Preliminary

(HSC)
Economics
The official
“Kelvinotes™”

Kelvin Wong
11 ECO 2010
Normanhurst Boys’ High
Chapter 1: Introduction to Economics

Economics is the study of the way in which people (society) with scarce resources produce,
distribute and exchange goods and services in an economy. Economics is a social science as it studies
human behaviour in the economy. The Economy refers to how groups in society are organised in an
economy and the economic system that organises them, in order for the economy to operate. The
things that economics can do are classified into two categories:

− Positive Economics:
− Describes and (through analysis) explains economic phenomena, this
includes the development of economic models and theories.
− Normative Economics:
− Makes judgements on what an economy should be like or policies that
should be implemented to improve economic outcomes.

Economists using economics, analyse the economy and the various factors that affect it in order to
further assist to solve the indispensible problem of the scarcity of resources or as it is dubbed “The
Economic Problem”.

The economic problem:

The economic problem can be very simply summed up in the phrase “Unlimited wants; Limited
resources”. Humans, place infinite demands or “ends” on an economy; these are called “Wants”. An
economy can only get hold of so many resources (called “The factors of production”) due to the fact
that the amount of resources we can get out of the world at one time is not infinite but actually
limited in reality. (AKA The scarcity of resources)

This means that all the “wants” of humans cannot be satisfied by an economy due to the limited
amount of resources available to that economy and the infinite wants that are created by humans.
This is what in turn limits the economy’s ability to produce goods and services and therefore only
allows it to satisfy some of the wants of the humans in an economy.

Wants

Wants are basically desires of humans for goods and services. These wants create demands that are
placed on an economy to supply good and services to satisfy them. Wants differ in importance,
which means that some wants will need to be satisfied (for a person) before other wants placed by
them can be. Wants by nature (characteristic), says that humans will always have unlimited or
infinite wants due to the fact that:

1. Humans will never be satisfied with what they have. Usually the satisfaction
of one wants creates more wants.
2. Wants are always changing with time due to changes in income, tastes and
fashions/trends.

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In order to better analyse and understand the economy, economics categorises wants into two basic
groups:

Individual wants:

− These wants are created to satisfy an individual in an economy. They are used for
individual purposes and are not used by the community. These “wants” are usually
the most profitable to produce as individuals would be prepared to pay for them in
order to satisfy their own wants.

Collective wants:

− These wants are made by the community for all individuals to use. These communal
wants are usually too big for individuals and therefore can be shared amongst the
community. Collective wants are usually the least profitable as individuals are less
likely to pay for them as they are not satisfying their own needs but others as well.
The satisfaction of collective wants are therefore commonly organised by the
government and its taxes.

In these two groups, wants can be further classified into categories according to their nature. They
include:

− Basic wants:
− These are wants that are considered the most vital for survival and are the
most important and fundamental of wants. (E.g. Food, Shelter, Clothing)
− Recurring wants:
− These are wants that are constantly renewed. (E.g. Food, Fuel, Toilet paper)
− Substitute wants:
− These are wants that can be satisfied in two or more ways (interchangeable),
meaning they can be replaced by something else. (E.g. Transport- Car or
Public transport)
− Luxury wants:
− These wants are considered non-essential to survival but are kinda neat to
have. (E.g. Holidays, Entertainment)
− Complimentary wants:
− These are created from the satisfaction of a want or having a certain good or
service. (E.g. Car Fuel / Macbook Noose/Morris Minor Piano)
− Wants for capital goods and services
− These are wants for the factor of production known as capital in order to
increase the production of goods. (E.g. Machinery, Tools)

Resources

Resources, called the “Factors of production” are the commodities that are used to produce goods
and services for the economy. The factors of production must be combined by producers to produce
goods and services to sell on the market. The factors of production also have a “factor income
return”, which is basically the income gained from the sale of that factor.

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There are 4 factors of production:

− Land:
− Natural resources and materials. (E.g. Minerals, Soil, Wood, Fish) The factor
income is called Rent.
− Labour:
− Human effort (Physical or Intellectual) used to produce goods. The factor
income is called Wages.
− Capital:
− Goods or Tools used to produce goods and services. (E.g. machinery, Office
equipment, tools and technology)The factor income is Interest.
− Enterprise:
− The ability to take risk (put operating money in for a business) and organise the
four factors of production effectively in order to produce goods or services for
the market. Usually, in the form of a business/company or entrepreneur. The
factor income is called Profit.

Due to the fact that an economy can only get hold of so many resources at one time, due to things
like the inability to increase supply in the short term (because we can only get so much out of this
world at one time) and (even in the long term if we increase our supply of resources) the fact there
is only so much world to go around, we have what is known as the “problem of scarcity”.

The problem of scarcity and the need for choice by individuals and society

Due to the fact that the factors of production are limited and wants are unlimited, the one thing that
almost all economists do agree on is that resources are scarce (relative to the amount of wants). So,
in order to get anything done, people in an economy have to make choices about how the limited
amount of resources in an economy must be used to produce goods and services to best satisfy
wants in the economy. In order to best satisfy the demands in the market, wants would have to be
prioritised so that wants of greater importance are satisfied first.

When choices are made, sacrifices or “trade-offs” are created as a result of decisions. For example: if
you had 20 litres of petrol and instead of drinking it with your friends (and having a really good
time!), you use it to travel to the hospital to see your grandma because she was drinking petrol with
her friends, you sacrifice the good time you would have had with your friends for getting to see and
laugh at your grandma. This “could of” or sacrifice is called “Opportunity Cost”.

Opportunity Cost

Opportunity cost is the alternative forgone by when an economic decision is made that has a trade-
off of some kind. (It is important to understand that there is no opportunity cost when the decision
is not to sacrifice anything. For example: WW2 General: “Fuehrer, you can either occupy Russia or
France” Hitler: “I know! We’ll take both” On an unrelated but related note, this was one of the
reasons the Germans lost the war…). In deciding what to do with our resources (produce), we are In
fact “allocating” resources to certain causes. The effects of different allocations can be illustrated
through a “Production Possibility Frontier” or PPF.

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Production Possibility Frontiers

These are basically models that can be used to show the effects (opportunity cost) of allocating
limited amounts of resources to the production of goods. However, a PPF has certain limitations and
assumptions:

− Only two goods can be compared

− All resources given are employed and utilised in making the goods (giving the
maximum production potential)
− The level of technology and productivity/efficiency are fixed
− Some of the resources given must be transferable between the production of both
goods

There are two ways of presenting a PPF:

− Production possibility Schedule:

Good/Service Combination points
Car washes 200 180 140 70 0
Gatorade 0 70 140 210 250

− Production possibility curves (or frontiers):

300

250

200
Gatorade

150

100
B
50

0 A
0 50 100 150 200 250
Car Washes
It can be seen that from the PPF curve and schedule ( in this economy), if all the resources were
allocated for the production of Gatorade, 250 units of it would be made and 200 units of Car washes
made if all the resources diverted to it. The line represents where the production numbers will be if
the resources was allocated in a combination to producing both goods. If the production
combination point was below the line in the PPF, the economy is said to not be fully utilising all its
resources and therefore not achieving its full economic or production potential. If it is on the line
then, the economy is utilising all its resources. The area above the line is out of reach of this
economy at the moment as more than the maximum potential of that economy.

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Based on the PPF, if an economic decision is made to allocate resources from a situation where 200
units of Car washes are produced but no Gatorade is produced (A) to a situation where 180 units of
Car washes are produced and 70 units of Gatorade is produced (B), then 20 units of Car washes
would be sacrificed as the resources that would have been allocated for it is shifted to produce
Gatorade. This sacrifice of 20 Car washes units is the opportunity cost of making the first 70 units of
Gatorade.

The “marginal rate of substitution” or MRS in basic terms is the rate at which you sacrifice one thing
over another while keeping at full utility when you move from one combination point to another on
the PPF. In going from A to B, you sacrifice 20 Car washes to gain 70 Gatorade. Therefore the MRS of
A to B is 20 ÷ 70 = 2/7. For every two units of Car washes you give up, you get 7 units of Gatorade, if
you wanted to move from A to B.

PPF Shapes

A PPF curve in general, can have three shapes:

− Concave:

− This curve is the most common as it allows for two economic phenomena that
usually occur in the real world.

One of them is the fact that when producing two goods, the resources used
for making one might not be easily transferable to be used for making the
other compared. For example: When we compared Car washes to
Gatorade, the water used to make both is easily transferrable, but the
sugar and soap isn’t. (The reason why this concave shape occurs is because
soap isn’t very good for making Gatorade and therefore levels out as you
allocate all the resources to making Gatorade)

The other cause of this shape is the “Law of diminishing returns”
− This curve has a constantly changing MRS (Marginal Rate of Substitution) as the
shape of the curve is, well… a curve…

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 − Linear:

− This curve is uncommon as it requires that the two goods being compared have the
resources used to make them be absolutely transferrable between the two

Yes, this can exist…kinda… For example: Boxes of Dozen eggs compared to
boxes of Half dozen eggs (you would get pretty close of a linear line, but
then again… you’re also kinda comparing the same thing…)
− The MRS on this curve is constant, as the shape of the curve is linear and therefore
proportional.
− Convex:

− This shape is less common than a concave but more than a linear as it requires that
the good being compared be very different in the resources they use (resources to
make one is not easily transferrable to another).

This can happen due specialisation of resources, especially labour. For
example: If you had most of the people being mechanics, fixing cars, it
would be pretty hard to get them to be great carpenters straight away to
start making tables and vice versa.

This curve would also be caused by “economies of scale”
− This shape could represent the PPF of an economy in the long run if considerable
economies of scale took place as specialisation would occur.
− This curve has a constantly changing MRS (Marginal Rate of Substitution) as the
shape of the curve is, again… a curve…

Shifts in the PPF curve

Over time, it would be hard for the resources available, technology and productivity/efficiency not
to change in an economy. Therefore, a PPF only applies to a certain time in an economy. If the
factors that affect production were to change a movement or “shift” in the curve would occur
(Though, shape change is also possible).

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There are two main shifts that can occur in PPFs:

− Outward:

− This allows an economy to produce more and occurs when the economy:

Obtains more resources

Becomes more Productive/Efficient

Becomes more technologically advanced (Though, if technology change is
product specific, the shape/gradient of the curve should change with a shift)

Grows
− Inward:

− This allows the economy to produce less and occurs when the economy:

Supply of resources decreases

Experiences diseconomies of scale

Experiences a loss of capital or technology

Experiences Recession/Depression

The implications of choices made by individuals, businesses and government

As people make choices in an economy, their decisions will have future implications due to the
resources in an economy being scarce. People would choose the option that gave them the best
returns or satisfaction from the resources put in. This is known as “Allocative efficiency”.

Two of the main choices individuals, businesses and governments face is whether to “invest” (Save
resources/Money) or consume (Spend resources to satisfy wants). Usually, saving more money now
or investing more will mean less products produced now (lower satisfaction) but an ability to
produce more in the future (more happiness later). Spending money/resources now to satisfy non
capital good wants will mean more products produced (more satisfaction) but equal or less products
in the future (less satisfaction). This is known as “inter-temporal budget constraints”. The
implications for different people in society are different:

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 − Consumers:
− Spending more money now on “essential type” goods like food, housing and
clothing may mean that they will have to forgo luxuries like holidays and new cars
in the future. Spending now can mean that future want satisfaction is decreased
as there are no savings to buy them with.
− Businesses:
− Allocating resources to producing certain goods, while not necessarily decreasing
satisfaction of the firm, will induce opportunity costs in the products that could
have been produced. Though, another decision a business makes is allocating
profit margins to pure profit (dividends or more satisfaction) or investing profits
for more capital in the hope of increasing its profitability.
− Governments:
− Allocating resources (money) to producing certain collective wants will produce
opportunity costs in the other collective wants that were not satisfied. Also
deciding to spend below tax income can mean a surplus which allows for more
spending later (Through investment and paying off debt to increase money
available for the future). The opposite is also true as spending beyond the tax
income, means governments have to borrow (higher debt in future means higher
repayments and consequently less spending).

Economic Factors underlying decision making

There are a wide range of different economic factors (E.g. social, cultural, psychological, historical)
that affect different people in an economy in their decision making:

− Consumers
− Decisions to save money

Transactionary motives: Saving money to finance purchases of the future
(spending less on clothes to save up for a car or getting paid once a month
and spending your income over the month after).

Precautionary motives: saving money for security against unforseen events.
(Saved up money can finance things like Funerals, Healthcare costs or daily
living after income source is lost) This is commonly affected by economic
confidence.

Speculative Motives: Saving money to invest in the hope of gaining a return
on assets. (Buying bonds, shares and houses as well as saving in term
deposits and bank accounts)
− Decisions to work, get education and retire

Work: people may choose to or not to work due to the amount of
benefits/money gained out of them. (Social security Vs. Net Income)

Education: More education and training allows the obtainment of more
skills, knowledge and competencies. Skills and competencies gained through
education and training will allow people to do higher skilled jobs that
contribute more to the production of goods and services and consequently
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 get a higher wage and better job as a result. Though, the opportunity costs
include the time (potential income) and the costs of education.

Retirement: the ability of someone to provide for themselves in retirement
will affect decisions to retire. (Compulsory Superannuation contributions and
incentives assist in giving people better ability to have a self-funded
retirement)
− Voting and participation in the political process

Economic circumstances of individuals can affect political loyalties (Upper
class-Liberal, Working class-Labor)

Economic performance of current government (It is common for
governments that fall on bad economic times to be dumped)

Lobby or interest groups for their economic situation can increase political
involvement (Trade Unions, Political parties, Professional associations)
− Businesses
− Product prices and supply

An increase in demand can make firms increase the price of goods or
increase supply (Allocate more resources) in that area.
− Resource usage

An increase in the price of one factor will mean less of it is used and more of
the others are used. (Rising labour costs induces a shift to use more
capital/machinery)
− Industrial relations

High unemployment may give employers more bargaining power against
employees and unions

Low unemployment may give employees and unions more bargaining power
against their employers.
− Government
− Economic factors influencing policy

Higher unemployment and/or recession can make governments to lower
interest rates (Monetary Policy) and increase spending (Fiscal Policy).

Higher inflation can cause governments to increase interest rates and
discipline their spending
− Policy influencing economic factors and therefore businesses and individuals

Spending on infrastructure (better productivity/efficiency in areas)

Fiscal and Monetary policy (induce consumption/saving and influence costs
of credit)

Redistribution of income or progressive income tax (take from the rich, give
to the poor)

Market regulation (price regulation/surveillance, legal frameworks for
dealings, competition policy, wages regulation, environmental regulation)

The operation of an economy:

The economy refers to the way in which a society is organised to solve the economic problem.
Economies (its systems and organisation) coordinate and facilitate the production and
distribution/exchange of goods and services to satisfy wants in the marketplace.

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An economy must aim to satisfy the greatest number of wants with the resources that it has been
given.

In order to produce goods and services and help solve the economic problem (making the best use
of the resources that an economy has and therefore satisfying the most number of wants in priority),
there are four questions that need to be answered to tackle the economic problem:

1. What to produce?
2. How much to produce?
3. How to produce?
4. To whom to distribute?

By answering these four questions, both functions of the economy (Production and
Distribution/Exchange) can be efficiently carried out and the economic problem solved as best an
economy can with the limited resources it has available to it.

Production

The first three questions apply to the production of goods and services:

− What to produce?
− To satisfy as many consumer wants while maximising profit, producers will have to
respond to demands by consumers about the goods and services they want and
will buy.
− In answering this question, resources will be allocated in the best way to satisfy
wants in an economy while maximising profit.
− How much to produce?
− When an economy has figured out what it needs to produce, it will need to know
how much of a certain good/service it will need to produce based upon the
demand in the market and the resources available.
− In answering this question, there should be a sufficient amount of that product
made for the market (no surplus or shortage of product and therefore wants left
unsatisfied). It also will affect the resources that need to be acquired to produce
goods.
− How to produce?
− Once an economy knows what it needs to produce and the various amounts of it to
best satisfy wants in the economy, it can start to figure out what and how much of
a resource (factor of production) it needs and how to best combine the factors of
production (method) to produce goods and services to satisfy demand and
maximise profit. In order to maximise profits, producers will try to minimise
production costs by producing in the most efficient way.
− The method used to produce a good/service will depend on the resource costs and
availability, the nature of the good/service and the technology that is available to
be used for production.
− The resource costs and availability is likely to have the most influence over method
of production the most as it detrimental to production costs. For example,
countries like China and India where labour is relatively abundant and cheap (low
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 per capita incomes), will be inclined to use labour more and therefore choose
labour intensive production methods. Countries like Australia and Germany where
there is (high per capita incomes) is would be inclined to use cheaper resources like
capital and therefore choose Capital intensive production methods.

Distribution and Exchange

Because resources are still scarce, goods and services and the resources needed to produce them
will still be limited, meaning not everybody will get everything what they want. So therefore,
economies face the question of “To whom to distribute?”

The economy solves this problem of distribution through attaching a value or “price” to goods,
services and resources. Being wealthy enough to pay for product will allow you to have them. As
people have a limited amount of wealth, they will have to best allocate their wealth for different
goods and services to give them the best amount of satisfaction. As person’s wealth is very much
attached to their income, a higher income would allow you to satisfy more wants as you are able to
buy more goods and services. The inverse applies to a lower income.

As distribution of goods, services and resources in an economy take place through products having a
value, the need for exchange will also need to be taken care of. Having a certain amount of wealth
will not allow you obtain a product. You will need to exchange the price of that product from your
wealth in order to get that product, so that the person you are buying from can then use that to get
the products they want. In ancient times, the exchange of goods was commonly facilitated by barter
(the exchange of products) but these days the exchange of goods is commonly facilitated by the
provision of money or rations.

Prices should act as an accurate indicator of the value of a product in relation to other products, the
supply of that product and the demand for that product. This helps people to be able to properly
compare goods, services and resources so that they can allocate resources in the best possible way.

Resources and the provision of income

As different people hold different resources (specialisation) they can either sell their resources for
the production of goods and services or use their resources to produce goods and services for them
to consume themselves or sell. When a resource or factor of production is sold, the factor income
return will be gained which is basically income.

The income gained from a resource is called its respective factor income name according to the
factor of production it belongs to (Rent, Wages, Interest, Profit) and the amount gained is affected
by the quantity and quality of that resource used in production. What this means is that the amount
of return on a resource depends on the resource’s productivity in production.

The provision of employment and the quality of life

When firms obtain resources for production from households (commonly labour), they give an
income in return for those resources. This exchange can be referred to as “employment”.
Households rely on both government and firms to provide employment so that they can obtain
productive resources owned by households.

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Employment can be categorised in economics according to the sector (industry) of economic activity
in which they lie:

− Primary Industry:
− This refers to the businesses that are involved in the extraction of raw materials.
(E.g. Agriculture, Forestry, Mining)
− Secondary Industry:
− This refers to the businesses that process raw materials for use by consumers and
other businesses. (E.g. Manufacturing)
− Tertiary Industry:
− This refers to businesses that are involved in the retailing, wholesaling and
distribution of goods/services to consumers. (E.g. Shops, banking, education,
hospitality)

As before, a human’s income is derived from employment (selling labour for wages). The level of
income will determine a person’s wealth and therefore their ability to purchase goods and services
in order to satisfy wants. The higher the income, the more goods and services they can acquire. The
amount of goods and services one can obtain and therefore wants satisfied, will determine their
quality of life.

In relation to an economy; a person’s quality of life is determined by the quantity and quality, they
are able to acquire in an economy, of three things:

− Material goods :
− This affected by the level of income they earn, the types and nature of employment
available and their access to a range of consumer goods and services.
− Non material goods
− These are affected by access to collective goods like healthcare, public transport,
defence and emergency services.
− Other factors in the economy:
− This includes factors like a clean environment, the relative freeness from crime and
disorder and freedoms/democracy.

An example of this in action is the economies of a developed country versus a developing country.
The developed country has a high per capita income, which means a person’s average income is
higher than that of a developing country and therefore is able to acquire more goods and services.
Developed countries also usually collect a high amount of tax and therefore can provide a
substantial amount of collective goods and services. Developed economies also come hand in hand
with democracy and therefore the freedoms given to people as well as their ability to lobby for
action on issues like the environment will give them a better quality of life. An economy’s ability to
provide better quality of life to the people in it, is known as its “living standards”.

The business cycle

As economy grows (More goods and services produced), its ability to provide a good quality of life is
better. The same is for the inverse, when an economy contracts. Economies, especially free market
ones usually follow a phenomenon called “the business cycle”, where there are times of economic
growth and times of contraction due to market failure. As the economy grows and contracts, the
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living standards can be adversely affected as the amount of goods and services produced fluctuate.
The total monetary amount of goods and services an economy produces in a year is called its Gross
Domestic Product (GDP).

The business cycle is a model that is used to represent the times of growth and contraction. The
model looks like this:

Peak (boom)
Trend line

Peak (boom)

Peak (boom)
Real GDP

Trough (Recession)

Trough (Recession)

Trough (Depression)
1 Cycle (trough to trough)

Time
There are four regions (stages) that the business cycle goes through:

− Upswing (growth):
− This is a phase where expenditure, output, income and employment levels rise in
the economy. This also means higher tax revenue of governments which could allow
more financing of collective wants.
− Boom (Peak):
− This is a phase where expenditure, output, income and employment levels are at its
peak or maximum for that upswing in the economy. This could create shortages of
labour and higher inflation.
− Downswing (Contraction):
− This is a phase where expenditure, output, income and employment levels falls in
the economy. This is usually sparked by a high amount of inflation or market failure
and shows a decrease in economic activity.
− Recession (Trough):
− This is a phase (AKA “Bust”) where expenditure, output, income and employment
levels are at its minimum for that downswing in the economy. This could mean high
unemployment and even deflation. If the trough is prolonged and very deep, the
phase could be described as a “depression”. (Note: Officially, two quarters with a
contraction in economic activity is declared a recession)

Over time, the trend for economies through the booms and busts is for economic activity on average
to increase. This would mean an increase of the standards of living in an economy over time. This is
represented in the model by the Trend line.

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Booms and busts can adversely affect the economy in ways like high inflation, high unemployment
and significant contraction of economic activity which will affect a person’s quality of life and the
standard of living in the economy. In order to make the upswings and downswings less
violent/severe governments try to smooth out the booms and busts (Dotted line) using “counter
cyclical macroeconomic policies”. This means that the government will make policies that stimulate
economic activity in downturns (Increase fiscal spending, Decrease interest rates, Tax Incentives)
and policies that curb economic activity in upturns (Increase interest rates, Preserve environmental
resources, decrease fiscal spending).

The circular flow of income

The circular flow of income is a model used to simplify and represent the flows or exchanges of
resources, income and money in the economy. The circular flow of income models the structure and
the interactions (flows) between sectors in the economy. In order to simplify the economy for the
model, various entities in an economy are classified according to the similar economic
activities/functions they do. These sectors include:

− The household sector:

− This sector contains all the individuals that earn an income (Y) (Rent, Wages,
Interest, Profit) from the productive resources they sell to the businesses in the
economy. They can also earn in an income from government in the form of social
security. With the income they earn, they can purchase goods and services from
firms (spend money or carry out expenditure (E)), pay taxes (T) or save their money
(S).
− The firms sector:
− This sector contains all the businesses/enterprises that produce and distribute goods
and services to consumers in the economy. Firms will produce goods and services
called output (O) for consumers to buy and will subsequently acquire productive
resources from households to produce goods/services.
− The Financial sector:
− This sector contains of all the financial institutions that facilitate the borrowing and
lending of money and the sale and purchase of financial assets/services to firms and
households. In the model, they take the money saved (S) from the income of
households and lend it to firms for investment (I) for the use of capital accumulation
(purchasing and building up of capital).
− The Government sector:
− This sector contains the governments that collect revenue of taxes (T) and with it
spend it through government spending (G) or “Fiscal Spending” in order to provide
collective goods as well as social security.
− The Overseas sector:
− This sector contains all the international importers and exporters of goods and
services outside the country/economy. When the overseas sector brings in
goods/services to the economy, money to pay for it goes out of the country and
therefore imports (M) is a flow of money out of the economy. When the overseas
sector buys and takes out goods and services out of the economy, money to pay for
it comes into the economy which therefore makes exports (X) a flow of money into
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 the economy. The transactions involving goods and services are known as “trade
flows”
− This sector can also contain the money or “financial flows” of the lending and
borrowing of money between foreign institutions and domestic sectors.

The circular flow of income model (5 sector) looks like this:

Income (Y)
Resources

Households Firms
Output (O)
Expenditure (E)
Leakages

Injections
Savings (S) Financial Sector Investment (I)

Govt. /Fiscal
Taxation (T) Government Sector spending (G)

Imports (M) Overseas Sector Exports (X)

Leakages, Injections and Equilibrium

In the circular flow of income, the flows between the firms and households (red lines) are said to be
flows within the economy. This means that the households will sell their resources to firms for
money which they can then spend on buying goods and services to replenish their resources and
satisfy their wants. If the economy consisted of just these flows, the money would be constantly
cycling between the firms and households. This means that all the income that households receive is
spent (expenditure) on buying all of the goods and services (output) that firms produce (Y = E = O).
This is known as the two sector model, where the amount of money in the economy stays constant.

Though, as the economy has the other sectors that also take money from the firms and households,
they stop the process of all income being spent and all output being bought. They are said to take
money out of the economy, called “leakages”. But these sectors also give money back to households
and firms, which would put money back into the economy. These flows are known as “Injections”. In
the 5 sector model, there are three sectors that facilitate leakages and injections:

− Financial sector :
− This sector will take savings made by both households and firms and lend it to
people in the economy (mainly firms) for capital accumulation (the purchasing of
capital). The leakage is known as “savings” (S) and the money lent or injection is
known as “Investment” (I). This sector makes a profit from their activities by

16
 charging a higher interest rate to the borrowers than the interest they pay to the
people in return for the money they have saved with them.
− Government sector:
− This sector will take its leakage of Taxes (T) of charges on firms and households and
injects the revenue into the economy through its spending of “Government/Fiscal
Spending” (G) on collective goods it buys from the firms that produce them to satisfy
collective wants.
− Overseas sector:
− When this sector sells goods and services to people in the economy, it will take
money out of the economy to pay for those products. This leakage is called
“Imports” (M). But when the economy sells goods and services to foreigners, money
for those products come into the economy. This injection is called “Exports” (X).
− Economies with an export sector, is known as an “open economy” as it has
international trade. An economy that has no overseas sector and therefore no
international trade is known as a “closed economy”.
− The record of transactions with the overseas sector is called the “Balance of
payments”. It is made up of the current account, capital account and the financial
account.

In an economy, a situation where the leakages are equal to the injections is said to achieve
equilibrium:

S + T + M= I + G + X
Leakages = Injections

If the leakages were to outnumber the injections into the economy, the economy would lose money
overall. This can have detrimental effects as theorised by the economist John Maynard Keynes
though the theory known as the “paradox of thrift”:

− Through money leaking out of the economy, while people may think they are better off as
they have more wealth by saving, the economy is getting smaller. This means that through
leakages, households would not spend all of their income but save some of it. This would
mean that all the goods and services produced by firms would not be all bought, which
would mean they would have to decrease production.
− In decreasing production, the firms would lower the amount of income given to households
(as they need less resources) and the number of products to satisfy wants in the economy as
a whole.
− This would be bad for the economy (and eventually its inhabitants) as incomes will fall
(causing savings to stabilise or fall) and the number of products in the economy to fall too
(lower standards of living/quality of life).
− On an unrelated but related note in case you missed it, the reason or whole point of the
paradox of thrift is not related to leakages (though the part about economies contracting is).
The actual point that the paradox is trying to make is that because the economy contracts,
this means less is produced which means less resources is needed which means less income
which means you can’t save as much anymore!! (you try to save more, but you decrease
your income and end up saving less or the same and hence, the “paradox of thrift”)

17
Therefore, it is very important to ensure that an economy is able to stop the paradox of thrift
propagating by ensuring that injections amount to the same as leakages, or in other words the
economy achieves “equilibrium” as best as possible. Theoretically speaking, an economy should be
able to regain equilibrium by itself if it were ever to move away from it. This is because:

− If leakages were to outnumber injections (S + T + M> I + G + X) households should cut back

on their saving, pay less in taxation and would try to buy less exports. This would mean that
the leakages would decrease until the injections were on par, giving a lower income
equilibrium.
− If injections were to outnumber leakages (S + T + M< I + G + X) households should save more
as their income grows, pay more in taxation and would buy more exports. The leakages
would increase until the leakages were on par, giving a higher income equilibrium.

Economies: Their similarities and differences:

As an economy can be defined by the ways in which various groups in society or economic activity
are organised to solve the economic problem, an economic system can be defined by the way it
solves the economic problem in terms of production and distribution and exchange (how it answers
the four economic questions).

Economic systems can be characterised by main traits that include:

• Who owns or who can own the productive resources

• How prices and incomes are determined (markets)
• The roles of government

Economic systems can be classified into two categories according to the train of thought that their
base principles come from, one of them being Capitalist and the other being Socialist/Communist.

Capitalist economies (AKA “Market economies”):

These economies base their principles around personal wealth and the control of market forces by
the entities that make up the market. The economy will be controlled by market forces controlled by
the people’s economic decisions in the market which are guided by self interest (what is best for
one’s self), the profit motive (Selling higher than cost) and the freedom to pursue the acquisition of
private property though freedom of enterprise.

− The free market economy (“laissez-faire”):

− The free market economy is based upon the government having no role in economy
apart from the provision of currency, law and order to uphold private property as well
as regulation against fraud or contravenes of official transactions.
− The economy is guided solely upon the entities that make it up. Their economic
decisions will guide the market.
− What to produce and how much to produce is guided by the market forces of supply
and demand or “price mechanism”.

18
 − How to produce is guided by producers trying to make the most efficient use and
combination of resources available to in pursuit of the profit motive.
− To whom to distribute is guided by the amount of income (or wealth) people have. The
more money people have the more they can afford and buy. Income determined
through price mechanism based upon the contribution to production
(higher skills higher pay) and the supply and demand for labour.
− Efficency increased though competition. This would call for the need for “consumer
sovereignty” (the ability for consumers to make the best decision for themselves).
− Low barrier of entry into market (Easy setting up of enterprise into a market) is also
required to increase incentives to compete (Free markets doesn’t mean competition is
inherent or that it can create and pull competition out of its arse) as people pursue the
profit motive. (E.g. Australia makes lots of money selling home fusion energy
reactors Chinese see that Australia is making heaps of money and start selling
Chinese home fusion energy reactors.)
− The mixed market economy:
− The mixed market economy is very similar to the free market economy in that the
entities that make up the market control the market forces that guide the
market/economy but the government has a larger and interventionist role in the
economy.
− The government roles in the economy includes:

Provision of currency, upholding of private property, outlawing fraud in
transactions

Provision of collective goods (E.g. Healthcare, education, infrastructure)

Redistribution of income through taxes and social welfare

Macroeconomic and Microeconomic policies to intervene or affect economy to
improve social/market outcomes (especially in times of recession). This includes
incentives (Taxes & Subsidies) that serve a purpose to manipulate the economy.

Can include Governmental monopolies (E.g. Railcorp, Australia post) or
Government granted monopolies (E.g. ASX, well it used to be and
patents/intellectual property)

Market regulation like:
• Environmental
• Industrial relations and minimum wage
• Protection of consumers and producers
• Competition Law
• Price regulation
− Newly industrialising economies (NIE):
− These economies are almost the same as free market or mixed market economies. They
are classified differently as they are developing/ growing at a high rate from their
previous classification as a developing economy.
− Previously characterised for low per capita incomes and living standards, they are
economies that are experiencing rapid growth towards developed economy status.
− These economies can be achieved through the government having a key interventionist
role in encouraging high levels of saving (capital), investment, counter-trade deficit as

19
 well as capital accumulation and raising labour productivity through education and
training.

Socialist/Communist economies:

These economies base their principles around the public ownership of everything, the equal
distribution of wealth and the control of market forces by the government. In these economies,
motivation to work or produce is usually through loyalty to the state or community to benefit
everyone in society.

− Planned economies:
− These economies are hinged on the government or central planner that controls the
economy.
− This means that there is very little personal economic or political freedom, but the
decisions are taken care of by central planners anyway
− What and how much to produce is decided by the government as it sets out national
goals to achieve. Production targets, estimates and quotas are all set out in order to
achieve these goals which spell out what and how much to produce.
− How to produce is also decided by the government. It will allocate resources based
upon production targets and quotas and resource estimates.
− To whom to produce is controlled by government through using either rations, set
prices, subsidies or at no cost.
− Market forces are either non-existent or controlled by the government.
− Production largely carried out through government owned enterprises.
− Governments can also use augmented incentives (E.g. Higher wages for a certain job,
slavery, floggings) to motivate people if loyalty isn’t enough.

Aside from capitalist and communist economies are the ones that are moving from one to the other
or have no defined economic organisation or principles. These are known as “Transition economies”.
These economies are commonly made up of ones that are moving from planned economies to more
capitalist economies (People have realised communism is a failed idea). Transition economies are
characterised by:

− High government role in facilitating changes to their economies of:

− Introducing/establishing independent markets determined by supply and demand.
− Opening up international trade
− Encouraging investment and Capital accumulation
− Developing frameworks (especially legal) for private ownership
− Deregulation of markets and lessening government controls as well as increasing
political and personal freedom
− Providing ongoing support and close monitoring of economy while in transition

Comparing economies (Australia Vs. Indonesia):

Australia is a relatively small (population 22 million approx) open economy that uses the mixed
market economic system. Australia, is classified as an “Advanced industrialised economy” or
developed economy by the world bank due to its features of:
20
 − High per capita incomes
− High trade orientation of the economy with exports ranging from agricultural to mining to
manufactured goods and services
− Highly industrialised with a manufacturing base
− High levels of investment
− A high level of standard of living with good access to education, health and social welfare

Indonesia is a relatively large open economy (population 220 million approx) which also uses a mixed
market economy. It is classified as a “developing economy” by the world bank due to its features of:

− Low per capita incomes

− Small but increasing trade orientation of its economy with exports mainly composed of
agricultural goods and raw materials
− A relatively low manufacturing base
− Low levels of saving and investment
− A relatively low standard of living with limited access to education, health and social
welfare. Poverty is widespread throughout the country.

Economic indicators:

Economic indicator Australia Indonesia

Per capita income (2004 $US) $30,331 $3,609
Per capita income rank (2004) 13 110
Inflation average (1990-2004) 2.4% 13.5%
Unemployment rate average (2000-2005) 5.4% 9.9%
Exports as a percentage of GDP (2004) 18% 31%
Imports as a percentage of GDP (2004) 21% 27%
Current account balance (2005 $US) -$42,286,000,000 $929,000,000

Structure of demand:
Indicator ( as a percentage of GDP) Australia Indonesia
Private consumption (2005) 59% 65%
Government consumption (2005) 18% 8%
Gross domestic investment (2005) 26% 22%
Gross domestic savings (2005) 20% 24%
External balance (2005) -6% 0.1%

Economic growth

Indicator Australia Indonesia

GDP (2004 $US) $637.3 billion $257.6 billion
GDP rank (2004) 13 22
GDP annual average change (1990-2004) 2.5% 1.8%

Employment and Unemployment

Labour force indicators:

Indicator Australia Indonesia
Population (2005-2006) 21 million approx. 220 million approx.
Population (aged 15-65 yrs old 2005-2006) 14 million approx. 146 million approx.
Total Labourforce (2006-2007) 11 million approx. 107 million approx.
Labourforce average annual growth (1990- 1.3% 2.4%
2005)

21
Participation rate (2006-2007) 64.8% 73.4%
Unemployment rate (percentage of 4.5% 9.9%
workforce 2006-2007)

Employment structure:
Sector (percentage of workforce) Australia Indonesia
Primary 4.8% 44%
Secondary 10.2% 17.5%
Tertiary 85% 38.5%

Quality of life

Quality of life indicators:

Indicator (2004) Australia Indonesia

Life expectancy at birth 80.5 years 67.2 years
Adult Literacy rate (percentage of people 100% 90.4%
over 15)
GDP per capita ($US) $33,301 $3,609
Prevalence of child malnutrition (1995- 0% 28%
2004)
Urban population (percentage of total) 88% 47%
Access to sanitation (percentage of urban 100% 55%
population)
Under 5 mortality rate (per 100 births) 6 29
Access to clean water (percentage of 100% 55%
population)

HDI (Human development Index) by World Bank indicators:

Indicator Australia Indonesia
HDI (2004) 0.957 0.711
HDI rank (2004) 3 108
HDI rank (2003) 3 110

Environmental Sustainability/Quality

Environmental quality indicators:

Indicator Australia Indonesia
Freshwater resources (m3 per capita 2005) 24,202 12,867
Access to safe water (percentage of Urban 100% 87%
population 2004)
Annual deforestation annual average (km2 170 10,844
1990-1995)
Nationally protected areas (km2 2004) 745,300 259,900
Protected areas percentage of total land 9.7% 14.3%
area
CO2 emissions (tonnes 2003) 354,100,000 295,000,000
CO2 emissions per capita (tonnes 2003) 12.8 1.4

The role of government

Central government finances:

Indicator (percentage of GDP 2005) Australia Indonesia
Tax revenue 26% 18.5%
Expenditure 24.8% 17%
Capital expenditure 1.3% 5.7%

Overall deficit/surplus 1.1% -1.1%

22
Public expenditure on education:
Indicator Australia Indonesia
Public expenditure on education 4.8% 0.9%
(percentage of GDP 2002-2004)
Public expenditure on education 13.3% 9%
(percentage of government expenditure
2002-2004)
Primary and secondary (percentage of all 73.5% 80.9%
levels of education 2002-2004)
Higher education (percentage of all levels 24.5% 19.2%
of education 2002-2004)

Health profile:
Indicator Australia Indonesia
Public expenditure on health (percentage 6.4% 1.1%
of GDP 2003)
Health expenditure per capita ($US 2003) $2,874 $113
Doctors (per 100,000 people 1990-2004) 247 13

Role of government in the economy:

Indicator Australia Indonesia
Subsides and current transfers (percentage 6% 63%
of expenditure 2005)
Military expenditure (percentage of GDP 1.9% 1.1%
2004)
Total government expenditure 18% 8%
(percentage of GDP 2005)
Highest marginal tax rate on individual 45% 35%
income (2007)
Corporate tax rate (2007) 30% 30%

23
Chapter 2: Consumers and Business
It can be said that an economy can be simply made up of two types of entities. One of them is the
households or consumers and the other is the firms or businesses. Both will interact with each other
in their own best interest with consumers trying to get the most amount of wants satisfied and the
businesses trying to make and maximise profit.

Consumers

Consumers are basically all the individuals in an economy that “consume” goods and services in
order to satisfy as many of their wants as possible. They purchase goods and services from the
businesses in an economy through the income they earn.

Consumer sovereignty

In a market economy, the questions of what to produce and how much to produce are controlled by
market forces that are guided directly through the demand of consumers. Consumers in controlling
market forces will make decisions in their own best interest (satisfying their wants as best as
possible) by buying the best products at the best price possible. Businesses, in order to maximise
profit, are compelled to make better products with better efficiency in order to sell their product
and make their money.

With consumers making economic decisions (purchases) in their best interest and businesses
responding to demand by increasing efficiency and producing to demand to maximise profit
(competition), the economy becomes more advanced and more importantly efficient in production.
Therefore, the ability of consumers to firstly, with their economic decisions, influence production
and to make those decisions in their own best interest is very important to have in the economy.
This ability of consumers to influence the production of businesses in their best interest is known as
“Consumer sovereignty”.

Patterns of consumer saving and spending

Consumers can basically do two things with their income. They can use part of it to spend on goods
and services which is known as “consumption” (C). They can also use part of it to not spend and
subsequently save which is known as “saving” (S). Therefore, the relationship between income (Y),
consumption (C) and saving (S) can be given by this rather blatantly obvious equation:

Y=C+S
(Income=Consumption + Saving)

The consumption function:

The consumption function, developed by economist John Maynard Keynes, is a mathematical
function that can be used to explain consumer spending. The consumption function states that
consumption is made up of two parts. One of them being Autonomous Consumption (Spending
regardless of income, or spending to satisfy basic wants) and the other being Induced Consumption

24
(Spending that is made related to the income earned). The function is below:

Where:
C is total consumption
C = C0 + cY C0 is autonomous consumption
(Total Consumption= c is the Marginal propensity to consume (MPC)
Autonomous consumption + Y is the disposable income (income after tax)
Induced consumption)

The “propensity to consume” is the tendency at which a person consumes based upon the income
they earn. “Average propensity to consume” (APC) is calculated by dividing consumption (C) by
income (Y) as seen here:

APC = C ÷ Y

“Marginal propensity to consume” (MPC) (the rate at which people will spend as their income
changes) is calculated by the change in consumption (ΔC) divided by the change in income (ΔY) as
seen here:

MPC = ΔC ÷ ΔY

MPC allows you to calculate how much people would spend of their disposable income, after they
had satisfied their basic wants (Autonomous consumption), if their income was to suddenly
increase/decrease. (This is important to the theory of the “Keynesian multiplier”). Also, theorised by
Keynes was that the higher your income is (because you could more easily afford your basic wants)
your consumption compared to your income actually decreases. This is because your basic wants are
more easily satisfied and therefore your ability to save increases. The same occurs for lower income
earners.

The savings function:

The savings function, also developed by Keynes, is a mathematical function that explains consumer
saving. The savings function states is also made up of two parts. One of them being Autonomous
Saving (Saving regardless of income, which is actually the amount you do not save (due to the need
for autonomous consumption and you needing to satisfy your basic wants)) and the other being
Induced Saving. (Saving that is made related to the income earned). The function is below:

Where:
S is total saving
S = -C0 + sY -C0 is autonomous saving (Negative “C0”)
(Total saving= Autonomous saving s is the Marginal propensity to save (MPS)
+ Induced saving) Y is the disposable income (income after tax)

25
(Note: When income is zero, the total saving ends up being –C0. This is because, of autonomous
consumption (Even if you don’t have income, you still need to satisfy basic wants to survive). This
means that the person would have to borrow or draw funds from their previous savings. This
“negative saving” is known as “Dissaving”)

The “propensity to save” is the tendency at which a person saves based upon the income they earn.
“Average propensity to save” (APS) is calculated by dividing saving (S) by income (Y) as seen here:

APS = S ÷ Y

“Marginal propensity to save” (MPS) (the rate at which people will save as their income changes) is
calculated by the change in saving (ΔS) divided by the change in income (ΔY) as seen here:

MPS = ΔS ÷ ΔY

MPS allows you to calculate how much people would save of their disposable income, after they had
satisfied their basic wants (Autonomous saving which is actually Autonomous consumption), if their
income was to suddenly increase/decrease.

Here’s an example consumption and saving schedule to demonstrate the four formulas above:
(Y = C + S) APC MPC APS MPS
0 50 -50 0 0.5 0 0.5
200 150 50 0.75 0.5 0.25 0.5

Now, the consumption function for this schedule is:

C = 50 + 0.5Y
And the savings function for this schedule is:
S = -50 + 0.5Y
The APC equations of the two:
0 (I know it’s undefined but it’s a percentage so deal with it…) = 50 ÷ 0 and 0.75 = 150 ÷ 200
The APS equations of the two:
0 (Again it’s a percentage so deal with it…) = 50 ÷ 0 and 0.25 = 50 ÷ 200
And as because I told you before that:
Y=C+S
Therefore: APC + APS = 1 (it’s a percentage)
And: MPC + MPS = 1 (you can only save or consume your income)

Not shown by the example above: John Maynard Keynes also theorised that the higher your income
is the lesser proportion of you income you will spend (MPC falls). This is because your basic wants
are more easily satisfied and therefore your ability to save increases (MPS increases) (Or, you could
be like an Australian and spend the extra money you have anyway…). The same occurs for lower
income earners. Their MPC is higher as their ability to save is lower (lower MPS) as they cannot
satisfy their basic wants as easily.

This phenomenon explains why developed economies, with their higher per capita incomes, have
higher economic growth rates than developing countries with low per capita incomes. The higher
your income the higher the MPS, which means there is more money saved and therefore available to

26
invest in more capital (Capital accumulation), growing the economy faster as more is produced.
Though developing economies struggle to have enough money for capital investment and often have
to rely on foreign aid or foreign investment to supplement the low levels of saving in investment for
capital accumulation to grow their economy faster.

Other things that affect consumer spending patterns:

Consumption patterns also vary with many other factors including age, circumstance as well as
changes in social/society’s mentalities and attitudes.

Age is one of the most prominent factors as it will affect tastes as well as income as it changes.
People who are younger are likely to spend more on technology, entertainment, communications
and products that come about from trends like free range eggs rather than on things like healthcare
and insurance. Older people are likely to consume more insurance and healthcare as well as
recreation than technology. Also the income levels changes as people go through life can also affect
consumption in different people. The life cycle consumption hypothesis demonstrates this:

As the youth and elderly tend

not to have any income (no
jobs) they are likely to borrow
Consumption & Income

or raid their savings to pay for

their basic wants.
Saving
In you working life, mature
age, you have a good amount
of income which allows you to
spend more but also save in
order to retire comfortably
Dissaving from your own savings.

Time/Age
Circumstance is also another factor with retirees likely to spend more on healthcare and holidays
while students are likely to consume more clothing, services and educational goods. Married couples
tend to spend more on household goods for the households while single people tend to spend more
on alcohol and entertainment.

Society’s changes and attitudes also change consumption patterns. People these days consume
more communications, health and recreation compared to people in the old days that tended to
consume more food and private transport. One example of pattern change is the shift to products
that are labelled more environmentally considerate as society becomes more influenced by and
sympathetic towards environmental issues.

Factors influencing individual consumer choice

There are many factors that influence the consumer in their decisions, some of them are:

27
− Income:
− From the consumption and savings functions above, it can be seen that the level of
income that a consumer earns will greatly affect their consumption and savings
habits. Increasing incomes come with lowering MPC and increasing MPS as their
income opens up new avenues to put their income towards (E.g. Luxury goods, Real
Estate investment, Share market investment)
− A fall in income usually affects the demand for normal goods and inferior goods.
Normal goods are ones that are usually demanded by the population for their
quality, price and brand. Inferior goods are ones of lower quality or band that
increase in demand when incomes fall (as people try to tighten up their belt and
substitute) but fall in demand when income levels rise again.
− Price:
− According to the demand curve (the demand line of a supply and demand curve), a
rise in price of a good/service will mean consumers will respond with less demand as
their income allows them to buy less of that good/service. The inverse happens as
the prices fall as people would be able to buy more if that product. Price changes
will affect what is known as “real income” of a consumer as it measures the
purchasing power of their income (what their income can actually buy, rather than
the amount).
− Price of substitutes:
− Substitute goods are ones that are able to be used in place of another good. This
assumes they are similar enough that they both can satisfy a consumer’s want fairly
well compared to each other (E.g. Brand vs. Generic, Tea vs. Coffee and Butter vs.
Margarine).
− The relative price (price compared to another) of Substitute goods will also influence
consumer decisions as people may be able to switch between each one and still
satisfy their wants while saving money.
− Price of compliments:
− Complementary goods are goods that are needed to be jointly used with another
good. (Cars and petrol, Macs and nooses, Morris Minors and pianos.)
− The price of compliments will also affect decisions to purchase goods as the costs of
their compliments will need to be factored into the price of the current good (So, as
to be able to make use of that product). For example: If petrol prices rise
theoretically, less cars and mechanical services will be bought.
− Consumer tastes and preferences:
− Probably only second to income, consumers are swayed considerably by their tastes
and preferences. This is probably mainly due to the fact that it is their tastes and
preferences that create the bulk of their wants in the first place. Individuals will have
different preferences and different annoyances. Preferences and tastes are also
always changing with time as they are influenced. (For example: before, everyone
just bought eggs… Now, “Free range” is all the rage!!)
− Tastes and preferences can be influenced by: Weather, Fashion, Education, Social
pressures and advertising. For example: hot weather will call for cold goods like ice,
chilled drinks and ice creams while cold weather will call for hot food like chips.

28
 − Advertising:
− Advertising is the dissemination of information or ideas about a good/service in
order to influence consumption. They are used to influence consumer preferences
and tastes through various media.
− Informative advertising conveys facts like price, quality, range and features of a
product/brand.
− Persuasive advertising attempts to build brand/product loyalty through linking a
certain social image or other non physical attribute of that product to that product.
− One good example is the consumption of red meat throughout the past 30 years. In
the 80’s it was linked to heart disease and consumption fell. 20 years, one monkey
and the guy off Jurassic park dancing in an advertisement later, consumption of red
meat has risen.

Sources of income:

There are five main income sources. They are:

− Wages:
− This refers to the wages, salary or “renumeration” that people can get through
selling their labour to firms (employment). This type of income is most common in
Australia with it making up 56% of household income in the 2005-06 financial-year.
This type of income can be referred to as “earned income” as it actually incurs work
by individuals.
− Rent:
− This refers to the income made from selling natural resources. This is commonly
rental of real estate/property.
− Interest:
− This refers to the income made from investments or savings that are given to other
people to use for capital accumulation. This includes interest from bonds, saving
account, term deposits and debentures.
− Profit:
− This refers to the income made from the provision of entrepreneurship to firms. This
includes: fees, royalties and dividends.
− Social welfare:
− This refers to payments made by the government to certain sections in society for
the purpose of promoting income equity. The money for this is usually funded
through taxes. Some of the “transfer payments” made by the government include:

Pensions for old, disabled, widows, veterans and sick

Family allowances to help fund expenses of children in low income families

Unemployment benefits for those unemployed but “actively looking” for
work

Youth/education allowances for people who undertake full time education

Special payments for natives to assist in the advancement of them in society
− Social welfare account for about 10% of household income in 2005-06.

The composition and amount of income from the various factor returns is largely influenced by
economic activity and rate of unemployment. For example: If there was a high rate of
29
unemployment as well as a high interest rate the amount/proportion of income from wages would
of fallen while the income from investments of interest would rise (Though, it is unlikely these days
that the two would go hand in hand).

As said before, a person’s wealth (the net value of real and financial assets owned) is usually
dependant on their income as it is their income level that allows them to be able to save more due
to a rising MPS. Though, the main exception is usually where there are owner occupied
housing/assets of the owner occupying a very valuable home but having very little income. Many
pensioners are known to end up in this situation.

Businesses:

Businesses are basically firms in the economy that combine the four factors of production to
produce and sell goods and services to satisfy consumer wants in the economy with the ultimate
goal to make profit at the end of the day. Businesses are essential to an economy as not only do they
produce goods and services but also provide employment (exchange of labour for money) and
income opportunities for households.

Definition of a firm and an industry:

Firms:

Firms can be described as a business organisation that owns rents and operates business equipment,
hires labour and buys materials. They then organise and co-ordinate these to produce goods/
services to satisfy consumer wants with the ultimate goal of making profit from the exercise.

Firms can be legal entities by themselves usually through the type of legal structure they have. If
firms are “incorporated” they are legal entities and are said to give their owners “limited liability”
(owners are not liable for the company’s actions and are only liable for debts to the extent of their
shareholding). Firms that are not fully legal entities are said to be “unincorporated” and give their
owners “unlimited liability” (owners are responsible for all company actions including debts even if
company ceases to exist).

Here are some characteristics of different business legal structures:

Unincorporated Incorporated
Features
Sole trader Partnership Proprietary limited Public company
Number of owners 1 2-20 1-50 Min 3 plus Secretary
Board plus paid
Management Owner-manager Shared by owners Board of directors
managers
Personal savings /bank Shares of
Start up capital Shares sold by invitation Shares sold to public
loans partners/borrowings
Liability Unlimited Unlimited Limited Limited
Profits/borrowing/privat Profits/ borrowings/
Expansion Profits/borrowing Profits/borrowing e invitation to selling new shares to
buy shares public
Doctors, Dentists, Law Family businesses. Small
Examples Trades people Multi-nationals
firms business
Registered business Partnership agreement Propriety limited Name has “Limited”
Legal status
name creates entity company (Pty Ltd) (Ltd)

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Industries:

An industry is basically a classification on a group of businesses that are producing similar products
to the economy. Industries can be classified according to the production they carry out:

− Primary industry
− Extraction of Natural resources
− Examples: agriculture, mining, fishing, hunting, forestry
− Secondary industry
− Processes raw materials into usable goods and capital
− Examples: Manufacturing
− Tertiary industry
− Selling final goods and services to consumers and other businesses.
− Branches of tertiary include: Quaternary( Information services)and Quinary
(Personal services)
− Examples: Retailing (tertiary), Information technology (Quaternary), Research &
Development (Quaternary), Education (Quinary)

A firm’s production decisions:

A firms production decisions basically rely upon answering the first three economic questions of the
production side of the economy. The firm would have to see what consumers demand and the
expertise of the company, to decide what to produce. Then also based on consumer demand and/or
price decide how much of that product to produce so that demand is met and that the company
makes a profit. Then finally once they know what and how much to produce, they can answer the
how to produce question in combining the four factors in the most efficient way (the cheapest way),
managing the production process and ensuring profit at the end of the day to give to the
entrepreneur for his risk taken.

Business as a source of economic growth and increased productive capacity

As businesses try to maximise profits, one of the avenues they can use to pursue larger profits is to
grow and expand their production so that they can sell more. As businesses grow and new
businesses are established, the amount of production in the whole economy increases which means
more goods and services or an increase in productive capacity (The ability to produce).

Businesses are extremely crucial to economic growth as when they increase productive capacity,
there are more products available (more wants satisfied) and more resources bought and employed
(increase in incomes) to buy the products produced.

The goals of the firm

There are many goals or pursuits that a business can have when it produces goods and services for
the market. They include:

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− Profit maximisation
− This is one of the main goals of a business. It ensures that businesses act rationally
making good use of resources in the pursuit of making profit on the products they
sell.
− Making profit encompasses making sure that the Total revenue (TR) (all the sales) of
the firm is more than the Total costs (TC) (costs of making products and selling
them). Profit is calculated as follows:

π = (TR) – (TC)
Profit = Total Revenue – Total costs

− The fixed costs of a business are the ones that are not variable to the amount of
input and have to be paid regardless of whether the company produces (Like offices,
managerial wages and insurance). Variable costs are ones that do vary with the
amount of input and are usually directly linked with production. (Like
materials/resources and wages).
− If (TR<TC) then the company is losing money and will have to reconsider its position.
If (TR=TC) then the company is neither losing money nor making it. AKA “break
even”. If (TR>TC) then the company is making profit which is great, but profit
maximisation is achieved when the positive difference is at its highest.
− Maximising sales or total revenue:
− This involves increasing productions so that more products can be sold rather than
finding efficiencies to produce larger profits.
− This can be carried out to increase market share or by managers to increase their
profile.
− This type of activity can usually encompass increasing output and increasing
spending on sales efforts which includes advertising.
− Usually firms do this by producing more product and lowering prices in the hope of
selling more to cover the profits lost by reducing prices at the end of the day.
− Maximising growth
− This can encompass growing business assets (for better survivability and capital
availability), investment into new equipment ready for demand increases, merging
and takeover activity to grow as well as franchising to grow brands and corporate
awareness.
− Increasing market share:
− This involves a firm selling its product to a greater proportion of the market to put
pressure on its competitors in the hope of long term profits. This can be carried out
through marketing or even price undercutting.
− Meeting shareholder expectations:
− This is another major goal of the business, to keep the owners happy. For public
companies, shareholders usually expect a good dividend, good/growing profits,
growing “price earnings ratio” (P/E) and a growing share price. Shareholders can also
expect a good corporate image (E.g. social/environmental responsibility).
− For other privately owned companies, owners can expect a good return on their
capital, employment for themselves/family as well as growth/expansion of the
business.
− Satisficing behaviour
− This refers to the motive of only achieving a minimum level of a particular variable
and not striving to achieve the maximum. In terms of firms, some will just try to
make a profit but once it is made, concentrate on achieving other goals.

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 −It has been said that while managers are supposed to be ensuring the firm achieves
a range of goals set for it (E.g. sales, profit, market share) they are actually
maximising manager benefits, job security, status and power.
− Other goals
− Profitable investments, cash flow, new technology, social objectives (profit sacrificed
for lowest prices typical for cooperative societies and government organisations)
Examples include: Credit unions and member health funds.
Cost and revenue theory

To calculate profits, it is imperative to understand the components of it being total costs and
revenues. Costs refer to the monetary expense made by firms to use the factors of production to
produce and sell goods. Revenue refers the payment from buyers for the exchange of goods/services
produced.

Costs (TC):
TC = Fixed costs (FC) + Variable costs (VC)

− Fixed costs (FC):

− The costs that are not variable to the amount of output and have to be paid (in the
short run) regardless of whether the company produces (Like offices, managerial
wages and insurance).
− Variable costs (VC):
− The costs that do vary with the amount of input and are usually directly linked with
production. (Like materials/resources and wages).
− Average costs(AC):
− The average cost of producing one unit of output by a firm.
Average cost (AC) = Total Cost (TC) ÷ Output (O)

− Marginal Costs (MC):

− These refer to the change in costs as more units are added onto production.

MC = ΔTC ÷ ΔO

Revenue (TR):

TR = Price x Quantity sold

− Average revenue (AR):

− The average revenue per unit of output or price a firm receives for selling their
product.

Average revenue (AR) = Total revenue (TR) ÷ Output (O)

− Marginal Revenue (MR):
− These refer to the change in costs as more units of output is sold.

MR = ΔTR ÷ ΔO

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Efficiency and the production process:

In the pursuit of profits, a firm will try to firstly ensure that they are being as efficient as possible
(getting more out of less) in the production of goods. The efficiency of production is known as
“Productivity”.

Productivity:
Productivity refers to how much output is made from its inputs. This is a measure of efficiency as a
higher productivity would mean lower inputs and higher outputs. There are three measurements of
productivity:

− Productivity:

Productivity = Output ÷ Inputs

− Multifactor/ total factor productivity (MFP):

− The productivity of all the factors of production used to make a certain quantity of

MFP = Output ÷ All Inputs

output
− Single factor productivity (SFP):
− The productivity of one or a single factor of production to make a certain quantity of
output

SFP = Output ÷ Single Input

It is in the interests of a firm to gain the maximum productivity possible as this will drive down costs
and allow a higher profit. Productivity increases can be gained from:

− Increased capital
− Advanced technology
− Economies of scale

Increasing productivity can have advantages and disadvantages:

Advantages Disadvantages
• Lower costs/high profits • Structural unemployment (cause by
• Lower prices/Higher real incomes technology)
• Economic growth • De-skilling of labour
• Technological progress • High rates of technological change and
• Increased competitiveness structural change in industry/firm

The law of Diminishing returns:

The law if diminishing returns refers to a phenomenon whereby when a resource/investment in

increased in one area (variable factor) but all other factors(Fixed factor) are held constant, including
technology (ceteris paribus), the output from combining the two will at first increase the output and
positive effect of the variable factor but after a certain point, output will:
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 1. Start to decrease in total number of output (Diminished return)
and/or
2. The efficiency or affect of the resource increase, falls (Diminished rate of return)

This phenomenon can be applied to many situations in economics including consumption and
savings theory (MPC/MPS), PPF curves (Convex shape) as well as production theory.

In production theory, increasing one variable while holding the rest constant (For example:
example:
Increasing the amount of labour employed on a farm while keeping the land constant) will make the
productivity increase for a while up until a point where increasing the variable factor (labour) with
the fixed factor (Land) starts not to make sense as the total output starts to decrease (Diminished
return or lower TPP) as well as the efficiency of the variable factor decreasing (Average physical
product) and effect of increasing production starting
start to go backwards (Diminished hed rate of return or
marginal physical product).

The law of diminishing returns is important to businesses in making sure that they reduce wastage
and are operating at maximum efficiency by finding the best ratio of the factors of production.

The law of diminishing returns in action

actio can be seen here:

Fixed Factor Variable Factor Total Physical Product Average Physical Product Marginal Physical Product
(Land) (Labour) (TPP) (APP) (MPP)
1 0 0 0 0
1 1 5 5 5
1 2 12 6 7
1 3 21 7 9
1 4 32 8 11
1 5 45 9 13
1 6 54 9 9
1 7 56 8 2
1 8 56 7 0
1 9 50 5.5 -6

1. Increasing returns
(TPP is increasing with MPP > APP)
2. Diminishing Returns
3. Negative Returns
(TPP still increases with
(Everything goes backwards)
MPP < APP)

Average Physical Product (APP) is a measure of the productivity of the variable factor. It is calculated
by:
APP = TPP ÷ Labour

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Marginal Physical Product (MPP) is the change in Total physical product (TPP) that occurs with
additional units of the variable factor. It is calculated by:

MPP = Δ TPP = TPP (Before) – TPP (After)

Examples of the law of diminishing returns in actions include:

− A factory with too many workers would all start to get in each other’s way; have to wait to
use machinery and tools as worker’s with their own each individual product that they’re
making would outnumber tools/machines that need to be used.
− A student squeezing another hour of study in after 3AM. (And don’t say he drunk red bull
cause that’s having two variable inputs not one…)

Economies/Diseconomies of scale

The reason why the law of diminishing returns takes hold in production is that some factors used to
made goods and services are more easily changeable with time while some aren’t. So in the short
run, there are only certain factors you can increase with all the rest staying fixed. When you over
saturate the fixed factors with the variable factors, the return on the extra variable factor is
diminished.

In the long run, all factors become variable (resources deposits found, new factories built, more
machinery purchased) and therefore the problem of diminishing returns is overcome if all factors are
increased in a efficient ratio over time. When the factors of production are increased over a large
amount of time, the business would be able to produce its product for cheaper costs as it expands.
This “savings of size” in the long term is known as “economies of scale”.

Though, it can also happen that the business gets too big or too big too quickly and therefore their
expansion in output, can lead to “diseconomies of scale”. This means that their expansion in
production will mean higher costs per product from their expansion.

Economies and diseconomies of scale can be illustrated through the following “Long run average
costs curve” (LRAC):
Average Cost of one unit

Economies of scale Diseconomies of scale

Output

In the curve, as output is increased the average cost (AC) would be lower right up till the (T) point
that represents maximum economy of scale or “technical optimum” (efficiency to do with
production). Once output is pushed further beyond this point, the average cost of making a unit

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rises. Now, it’s all good to say that economies and diseconomies of scale is dictated by the LRAC but
for the reasons why it actually does occur, economics splits up these factors (reasons) into two
categories: Internal and External.

Internal economies/diseconomies of scale:

This refers to the cost advantages/disadvantages accrued within the firm or controlled by the firm.
These factors cause the point where a business is producing to move along the curve.

− Internal economies of scale include:

− Technical Economies: Efficiency in the production of products

Specialisation of labour/capital

Indivisibility of capital: Large machines should be used to produce large
amounts (for example: A huge harvester used for a large farm, small farms
manually harvest)

Recycling of waste materials (for example: A printing company using waste
paper to create small writing pads/packaging)
− Commercial Economies: Lower input costs from increased buying power or buying in
bulk

Wholesale rates for resources

Better negotiating power
− Managerial Economies: Efficiency in the administration of firm

Administration of the business can be fully utilised and therefore
fixed/autonomous costs spread (E.g. One principle can look after a school of
1 or 600)

Increased specialisation (E.g. Accounting, Marketing, Operations, Marketing
departments)
− Financial Economies: Easier access to credit/Finance

Buying power lowers interest rates,

Increased options for finance- Loans, Share options)
− Marketing Economies: High costs of marketing can be spread amongst a large level
of output
− Research and development economies: The high cost of R&D for one product is
spread over many
− Risk bearing economies: The cost of risk is spread over a large level of output.

Diversification

R&D (E.g. Experimental new drugs will only be taken on by big
pharmaceutical companies)

− Internal Diseconomies of scale include:

− Division of labour disadvantages start to take effect (overspecialisation)

Monotony and boredom Mucking around or quality decrease

Dependence on certain people (E.g. One person fall sick, everything stops)

Inflexibility/Deskilling (Experience usually increases reluctance to change)

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 − Management becomes too inefficient and out of touch

Lack of communications or communication errors between people or
departments

Bureaucracy leading to inflexibility

Can become “out of touch” with real operations
− Duplication of work/congestion in production process

Different people could end up doing the same job over and over again

Congestion leads to increased errors and more waiting around

External Economies/diseconomies of scale:

This refers to the cost advantages/disadvantages accrued outside of the firm or those not controlled
by the firm due to an increase in production over the whole industry. A change in these factors will
cause the curve to shift.

− External economies of scale include:

− Good Labour supply in area (Education biased towards industry- lower wages and
higher skills)
− Infrastructure (Transport, Govt. specially catering for industry)
− Local supply chain
− Research and development (Industry/government share R&D costs )
− Reputation of area/industry
− Area/industry can become renowned for producing a particular good. (E.g. Hunter
valley Wine)

− External Diseconomies of scale include:

− Increased demand/competition for resources (Wages, rents, prices rise)
− Infrastructure utilisation at capacity or over capacity
− Increased government regulation

Governments can intervene to combat diseconomies and assist economies of scale by adopting
policies that include:

− Microeconomic reforms

To achieve technical/dynamic/allocation efficiency
− Taxation reform (incentives for capital/ business)
− Increased Infrastructure
− Immigration (supply of labour)
− Research and development (Subsidies or government initiated research,
For example: CSIRO)
− Education (Skilled labour, Increased utility)
− Promotion of Industry/Area
− Land Releases

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Returns to scale:

This refers to the relationship between input and output and how an increase in input can lead to
either Increasing (input doubles, output more than doubles), Constant (input doubles, output
doubles) and decreasing (input doubles, output less than doubles ) returns to scale.

The impact of investment and technological change on the firm

Investment refers to the creation of capital goods to assist in increasing production. Capital widening
refers to when a firm’s growth in capital matches its growth in labour. Capital deepening is where a
firm’s capital growth exceeds its growth in labour.

Investment taken out by a firm can be composed of Inventory investment (raw materials/unsold
goods) which makes up net investment (new plant and equipment as well as inventory) and
replacement investment (Depreciation on existing capital/inventory). This can be seen by the
following equation:

Gross investment = Net Investment (inventory included) + replacement Investment

Technological change refers to changes in methods and techniques used to produce, distribute and
market goods and services. Both investment and technological change come hand in hand as while
technology might be developed, it takes investment to implement them in the economy. Some of
the impacts of investment and technological change include:

− Change in production methods

− Production becomes less labour intensive and faster as automation, computerisation
and machines take over in production process
− Prices
− New technology can allow for cheaper production costs which get passed on to
consumers, increasing their real income.
− Employment
− Structural unemployment as capital makes some disciplines obsolete (De-skilling)
− New disciplines for the operation/maintenance of new capital (Re-skilling)
− Output
− Increased levels, lower production costs
− Economies of scope(one input can make two different outputs) increased
− More variety and better products for market
− Profits
− Increased profits as production lowers prices and therefore increases consumption
as it becomes more available to people.
− Types of products
− New products and services can be introduced as integration and diversification takes
place.
− Globalisation
− Increased technological investment
− “E-commerce and opening up of new markets”
− Production networks/webs create product standardisation internationally
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