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1. WHAT IS ECONOMICS ABOUT?

Opportunity Cost

Opportunity cost is the alternative want that we have to forgo when we satisfy another want.
Note: This is not the monetary value of that want but the actual want
Individuals: individual consumers have limited resources (limited income) and example may
be that she has to choose between a holiday and a car. If she choose the car, her opportunity
cost is the overseas travel she had to forgo.
Businesses: businesses make choices when allocating scarce resources. The opportunity
cost of using particular resources to produce shoes is the alternative option of using those
resources to make furniture.
Government: the government has limited resources to satisfy community wants. If the
government allocates resources to build a new motorway, the opportunity cost may be the
construction of a new hospital.

The Production Possibility Frontier

A production possibility frontier is a curve depicting the maximum output possibilities for two
goods or services, assuming that all resources are used efficiently, the quantity of resources
remains constant and the state of technology is unchanged.

All points on the frontier itself (A, B & C) respresent points at which resources are fully
employed and the economy is operating at full productive capacity.
A point inside the curve (X) signifies that resources are unemployed and the economy is
producing less than its maximum possible output.
Point Y cannot be attained with the given input. An outward shift of the PPF signifies that a
higher quantity of goods are produced. This can occur with the application of new
technology; this may lead to more efficient methods of production, leading to an increase in
output using the same resources. The increase in inputs available for production, such
as the discovery of new resources, the expansion of the population through immigration,
leading to an increase in the number of people available for work.
The PPF would be drawn concave to the origin in real life as it is unlikely that there will be no
loss of productive capacity as resources are moved from the production product A to product
B (as a straight line PPF suggests that the opportunity cost of producing product A over
product B is constant).

Economic Factors Underlying Choices

Individuals: Individuals must make a choice about how much of their income to spend and
how much to save. Individuals may choose to spend more if they are confident about the

future and the future of the economy. Personality factors such as an individuals willingness
to embrace risk or prefer security will also influence economic choices. People receiving
unemployment benefits may be reluctant to work as they may be worse off financially if
they do since there are expenses associated with working (eg. Travel, clothing) and they may
lose privileges associated with unemployment benefits. The decision to undertake education
is to be reward with a higher income and a more satisfying job. However, the opportunity cost
is the foregone income. Individuals choices are influenced by economic considerations when
voting in elections economic policy issues were the major priorities in government
programs and electoral campaigns, and sound economic performance by a government would
ensure its political success.
Businesses: Businesses seek to maximise profits but minimise costs, so may choose the
highest price to ensure that profit is maximized but the level of sales will not be greatly
affected when pricing products. Businesses may decide to increase the price of a product
when there is an increasing demand but reduce the price when there is lower demand. The
level of production is also influenced; when there is low demand, the business will likely
reduce production and expand production in a booming economy. The pricing decisions are
also based on their marketing strategy whether the product is aimed at a mass market or an
exclusive group of consumers. Production levels will determine resource use, as will the
relative price of resources. For example, lower production levels will lead to reduced use of
resources. Also, if the price of labour increases relative to the price of capital equipment,
fewer labour resources will be used. Ethical issues may be considered, eg. A business
deciding on whether it should pay a higher cost for recycled paper rather than non-recycled
paper. Businesses also decide how to manage industrial relations issues, eg. In times of high
unemployment, the relative bargaining position of employers will improve in relation to that
of workers; employers will be less inclined to grant larger wage increases and accommodate
the demands of unions and workers.
Government: Governments can make it less or more expensive to make certain choices, eg.
Taxing cigarettes heavily to discourage smoking. Governments can also influence economic
behavior by prohibiting certain activities and imposing heavy penalties on those who break
the law, eg. Businesses operating in the same industry are prohibited from meeting together
and setting prices for their industry because this would harm the interests of consumers.
Governments may desire to encourage certain economic activities by providing incentives,
eg. To encourage individuals to join a private health insurance scheme, the government
provides tax rebate to low and middle income earners for private health insurance payments
and imposes tax penalty on high income earners who do not take out private health
insurance. Another example is when the government wants to encourage individual and
business spending, RBA may adopt a policy of lowering interest rates and the government
may increase its spending.

2. HOW ECONOMIES OPERATE


The Production of Goods and Services
Factor of Production (Resource)
Natural Resources
Labour
Capital
Enterprise

Reward
Rent
Wages
Interest
Profit

A factor of production is any resource that can be used in the production of goods and
services, ie. A resource.

Natural Resources: all the resources provided by nature that are used in the production
process. Includes soil, water, forests, mineral deposits and fishing areas. The reward to
owners (individuals) of natural resources is called rent. Rent covers all the income rewards
from the productive use of natural resources.
Labour: Labour is human effort, both physical and mental, used to produce goods and
services. The size of a countrys population determines how much labour is available. Factors
that influence the availability and quality of labour resources is school leaving age, social
attitudes towards women in the workforce, amount of on-the-job training, retirement age,
educational standards and availability of childcare. Wages are the reward to owners of labour
(workers).
Capital: the produced means for production capital goods are produced to be used in the
production of other goods and services and are not used for immediate consumption. This
includes machinery, tools, factories and computers. These types of capital goods are
generally owned privately by individuals or firms. Infrastructure is another form of capital that
is owned by the community as a whole. Capital equipment can increase the level of
production from the existing workforce and natural resources, enabling the satisfaction of
more wants. When entrepreneurs borrow money that has been stored in a bank as savings by
consumers to invest in capital goods, they pay interest. The owners of capital are reward by
earning interest.
Enterprise: enterprise involves organizing all the other factors of production for the purpose
of producing goods and services. It brings the production process together.
Each of the four resources are limited: the amount of natural resources are finite (land,
fossil fuels); supply of labour is limited due to population size, labour market skills, and
willingness to work; capital is limited by the extent to which the private sector and
governments are willing to invest, as well as the level of domestic (or overseas) savings
available for investment; supply of entrepreneurial skills are limited by the population size
and individuals willingness and ability to innovate and embrace risk.

The Distribution and Exchange of Goods and Services

The Gross Domestic Product (GDP) is the total market value of all final goods and services
produced in an economy over a period of time.

Market Economies
Provide people with income as a reward for their contribution to the production process.
The price that is paid for inputs depend on how scarce or highly demanded their resources
are, eg. Labour of a highly skilled manager involves a larger sum of money as sophisticated
management skills are in high demand and scarce supply.
Market economies do not attempt to distribute output equally within society.
Workers will not receive the same level of wages as income received is dependent on how
much they work, educational qualifications, skills and expertise, and bargaining power in
wage negotiations with employers.
Benefits of this distribution: unfair for people who are unable to contribute to the production
(ill, disabled, age) and those with less bargaining power
Government intervention to equitably distribute income and goods and services: taking
money from higher income earners through taxation and redistributing it to lower income
earners through social welfare payments.
The Business Cycle

The business cycle refers to fluctuations in economic activity due to either domestic or
international factors.

A cyclical pattern that an economy usually experiences: period of strong growth economic
slowdown economy stay weak faster level of economic growth peak etc.

During economic downturns, known as recessions, business postpone plans for investment,
reduce their production and their demand for labour. This leads to unemployment.
As those who are unemployed will decrease their consumption, the economy can contract
further, leading to more people being put out of work. Rise in unemployment leads to higher
poverty. As living standards fall, increasing health problems arise, educational opportunities
are disrupted, and social issues such as crime and suicide can occur. This leads to a lower
quality of life.
During an economic upturn or a boom in economic growth, there is increased investment and
production. This leads increased demand for labour, resulting in a fall in unemployment
levels. So most consumers will have a higher disposable income (gross income taxation),
leading to increasing consumption levels which in turn results in the further expansion of the
economy. Poverty levels fall, so there is a higher quality of life.

IMPACTS OF THE BUSINESS CYCLE


Recession
Falling production levels of goods and services
Rising unemployment
Falling income levels
Falling consumption levels and investment
Falling quality of life
The Circular Flow of Income

Boom
Increasing production levels of goods and
services
Falling unemployment
Rising income levels
Rising consumption levels and investment
Rising quality of life

Savings represents a leakage as it involves money that is put aside and withdrawn from the
circular flow of income. The leakage of savings fall in expenditure on goods and services
fall in production decreasing demand for resources fall in income to owners of those
resources rising unemployment. This cycle is counteracted by the injection of investment.
Savings are essential for investment to occur. Investment in capital goods means that firms
have to make a capital expenditure now in order to gain profits in the future from the output
the capital goods will help produce. Investment increase demand for capital goods rise
in production levels in the firms that produce those capital goods increase demand for
resources increase in incomes of the owners of those resources rising employment
etc.
Individuals, businesses and financial institutions make up the private sector in the economy.
The government imposes taxes on individuals and businesses and uses this tax revenue to
undertake government expenditures.
Taxation is a leakage as individuals will have less money to spend on goods and services and
businesses will have reduced funds available to pay for resources.
Government expenditure is an injection as when the government spends money on
collective goods and services, it provides income to government employees and the
employees of private businesses from which it purchases goods and services from. Also, the
government uses part of the tax revenue for transfer payment/social welfare payments.
The government sector represents the public sector. Both the public sector and the private
sector together make up the domestic sector in the economy.
Imports are goods and services that are produced overseas but sold in Australia. Payments
for imports are leakages as money is withdrawn from the Australian economy is paid to
businesses overseas.
Exports are goods and services that are produced in Australia but sold to overseas
customers. Payments for exports are injections as money is paid to Australia businesses from
overseas consumers.

Equilibrium

Leakages = Injections
Savings + Taxation + Imports = Investment + Government expenditure + Exports
S+T+M=I+G+X

Disequilibrium

When total leakages are greater than total injections, there will be an economic downturn. As
economic activity falls, the total leakages will also fall as individuals will have less income to
save, pay tax and spend on imports. Therefore, leakages will eventually equal injections, but
at a lower level of income in the circular flow.
When total injections are greater than total leakages, there will be an economic upturn. As the
level of economic activity increases, the total leakages also increase as consumers have more
income to invest, to have collected as taxes (and be used for government expenditure), and
spend on imports. Therefore, leakages will eventually equal injections, but at a high level of
income in the circular flow.
The government has great influence on the circular flow as it can alter its contribution to
leakages (changes to taxation) and injections (levels of government expenditure).

3. HOW ECONOMIES DIFFER


The Market Economy

Most economic resources are owned by the private sector and people are able to seek wealth
without the government intervening

A product market is a market for outputs for production, i.e. goods and services. In a market

economy, price mechanism brings supply and demand to determine the market price at
which goods and services are sold, and the quantity produced. Changes in demand and
supply in the product market will also influence supply and demand in the factor market,
which is the market for factors of production. Eg. If there is an increased consumer demand
for sunglasses, then producers will need more factors of production (inputs including plastic,
lens, etc.) in order to increase supply of sunglasses. Thus the manufacturer will increase the
prices of factors of production in order to attract these resources away from other areas of
production. So price mechanism influences the way resources are allocated in an economy.
Private ownership of property: individuals have the right to own the means of production
(resources) and can use these to derive income and wealth. They have the right to sell their
property and transfer ownership to someone else.
Consumer sovereignty plays a major role in a market economy; businesses will produce
whatever goods and services are in demand, so consumers determine what is produced and
the quantity of production.
Freedom of enterprise individuals have the right to use their resources as they choose, so
entrepreneurs can choose what goods and services to produce and how they will undertake
production. Workers are free to choose their occupation and whether they work or not.
Competition the pressure on business firms in a market economy to lower prices or increase
the quality of outputs in order to increase sales of goods and services to consumers.

Centrally-Planned/Command Economy

Government determines what, how, and for whom goods and services are produced.

Australia as a Mixed Economy

Some necessary goods and services may not be provided under a free market system, so the
government provides those goods that are beneficial to the whole community as the private
sector will often not provide collective goods and services.

It is sometimes better for certain goods and services to be provided by the government rather
than being privately owned. Eg. For reasons of security, it is safe for the defence force to be
managed by the government rather than private armies.
Markets do not always operate competitively and in the best interests of the economy as a
whole. So the government provides regulations to prevent producers from exploiting
consumers with misleading information or by agreeing to raise prices. The government can
also prohibit certain illegal products (eg. Illicit drugs) to ensure adequate safety standards.
The government also intervenes in the distribution of output (income) through making social
welfare payments to those who do not contribute to the production process. The
government also uses a progressive income tax system that works in that high-income
earners pay proportionately more tax than low-income earns, leading to a more equitable
sharing of produced output.

4. CONSUMERS IN THE MARKET ECONOMY


Consumer Sovereignty

Demand is high relative to supply, prices will rise as consumers compete for limited stock.
Consumer sovereignty is not absolute as advertising and direct marketing can manipulate the
behavior of consumers markets conduct extensive research into wants, interests, desires
and fears of consumers and use this as the basis for mass marketing and direct marketing.
Misleading or deceptive conduct so that consumers are deceived by false or dishonest claims
about a product can lead them to pay for items that they do not really want to buy, eg.
Weight-loss programs. Planned obsolescence may diminish consumer sovereignty as firms
sometimes produce goods that are designed to wear out quickly, encouraging future
purchases, eg. Electric goods. Also, by emphasizing the importance of keeping up to the
latest fashions and recent products, firms can manipulate consumers to purchase a product
more often than they would otherwise, eg. People purchasing the latest Iphones. Anticompetitive behavior involves operating in markets where there are few other sellers which
may diminish the ability of consumers to purchase what they really want, eg. Electronic
devices may be designed so that only the companys brand of accessories are compatible
(Microsoft Word is not compatible on Apple products).

Decisions to Spend or Save

After receiving their income and paying tax, consumers either spend or save their disposable
income.
Y=C+S
Y = disposable (after tax) income
C = consumption expenditure
S = Savings
Average
propensity to consume (APC) is the proportion of total income that is spent on
consumption.
Average propensity to save (APS) is the proportion of the total income that is not spent, but
save for future consumption.

APC =

C
Y

APS =

S
Y

As income rise, people tend to save a higher proportion of their income, i.e. APS rises, but
APC falls. Consumption will tend to rise as income rises, but income will still grow faster than
their consumption levels, which is why APC falls. Savings just increase relative to
consumption.
Marginal propensity to consume (MPC) is the proportion of each extra dollar of income that
goes to consumption.
Marginal propensity to save (MPS) is the proportion of each extra dollar of income that is
saved.

MPC =

C
Y

MPS =

S
Y

As income rises, MPC falls but MPS rises.

Age

Young people tend to have lower levels of income because they lack skills, experience and
education. They tend to spend most of their income and save very little they often tend to
dis-save or borrow to finance their eduation.
Once people start working, especially middle age, they would tend to save more and
consume a smaller proportion of their income as they are accumulate assets for retirement.
In retirement, people no longer earn income for labour, so will start dissaving as they
consume out of past savings or rely on government pension benefits.

Factors Influencing Individual Consumer Choice

The level of income


The price of the good or service itself goods that are necessities may not see changes
in demand as people will purchase them regardless of price changes. However, consumers
are likely to reduce their demand for other goods as price increases.
The price of substitute or complement goods eg. Butter and margarine are considered close
substitutes, so if the price of margarine increases, the demand for butter will increase. Other
goods are considered complements, meaning consumers tend to purchase them together,
eg. DVD and DVD player. If the price of a DVD player falls, then there would a an increase in
demand for DVD players as well as DVDs.
Consumer tastes and preferences consumers will purchase goods and services that give
them the highest utility or personal satisfaction. As consumer tastes and preferences
fluctuate, so will the demand for particular goods. Also, technological progress and
innovation may cause a higher demand for newer and better products, eg. Sales for digital
mp3 music are increasing compared to the physical sales of CD albums.
Advertising

Sources of Consumer Income


Consumer income comes from returns for factors of production (resources) such as natural
resources, labour, capital and entrepreneurial initiative. It also comes from the government in the
form of social welfare.

Return to Factors of Production

Wages from labour

Rent from land consumers that own land and rent it out will earn income.
Interest from capital
Profit from entrepreneurial skills

Social Welfare
Examples of transfer payments include:

Assistance to the aged (for those over 65 years and retired from working)
Family payments (for families with children)
Disability support payment
Unemployment benefits

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