Introduction to Economics

The Economic Way of Thinking

Economics
This unit of work is an introduction to the science of economics. It begins by
defining economics as a science and continues with information pertaining to
economic systems and principles.
Economics. A science?
Economics is considered a science because it uses a specific scientific approach
when establishing laws and theories. A typical sequence of events would be:
1. Defining the issue
2. Gathering empirical data
3. Forming a hypothesis
4. Testing the hypothesis
5. Establishing an economic law
Economics is one of the social sciences. Alfred Marshall, an early economist, in
his book The Principles of Economics (1890), highlighted the human element of
economics by defining it as 'the study of mankind in the ordinary business of life'.
Today we view economics as the study of human behaviour in relation to the
production and distribution of goods and services.

Other Social Sciences

Other social sciences include history, law and psychology. All of them deal with
people and how they behave. Economics, being a social science (unlike the
natural sciences like physics and chemistry), is an inexact science dealing with
both positive issues and normative issues.
Economics is divided into two inter-related studies - microeconomics and
macroeconomics. Microeconomics looks at parts of the economy, that is,
individual economic units, such as a particular firm and its price and output
decisions. Macroeconomics, on the other hand, examines the whole economy. It
studies economic variables such as unemployment in totality.

Relative Scarcity
Human wants for goods and services can never be fully satisfied because the
resources, also known as the factors of production or inputs in the production
process, are limited.
Wants are the material desires of individuals and groups of people that stimulate
economic activity as producers try to satisfy the wants.
Goods are the tangible (visible) output of the production process. Some goods
are made into something else, such as flour that the baker transforms into bread,
and are known as intermediate goods. Final goods, on the other hand, are the
end result of the production process and are not transformed into anything else.
Services are the intangible (invisible) output of the production process, including
plumbing, transport and education.
Resources are the factors of production that are combined to produce goods and
services, and they can be divided into four main categories. Natural resources
like fertile soil, water, trees and minerals that can be used as inputs in the
production process are classified as land.
Capital refers to manufactured elements of production, such as machinery and
buildings, used to produce other goods and services. The government produces
capital on a large scale to help private businesses operate efficiently. This is
known as infrastructure or social overhead capital, and includes public transport,
public hospitals, roads and railway lines. The human effort in the production
process is termed labour.
A special labour skill that is sometimes classified as a resource is the ability to
combine the resources in a way that produces goods and services. This
management skill is called enterprise.

Relative Scarcity: characteristics of wants and resources

Characteristics
There are certain characteristics of wants:
They are unlimited.
Some are recurrent.
Some are complementary.
Some have substitutes.
There are certain characteristics of resources:
They are limited.
They have alternative uses.

The Concept of Relative Scarcity

The concept of relative scarcity is based on the relationship between wants and
resources. Human wants for goods and services are unlimited and cannot be fully
satisfied because the resources used to produce the goods and services are
limited.
Resources are scarce relative to the demand for goods and services. Relative
scarcity is known as the 'economic problem', a problem faced by every country in
the world and a problem that can never be solved.

Choice
As resources are limited compared to the wants of society, and because
resources have alternative uses, choices must be made by producers regarding
resources. Many choices exist. For example, should a firm use their resources to
produce motor cars or motor bikes; should a firm use capital or labour to
produce a good; and should the government provide goods and services to those
in need or to those who can afford the good or service.

Cost of Choices
In economics, when a choice is made with regard to resources, the opportunity
to do something else with the resources is given up. The cost of the choice,
therefore, is the next best alternative foregone.
Individuals make decisions about many things, including the following:
How long to work.
How much money should be saved.
What to spend money on.
Each decision involves an opportunity cost. For example if an individual works
overtime, the opportunity cost is the leisure time that is sacrificed. Spending
more of your income means less is saved, and buying a CD means less money is
available for dining out.
Business decisions include:
What goods to produce.
What resources will be used.
What to spend money on.

Opportunity Costs
A footwear manufacturer, who decides to produce more joggers with its limited
resources, will find it must produce fewer shoes. The decision to use more
machines to produce joggers and shoes means fewer jobs for people, and a
decision to produce the joggers and shoes overseas means less income for the
manufacturer's home country and fewer jobs.
Governments face many decisions, including:
How to tax people.
What to spend money on.
The opportunity cost of the government spending more on defence may be
hospital patients waiting longer for elective surgery because funds are taken
away from the health system.
Examination of opportunity cost leads to improved and effective decision
making. Unlike an accountant who worries about the financial cost of a choice,
economists are interested in making the best decision. By this we mean
comparing the benefits with the costs. Instead of the government worrying
about how much money it will cost to build a new public hospital, for example, it
would examine the benefits/satisfaction gained by consumers if the hospital is
built and the benefits/satisfaction lost by not using the resources in an
alternative project. Decisions are based on a cost/benefit analysis rather than
dollars and cents.

Efficiency and Welfare

Resources are said to be allocated efficiently if consumer satisfaction is
maximised and opportunity cost is minimised. If resources are being efficiently
allocated, more goods and services will be produced, and so more goods and
services will be consumed. Individual and collective consumption together
contribute towards the economic welfare of the community.
Economic welfare, however, is more than just increased production. Social justice
has to also be considered. The economic welfare to the community is
determined not only by the amount of goods and services available to satisfy
wants and needs, but also by the way these goods and services are distributed to
individuals and groups within the community. If we are all better off, then
maximisation of economic welfare has been achieved.

Economic Systems
In attempting to reduce the economic problem, nations develop economic
systems. An economic system is the administrative and organisational structure
that determines:
What will be produced.
How it will be produced.
How the production is distributed.
Economic systems can be distinguished in terms of political ideology and
economic coordination.
Political ideology is the set of beliefs that governs the values of a nation,
including the system of property ownership. The options are:
Capitalism - a belief that resources should be predominantly owned
privately by individuals and businesses.
Socialism - a belief that resources should be predominantly owned
collectively by the people of a nation and administered by the
government on their behalf.
Economic coordination is the mechanism that is adopted to convert scarce
resources into goods and services. The options are:
A Central Planning Authority - a government authority answers the
fundamental economic questions of what to produce, how to produce the
goods and services, and who gets the goods and services.
The Market - the market forces of demand and supply answer the
fundamental economic questions.
Economic Systems

The four main economic systems as shown above are market capitalism, centrally
planned capitalism, market socialism and centrally planned socialism. None of
these economic systems exist in their pure form. All have some market decision
making and some government planning as well as some private ownership of
resources and some public ownership of resources.
Economic systems are never static. They are continually changing and evolving.
Most economies now use the market to coordinate economic activity. Even
countries like China, that have traditionally relied on government directives,
today place great importance on the role of the price mechanism.

Economic Activity

Economic Activity
This unit of work looks at economic activity over a range of spheres including
private consumption and investment expenditure, economic activity and
household services, trade unions and company profit.
Economic activity and household services
Measurement of economic activity is based on goods and services that are
marketed. Many goods and services, while produced, are not exchanged, and so
no productive income is generated. Household activity includes housework
(washing, cleaning and cooking), house repairs and gardening by the owners.
This is non-market activity and so is not included in official measures of economic
activity

The Nature of Economic Instability

Economic activity is constantly changing as leakages and injections fluctuate. In
all contemporary markets, there is a long-term trend of rising production, income
and expenditure, but there has not been a steady yearly increase in economic
activity. Rather, economic activity is unstable by nature. It proceeds in irregular
stages, with economic upswings followed by much slower periods of economic
activity. The pattern of fluctuations in the general level of economic activity is
known as the trade or business cycle.
The role of the government is to reduce the amplitude of the trade cycle. This
means it tries to stop excessive highs and lows.
To understand why macroeconomic instability occurs, it is important to
understand the nature and influences on aggregate demand and aggregate
supply

Aggregate Demand
Aggregate demand is the total level of planned spending on goods and services.
As a consequence, it includes spending on exports and excludes spending on
imports.
English economist, John Maynard Keynes, was the first person to examine in
detail the concept of total spending in an economy. He called this concept
Aggregate Demand, which he divided into certain components
(categories/groups) of spending.

Private Consumption Expenditure (C)

This is the largest component of aggregate demand, accounting for
approximately 60 per cent of total aggregate demand. Despite its size, it is a very
stable component. It is spending by individuals and households on new
consumption goods and services that directly satisfy wants and needs.

Private Investment Expenditure (I)

This is spending by businesses/firms on capital goods. It includes spending on:
plant and equipment (factories and machinery)
dwellings and non-dwelling buildings (houses and office blocks)
 stocks of goods (working capital).
This type of expenditure is a very important prerequisite for future economic
growth. It is considered a risk, and, as such, is a very sensitive component. It
accounts for approximately 15 per cent of aggregate demand.

Government Current/Consumption Expenditure (G1)

This is a relatively stable component and is spending by the government on
current goods and services that contribute to the day-to-day running of the
public sector. The major item of G1 is the wages and salaries of public servants.
An unusual item included in G1 is all defence expenditure regardless of whether
it is current or capital in nature. This component accounts for approximately 20
per cent of aggregate demand.

Government Capital/Investment Expenditure (G2)

This is spending by the government on capital goods. The majority of G2 is on
infrastructure. G2 provides the framework that will encourage greater I spending.
G2 accounts for about five per cent of aggregate demand and, while more
volatile than G1, is still considered relatively stable.

You should note that transfer payments made by the government, including
unemployment benefits and the aged pension, are not included in either G1 or
G2 because they are not a payment for a good or service. Transfer payments do,
however, increase disposable income, so they therefore influence C.

Net Exports (X-M)

Spending on exports is included in aggregate demand as it contributes to
economic activity in Australia, whereas imports are deducted from the other
components of aggregate demand because they have an imported component
within them, which provides economic activity overseas, not in Australia. Both
exports and imports account for about 20 per cent of aggregate demand. A
depreciation of the currency, by making exports relatively cheaper and imports
more expensive, should promote domestic economic activity

FORMULA 2

Disposable Income
Disposable income is the amount of money available for either spending or
saving. It includes factor income (income earned for employing resources in the
production process) and transfer income (income given by the government to
those in need). In Australia, income tax and the Medicare Levy are deducted from
money income to determine disposable income. Any increase in disposable will
cause C and AD to increase.

Interest Rates
Interest rates are primarily determined by actions of the Reserve Bank of a
country. A wide range of interest rates exist, including cash rates, mortgage rates,
credit card rates and business loan rates. An increase in interest rates will mean
the rates on deposits and on loans both go up. This is likely to mean less
borrowing and spending by households and businesses, and more saving. C and I,
as well as AD, will decrease.

Consumer Sentiment/Confidence
If consumers have pessimistic expectations about the future and are worried
about high unemployment and inflation, they are likely to cut current
expenditure, and save for a rainy day. C and AD will fall.
Redistribution of Income
An increase in income directed toward low-income earners rather than high-
income earners is likely to have a very powerful impact on economic activity.
Low-income earners tend to spend most of any extra income they are given,
while high-income earners tend to save the majority of any extra income they are
given. Technically, this means low-income earners have a high marginal
propensity to consume, whereas high-income earners have a high marginal
propensity to save and a low marginal propensity to consume.

Business Sentiment/Confidence
If businesses have an optimistic view about the future, based on expectations of
future sales, interest rates and inflation, they are likely to bring forward plans to
invest, causing I and AD to rise.

Budgetary Action
If, as in recent years, the Federal Government reduces the size of its budget
deficit and moves into surplus, less liquidity is injected into the economy,
contributing to slower economic activity. On the other hand, as the government
moves into surplus, it does not need to borrow funds, which should help reduce
interest rates and boost economic activity (a crowding in effect). Specific
budgetary measures also have the potential to affect aggregate demand,
including changes to company tax, depreciation allowances and investment
allowances.

The Exchange Rate

If the exchange rate depreciates, exports become relatively cheaper, contributing
to greater export revenue. At the same time, imports are more expensive. The
demand for exports should go up and the demand for imports should go down,
although the exact impact will depend on the elasticity of supply for exports and
the elasticity of demand for imports.

Aggregate Supply
Classical economists, such as John Stuart Mill and Jean Batiste Say, as well as
modern economists, including Milton Friedman and John Galbraith, have
promoted the importance of supply side factors.
Aggregate supply is the total value of an economy's production of final goods and
services available for purchase.
Aggregate supply is determined by three important factors:
1. The quantity of resources
2. The quality of resources
3. The costs of production.

Trade Union Activity

The trade union movement aims to achieve better wages and working conditions
for its members. To achieve this goal, trade unions often direct their workers to
'go slow', strike or even ban a project. These types of action have the potential to
cut production and economic activity by restricting the supply of labour.

Immigration
An increase in the number of immigrants of working age population is likely to
increase the size of the labour force and contribute to higher levels of aggregate
supply and economic activity.

Productivity
Productivity is the output per unit of input. An increase in labour productivity as,
for example, a result of employees working harder or the introduction of new
technology, improves the quality of resources and leads to higher levels of
production.

Company Profits
Company profits are the gross operating surplus of the business sector. An
increase in company profits, particularly as a result of increased sales, may
encourage firms to supply more.
Real Unit Labour Costs
Businesses may reduce production if real wages (money wages adjusted for
inflation) are increasing faster than productivity. When real unit labour costs rise
it makes it more expensive for businesses to employ labour.

Participation
Participation measures the number of people in the labour force. It tends to be
pro-cyclical because as economic activity increases, so does participation, adding
a further boost to production levels. During a period of strong growth, previously
discouraged workers will seek employment.

Real Interest Rates

For most businesses, the cost of capital is the real interest rate, which is the
nominal rate of interest less the inflation rate. A decrease in nominal interest
rates and, consequently, real interest rates, affects firms who pay a variable rate
of interest on borrowings. The cost of financing the loan falls, profit rises and
increased production is encouraged.
Economic Growth

Definition of Economic Growth

Economic growth can be defined as a sustained increase in the amount of goods
and services produced over a period of time.

Measurement of Economic Growth

Economic growth is measured by the percentage change in Real GDP. Real GDP
adjusts the
Nominal GDP figure for the impact of price changes (inflation or deflation).

Formula 3

Example: If the Money GDP is $1155 billion and the GDP deflator is 110, what is
the Real GDP?

Real GDP is $1050 billion.

If Real GDP was $1000 billion the previous year, what is the rate of economic
growth?
While the rate of economic growth goes up and down in cycles, a trend rate of
economic growth can be calculated for an extended period of time.

While Real GDP is the preferred measure of economic growth, it does have its
limitations.
Certain forms of productive activity, such as housework and home repairs,
are excluded.
Some forms of productive activity, including farm produce consumed on
the farm, are not marketed (sold) and so cannot be measured accurately.
The ABS estimates their value.
While the quantity of goods and services is measured, the quality is not.
The distribution of the GDP is not shown.

The Sources of Economic Growth

An increase in aggregate demand.
The use of idle resources if excess productive capacity exists.
Improved quality of existing resources.
New resources if the economy is at full productive capacity.

Factors Contributing to Economic Growth

Effects of Economic Growth
Reduction in absolute and relative poverty: Strong growth will tend to
increase the chance of the poor gaining employment and reducing the
numbers of people living in relative poverty. The proceeds of economic
growth may even be used to help the homeless, thereby reducing the
numbers living in absolute poverty.
A more equitable distribution of income: With the increased taxation
revenue generated from strong economic growth, the government may
be able to provide more collective goods and services. Higher social
welfare payments also become an option.
Improved standards of living: With more goods and services produced,
material living standards certainly increase. Non-material living standards
may also improve if economic growth contributes to more leisure time.
Negative externalities: The pursuit of growth may lead to atmospheric
and water pollution as factories try to dispose of their waste and more
motor vehicles clog our roadways. Growth could also lead to the
depletion of our non-renewable resources.
Possible inflation: Inflation will occur if aggregate supply cannot keep up
with strong growth in aggregate demand.
Possible external problems: The increased demand for imports usually
associated with strong economic growth, will add to the trade deficit.
Economics and Employment

Factors Contributing to Full Employment

Economics and Employment

Full employment is where most people over the age of 15, who are willing and
able to work, find a job. It is not possible to have zero unemployment, as some
people will always be unemployed due to structural, frictional and seasonal
factors. Full employment can be viewed, therefore, as an acceptable zone of
unavoidable unemployment.
Some economists view full employment in terms of a natural rate of
unemployment. Natural unemployment can be measured by the NAIRU (Non-
Accelerating Inflation Rate of Unemployment). The NAIRU is the lowest level of
unemployment possible before labour shortages cause wages and, therefore,
inflation to rise.
The Unemployment Rate
The unemployment rate is calculated using the following formula:

FORMULA 4

Example:
Consider the following figures and calculate the unemployment rate.
Unemployed people: 8000
Employed people: 92000
People not seeking employment: 6000

The labour force consists of everyone who is employed and everyone who is
classified by the ABS as unemployed.

Participation
Everyone in the labour force is considered to be participating. The participation
rate is calculated as follows:

FORMULA 5
Example:
Consider the following figures and calculate the participation rate:
Unemployed people: 8000
Employed people: 92 000
People not seeking a job: 6000
Population over 15 years of age: 125 000

If, for example, the participation rate is 60%, this means that 60% of people over
the age of 15 years are either working or actively looking for work. It also means
that 40% of people over 15 years of age are not participating, that is they do not
have a job and are not looking for a job. People who are not participating include
the elderly, the physically and mentally disabled, students and discouraged
workers. If the participation rate does change it's most likely due to changes in
the number of discouraged workers.

Limitations of the Unemployment Rate

Employment statistics do not show the extent of underemployment. Some
people who work part-time want to work full-time, and some people are working
in jobs well below their qualifications, e.g. a lawyer working as a sales assistant.
To be considered unemployed, a person must be actively seeking employment.
Many people, however, who have been unable to find work for a long time,
become so discouraged that they stop actively looking for a job. These people are
the hidden unemployed (sometimes called discouraged workers). There are three
main categories of hidden unemployed.
Housewives whose families have grown up. They want a job but can't find
one, as they don't have the required skills.
Older males who are forced into early retirement because employers are
unwilling to give them a job.
 Teenagers who can't find a job and so go back to school to improve their
qualifications.

Types of Unemployment
Frictional unemployment. This is the time between when a person
voluntarily leaves a job and finds a new one.
Seasonal unemployment. Some people become unemployed in the 'off
season', e.g. fruit pickers become unemployed because they have no
other skills.
Hardcore unemployment. This occurs when employers refuse to employ
people due to certain personal characteristics of the potential workers,
such as having a criminal record or a drug addiction.
Cyclical unemployment. This term is based on the business cycle. J.M.
Keynes believed a drop in the business cycle and, therefore, a drop in
demand and production cause this type of unemployment. It is where
aggregate demand falls.
Structural unemployment. This is where the structure of the industry
changes, that is, the way goods and services are produced changes. This
results in a mismatch between the skills of the existing workers and the
skills required to do the job.

Causes of Unemployment
The main causes of recent unemployment are:
Falling levels of economic activity. If economic activity begins to slow due
to such factors as higher interest rates or pessimistic expectations, private
consumption and investment, expenditure will fall, as will aggregate
demand. With people buying less goods and services, businesses will
reduce production levels and, consequently, will require less labour.
Rising wages. Wages are the largest cost of production for most firms.
Increased wages mean it is more expensive for business to hire
employees. If real wages are increasing faster than productivity, firms may
reduce their workforce. They may even replace labour with capital.
The introduction of new technology. The introduction of new technology,
such as robotics and computers, has replaced labour in the affected
industries.
Lower Tariffs. Tariffs are a form of protection for local firms. If they are
reduced, local producers are faced with more competition from imports.
This may force the producer to restructure the industry leading to job
losses.
Privatisation. The selling of government owned businesses to the private
sector.

Effects of Unemployment
 Personal costs. Unemployed people often feel rejected and humiliated.
This can lead to stress, drug and alcohol abuse, and depression.
Social costs. Social economists acknowledge that there is a direct
relationship between high unemployment and crime. Welfare agencies
suggest that there is also a direct relationship between unemployment
and domestic violence and family breakdown.
Inequitable distribution of income. Higher unemployment means more
people are receiving transfer income and fewer people are receiving
factor income. This could increase relative poverty and exacerbate the
'haves and have-nots' mentality.
Wasted productive potential. High levels of unemployment indicate that
an economy is not achieving its productive potential. Also, as the number
of long-term unemployed (people unemployed for more than a year)
increases, skills are lost.
Budgetary problems. High unemployment means large sums of money
are paid by the government in the form of unemployment benefits. At the
same time, high unemployment means less income tax revenue. Also, the
government may be forced to spend more on health, social welfare, law
enforcement and retraining schemes because of the associated problems
with unemployment. This often forces the government into a series of
 budget deficits that can cause a number of economic problems, such as
inflation and high interest rates.

The Competitive Market System

Shifts in the Demand Curve

Sometimes certain factors influence consumers to change their demand for a
product at a particular price. Demand will either increase (meaning a shift to the
right of the entire demand curve) or decrease (the demand curve shifts to the
left). The factors that can change demand include:
A change in consumer preferences. Some goods become fashionable
while others become unpopular.
A change in disposable income. A change in wages or income tax rates will
change the amount of money consumers have to spend and demand.
A change in the price of a substitute. The demand for a product will rise,
for example, if the price of its substitute goes up.
A change in the price of a complement. If the price of Sony Playstations
falls for example, the demand for Playstation games will increase along
with the demand for the Sony Playstations.
The size of the population. Immigration and natural population increase
will increase demand for certain goods and services.

The Competitive Market System

The market system is coordinated by the price mechanism, also known as the
market mechanism, which is, in turn, based on the market forces of demand and
supply.

Demand Schedule
Demand schedule for T-shirts

This information can be presented in the form of a demand curve. Note that the
demand curve visually displays the law of demand.
Demand is the quantity of a good or service that will be bought at a particular
price at a point in time. The law of demand states that there is an inverse
relationship between the price and the quantity demanded. The lower the price,
the higher the quantity demanded. This is because the consumer is trying to
maximise satisfaction. The quantity of a product that will be demanded at
various prices at a point in time can be presented in the form of a demand
schedule.
This information can be presented in the form of a demand curve. Note that the
demand curve visually displays the law of demand.

Demand Curve
Movements Along the Demand Curve
As the price falls, we move down the curve. This is know as an expansion of
demand. As the price rises, we move up the curve, known as a contraction of
demand.

Shifts in the Demand Curve

The shift in the demand curve from D to D1 indicates an increase in demand,

while a shift from D to D2 shows a decrease in demand.

Supply Schedule
This information can also be shown on a supply curve.
The supply of product is the amount of a good or service that producers are
willing to sell at a particular price, at a point in time. The law of supply states that
there is a direct relationship between the price of a product and the quantity
supplied. More will be supplied at a higher price because producers wish to
maximise profit.
The quantity of a product that will be supplied at a range of prices, at a point in
time, can be presented in the form of a supply schedule.

Supply schedule for T-Shirts

Movements Along the Supply Curve

The supply curve shows that a change in price results in a movement along the
curve (an expansion or a contraction of supply). The curve itself does not shift.
This means, therefore, that a change in price does not change supply.

Shifts in the Supply Curve

Factors that change supply and shift the supply curve include:
A change in the cost of production. Lower costs, with other things
remaining the same, including price, will mean greater profits and so
increased supply.
Technological change. New technology invariably means greater
productivity, lower unit costs and increased supply.
Natural disasters. Floods, bushfires and earthquakes, to name a few, have
the potential to severely restrict the supply of certain goods and services.
Government action. Policies by the government, such as changes to tariffs
and subsidies, have the potential to affect the amount supplied by
producers.
If the supply curve shifts to the right, it indicates an increase in supply at each
and every price. A decrease in supply is shown by the supply curve shifting to the
left.

Market Equilibrium

Market equilibrium occurs where the quantity demanded of a product equals the
quantity supplied.
At equilibrium, there is neither a shortage nor a surplus of the product, which
means the market is cleared during the trading period. It is where the conflict
between consumers wanting low prices and producers wanting high prices is
resolved.

Disequilibrium

If the price was above the equilibrium price, excess supply and a surplus would
occur. If the price was below equilibrium, excess demand and a shortage would
occur. If the price mechanism is allowed to operate free of government
intervention, equilibrium will automatically be established.
The equilibrium price and quantity traded in a free and competitive market will
change when there is change in the factors that affect demand or supply. Such
changes will cause the demand or supply curve to shift and intersect at a
different point, and so a new equilibrium position is established with a new
equilibrium price and a new equilibrium quantity.

Market Equilibrium Graphs

An Increase in Demand
An Increase in Supply

A Decrease in Demand
A Decrease in Supply

Resource Allocation in the Competitive Market

Resource allocation in a competitive market system is based on the principle of
consumer sovereignty. Consumer sovereignty is where consumers, through their
effective demand, determine the composition of output. In other words, what
consumers want, producers will supply.
Reallocation of resources begins in the product market (the market for a good or
service). If there is a change in the conditions of demand, for example, an
increase in disposable income, there will be an increase in effective demand for
the product. As a result, there will be an increase in the derived demand for the
resources that make the product. The market for the resources is known as the
factor market. As the derived demand in the factor market increases, price in the
factor market will increase. As price in the factor market is the reward for
employing the resources (profit), it signals to producers that producing more of
the product can make supernormal profit. As a result existing producers and new
producers will allocate more resources into this industry. Resources will,
therefore, be allocated away from areas with low consumer demand toward
areas of high consumer demand.
Many markets are related and what happens in one market can affect the actions
of buyers and sellers in other markets. There will be a structure of relative prices
established throughout the economy, which can be affected by changes in
related markets.
If demand increases for a product, as discussed before, it has the potential to
alter the allocation of resources in many associated markets.

Behaviour of Economic Participants

A fundamental conflict exists between consumers and producers. Consumers are
motivated by satisfaction, known as utility in economics, and as such want low
prices. Producers are motivated by profit and, therefore, want high prices. The
price mechanism resolves this conflict, and in so doing, performs a rationing
function.
The equilibrium price will attract a certain number of producers who are happy
to make normal profit. These producers require resources to make the goods and
services demanded by consumers. Producers who are willing to pay the market
price for the resources will do so. This forces the producers to allocate the
resources efficiently.
The market price also allocates the product in an efficient way. If there is a
shortage, prices begin to rise, forcing some consumers to leave or reduce their
consumption. The product will be distributed to the consumers who have the
greatest need or desire for the product as shown by their willingness to pay the
equilibrium price. As Adam Smith observed in 1776, when producers and
consumers act in their own self-interest, the welfare of society in general is
enhanced
Elasticity
While the laws of demand and supply state that the quantity demanded and
supplied will change with a price change, it is very important to know by how
much the quantity demanded and supplied changes. Elasticity refers to
responsiveness. A strong response (more than proportional response) to a price
change is known as elastic demand or supply.
A weak response (less than proportional response) to a price change is known as
inelastic demand or supply.
A coefficient (number) of elasticity can be calculated.
A coefficient of more than one - ELASTIC
A coefficient of less that one - INELASTIC

Formula 1

Example:
If the quantity demanded of a good increased by 600 from 1000 as a result of its
price falling from $20 to $12, what is the coefficient of elasticity?
The product has elastic demand.

Elasticity of Demand

The following factors have great influence over the elasticity of demand for a
good or service.
The number of substitutes. Products with a lot of substitutes are price
sensitive, meaning they have elastic demand, because consumers can
easily switch to the substitutes if the price of the product goes up.
Products with very few substitutes have inelastic demand.
Necessity. Most consumers will accept a price rise if they believe the
product is a necessity. The demand is, therefore, very inelastic. Also,
products that are addictive have very inelastic demand.
Relative cost. If the product is relatively cheap, like a newspaper, its
demand is quite inelastic, as most consumers would accept, for example,
a 10 per cent price increase. If, however, the product is expensive, like a
motor car, a 10 per cent increase in price is likely to have a significant
effect on the quantity demanded.
The demand in this case would be quite elastic.
Elasticity of Supply
The following factors have great influence over the elasticity of supply for a
product.
Time. In the case of some products, it takes time to increase output
quickly in response to a change in demand and price. Agricultural
products take time to sow, grow, harvest and be sold. Their supply is
inelastic. The supply of manufactured goods like televisions can be quickly
increased, making their supply elastic.
Ability to store the product. While the nature of agricultural goods makes supply
inelastic, it is possible to make it more elastic if the producer can store the
product. Wheat and wool, for example, can be stored for long periods of time
making it possible for producers to respond quickly to an increase in price.

The Contemporary Market

The government has (and still does) intervened in the market and the operation
of the price mechanism. Governments have used price controls, specifically a
fixed price above equilibrium (floor price) for products such as eggs and milk. The
purpose was to maintain an adequate income for the producers. The government
does not allow the market to set the price.

Consumption-based taxes, like excise duties, increase costs of production, and so

market supply decreases.
Pressure groups, lobbyists and institutional forces have been able to influence
prices in many markets. Conservation groups and environmentalists have been
able to stop production in some areas, restrict production in others and force
businesses to be financially responsible for the social costs of their production.
IRC (Industrial Relations Commission) decisions on award wages can affect
disposable income, costs of production and the equilibrium price in most
markets.

Types of Inflation

Causes of Inflation
The main causes of inflation are:
 Increased levels of aggregate demand. Periods of strong growth in
expenditure have contributed to inflation, as the economy has not been
able to meet the higher demand for goods and services.
Higher input prices. Increased prices of raw materials, semi-finished
goods and capital goods have contributed to inflation.
Inflationary expectations. If inflation is expected to rise, groups in the
economy, such as trade unions and businesses, move to protect
themselves against the loss of purchasing power. This adds to inflationary
pressures.
Imported factors. If the price of overseas goods increases, due to factors
such as overseas inflation or a depreciation of the Australian dollar,
consumers are faced with higher prices and firms are faced with higher
input prices. This contributes to inflation.

Demand inflation
Demand inflation occurs when aggregate demand is greater than aggregate
supply at, or near, the full employment level. Anything that increases the
components of aggregate demand will lead to demand inflation.

Cost Inflation
Cost inflation occurs when structural or institutional forces cause costs and/or
prices to rise. Any factors that increase the costs of production can initiate cost
inflation if businesses do not absorb the increased costs through lower profit
margins and, instead, 'pass on' the increased costs in the form of higher prices.

Factors contributing to price stability

Effects of Inflation
Inflation affects three main areas:
Resource allocation. The pattern of resource allocation is distorted.
Speculative investment in things like real estate, antiques and artwork
become popular, as their value tends to go up faster than inflation.
Productive investment in capital goods is discouraged, as there is now
greater uncertainty and, therefore, risk.
The share of income and wealth is changed. Some groups 'win' at the
expense of others who 'lose'. Those who tend to benefit from inflation
include borrowers of funds as the value of their repayments diminishes
over time. Those who have market power, including strong trade unions
and businesses, that have very little competition; and the government,
who gain from bracket creep as workers move into higher tax brackets.
External stability. A country's inflation rate is higher than that of its
trading partners, reduced international competitiveness leads to external
instability. The demand for exports falls and local demand for imports
increases. The trade deficit (where M is greater than X) rises.
The benefits of achieving low inflation include the following factors:
 improved international competitiveness, as Australian goods and services
become relatively cheaper
a reduction in the trade deficit, as there will be more sales of goods and
services
higher levels of investment, as business becomes more confident
inflationary expectations are reduced, helping to maintain a low inflation
environment.

Wealth and Income Distribution

Equity in the Distribution of Income and Wealth

Income and wealth distribution is the manner in which the income and wealth is
divided amongst participants in the production process and other dependent
members of the economy. As an objective, the government does not aim for
absolute equality in income and wealth distribution, as this would reduce the
incentive to work harder. The government does, however, aim for equity or
fairness in income and wealth distribution in order to provide everyone with a
minimum standard of living.
Wealth is achieved through accumulated saving. Savings can then be mobilised
to purchase productive assets like land and buildings, or used to purchase
speculative assets such as antiques and artwork. Wealth can also be accumulated
through inheritance.

The Lorenz Curve

Income distribution can be illustrated using a Lorenz curve.
The Lorenz curve, in the diagram, shows that the wealthiest 10% of the
population earn approximately 35% of the income. The further the Lorenz curve
is away from the line of absolute equality, the more unequal the income
distribution.

The Gini Coefficient

Another method of measuring the degree of equality/inequality in the

distribution of income and wealth is to calculate the Gini coefficient. It is a ratio
of the area between the line of absolute equality and the Lorenz curve to the
total area below the line of absolute equality.

The Poverty Line

The Henderson poverty line (income-based) is a useful guide when examining the
concept of equity. The proportion of people living below the poverty line has
increased from approximately 8% in the 1970s to over 14% in the 1990s.
Unfortunately, poverty amongst dependent children has risen the most.
Factors affecting the distribution of income and wealth
Education and training: improved skills and qualifications mean higher
factor income.
Socioeconomic background: generally, people who are born into
wealthier households have greater opportunities to earn higher factor
income than children of low-income earners do.
Age: it is usually found that young people beginning a job are paid less
than older workers who are paid more highly due to their greater
knowledge and experience.
Inheritance: wealth distribution is very much based on inheritance where
money and assets are passed from one generation to another at death or
persons still living make gifts.
The state of the economy: strong economic growth will mean less
unemployment and so more people on factor income rather than transfer
income.
Government policies: particularly with respect to taxes and social welfare
payments.