change in the price of another good *he value calculated for the cross-price elasticity of demand may be positive or negative, and high or low 3f the value calculated is positive, the goods are substitutes; if the value is negative, the goods are complements Nnowledge of cross-price elasticities may help in defining industries and seeing the strength of the cross-price link between goods 0or example, the cross-price elasticity of demand between *oyota four-wheel drives and 7itsubishi four wheel drives would be of interest to firms producing those vehicles as they determine their pricing policy
( 7 7 2ncome elasticity of demand

!ncome elasticity of demand is defined as the responsiveness in quantity demanded of a good to a change in money income *he value calculated for income elasticity of demand may be positive or negative, and high or low *he sign for the calculated value tells whether the good is a normal one 5positive value6 or an inferior one 5negative value6 Nnowledge of
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ECO1000 Economics
this elasticity would be of use to business and governments seeking to cater for populations with rising incomes
( 7 , /%ice elasticity of supply

*he price elasticity of supply 5often 9ust the elasticity of supply6 is defined as the responsiveness in quantity supplied of a good to a change in the price of that good *his elasticity may be of high or low value, and various cases are distinguished in terms of that value 3t is of interest to market analysts as they consider supply responses; for example, the change in the quantity of oil supplied to the world market as the price of oil rises
0eadin* acti$ity ( (
-tudy chapter A of the text 5!ubbard et al 6 7ake sure that you can:

define and calculate .price elasticity of demand/ explain the midpoint formula for the calculation of price elasticity of demand distinguish among elastic demand, inelastic demand and unit elastic demand outline the determinants of price elasticity of demand interpret calculated price elasticities of demand explain why price elasticity of demand varies along a straight line demand curve and the relationship between price elasticity and total revenue define .cross-price elasticity of demand/ define the terms .complements/ and .substitutes/ in terms of the cross-price elasticity of demand interpret calculated cross-price elasticities define .income elasticity of demand/ define the terms .normal/ and .inferior/ goods in terms of income elasticity of demand interpret calculated income elasticities of demand define price elasticity of supply understand the determinants of the price elasticity of supply distinguish and illustrate the various cases of elastic and inelastic supply interpret calculated supply elasticities
ECO1000 Economics
23
Lea%nin* acti$ity ( (
?%: *his is the essential set of exercises 3f you have additional time, you should practise the qui88es and tests in 7y2conlab &D( &D& +nswer >eview @uestions (-(& for chapter A 5check your answers with those from the -tudy1esk6 +nswer ;roblems and +pplications (, &, ), A, B, C, D, I, H, (', (&, (), (B, (D, (I, (H for chapter A 5check your answers with those from the -tudy1esk6
( , Economic efficiency and ma%ket failu%e

?ow that we have developed a number of the tools used by economists, let us turn our attention to the use of those tools 3n this section of the module, we explore the effects of government policy to control prices in a market, the economic impact of taxes and the interesting question of why markets may fail to provide desirable outcomes in an economy %efore we go into all these applications, we introduce the concepts of consumer and producer surplus first
( , 1 Consume% and p%oduce% su%plus and economic efficiency

#onsumer surplus is the difference between the highest price a consumer is willing and able to pay and the price the consumer actually pays Producer surplus is the difference between the lowest price a firm would have been willing and able to accept and the price it actually receives ,hen equilibrium is reached in a competitive market, the marginal benefit from the last unit sold will equal the marginal cost of producing that last unit *his is an economically efficient outcome 3f less than the equilibrium output were produced, the marginal benefit of the last unit bought would exceed its marginal cost 3f more than equilibrium quantity were produced, the marginal benefit of this last unit would be less than its marginal 5opportunity6 cost "conomic surplus is the sum of consumer and producer surplus 2conomic surplus, or the net benefit to society from the production of a good or service, is maximised at equilibrium in a competitive market 5when there are no externalities6 $ deadweight loss is the reduction in economic surplus resulting from a market not being in competitive equilibrium
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ECO1000 Economics
"conomic efficiency is a market outcome in which the marginal benefit to consumers of the last unit produced is equal to its marginal cost of production, and where the sum of consumer and producer surplus is at a maximum
( , ( /%ice floo%s and p%ice ceilin*s

*hough the total benefit to society is maximised at a competitive market equilibrium, individual consumers would be better off if they could pay a lower than equilibrium price, and individual producers would be better off if they could sell at a higher than equilibrium price =onsumers and producers sometimes lobby government to legally require a market price different from the equilibrium price *hese lobbying efforts are sometimes successful + price floor is a legally determined minimum price that sellers may receive ;rice floors were established in agricultural markets in the J-+, 2uropean Jnion 52J6 and in many other countries in response to pleas from farmers who could sell their product only at low prices + price ceiling is a legally determined maximum price that sellers may charge 3t is reported that Eene8uelan ;resident !ugo =have8$s policy of keeping a tight control on food retail prices have caused severe food shortage in recent years
( , ) 3he economic impact of ta5es

,e are now in a position to return to market analysis and to see how knowledge of elasticity enables us to draw useful conclusions about market changes !ere we focus on the effects of a tax 5such as a sales tax6 imposed on the sale or the production of goods and services + tax on the sale of a good or service also results in a reduction of economic efficiency 0or example, if the federal government were to impose an additional tax on cigarettes of F( '' per pack, this would decrease the supply 5shift the supply curve of cigarettes to the left, or shift it up by F( ''6 *he tax would result in a loss of consumer and producer surplus -ome of the reduction of consumer and producer surplus becomes government revenue and the rest is a deadweight loss, which is referred to as the excess burden of the tax *he incidence of a tax is the actual division of the excess burden between producers and consumers in the market *he tax incidence varies depending on how responsive producers and consumers are to the price change caused by the tax 5ie, elasticities of demand and supply6
ECO1000 Economics
25
0eadin* acti$ity ( )
-tudy chapter B of the text 5!ubbard et al 6 7ake sure that you can:

explain the concepts of consumer surplus and producer surplus explain the concepts of marginal benefit and marginal cost explain and illustrate the concept of economic efficiency explain and illustrate the effect of the policy of setting a price floor in a market explain and illustrate the effect of the policy of setting a price ceiling in a market illustrate the effect of taxes on economic efficiency define the term ta% incidence use a supply and demand diagram to illustrate the tax incidence of a unit tax 5tax placed on each unit of a good6 in terms of prices paid and received, and in terms of tax paid by buyers and sellers discuss the importance of demand and supply elasticity for the determination of the tax paid by buyers and sellers when a unit tax is imposed
Lea%nin* acti$ity ( )
?%: *his is the essential set of exercises 3f you have additional time, you should practise the qui88es and tests in 7y2conlab &I( &I& +nswer >eview @uestion (-(& at the end of chapter B 5check your answers with those from the -tudy1esk6 +nswer ;roblems and +pplications (, &, ), A, B, D, I, H, (', ((, (A, (D, (H, &' at the end of chapter B 5check your answers with those from the -tudy1esk6
Summa%y
3n this module, we introduced a number of important tools for use in economic analysis *hese were the concepts of demand, supply, market equilibrium, consumer surplus, producer surplus and elasticity Jse of these concepts, often in terms of graphical analysis, enables us to work out the effects of changes in a competitive market in terms of changes in prices, quantities, and revenues ,e are now able to use the economic way of thinking to analyse a wide range of market situations
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ECO1000 Economics
ECO1000 Economics
27
9odule ) A Fi%ms and ma%ket st%uctu%e

Lea%nin* ob4ecti$es

explain the concepts of .explicit/ and implicit/ costs use the law of diminishing returns to explain and illustrate the short-run production function explain the relationship between short run costs and output in terms of total, average, and marginal cost curves explain the relationship between marginal and average cost and between marginal product and marginal cost explain the construction and shape of the firm/s long run average cost curve explain the model of perfect competition explain the model of monopoly discuss the efficiency issues in both perfectly competitive market and monopoly market
Lea%nin* %esou%ces
3e5t
!ubbard et al &'(), Economics, chapters C, D and I
Essential
Study book: module )
) 1 2nt%oduction
3n modules ( and &, we used the concepts of the production possibilities frontier, the supply curve, and market equilibrium without going into much detail about the underlying economics 3n this module, we will explore the economics of production, costs and the market structures of perfect competition and monopoly Our earlier analysis of market equilibrium assumed a market structure of perfect competition: one in which there are many buyers and sellers and in which no individual buyer or seller has any market power over price
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ECO1000 Economics
3n this module, we add to our study of economic models by examining the model of perfect competition *his is the well-known model of the .free market/; a model which lies at the heart of much of the argument about the need to make actual markets more competitive *o understand the operation of this model, we need to consider carefully the relationships between production and cost in both the short run time period and the long-run time period Once we know a typical firm/s short run and long run cost functions 5the relationships between cost and output6, we can combine this information with information about the revenue function 5the relationship between output and revenue6 to work out how much output a firm will be willing to supply 0rom this, we can deduce the shape of the market supply curve which is used in market analysis + monopoly is a firm that is the only seller of a good or service that does not have a close substitute 0or a monopoly to exist barriers to entering the market must be so high that no other firms can enter + monopolist will produce less and charge a higher price than would a perfectly competitive industry producing the same good *he monopolist/s profit-maximising price exceeds marginal cost *he monopoly equilibrium is neither productively efficient nor allocatively efficient *here are a number of production, cost and revenue concepts to be understood in this module ,e begin with production and costs in the two time periods and then turn to the analysis of the perfectly competitive firm and market
) ( 3he concept of cost %e$isited

3n module one, we introduced the concept of opportunity cost Opportunity cost is an important consideration when business decisions are made 7ost people would be familiar with the basic idea of business costs, which would include wages for workers, materials, other production costs, and capital costs for buildings and equipment *hink of these as accounting costs, or the payments for actual things; that is think of them as e%plicit costs %usiness profit is calculated as: >evenue 5or income6 < accounting costs M profit
:udio: e5plicit costs

explicit costs
*his seems quite simple, but economists believe that such a simple calculation misleads the business person *he economic question is: what has the business owner foregone in order to be in a particular business4 -uppose that -ally earns F('' ''' a year as a corporate economist, but like many people she wants to .be her own boss/ -he buys a small business for F)'' ''', using funds she inherited !owever, she realises the new business can only afford to pay her a managing director/s salary of FI' ''' -ally is .paying/ an implicit cost for her decision to be an owner operator *his implicit cost is the F&' ''' a year in her personal income 5F('' ''' < FI' '''6 that she foregoes
ECO1000 Economics
29
-he also foregoes interest income by investing her funds in the business, rather than in financial assets -uppose that the current interest rate is ('O *his is taken to be the return on the best alternative use of her funds -ally could be earning F)' ''' a year from a financial investment of F)'' ''' at ('O per year 3n total, the annual implicit cost she incurs by investing in the business is: F&' ''' G F)' ''' M FB' ''' per year *his cost should be added to the explicit accounting cost to give the economic cost of choosing the business option *hat is: "conomic cost & accounting cost 5explicit costs6 G implicit cost 5implicit costs6
:udio: economic costs

economic costs
:udio: implicit costs

implicit costs
*his does not mean that business people should slavishly follow such a principle and always pursue the alternative yielding the highest return ;eople go into business for all sorts of reasons, including 9ob satisfaction, the desire for independence and to create family assets 3n addition, in some years, profits will be down compared to other investments, so the opportunity cost will be higher, but you would not necessarily sell out to pursue always the short term best option *here are costs in transferring assets and skills *here may also be taxation benefits in having a business which yields a better return than salaries, although this can be overestimated *he important point to note is that as a business person, you should know what the options are and how much your choices really .cost/ !arsh as it may seem, if you stay in an enterprise that has a persistent negative economic profit, you might have difficulty Over time, the temptation to pursue better options will increase 3n summary, in economics we measure costs as opportunity costs including explicit costs and implicit costs 2xplicit costs are the payments to non-owners of a firm for their resources, e g , wages, lease payments, cost of materials, etc 3mplicit costs are the opportunity costs that do not require an outlay of money by the firm, e g , the use of the owner$s time, money and car for production
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ECO1000 Economics
) ) 3he sho%t %un p%oduction function

2conomists usually consider the economics of a firm/s production in two time periods *he short run is that time period in which at least one of the firm/s inputs is fixed in quantity *he long run time period is that time period in which all of a firm/s inputs can be considered to be variable in quantity *his leads to the classification of inputs as variable or fixed, depending on the time period in question "iven this time period distinction, we can speak of the firm/s short and long run production functions, where a production function refers to the relationship between the inputs used by a firm and the output it produces *hese production functions become the basis for the firm/s cost functions in the long and short run time periods 3f we assume that labour and machine capital are the only two inputs for a firm and the number of machines is fixed *he marginal product of labour is the additional output the firm produces as a result of hiring one more worker *he law of diminishing returns states that at some point, adding more of a variable input, such as labour, to the same amount of a fixed input, such as capital, will cause the marginal product of the variable input to decline *he average product of labour is the total output produced by a firm divided by the quantity of workers ,hen the average product is rising, the marginal product is above the
average product; when the average product is falling, the marginal product is below the average product *herefore, the marginal product curve cuts the average product curve
at the point where the average product is at its maximum
) 6 Sho%t %un cost functions

,ith our knowledge of the short run production function, we can turn to a consideration of a firm/s short run cost function *his is the relationship between a firm/s output and costs *he cost function can be displayed in terms of its output and total costs 5total fi%ed cost' total variable cost and total cost6, or in terms of its output and its average costs 5average fi%ed cost, average variable coast, and marginal cost6 ,e need to understand the shape of the typical cost curves 5functions6 and to appreciate that there are geometrical relationships between the various cost curves that need to be observed when we draw and interpret the cost relationships (arginal cost is the change in a firm/s total cost from producing one more unit of a good or service *he law of diminishing returns explains why the marginal cost curve is J-shaped *he relationship between marginal cost and average total cost can be explained as: when 7= is below +*=, +*= will fall; when 7= is above +*=, +*= will rise; 7= curve cuts +*= curve when +*= is at its lowest point; the +*= curve is J-shaped because 7= is J-shaped *he same reasoning applies to the relationship between 7= and +E=
ECO1000 Economics
31
) 7 Lon* %un a$e%a*e cost

3n the long run period, all inputs are variable =onsequently, all costs are variable as well 0or this time period, economists use the concept of long run average cost to represent the long run cost function *his cost function is typically J-shaped and is formed by the lowest portions of the set of short run cost functions that enable production at least cost as output is increased +s we explore the long run cost function, we need to note that the long run is essentially a firm/s planning period Once a decision has been made to build a certain si8e of plant, the firm is operating in the short run
0eadin* acti$ity ) 1
-tudy chapter C of the text 5!ubbard et al 6 7ake sure that you can:

understand the concepts of $short run$ and $long run$ define total cost, variable cost and fixed cost define the terms .explicit/ and e%plicit cost explain the concept of a .production function/ calculate average cost explain the concepts of .marginal product/ and $average product$ state the law of diminishing returns explain the relationship between marginal and average product define and calculate average marginal cost, fixed cost, average variable cost, and average total cost explain and illustrate the relationship between marginal cost and average cost interpret graphs showing either total cost curves, or average cost curves explain and illustrate a firm/s long run average cost curve in terms of a series of short average run cost curves explain the typical shape of the long run average cost curve in terms of .economies/ of scale; .diseconomies/ of scale and .constant returns/ to scale
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ECO1000 Economics
Lea%nin* acti$ity ) 1
?%: *his is the essential set of exercises 3f you have additional time, you should practise the qui88es and tests in 7y2conlab )A( )A& +nswer >eview @uestions (-(' for chapter C 5check your answers with those from the -tudy1esk6 +nswer the study questions and problems (, ), A, B, C, D, I, (', ((, (&, (), (A, (B, (I, &' for chapter C 5check your answers with those from the -tudy1esk6
) , 3he model of pe%fect competition

) , 1 2nt%oduction
*his is one of the most well-known models of the standard microeconomics literature 3t deals with a market structure in which there are many buyers and sellers, and in which no buyer or seller has any power over the price in the market #ike all models, there are a number of assumptions made about this market structure "iven these assumptions, a number of important conclusions about firm and industry pricing and production follow ,e will find that, although it might be somewhat unrealistic in terms of typical market structures in existence today, it still provides a very useful beginning to our study of the way in such competitive forces work 3n our study of this model, we will look at the firm and the market 5industry6 in both the short and the long run periods ,e will use our knowledge of cost functions for these periods to see how firm/s decide on their choice of output, and how these choices flow into industry supply *his will complete our understanding of the economics .beneath/ the market supply curve that we have met already in the previous module
) , ( 3he pe%fecti$ely competiti$e model: in the sho%t %un

3n a perfectly competitive market, each individual firm is a price taker and its demand curve is hori8ontal, which is different from the downward-sloping market demand curve *he individual firm cannot decide the market price, but it can decide its optimal output level based on its marginal cost information to maximise the profit *he profit is maximised at the output where the difference between total revenue 5*>6 and total cost 5*=6 is the largest 3t is equivalent to say that the profit is maximised at the level of output where the firm$s marginal cost equals the market price *he firm will make an economic profit if ; P +*= *he firm will break even if ; M +*= *he firm will experience a loss if ; Q +*= 3n the short run, the firm will stay in the business if ;P+E= *he firm will shut down if ;Q+E= *here is no difference for the firm to shut down or to continue to operate if
ECO1000 Economics
33
;M+E= -o the firm$s marginal cost curve is its supply curve only for prices at or above average variable cost *he market supply curve is the hori8ontal sum of the individual firms$ supply curves
) , ) 3he ent%y and e5it of fi%ms in the lon* %un and efficiencies in pe%fect competition
,hile entry into, and exit from, the industry is not possible in the short run 5firms ad9ust by changing their output6, in the long run firms may exit the industry and new firms may enter 3f a firm cannot make a normal profit 5a term that means 8ero economic profit or break even6, it will leave the industry 3f firms outside the industry observe that more than normal profits are made within it, they will seek to enter the industry =onsequently, in the long run there are both industry and firm ad9ustments to consider *his makes the analysis slightly more complicated + long-run supply curve represents the relationship between market price and the quantity supplied 3ts position is determined by the minimum point of the +*= curve 3n the long run, the +*= could increase, decrease or remain constant *herefore, the long-run supply curve could be upward sloping, downward sloping or hori8ontal ;erfect competition can be used as a benchmark to compare with other market structures such as monopoly 3n the absence of external cost or benefits a perfectly competitive market can achieve allocative efficiency in both short run and long run as the price is equal to the marginal cost5;M7=6, meaning that the scarce resources are allocated in accordance with the wishes of consumers ;roductive efficiency also occurs when price equals the minimum of average total cost 5;Mmin+*=6 *his may not be achieved in the short run, but productive efficiency is attained in the long run in perfect competition ;roductive efficiency is the situation in which a given quantity of a good or service is produced using the least amount of inputs 5;Mmin +*=6 +llocative efficiency is a state of the economy in which production reflects consumer preferences; in particular, every good or service is produced up to the point where the last unit produced provides a marginal benefit to consumers equal to the marginal cost of producing it 5;M7=6 1ynamic efficiency is the ability for firms over time to develop and utilise technological innovation, and to adapt their product to changes in consumer preferences and tastes !owever, it is debatable whether a firm in a competitive environment is more innovative or a monopoly firm tends to be more innovative
34
ECO1000 Economics
0eadin* acti$ity ) (
-tudy chapter D of the text 5!ubbard et al 6 7ake sure that you can:

describe the characteristics of the market structure of perfect competition explain why a perfectly competitive firm is a price taker and that its demand curve is perfectively elastic explain and illustrate why a perfectly competitive firm maximises profit 5or minimises losses6 when marginal revenue is equal to marginal cost, or total revenue minus total cost is a maximum explain why a perfectly competitive firm will .shut down/ if the price falls below average variable cost explain and illustrate the construction of perfectly competitive firm/s short run supply curve explain and illustrate the construction of the perfectly competitive industry/s supply curve explain why a perfectly competitive firm in long run equilibrium makes 8ero economic profit 5normal profit6 explain why a perfectly competitive industry is in long run equilibrium when each firm is producing an output for which price is equal to short run marginal cost, short run average total cost and long run average cost explain productive, allocative and dynamic efficiencies
Lea%nin* acti$ity ) (
?%: *his is the essential set of exercises 3f you have additional time, you should practise the qui88es and tests in 7y2conlab )C( )C& +nswer >eview @uestions (-(& for chapter D 5check your answers with those from the -tudy1esk6 +nswer ;roblems and +pplications (, &, ), B, C, D, I, H, (', ((, (&, (), (A, (C, (D, (I, (H for chapter D 5check your answers with those from the -tudy1esk6
) < 9onopoly ma%kets

) < 1 9onopoly model
+ monopoly is a firm that is the only seller of a good or service that does not have close substitutes +lthough few firms are monopolies, the economic model of monopoly can still
ECO1000 Economics
35
be very useful +s with the perfect competition model, which provides a benchmark for how a firm acts in an industry where many firms supply identical product, monopoly provides a benchmark for the other extreme, where a firm is the only supplier and faces no competition from other firms *here are higher barriers in the monopoly market which prevent other firms from entering *he barrier could be created by the government, for example, blocking the entry of more than one firm into a market, or because the firm controls over a material necessary to produce a product *he barriers could also result from important network externalities and economies of scale *he monopoly firm is a price maker %ut it is constrained by the downward-sloping demand curve + monopoly firm/s demand curve is the market demand curve + monopoly firm maximises profit by producing the level of output where marginal revenue equals marginal cost ;lease note that profit is not guaranteed in a monopoly market 3f the demand is very low while the firm$s +*= is very high, the firm could make a loss !owever, if the monopolist/s price exceeds its average total cost at the output where marginal revenue equals marginal cost, it will earn an economic profit %ecause of high entry barriers new firms will not be able to enter the market, so if other things remain the same, the firm will be able to continue to earn economic profits, even in the long run + monopolist will produce less and charge a higher price than would a perfectly competitive industry producing the same good *he monopolist/s profit-maximising price exceeds marginal cost 5;P7=6 and the firm does not produce at the minimum point of +*= 5;Pmin +*=6 *hus the monopoly equilibrium is neither productively efficient nor allocatively efficient
) < ( Economic efficiency and *o$e%nment %e*ulation in monopoly ma%ket

=ompared to equilibrium in a perfectly competitive market, which results in the maximum amount of economic surplus, a monopoly will produce less and charge a higher price, resulting in reduction in consumer surplus and allocative efficiency *his is actually another form of market failure *herefore, government plays an important role in such markets to promote competition, thereby improving efficiency *he +ustralian =ompetition and =onsumer =ommission 5+===6 monitors competitive behaviour in +ustralia, and enforces the Competition and Consumer Act 2010 (CCA , which contains laws against anti-competitive actions by firms *he +=== cracks down price-fixing activities 5collusion6 and regulates business mergers 0ederal, state or territory government regulatory commissions usually set prices for natural monopolies !owever, given the important role played by the application of new production methods and equipment in the productive growth of industrial countries, some economists argue that
36
ECO1000 Economics
dynamic efficiency should be given the highest priority, followed by productive efficiency +s a result, allocative efficiency is said to be of less policy importance 5a normative statementR6 !aving done this module, students should be able to formulate their own argument on this issue
0eadin* acti$ity ) )
-tudy chapter I of the text 5!ubbard et al 6 7ake sure that you can:

explain entry barriers created by government action, control of key resources, network externalities and natural monopoly explain and illustrate how a monopoly firm determines its output and price explain and illustrate consumer surplus, producer surplus and deadweight loss in a monopoly market Jnderstand the concept of $market power$ explain why there is a need to regulate collusive behaviour and merger activities Jnderstand the practices in regulating natural monopolies
Lea%nin* acti$ity ) )
?%: *his is the essential set of exercises 3f you have additional time, you should practise the qui88es and tests in 7y2conlab )C( )C& +nswer >eview @uestions (-(& for chapter I 5check your answers with those from the -tudy1esk6 +nswer ;roblems and +pplications (, &, ), A, D, I, H, (', ((, (&, (), (A, (B, (C, (D, (H, &' for chapter I 5check your answers with those from the -tudy1esk6
Summa%y
3n this module, we have explored the concepts of short and long run production and cost functions and used these in the analysis of two extreme market structures: perfect competition and monopoly ,e have seen how a firm/s short run cost curves may be displayed in terms of total or average costs and that there are definite geometric relationships between the various cost curves *he long run cost curve was displayed in terms of the long run average cost curve 3n the short run, the shape of the cost curves 5apart from the fixed cost curve6 reflects the operation of the law of diminishing returns 3n the long run, it is the presence of economies and diseconomies of scale that determines the shape of the average cost curve
ECO1000 Economics
37
=ombining our knowledge of short and long run costs with the revenue function of a firm in the market structure of perfect competition, we developed the firm/s, and industry/s, short run supply curve and explored the long run ad9ustment of the firm and the industry *his analysis of the perfectly competitive market has given us insight into the operation of a competitive firm and the implications of this operation for the supply curve in a competitive market *his is the supply curve we used in module two when exploring market analysis in terms of demand and supply ,e now know something about the economics of supply 3n a monopoly market, we have shown that deadweight loss is created as a result of higher price and lower output than those in a perfectly competitive market *herefore, government plays an important role in safeguarding consumer welfare and promoting competition in an imperfectly competitive market
38
ECO1000 Economics
ECO1000 Economics
39
9odule 6 A 9ac%oeconomic Foundations

Lea%nin* ob4ecti$es

explain how total production in an economy is measured discuss problems encountered in the measurement of economic activity calculate nominal and real values of selected economic variables understand how the economic growth rate is measured discuss the importance of long-run economic growth and its impact on living standards define and calculate the unemployment rate and the labour fore participation rate explain the economic costs of unemployment identify the types of unemployment and explain what factors determine the natural rate of unemployment define the price level and the inflation rate, and understand how they are calculated discuss the measurement and causes of inflation Jnderstand the difference between demand-pull and cost-push understand what happens during business cycles and their relationship to long-run economic growth discuss the determinants of aggregate demand and aggregate supply use the aggregate demand and aggregate supply mode to illustrate the difference between short-run and long-run macroeconomic equilibrium use the dynamic aggregate demand and aggregate supply model to analyse macroeconomic conditions
Lea%nin* %esou%ces
3e5t
!ubbard et al &'(), Economics, chapters H, (' and ((
Essential
Study book: module A
40
ECO1000 Economics
6 1 2nt%oduction
3n this module, we swing our attention to the economy as a whole 3n the previous modules, we considered the activities of single markets that exist within a much larger set of markets and associated economic activity *his is something like flying over a forest and looking at its wide extent, rather than being inside the forest and looking at the individual trees ?ow we are concerned with the overall si8e of the forest and at the rate at which it is changing in si8e !owever, we will speak of the rate of economic activity, and the rate of growth of that activity, rather than si8e and growth of a forest *his field of economics is often called macroeconomics, to distinguish it from the field known as microeconomics which deals with specific product, service or factor markets ,e need to be aware, however, that this distinction is a modern one, and that the two fields of economics are really different ways of considering the same economy 3t does not do to put these fields into separate, never to be linked, compartments +fter all, the forest is made up of separate trees, and the separate trees are parts of a much larger whole 3n dealing with the economy as a whole, we have to think about the totality of economic activity and to develop ways of making sense of it 3t is a rather sobering to be reminded that prior to the (H)'s there were few measurements available of the si8e of an economy 3t is only since then, and after the pioneering work of Sohn 7aynard Neynes 5The !eneral Theor" of Emplo"ment# $nterest and %one" (H)D6 that more refined tools of economic analysis were available *oday, we speak of )*P and rates of growth of "1; with almost no appreciation of what these terms really mean and what pitfalls await the unwary as they use them very casually ;erhaps the protestors against globalisation have a point: what is the purpose of trying to grow as fast as possible in terms of "1; growth4 3s the measure, and the underlying concept of macroeconomic activity, valid4 ,e turn to an examination of key macroeconomic performance data and its potential use for the design of macroeconomic policy in this module
6 ( =1/ measu%es total p%oduction

6 ( 1 9easu%in* the si>e of the total p%oduction
0ollowing the experience of the "reat depression of the (H)'s, when world economic activity fell to very low levels and high levels of unemployment were widespread, the need for macroeconomic data was obvious *his ushered in the development of national accounting systems; systems which enabled the consistent measurement of macroeconomic variables, such as "ross 1omestic ;roduct 5"1;6 3t was thought that if reliable measures of the si8e and growth of the economic activity were available, policy-makers would be able to ensure that another great depression did not occur 1ata available today for many countries is the result of the theoretical and statistical work in the field of macroeconomics ,hile there has not been another great depression, there has been much debate on the question of the appropriate measurement of economic activity +s a result, we are in a much better position today in our endeavour to .take the pulse/ of the economy
ECO1000 Economics
41
3n this section of the module, we consider the components and the measurement of "1; *hese are important building blocks for our later work in which we seek to explain how the si8e of the circular flow changes over time
6 ( ( 3he ci%cula% flow model of an economy

2arly economists talked about the idea of a .wheel of circulation/ ;erhaps they had in mind something like the great rotations of the planets, as did early viewers of the cosmos #atterday economists have fashioned this idea into that of the circular flow of economic activity 3t is an intuitively appealing idea for we all have some appreciation of it ,e know that income is earned in various ways in various activities, and that income is spent in turn on a range of goods and services, themselves the output of countless other economic activities -o, it makes some sense to us to speak of a circular flow of activity within an economy with easily recognised boundaries ,e can sit back, close our eyes, and think of all the many activities that go to make up the finished goods and services and make them available to final purchasers 3t is a very complex mosaic; but the idea of the circular flow helps to make sense of the overall activity that goes on every hour in any economy *he circular flow is usually represented by a simple diagram that shows the ma9or, aggregate flows in an economy *hese diagrams can be made very complex; but that might defeat the purpose of the exercise Our aim is to develop a workable understanding so that we can measure the si8e of the flow and its rate of growth ,e note that underlying this idea of the flow lies that of the economy as a system *hat is, of something that is characterised by input-output relations *his is very convenient for mathematicians and modellers, and has much to offer us !owever, we must ask at some stage about the validity of the mathematical analogy ,e might note that implied recognition of the environment as a .sink/, into which waste is channelled, maintains this essential .input-output/ conception of overall economic activity *herefore, when we measure the value of total production in the economy by calculating "1;, we are simultaneously measuring the value of total income "1; is the market value of all final goods and services produced in an economy during a period of time *here are three methods to calculate "1;: the production method, the expenditure method and the income method 3n this course, we place the emphasis on the expenditure method *here are four ma9or categories of expenditures: consumption, investment, government purchases, and net exports "1; is not a perfect measure of total production, nor a perfect measure of wellbeing !ousehold production and the black economy are excluded from "1; *he "1; measure does not give us the information of the distribution of the income and output among the population *he value of leisure is not included in "1; 3t does not contain the information about the level and quality of health care and education 0inally, "1; is not ad9usted for pollution or other negative effects of production, changes in crime and other social problem ?ominal "1; grows over time not only as result of increases in output but also as a result of general price rises =hanges in nominal "1; that result from price changes do not tell us anything about the performance of the economy in producing goods and services *o get a clearer picture of how much an economy is growing over time, it is necessary to ad9ust nominal "1; so that it reflects only changes in output and not changes in prices *his ad9usted "1; allows meaningful comparisons of aggregate economic activity over time when prices are changing and is referred to as real "1; >eal "1; is the value of all final
42
ECO1000 Economics
goods and services produced during a given period based on the prices existing in a selected reference year
6 ( ) Economic *%owth
#ong-run economic growth is the key to rising living standards *he issues of growth rates and living standards are of considerable importance in the contemporary world ,ith much of the world/s population in relative, if not absolute, poverty the need to understand the causes of economic growth, and to implement effective growth policy, is urgent 7any economists have turned their attention to the causes of economic growth One of the most well-known models of economic growth is the .-olow/ model, developed by >obert -olow *his model focuses upon the roles of expenditure, saving, the capital stock and technological change in the determination of an economy/s rate of economic growth 3n this section of the module, we explore the main causes of economic growth and consider their implications for economic policy to promote economic growth 3ncreases in real "1; per capita depend on increases in labour productivity #abour productivity is the quantity of goods and services that can be produced by one worker or by one hour of work *wo key factors determine labour productivity: the quantity of capital per hour worked and the level of technology *herefore, economic growth occurs if the quantity of capital per hour worked increases and if technological change occurs One important concept here is potential "1;, which is the level of "1; attained when all firms are producing at maximum capacity ,e will frequently use this concept in the following chapters when we study macroeconomics
-tudy chapter H of the text 5!ubbard et al 6 7ake sure that you can:

define the term .)*P/, understand the three methods of measuring "1; understand the four components of "1; in the expenditure method discuss limitations of "1; as a measure of total production and a measure of wellbeing calculate nominal "1; to real "1; calculate the economic growth calculate the "1; deflator explain the determinants of the rate of long-run growth use the economic growth model to explain why economic growth rates differ between countries
ECO1000 Economics
43
?%: *his is the essential set of exercises 3f you have additional time, you should practise the qui88es and tests in 7y2conlab A(( A(& +nswer >eview @uestions (<(& for chapter H 5check your answers with those from the -tudy1esk6 +nswer ;roblems and +pplications &, ), A, B, C, D, I, H, ((, (), (A, (D, (I, (H, &' for chapter H 5check your answers with those from the -tudy1esk6
6 ) #nemployment and inflation

6 ) 1 #nemployment
+s most people earn their livelihoods from employment, the rate of unemployment in an economy is of considerable interest to citi8ens and economists alike 7any people remember the economic depression of the (H)'s when there was large scale unemployment across the world *he suffering and poverty that resulted sparked the desire to attempt to manage economies so that the rate of unemployment remained at acceptable levels -uccess has been elusive and, at the start of the &(st century, governments still tussle with the policy mi% that will provide desired rates of unemployment 3n this section of the module, we consider the concept and measurement of unemployment, and the classification of unemployment by economists ,e have strict definitions for employed and unemployed for statistical purpose ;eople are considered employed if they worked for at least one hour in paid employment in the week before the survey Only those who have actively looked for work in the previous four weeks and are available to work are classified as .unemployed/ 1iscouraged workers are defined as people who are available for work but have given up looking for a 9ob during the previous four weeks because they believe no 9obs are available for them *he labour force is the sum of the employed and employed 1iscouraged workers are measured as .not in the labour force/ *here are several types of unemployment: cyclical unemployment, frictional unemployment and structural unemployment -tructural unemployment is long-term unemployment and possibly even permanent unemployment because workers need time to learn new skills and some may never learn these *he government should indeed be concerned about it since such unemployment can lead to permanent unemployment On the other hand, cyclical unemployment is caused by lack of 9obs during a recession 0ull employment occurs when the unemployment rate is equal to the total of the frictional and structural unemployment rates 0ull employment, therefore, defines the rate of unemployment that exists without cyclical unemployment *he full employment rate of unemployment is also referred to as the .natural rate of unemployment/
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ECO1000 Economics
6 ) ( 2nflation
,e are all aware that the overall price level in an economy changes from time to time, usually in an upward direction 5although declines are possible6 ,e recognise this when we speak of the rate of inflation: an inflation rate of BO means that the overall, or general, level of prices is rising at BO 2conomists have been interested for a long time in the development of measures of the change in the overall price level *oday, such changes are measured using a price index 5several indices are usually published by a country/s statistics bureau6 *he most familiar price index 5in +ustralia and many other countries6 is known as the =onsumer ;rice 3ndex 5=;36 !owever, =;3 has some biases as a measure of inflation, which include substitution bias, increase in quality bias, new product bias and outlet bias +nticipated inflation does not reduce the affordability of goods and services to the average consumer, but it still imposes costs on the economy ,hen inflation is anticipated, its main costs are that paper money loses some of its value and firms incur menu costs 7enu costs are the costs to firms of changing prices on products and printing new catalogues %y contrast, when inflation is unanticipated, the actual inflation rate can turn out to be different from the expected inflation rate +s a result, some people gain and some people lose 3nflation affects the distribution of income, as some people will find their purchasing power is rising while other people will find their purchasing power is falling 3nflation can be caused either by an increase in aggregate demand or by a decrease in aggregate supply 3n =hapter ((, we will use the +1-+- model to illustrate demand-pull inflation and cost-push inflation
-tudy chapter (' of the text 5!ubbard et al 6 7ake sure that you can:

define the terms: unemployment rate, labour force; discouraged worker, and $labour force participation rate+, discuss limitations of the unemployment rate as a measure of economic performance discuss the costs of unemployment distinguish among the four types of unemployment identified by economists discuss the concept of full employment explain what factors determine the natural rate of unemployment define the term: .inflation/ explain how inflation is calculated using a consumer price inde% discuss limitations of using a consumer price index to measure inflation use price indexes to ad9ust for the effects of inflation discuss the costs of inflation to the economy outline the cause of inflation in terms of .demand pull/ and .cost-push/ theories of inflation
ECO1000 Economics
45
?%: *his is the essential set of exercises 3f you have additional time, you should practise the qui88es and tests in 7y2conlab AA( AA& +nswer >eview @uestions (-(A for chapter (' 5check your answers with those from the -tudy1esk6 +nswer ;roblems and +pplications (, &, ), A, B, C, D, I, (', (&, (), (A, (D, (I, (H, &' for chapter (' 5check your answers with those from the -tudy1esk6
6 6 3he business cycle

2conomists refer to the concept of the business cycle when observing the short run performance of an economy >esearch has shown that, typically, the economy traces out a cyclical path of peaks and troughs separated by recession and e%pansion periods Nnowledge of the economy/s position in the cycle is important for the design of macroeconomic policy to .smooth/ the cycle
6 7 :**%e*ate demand and a**%e*ate supply

3n this section we build a macroeconomic model of the economy which may be used for macroeconomic analysis *he purpose of such analysis is to explain the current performance of the economy and to work through the effects on macroeconomic performance of possible policy changes ,e begin with some reflections on the (H)'s depression and the radical work of Neynes; Neynes suggested the policy-makers should focus on aggregate demand in the economy if they wished to .manage/ the business cycle ,e then move from the early Neynes/ model to a more recent aggregate demand ($*) and aggregate supply 5+-6 model which captures some of Neynes/ insights as well as those of other noted macroeconomists *his model provides quite a powerful tool for macroeconomic analysis *hree theories can be used to explain why the +1 curve is downward sloping: the wealth effect, the interest-rate effect and the international-trade effect ,e need to pay special attention to the variables that shift the +1 curve: changes in government policies, changes in the expectations of households and firms and changes in foreign variables 3f there is an increase in resources such as workers, new mineral discoveries, quantity of capital and advance in new technology, the long-run +- will increase, shifting to the right *hese factors also increases short-run +- Other variables that can shift ->+- include
46
ECO1000 Economics
expected changes in the future price level, ad9ustments of workers and firms to errors in past expectations about the price level, and unexpected changes in the price of an important natural resource *he #>+- is vertical while the ->+- is upward sloping because the wages and prices are $sticky$ in the short run *he +1-+- model can be used to illustrate the effects of an decreaseKincrease in +1K+- on the price level and real "1;
-tudy chapter (( of the text 5!ubbard et al 6 7ake sure that you can:

define the terms: .peak/, .recession/, trough, .expansion/ explain what happens during a business cycle explain why the aggregate demand curve downward slopping discuss the variables that shift the aggregate demand curve discuss and illustrate the shapes of the long-run and short-run aggregate supply curves discuss the factors that shift long-run and short-run aggregate supply curves understand why some firms and workers fail to predict accurately changes in the price level illustrate the difference between long-run and short-run macroeconomic equilibrium using +1-+- model use +--+- model to illustrate recession, expansion and supply shock use the dynamic +1-+- model to analyse macroeconomic conditions
?%: *his is the essential set of exercises 3f you have additional time, you should practise the qui88es and tests in 7y2conlab A)( A)& +nswer >eview @uestions (-(A for chapter (( 5check your answers with those from the -tudy1esk6 +nswer ;roblem and +pplications (, &, ), A, B, D, I, ((, (&, (), (A, (B, (C, (D, (I, (H, &' for chapter (( 5check your answers with those from the -tudy1esk6
Summa%y
ECO1000 Economics
47
3n this module, we have explored the circular flow model of the macroeconomy and used it to consider how economic activity might be measured +ny description or analysis of an economy relies upon a concept of the economy and on measurement of the economy/s rate of economic activity *he circular flow model provides one way of thinking about the activity that goes on in an economy 3t also provides suggestions as to how the flow of economic activity could be measured *he concept of "1; 5and related concepts6 enables us to measure changes in economic activity over time, to make comparisons among countries and to explore the outcomes of policies designed to affect the rate of economic performance ,hile suggestions for improved concepts are often discussed, the framework for national accounting that is currently used provides a consistent method of measuring economic activity ;roduction, productivity of inputs, and economic growth are very important topics in the discipline of economics and for the people of the world 1iscussion about economic growth involves issues such as the rate and type of growth that is desired, ways to achieve that growth, and economic performance over a relatively long period of time #iving standards are dependent on the rate of and type of growth =onsequently, it is important that there be careful analysis of the causes of growth and of policy to promote growth *he +1-+- model enables us to work out the effects on the price level and "1; of changes that affect either or both of the +1 and +- curves *he +1 curve shows the relationship between the price level and the quantity of real "1; demanded by households, firms and the government, while the short-run +- shows the relationship between the price level and the quantity of real "1; supplied by firms *he long-run +- is vertical as in the long run, real "1; is always at its potential level and is unaffected by the price level *he short-run aggregate supply curve is upward sloping because the workers and firms fail to predict accurately the future price level Jnemployment remains a very important issue in most economies, though in some instances it appears to be surprisingly low in the order of policy ob9ectives 1espite advances in economic understanding over the last century, there is considerable controversy over the policy a government should pursue to achieve .full/ employment %ecause of the existence of inflation 5and sometimes deflation6, it is necessary to distinguish nominal and real values of economic variables, such as "1; ;rice indices, such as the =;3, are used for this purpose *hese are constructed to show changes in the general price level from one period to another
48
ECO1000 Economics
ECO1000 Economics
49
9odule 7 A 9oneta%y and Fiscal policy

Lea%nin* ob4ecti$es

understand the definition of money and its functions understand the definitions of money supply explain how financial institutions create money describe the +ustralian financial system as an example of a typical financial system in the &(st century explain monetary policy and the main goal of monetary policy in +ustralia discuss how the >eserve %ank of +ustralia influences interest rates explain fiscal policy and how the government can use it to stabilise the economy explain the multiplier process understand .automatic stabilisers/ demonstrate the effects of monetary and fiscal policy using the dynamic +1-+- model
Lea%nin* %esou%ces
3e5t
!ubbard et al &'(), Economics, chapters (&, () and (A
Essential
Study book: module B
50
ECO1000 Economics
7 1 2nt%oduction
*he study of macroeconomic policy can be a frustrating experience for students 3t takes some time to understand the concepts because the operations of the economy are not easily observed and understood +t least with microeconomics, students can relate the relevant concepts to specific markets they are familiar with, such as the market for =1s, or the particular labour market in which they operate 3n addition, there is considerable disagreement about how an economy works, let alone how it should be managed, or even if it should be managed *hird, the relationships within the economy are highly interconnected, so that whenever one variable is changed to try and achieve a positive outcome there are many potential side-effects, some of which in turn, have negative consequences for the economy 0inally, macroeconomic policy, and the politics associated with it, seems to be far removed from the lives of students and working folk !owever, while micro economic factors seem to have the most immediate effects on our lives, in relation to the cost of living and our incomes, macroeconomic factors can have a great impact on us "overnments of differing persuasions and in different time periods try to achieve different things but, in liberal democratic countries, there are some generally agreed policy goals *hese include:

keeping inflation down keeping the growth rate up keeping unemployment down keeping the economy stable, so growth is relatively steady, rather than fluctuating wildly encouraging an increase in net exports 5exports < imports6
3n addition to all that, some governments also want to:

assist the disadvantaged or, in some cases, to try and ensure a more equal distribution of income andKor wealth maximise economic freedom within the economy 5a political principle6 provide opportunities for people to participate in the market economy
+s might be observed, many of these goals are potentially contradictory, and the pursuit of one can compromise another 3n this module, we focus on the main types of macroeconomic policy: monetary and fiscal policy +lthough we will treat them separately, we need to note that they both operate at the same time, although with different emphases ,e need to note, also, that there is considerable debate among economists about how the macroeconomy works and what are the best policy settings for the purpose of achieving the policy goals
ECO1000 Economics
51
7 ( 9oney' banks and the 0ese%$e Bank of :ust%alian

3n modern economies, the financial sector, and the financial markets associated with it, provides an essential institutional structure for the operation of the economy *he financial sector includes the banking system, a number of financial markets 5such as the money market and the stock market6, and a set of policy institutions 5such as the central bank6 3t is necessary that we have a sound understanding of the nature and operation of the financial sector for our study of macroeconomic policy 7oney is any asset that people are generally willing to accept in exchange for goods and services or for payment of debts ,hether an asset can be used as money depends on whether it can fulfil the following A functions: medium of exchange, unit of account, store of value, standard of deferred payment 2conomists have developed several different definitions of the money supply *he narrowest definition of the money supply is 7(, which includes currency in circulation and demand account balances + broader definition of the money supply is (-, which includes 7(, plus all other deposits with domestic and foreign-owned banks operating in +ustralia, including certificates of deposit, term deposits, and deposits with banks from building societies, credit unions and other authorised deposit-taking institutions %road money is the widest measure of +ustralia$s money supply, and includes 7) plus deposits into non-bank deposit-taking financial institutions less holdings of currency and deposits of non-bank depository corporations such as finance companies, money market corporations and cash management funds + bank balance sheet lists a firm/s assets on the left and its liabilities and stockholders/ equity on the right >eserves and loans are assets and deposits are liabilities ,hen a commercial bank receives a deposit, it keeps a part of the funds 5say, ('O which is called reserve ratio determined by the central bank6 as reserves and loans out the remainder ,hen the loan borrower buys something with the loan, the seller will deposit the payment in a bank *he seller$s bank will keep a fraction of the deposit 5say ('O6 as reserves and loan out the remainder *he process will continue until no banks have excess reserves 3n this way, the volume of deposits is created and according to the definitions of money discussed above, money supply increases *he financial system facilitates the flow of funds from savers to borrowers *he >eserve %ank of +ustralia 5>%+6 is the central bank of +ustralia 3ts main roles are to maintain the integrity and stability of the financial system and to manage and implement monetary policy *he >%+ influences financial liquidity and interest rates through the use of open market operations
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ECO1000 Economics
-tudy chapter (& of the text 5!ubbard et al 6 7ake sure that you can:

define money and discuss its functions discuss the definitions of the money supply explain how financial institutions create money understand the role of the >%+ explain the terms .simple deposit multiplier/, .cash rate/, and .open market operations/
?%: *his is the essential set of exercises 3f you have additional time, you should practise the qui88es and tests in 7y2conlab B(( B(& +nswer >eview @uestions (-(' for chapter (& 5check your answers with those from the -tudy1esk6 +nswer ;roblems and +pplications (, &, A, B, I, H, (', ((, (A, (B, (D, (I, (H, &' for chapter (& 5check your answers with those from the -tudy1esk6
7 ) 9oneta%y policy
+s noted earlier, monetary policy is implemented by a country/s central bank and is concerned with the availability and price of money *he ma9or ob9ective of monetary policy in many countries is now seen to be the control of inflation *he actual implementation of monetary policy is a complex process, involving the monetary transmission mechanism in a country, appropriate policy choices by the monetary authorities, and the actions and reactions of consumers and firms to announced policy changes 3n this section of the module, we will examine a number of key aspects of monetary policy *he >%+ is responsible for carrying out monetary policy, which in +ustralia refers to the actions taken by the >eserve %ank of +ustralia 5>%+6 to affect interest rates to enable it to target the rate of inflation *he >%+ and the federal government have agreed that the >%+ will target an inflation rate in the range of &-)O per annum on average over the business cycle 7oney demand curve is downward sloping ,hen the interest rates fall, households and firms switch from holding interest-bearing financial assets to holding money *he interest rate is the opportunity cost of holding money ,hen the interest rates are high, firms and
ECO1000 Economics
53
households will lose if they hold too much money *herefore, they will reduce the amount of money and switch to financial assets 0actors that can cause the money demand curve to shift are real "1; and the price level +n increase in real "1; and price level will shift the money demand curve to the right 3t was believed that the central bank could be able to control the supply and availability of money !owever, these days, the money supply has become increasingly difficult to target due to financial innovation, the huge growth of credit and the growth of the private sector$s ability to affect the money supply via private bonds, securities and loans *herefore, today the >%+ has given up targeting money supply and interest rate targeting is now used *he >%+ sets the cash rate on overnight loans in the money market Other interest rates in the economy are influenced by the cash rate 5usually move in the same direction6 =hanges in interest rates affect aggregate demand through influencing consumption, investment and net exports *he +1-+- model can be used to demonstrate the effect of expansionaryKcontractionary monetary policy on the price level and real "1; +n expansionary monetary policy lowers interest rates to increase =, 3 and ?T *his causes a rightward shift of the +1 curve, leading to a higher level of price 5inflation rate6 and real "1; + contractionary monetary policy works in the opposite direction
-tudy chapter () of the text 5!ubbard et al 6 7ake sure that you can:

state the goals of monetary policy describe how the >eserve %ank of +ustralia affects interest rates understand the difference between nominal and real rates use +--+- model to show the effects of monetary policy on real "1; and the price level understand the arguments for and against the independence of the >eserve %ank of +ustralia
?%: *his is the essential set of exercises 3f you have additional time, you should practise the qui88es and tests in 7y2conlab B&( B&& +nswer >eview @uestions (-(' for chapter () 5check your answers with those from the -tudy1esk6 +nswer ;roblems and +pplications (<(', (&-&' for chapter () 5check your answers with those from the -tudy1esk6
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ECO1000 Economics
7 6 Fiscal policy
*he other ma9or type of macroeconomic policy is fiscal policy *his is the responsibility of the *reasury in most countries and is most readily seen in the design and implementation of annual budgets 0ollowing the work of Neynes, for some time it was thought that governments could use fiscal policy to maintain their employment, growth and price stability ob9ectives *his was especially so in the period immediately after the -econd ,orld ,ar 5post (HAB period6 !owever, subsequent economic experience showed that fiscal policy may not be as useful as originally thought for economic management *oday, many commentators see economic virtue in a surplus budget !ere, we will examine the nature, implementation and possible effectiveness of fiscal policy *iscretionary fiscal policy stems from Neynes/ argument that a government could increase aggregate demand in times of recession to stabilise the economy at a desirable level of economic activity *his would involve the government running a deficit budget 5spending more than it received in revenues6 =onversely, it could dampen an .overheated/ economy by reducing aggregate demand by running a budget surplus 3n an attempt to develop successful fiscal policy, economists have explored the economic impacts of deficit and surplus budgets, the role of expenditure multipliers, and the reliance on automatic stabilisers 2xpansionary fiscal policy involves increasing government purchases or decreasing taxes, while contractionary fiscal policy involves decreasing government purchases or increasing taxes *he +1-+- model can be used to demonstrate the effects of the fiscal policy on price level and real "1; *he multiplier effect amplifies the effect of an increaseKdecrease in government purchases or a cutKrise in taxes *he government purchases multiplier is the change in equilibrium real "1; divided by the change in government purchases *he tax multiplier is the change in equilibrium real "1; divided by the change in taxes *he larger the 7arginal ;ropensity to =onsume 57;=6, the larger the multiplier !owever, the multiplier effect might be offset by the crowding out effect -ince the government competes with other borrower for available savings, interest rates experience upward pressure as the government seeks to borrow funds from the financial markets *he result of this rise in interest rates may be lower consumption and business investment, which would act to offset the boost in +1 from the increased government spending *he government may go into budget deficit during economic downturn and into budget surplus during economic expansion without taking any action because of the effects of automatic stabilisers *he former is caused by a drop in government tax revenue 5eg, fewer wages and profits mean fewer tax revenues for the government6 and an increase in transfer payments 5eg, more people lose 9obs and apply for unemployment benefits6 *he latter is caused by an increase in tax revenue and a decrease in transfer payments due to the economic expansion -ome fiscal policies have long-run effects by expanding the productive capacity of the economy and increasing the rate of economic growth *hese policies can shift the long-run +- curve to the right
ECO1000 Economics
55
-tudy chapter (A of the text 5!ubbard et al 6 7ake sure that you can:

define the term .discretionary fiscal policy/ distinguish between e%pansionary and contractionary fiscal policies explain the role of the .multiplier/ in fiscal policy explain the role played by .automatic stabilisers/ in fiscal policy discuss the long-run effects of fiscal policy
?%: *his is the essential set of exercises 3f you have additional time, you should practise the qui88es and tests in 7y2conlab B)( B)& +nswer >eview @uestions (<(' for chapter (A 5check your answers with those from the -tudy1esk6 +nswer ;roblems and +pplications (<&' for chapter (A 5check your answers with those from the -tudy1esk6
Summa%y
3n this module, we have explored the important area of macroeconomic policy Our focus was on monetary and fiscal policy and the use of macroeconomic theory to explain policy choice and to predict the macroeconomic effects of that choice 1esigning and implementing macroeconomic policy is a complex task ,e should now be in a position to use available data and policy information to explain and critique contemporary macroeconomic policy *ables B ( and B & summarise the consequences of policy and monetary policy 5some points are not covered by our text, so 9ust for your interest6 which can help you to better understand the content of this module
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ECO1000 Economics
Table 5*1+ 3he policy se!uence: fiscal policy "%pansionary (loose) fiscal policy #ontractionary (tight) fiscal policy 3ncreased government spending andKor ( 1ecreased government spending andKor tax cuts tax increases & 3ncreased consumption 5more disposable & 1ecreased consumption income6 ) %usiness confidence increases ) %usiness confidence declines A 3nvestment and output increase A 3nvestment and output decrease B "1; increases 5assuming economy not B "1; decreases at full capacity6 Possible second round effects on investment (a 3ncreased demand for money, by (a 1ecreased demand for money consumers and firms &a 3nterest rates rise &a 3nterest rates fall )a ;ossible decrease in investment in )a ;ossible increase in investment in response to higher interest rates U response to lower interest rates U Aa 7ay partially offset benefits of increased Aa 7ay partially compensate for decreased consumption because investment consumption because investment increases decreases. 5works against original policy6 /low on effects related to the overseas sector (b 7oney flows in to the country to take (b 7oney flows out of the country to take advantage of higher interest rates advantage of higher interest rates &b 1emand for domestic currency increases &b 1emand for domestic currency decreases )b 2xchange rate increases )b 2xchange rate decreases Ab Ealue of goods and services sold on Ab Ealue of goods and services sold on overseas markets increases overseas markets decreases Bb *otal quantity of exports sold declines Bb *otal quantity of exports sold increases Cb Ealue of overseas goods decreases for Cb Ealue of overseas goods increases for domestic buyers domestic buyers Db =onsumption of imported goods Db =onsumption of imported goods increases decreases Ib ?et exports declines because of decrease Ib ?et exports increase because of decrease in exports and increase in imports in exports and increase in imports *his leads to a further potential drop in *his leads to a potential increase in expenditure 5,orks against original policy6 expenditure which may offset the cut in spending ( U V
?ote that investment is an inverse function of the rate of interest *hat is, if the interest rate is high, households and businesses would prefer not to invest *his is because households and businesses find that borrowing for investment purposes is relatively costly *here is much debate about this second round effect Neynesians 5see +ppendix B (6 do not believe that firms are so responsive to changes in interest rates *herefore, investment will not decrease that much On the other hand, monetarists and other free market economists, tend to believe that there will be a drop in investment *his is known as the crowding out effect *he government .crowds out/ the private sector, by undertaking activity that raises interest rates, thereby pushing aside investment by the private sector
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,ith regard to international 5overseas6 effects, it is argued that smaller, open economies, such as the +ustralian and ?ew Wealand ones, are highly sensitive to overseas responses to their domestic policies 5because of a high reliance on overseas investment and on income from exports6 3n addition, currency traders engage in speculation; they may not always respond according to this theory *hey try to anticipate and even influence government policy "overnments of these countries are very concerned about what international investors think about the prospects for those countries 3n a sense, as globalisation increases, governments lose some of their capacity to make independent policy *his is part of the reason why fiscal policy has fallen out of favour *he expectation is that governments will keep a tight rein on their spending On the other hand, monetary policy works on some of the same aspects of the economy, but in a different way *his is shown in table B & Table 5*#+ 3he policy se!uence: moneta%y policy "%pansionary (loose) monetary policy #ontractionary (tight) monetary policy ( =entral bank buys securities from trading ( =entral %ank sells securities banks and financial intermediaries & 0inancial institutions can lend money & 0inancial institutions increase the cost of more cheaply, 5lower interest rates6 borrowing 5higher interest rates6 ) =onsumption increases ) =onsumption decreases A 3nvestment and output increase A 3nvestment and output decrease B "1; increases 5assuming economy not B "1; decreases unless it was at full at full capacity6 capacity "ffects related to the overseas sector (b 0inancial capital flows out of the country (b 0inancial capital flows into the country in response to relatively higher interest to take advantage of higher interest rates rates overseas &b 1emand for domestic currency decreases &b 1emand for domestic currency increases )b 2xchange rate decreases )b 2xchange rate increases Ab Ealue of goods and services sold on Ab Ealue of goods and services sold on overseas markets decreases overseas markets increases Bb *otal quantity of exports sold increases Bb *otal quantity of exports sold decreases Cb Ealue of overseas goods increases for Cb Ealue of overseas goods decreases for domestic buyers domestic buyers Db =onsumption of imported goods Db =onsumption of imported goods decreases increases Ib ?et exports increases because of relative Ib ?et exports decrease because of decrease increase in exports and decrease in in exports and increase in imports imports *his leads to a further potential increase in *his leads to a potential decrease in expenditure 5works with original policy6 expenditure 5works with original policy6
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ECO1000 Economics
:ou can see from this how governments must try to anticipate the possible outcomes *here are many variables, and responses will often depend on the situation 3n general, the theory and recent practice favours monetary policy !owever, there are political pressures for governments to spend money, though not always 9ust to influence the state of the economy *ax cuts are thought to be a popular policy, so there is always pressure for some stimulation
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:ppendi5 7 1 ?optional %eadin*' and not e5aminable@

Epilo*ue: b%ief %e$iew of selected schools of thou*ht in economics
3t has become apparent as we have progressed through the course that economists disagree about both theory and policy prescriptions 2ssentially, it is argued that they disagree because:
at the most fundamental level, they disagree about the assumptions in economic models, including what motivates people and how economies work 3n other words, they disagree about what is really going on and, if you start with a different set of assumptions, then you are bound to finish with different conclusions about what .should be done/ like all of us, economists/ views of the world and advocacy for certain courses of action are influenced by their fundamental values 0or example, someone who strongly believes in economic equity is going to have greater reservations about a market system, than someone who strongly believes in the principle of individual freedom
7uch of this course has been taught as if there is not too much disagreement about economic theories and it is fair to say that much of what has been taught is considered mainstream economics !owever, the reason for having limited discussion of the key debates in economics is not so much a commitment to the mainstream, as a problem of time and teaching restrictions 3n a relatively short course, the idea is to teach some ma9or principles and models from economics; there is little time to critique them *he .opportunity cost/ of trying to cover so many basic economic concepts is the incapacity to delve into the ma9or economic debates ?onetheless, in this epilogue to the course, we do consider an area where there are some important debates going on *o better understand the origins of these debates, it is necessary to consider the diversity of opinion within economics *he development of the economics discipline has been illuminated by the publication of great and lasting works such as +dam -mith/s, &ealth of 'ations 5(DDC6, Narl 7arx/s, Capital 5(IID6, +lfred 7arshall/s, (rinciples of Economics 5(IH'6, Sohn 7aynard Neynes/, Theor" of $nterest# Emplo"ment and %one" 5(H)D6 and ;aul -amuelson/s, )oundations of Economic Anal"sis 5(HAD6 *he ideas in texts such as these, and the results of new investigations, have led to the development of a diverse range of schools of thought in economics *hese include the: =lassical, 7arxian, ?eoclassical, Neynesian, ;ost-Neynesian, 3nstitutional and >adical schools +ttempts to explain the operation of economies in the &(st century and to find ways of achieving countries/ economic ob9ectives draw on one or more of these schools of thought 2conomic policy often reflects the temporary dominance of one of these schools; for example, the drive for microeconomic reform in +ustralia is a reflection of the neo-=lassical teaching that a free market system is more efficient than a highly regulated economy !owever, it is possible to see that modern economics is also heavily influenced by the ideas of the classical economists
3he classical economists
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ECO1000 Economics
#lassical economics was a school of thought that emerged in ,estern 2urope, especially %ritain, in the late (C''s, and was influential until late in the (I''s *he classical economists are considered the immediate forerunners of modern economics because they focused on the outcomes from the sum of individual decisions, rather than thinking only about the actions of the rulers of nations *he classical economists included +dam -mith 5(D&)<(DH'6, 1avid >icardo 5(DD&<(I&)6 and Sohn -tuart 7ill 5(I'C<(ID)6 *he ideas of the classical economists now seem very orthodox, but they were radical at the time 0rom that era, key ideas included:

-mith/s notion of the role of specialisation in driving economic growth >icardo/s analysis of comparative advantage and the consequent advantage of free trade 7ill/s argument for the need for a high degree of individual freedom, both for economic and moral reasons
*he classical economists saw the economy as a system that could largely operate effectively without the need for much government intervention 0reedom in the market place was efficient and desirable -ome of the classical economists were rather gloomy about the longterm prospects for growth; indeed some predicted an eventual steady state 5no growth6 !owever, they generally thought that even if this were the case, there was little a government could do to improve the situation 7arkets could not really be managed
9a%5ian economics
;erhaps the most radical challenge to =lassical economics was from Narl 7arx 5(I(I<(II)6 ,hile 7arx/s work is well out of the .mainstream/ now, his political and economic thought had a ma9or impact on economic development throughout much of the world in the &'th century .*he history of all hitherto existing society is the history of class struggles/ *hus wrote Narl 7arx in the Communist %anifesto 5(III6 < a small polemical work that reflected the essence of his understanding of the capitalist economy of the time and his prediction of its violent replacement by communism, according to the operation of the forces of history 7arx offers an alternative explanation of how the capitalist system works as well as being a formidable critic of the political economy of the classical school 1espite his failure to predict the nature of mature capitalist economies and despite the recent collapse of many communist economies, it is important that we give serious consideration to his teaching < his doctrine has been a powerful force in world history and still influences economic, political and social thought and action 7arx presents his understanding and re9ection of the economics of the classical school in his famous work, Capital 5first 2nglish edition published in (IID6 ,hile he builds on the work of economists such as -mith and >icardo, he re9ects their system with its acceptance of profit 0or 7arx, all is flux and motion and the categories of political economy 5such as exchange6, can be seen in the sequence of affirmation 5thesis6, negation 5antithesis6 and negation of negation 5synthesis6, a pattern which, for 7arx, reflected the universal law of motion or history *hat is, there is inevitable change to social and economic systems
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*he mode of production in society provides the driving force of .dialectic/ and, therefore, the basis for explaining the history of society 3ndeed, the material conditions of life 5the production system6 determine all aspects of life < social, economic and religious +s 7arx notes, .the hand mill gives you society with the feudal land; the steam mill society with the industrial capitalist/ 1ialectical materialism/ comes to light as a linking of the dialectic sequence and the mode of production =ontradictions 5negations of the thesis6 in this mode, such as those visible in class conflict, bring about a new society 5synthesis6 via revolution and the sweeping away of the old modes and their social and political superstructures 7arx explained capitalism as a system of capital accumulation based on the generation of profit from the employment of labour by the resource owner 5capitalist6 0or 7arx, the capitalist system was one of exploitation whereby those who generated the surplus value did not retain it *he emergence of contradiction in the system would lead eventually, via the operation of the dialectic process, to its overthrow and replacement by communism 3n the capitalist mode of production, the capitalist hires labour power 5the ability to work for a given number of hours6 and pays for it at a value given by the hours of labour 5labour time6 needed to provide the sustenance of that labour power 0or example, a capitalist might hire ten hours of labour power for the output produced by six hours of labour 3n doing so, she gains a surplus value of the output from four hours of labour < this is the source of the capitalist/s profit !ere is one of the many contradictions of capitalism noted by 7arx *he employer pays .correct/ value for the labour power, yet .cheats/ the worker by retaining the extra four hours/ output < the system is one of .cheating/ and .not cheating/ +nother contradiction lies in the capitalist/s desire to raise productivity 5through new technology6 *his has the effect of reducing labour requirements, thereby reducing surplus value *o counter this, the capitalist will seek to lengthen the working day *hus, capitalism is a system characterised by a restless struggle for profit *his, according to 7arx, inevitably leads to competition, unemployment and poverty =apitalism contains within itself the seeds of its own destruction 7arx provides a very different explanation of the operation of capitalism to that presented in the text *he scope of this work goes far beyond economics but has economic conditions as the driving force in the history of society ,hile drawing on earlier economists/ ideas, 7arx breaks completely from them and presents a radical account of society 7arx/s work, or at least various interpretations of it, was to be adopted in much of 2astern 2urope, =hina and some countries in -outh 2ast +sia !is ideas now appear to be falling into the .dustbin of history/, but they were influential
.eo8classical economics
0eo classical economics is the basis for the microeconomics you studied earlier in the course 3n the late (Hth century, ,illiam Sevons, =arl 7enger, #eon ,alras and +lfred 7arshall independently developed ideas relating to the role of marginal utility in economic activity *he classical economists had generally assumed that the price of goods was set by the cost of labour !owever, the neo-classical economists set the case for the price being the result of the interaction of supply and demand, with those in turn determined by marginal utility and the marginal cost of production 2ffectively they developed modern market theory
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ECO1000 Economics
*he neo-classical economists retained many of the underlying assumptions of the classical era; the emerging orthodox microeconomics was based on the following:
the individual is the .building block/ of the community and governments *he latter may impinge .too much/ on the freedom of the individual in the interests of some idea of .the common good/ people are basically rational and will generally act to maximise their own .happiness/ *herefore, governments that limit individual autonomy should be viewed as inefficient, paternalistic and, for some, .immoral/ individuals acting in a market, from motives of self-interest, will produce .progress/, as denoted by increased material comfort and consumer goods +ttempts to control or regulate such individual initiative will tend to lower economic welfare
*he key neoclassical tools of analysis include the familiar supply and demand curves and the development of sophisticated econometric models based on the assumption of the maximisation of utility 3t took some time for neo-classical thinking to dominate the mainstream; indeed, for much the &'th century, prescriptions for no government intervention were largely ignored 3n addition, in the mid &'th century, there was an increased interest in macroeconomic management
3he Ceynesian %e$olution

1ohn (aynard 2eynes 5(II)<(HAC6 revolutionised economics !e graduated in mathematics and then studied economics and philosophy Neynes was both a theoretical and applied economist !e served in the %ritish *reasury during both ,orld ,ars and wrote one of the most famous of economics books, The !eneral Theor" of Emplo"ment# $nterest and %one", commonly known as The !eneral Theor" +s we have seen, Neynes challenged some of the key assumptions of the classical school of economics *he classical economists believed that in a .trade cycle/ 5an early version of the business cycle, as it was called at the time6, wages and interest would fall and rise with the cycle 3n a downturn, once they both fell low enough, businesses would become profitable again and there would be an expansion or upturn *he solution to a downturn, therefore, was to cut wages >emember, the early part of this century saw the rise of trades unions, and the classical economists believed that the best policy was to persuade the unions to accept a wage cut Neynes argued that if there was a general cut in wages, consumption would drop and this could have a further negative impact on the economy +s we have noted, the ideas of Neynes have been strongly attacked in recent years
3he %e$i$al of neo8classical economics

1uring the later half of the &'th century, following the expansion in democratic demands, two world wars and a ma9or depression, governments tended to adopt a more interventionist line Neynesian analysis, or a version of it, was adopted as the basis for macroeconomic management by many post-war governments
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!owever, with the social unrest of the (HC's and the stagflation of the (HD's, interventionist policies were seen to have .failed/ *he welfare state did not deliver universal prosperity "overnments sought .new ideas, and found an old one that would allow them to say .no/ to what seemed an endless list of demands +nti-interventionist ideas were, at first, promoted in the J-+ and the JN by privately run think tanks/ #ater, these ideas filtered into the mainstream media and academia and in the early to mid<(HI's, some governments started to adopt more market orientated policies, including:
*he privati8ations of government enterprises, such as airlines and telephone companies, in order to try and make those sectors more efficient 5the assumption being that government enterprises are protected from market forces and are therefore inefficient6 -ervices to government were .contracted out/ so the provider became part of the private sector Jsers of public goods, such as tertiary students and visitors to national parks, were asked to pay for at least some of the presumed private benefits *he labour market started to become more .flexible/ so demand for labour would supposedly match supply 5wages, and the associated hiring costs, were reduced by way of workplace .reform/6 3ariffs were scaled down, so that domestic industries become more internationally competitive 5according to the rationalists, this would increase trade and, thereby, increase overall welfare6 !ndustry assistance measures were cut ,elfare was reduced ;olicies to encourage competition in markets were introduced
Once again, .mainstream/ of economics was back to the market focus, including the importance of markets within macroeconomic policy
0adical political economy

,hile (ar%ian economics has tended to lose its influence, the ideas from 7arx have influenced the later >adical -chool, in which it/s .members/ continue the critique of capitalism and of mainstream economics +ccording to -tilwell 5(HII, pp (C<(D6 the mainstream approach is inadequate because of the:

rude positivistic methodology of positive economics excessive emphasis on the exchange relationship and on resource allocation at the expense of production relationships and resource creation activities use of .>estrictive +xioms/ < the analysis leads to a .distorted view of economic behaviour/ ideological bias of market theory leading to neglect of .command and coercion/ as important aspects of economic activity < harmonious market outcomes are unrealistic flawed theory < for example, in the treatment of capital failure of welfare economics to link neoclassical economics and policy advice poor analysis of the -tate and its role in the economy
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ECO1000 Economics
4adical political economy emphasises a number of aspects not included in neoclassical theory *hese include:
a conception of class that encompasses not 9ust the distribution of .property claims/ but also the effects of resource ownership on the production process, technology choice and the operation of labour markets < the power of capital is widespread labour market analysis that, reflecting the power of capital, suggests that markets do not clear and that the function of unemployment is to support positive profit rates the inefficiency of .profit-maximising/ technical choice the importance of social relationships, rather than mere contractual relationships, for the operation of the economy the treatment of a range of economic phenomena as endogenous rather than exogenous 5e g preferences6 the tendency for .uneven development/ based on .structurally determined inequalities/ in the economy 5e g access to credit6 the role of social institutions in influencing, and being influenced by, economic activity
:ou do not need to know about radical political economy for assessment purposes, but the information is here to remind you that the economics you learn about in this course is sub9ect to considerable debate
/ost8Ceynesian economics
*extbook discussions of the debate within the discipline of economics often characterise macroeconomics as comprising two extremes, namely 2eynesianism and (onetarism *his was the division underlying the discussion in the latter part of our text -ome groups of economists have attempted to synthesise the extremes into a general framework within which arguments can, in principle, be resolved by reference to empirical research !owever, other groups of economists have re9ected this approach One such group is the post 2eynesians who assert that most of the richness of S 7 Neynes/s original insights into the working of a capitalist economy is completely lost in the synthesis 5combining neo-classical and Neynesian ideas6 ;ost Neynesians have set themselves the task of developing a body of theory that builds upon the fundamental insights of Neynes and some of his contemporaries Neynes argued that economic theory should recognise the reality of monetary exchange, the importance of which can be explained fairly simply ,here there is no money to act as a medium of exchange, a seller of an article must find someone who is willing to give in exchange some other article which the seller wishes to acquire *his is the so-called double coincidence of wants Once a medium of exchange is introduced, the single transaction of barter is decomposed into two separate .legs/ 5sale and purchase6 which may be separated in historical time *his provides scope for a high degree of specialisation in production of goods and services which serves to accentuate transaction .legs/
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;ost Neynesians believe that a key to understanding modern economies is to recognise the importance of historical time 3n a modern economy, incomes in the forms of wages, interest, and rent are paid by firms at the time their specialised output is produced !owever, sales revenues 5and profits6 accrue to firms only when finished products are actually sold *herefore, firms require finance in order to produce goods that will be sold in the future, with sales proceeds being used to extinguish debt 5or restore retained earnings where firms self-finance their production6 *his aspect of modern economics is ignored in orthodox economics 0irms cannot get by without finance *herefore, banks are an important focus of post Neynesian economics ;ost 2eynesians argue that modern banks can make loans in aggregate before they have deposits to back up those loans 5for example, banks can borrow money on the short term money market, or from overseas or, as a last resort, from central banks6 *his means that it is banks that determine the upper limit on the volume of finance available to firms 3f banks are pessimistic about the future, then that upper limit will be so low that firms cannot obtain all the finance they require *his will lead to recession ;ost 2eynesians believe that it is important to emphasise the role that banks play in determining the volume of finance available "overnment policy has no or little direct effect on bank lending, so the money supply must be regarded as being endogenous *his stands in sharp contrast to the assumption of .erogeneity/ that is made by both the Neynesians and monetarists discussed in most textbooks ;ost Neynesians believe that most prices are set by oligopolistic firms who use a .costs plus mark-up/ rule which is modified to some extent in industries where there is a degree of competition *hey believe that money wages are set by a process of negotiation between workers and bosses with each group trying to secure a growing share of the economy/s total income +ny inconsistency between share claims results in inflation which, of course, imposes ad9ustments in real wages and real profits such that they sum up to real national income 3t is noteworthy that the processes of setting prices and wages are resource-consuming activities and take time *herefore, post-Neynesians believe that both prices and wages are .sticky/ *his is quite the opposite to the assumption of instantaneous ad9ustment of prices and money wages that is universal among monetarist, classical and neo classical economists ;ost Neynesian economics has been developing quietly for over B' years now and represents a radical departure from orthodox economics ;erhaps because of this, it has not become established as mainstream !owever, interest is growing and, even in +ustralia, conferences on post Neynesian economics are held regularly
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ECO1000 Economics

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ECO1000 Economics

Faculty of Business and Law

1 ( 3hinkin* like an economist

1 ) #sin* *%aphs in economics 1 6 /%oduction economics

Module # $ow the mar%et wor%s

( 1 2nt%oduction ( ( 3ools of analysis: demand

( ) 3ools of analysis: supply

( 6 3ools of analysis: ma%ket e!uilib%ium ( 7 Elasticity

( , Economic efficiency and ma%ket failu%e

Module 3 &irms and mar%et stru"ture

) < 9onopoly ma%kets

Module 4 Ma"roe"onomi" &oundations

6 1 2nt%oduction 6 ( =1/ measu%es total p%oduction

6 ) #nemployment and inflation

6 6 3he business cycle 6 7 :**%e*ate demand and a**%e*ate supply Summa%y

Module 5 Monetary and &is"al )oli"y

9odule 1 A 2nt%oduction to economics

University of Southern Queensland

1 1 1 3he economic way of thinkin*

University of Southern Queensland

1 1 ( 3he lan*ua*e of economics

1 ( 3hinkin* like an economist

1 ) #sin* *%aphs in economics

University of Southern Queensland

University of Southern Queensland

/%oduction possibilities f%ontie% ?//F@

Specialisation and the *ains f%om t%ade

University of Southern Queensland

3he ma%ket system

University of Southern Queensland

University of Southern Queensland

9odule ( A Bow the ma%ket wo%ks

University of Southern Queensland

( ( 3ools of analysis: demand

( ( ( 3he demand cu%$e

University of Southern Queensland

&i,ure #*#+ 3he ma%ket demand fo% hambu%*e%s

( ( ) 3he downwa%d8slopin* demand cu%$e

( ( 6 9o$ements alon* and shifts of the demand cu%$e

University of Southern Queensland

( ( 7 0easons fo% the demand cu%$e to shift

( ) 3ools of analysis: supply

University of Southern Queensland

( ) ( : sin*le fi%m;s supply

University of Southern Queensland

University of Southern Queensland

( ) 6 9o$ements alon* and shifts of the supply cu%$e

( ) 7 0easons fo% the supply cu%$e to shift

( 6 3ools of analysis: ma%ket e!uilib%ium

University of Southern Queensland

*his can be shown on an appropriate graph &i,ure #*5+

University of Southern Queensland

( 7 ( 3he concept of elasticity

( 7 ) /%ice elasticity of demand

( 7 6 C%oss8p%ice elasticity of demand

( 7 7 2ncome elasticity of demand

University of Southern Queensland

( 7 , /%ice elasticity of supply

University of Southern Queensland

( , Economic efficiency and ma%ket failu%e

( , 1 Consume% and p%oduce% su%plus and economic efficiency

University of Southern Queensland

( , ( /%ice floo%s and p%ice ceilin*s

1 1 ( 3he lanuae of economics

&i,ure ##+ 3he ma%ket demand fo% hambu%e%s

his can be shown on an appropriate graph &i,ure #5+

) < ( Economic efficiency and o$e%nment %eulation in monopoly ma%ket