Preliminary Economics

Topic 1: Introduction to Economics 

What is Economics About? (Chapter 1)
● Economics is the study of choices concerned with production, consumption and the transfer of
wealth through goods and services within an economy.
An ​economy​ is a set of interrelated production and consumption activities that aid in the allocation of
scarce resources. It is the way in which an economy is organised to solve the economic problem.
The ​economic problem​: How can a society satisfy its unlimited wants with its limited resources? A
society's wants must be prioritised. The different types of wants (a material desire) are:
● Individual wants​: The wants of each person, which depends on their preferences, how the
wants can be satisfied and their ability to purchase the wants.
● Collective wants​: The wants of the whole community and are usually provided by the
government through their taxation revenue.
The key economic issues are:
● What to produce​: Resources are finite, and we must choose between what wants will be
satisfied and what goods or services will be produced
● How much to produce​: Resources must be allocated efficiently to maximise the satisfaction
of wants and hence only a certain amount of a good or service will be produced.
● How to produce​: Concerns the method of production; in any economy the most efficient will
be desired.
● How to distribute production​: A good must be priced; this price will affect what share of
total production an individual will have (income). In most economies, this can be either
equitable or inequitable.
The ​opportunity cost​ is the cost of the alternative foregone
● Individual, firms and businesses must make decisions. When one want is satisfied, another
must be left unfulfilled.
what is f oregone
● Opportunity cost = what is gained
Utility​ is a measure of ​“want-satisfying-power”​, or the satisfaction that a good or service provides,
when consumed. ​Marginal Utility​ is the satisfaction provided from consuming ​an additional unit​.
The ​production possibility frontier​ is a graphical representation of all the possible combinations of
the production of two goods or services that an economy can produce; it is a representation of
opportunity cost. It goes by the assumption that:
● The economy produces only two goods
● The state of technology is constant
● The quantity of resources is constant
● All resources are fully employed

The PPF can move outwards due to:

● Technological progress: Which
may lead to more efficient means
of production, increasing the
productive capacity with the same
resources
 ● New materials: This increases the amount of inputs into producing products, increasing output
Or the position on the PPF may change due to:
● Unemployment: Leads to resources that are not fully employed, resulting in the position in
relation to the curve moving inwards.
All current economic decisions have bearing on or influence future economic outcomes. This concept
is diagrammatically represented as:
● Tradeoff between a capital and consumer goods
● A capital good is a good used in the production
of other goods, whereas a consumer good is one
that proves immediate satisfaction.
● Capital goods increase an economy's future
productive capacity, however reduce the current
standard of living (and the converse).
● This concept can be extended to all groups of a
society.
Any choice an individual makes, always has underlying
economic influences
1. Individuals: Age, income, education, family, culture, etc.
2. Firms: Product price, industrial relations, ethical issues etc.
3. Governments: Taxation, penalties, laws, bills etc.

The operations of an Economy (Chapter 2)

● The process of making a good or service is known as the production process, its outputs are a
good (tangible objects) or a service (intangible acts)
Factors of production (FOP’s):
Resources refer to the factors of production​. The quantity and quality of a country’s resources will
affect the standard of living of its residents, and economic growth. There are four factors of
production, which each have a return (money earned from owning a factor of production):
Resource Definition Return

Land The natural resources that are used to produce Rent

goods and services e.g. trees, fish, minerals.

Labour The mental and physical effort that people devote Wage, Salary,
to producing goods and services e.g. doctors. Commission

Capital The tools, instruments, machines, buildings and Interest

other items that businesses use to produce goods
and services e.g. machinery, tractor. They greatly
improve the productivity of other resources.

Enterprise / The human resource that bears risk by organising Profit

Entrepreneurship the other factors of production to produce goods
and services e.g. Elon Musk.
The factors of production have limitations to:
● The ​amount of natural resources available​ for production e.g. land, fossil fuels, clean air
and water
 ● The ​supply of labour​ due to the production size, labour market skill and people’s willingness
to work
● The ​supplies of capital​ due to the extent to which the government and the private sector are
willing to invest, as well as the level of domestic saving available for investment
● The ​supply of entrepreneurial skills​ due to the size of the population and the ability and
willingness of individuals to innovate and take risks
An economy is the way a society is organised to solve the economic problem, and perform the
functions of:
● Coordinating economic activities such as resource allocation, production and distribution
● Framework of law and order for the operation of markets where goods and services are
exchanged
Consumers spend money​ → Firms respond to ​demand​ (profit) → ​Obtain FOP’s​ to make good or
service → ​Efficient ​industries attract ​more​ resources → ​Cheaper​ resources are more ​attractive​ →
Firms ​combine ​multiple FOP’s
The distribution and exchange of goods and services
● Gross Domestic Product​ measures the ​total value​ of all goods and services produced, this
value is also the total income of a society.
● An economy assigns an individual an ​income​ as a ​return for their input​ (value, S&D) into
the production process; this income determines their share of total production.
● This incentivises work, as working harder equals greater income; increases innovation and
technological advancement.
● Money is a medium of exchange; it creates efficiencies in transactions
The business cycle is the level of fluctuations in economic activity; a cycle of ups and downs in
economic output.
1. Upswing is when ​expenditure, output, income and
employment​ levels rise
2. Boom is when ​expenditure, output, income and
employment​ levels reach a maximum point as
economic activity peaks.
3. Downswing is when ​expenditure, output, income
and employment​ opportunities begin to fall as
economic activity decelerates.
4. Recession is when ​expenditure, output, income and
employment​ reach a minimum point as economic activity is at minima
Phase Characteristics
Upswing (​Expenditure, output, income, inflation, investment, quality of living, resource demand and
employment​) ​↑
Boom (​Expenditure, output, income and employment​) at a stationary point (relative maximum)
Downswing (​Expenditure, output, income, inflation, investment, quality of living, resource demand and
employmen​t) ​↓
Recession (​Expenditure, output, income and employment​) at a stationary point (relative minimum)
● Because of the dynamic nature of the business cycle governments intervene in the market, to
reduce the severity of these impacts on the individual and the overall economy.
● A key aspect of this intervention is known as macroeconomic policy — it aims to smooth out
the business cycle, and promote sustainable economic growth.
The circular flow of income within an economy​ is a theoretical economic model describing the
operation of an economy, and the linkages between the main sectors of the economy (everything
above the red dotted line is the private sector, the public sector consists of the government sector and
the private sector:

1. Individuals​ ​are all the people in an economy earning an income, and spending it on goods
and services; they are the owners of productive resources.
a. Individual receive income from firms for their input. This income is taxed. Then an
individual can either spend it or save it. If it is spent the good or service, is either
domestically or internationally made.
2. Businesses​ ​are all the firms engaged in the provision of a good or service. It concerns all
their activities such as the purchase of FOP’s and resultant use.
a. Pay individuals for input, and receive money for goods and services from them.
3. Financial Institutions​ are ​all those institutions engaged in the borrowing and lending of
money, such as banks, insurance companies, superannuation companies etc.
a. Enable investment and saving within an economy, through taking deposits (savings)
and loaning them to businesses. This is known as the mobilization of funds
4. Governments​ ​are all the levels of controlling bodies in an economy.
a. Satisfies collective wants, through taxation of income and gov’t expenditure.
5. International Flows​ ​consist of all the transactions an economy undertakes with the rest of
the world.
a. Imports are goods and services that are produced overseas but bought by Australia
b. Exports are goods and services produced by Australia, but sold to other countries
Injections​ are those flows of money that increase aggregate income and the general economic level of
economy activity:
● Investment → ​Current expenditure that is made in order to obtain benefits for the future. Increases
demand for capital goods, stimulating production by firms leading to rising production and
employment, and overall income levels in the economy
● Expenditure → ​When the government spends revenue on collective goods and services, income is
received by government employees, and employees of private businesses from which it purchases
goods. Government may also make transfer payments such as pension, and unemployment benefits.
● Exports → ​Money paid for a good or service is funneled from another economy into the Australian
economy, increasing the flow of money.
Leakages​ are those items that remove money from the circular flow of income, decreasing aggregate
income and the general level of economic activity
● Taxation → ​Reduces the amount of money available for consumers to purchase goods or services.
Similarly for businesses this reduces the amount of money available for the purchase of resources.
● Imports → ​The money paid for a good or service is funneled from Australia into the other economy
where the good or service was produced
● Saving → ​Consumption is deferred to a later point of time reducing money spent on goods or services.
This enables investment within an economy, and increases the productive capacity and stock of
productive resources of an economy.
Equilibrium​ is when total injections are equivalent to total leakages; when all the money leaving the
circular flow is equal to the money entering.
Disequilibrium​ occurs when total injections are imbalanced with total leakages
● Total Leakages ＞ Total Injections
○ Economic activity slows down along with income, production and employment.
Consumers will have less income to be spent, taxed and saved. Therefore the
economy will tend back to equilibrium, but with a lower level of income in the
circular flow.
● Toal Leakages ＜ Total Injections
○ Economic activity rises along with income, production and employment. More
income will be spent and taxed. Thus equilibrium will be restored.
The government has a significant role on the circular flow of income, as through their macroeconomic
and microeconomics policies they can stimulate or dampen the economy in relation to leakages and
injections of the circular-flow.

How Economies Differ (Chapter 3)

There are two types of economies that exist
● Market economy; an economic system in which decisions are made by individuals and profit
driven firms motivated by self interest. It is characterized by economic resources being owned
by the private sector, and a lack of government intervention
● Command economy; an economic system where government entities make all the decision,
with resources only allowed to be held by the government. There is little scope for individual
choice, and a high degree of government intervention
In reality, all economies are a blend of the above as by not intervening there are severe economic and
social repercussions, hence we call this third economy, a mixed economy.
What is a market?
A market is a network of buyers and sellers, seeking to exchange a good or service for an agreed upon
price. In a free-market, there are various types of markets for both goods and services, as well as for
resources.
Example: The product market
● The interaction of supply and demand of the outputs of production (G&S)
● The sellers are businesses, and the buyers are consumers
● Price at which the good is sold affects consumer demand
● Consumers want to buy at the lowest price so they can satisfy more wants, whereas businesses
want to sell at the highest price to maximise their profits.
● It is this interplay between supply and demand that determines the price at which a good or
service is sold.
Price mechanism ​is the process by which the forces of ​supply and demand interact​ to determine
the ​market price​ at which goods and services are sold, and the quantity produced.
Example: The factor and goods market

● The factor market is where the FOP’s are bought and sold
● The goods market is where goods and services are bought and sold
● The interaction between these two markets provides income within an economy, with the
government redistributing the flow of money between the two.
Some other areas of differences:
➔ Private ownership of property: Individuals can own, buy and sell FOP’s to derive income and
wealth.
➔ Consumer sovereignty: Consumers collectively through market demand decide what is
produced in an economy and how much is produced, through exercising their freedom of
choice
➔ Freedom of enterprise: “​Free enterprise refers to business activities that are not regulated by
the government but are defined by a set of legal rules such as property rights, contracts, and
competitive bidding.”
➔ Competition: is the pressure on firms in a market to lower prices or improve the quantity or
quality of output to increase sales of G&S, as caused by other firms or factors.
Role of the government in the market economy
● Resource allocation:
○ Provision of essential goods and services that the private sector is not willing to
produce, or otherwise can not be entrusted with
○ Restrict production of harmful goods
○ Allocative efficiency refers to the economy’s ability to allocate resources to satisfy
consumer wants
● Income distribution:
○ Create a more equitable society and take care of citizens
● Economic stability:
○ Smooth out the sharp fluctuations in the business cycle
○ Ensure stability in the economy and the financial system
Intervention in the key economic concerns
 ● What to produce​: The government influences what is produced through either encouraging
the production of a good through tools such as subsidies, tax incentives or discouraging a
certain product through taxation, and laws. The government can also provide collective goods.
● How much to produce​: Likewise the government can affect the quantity of a good or service
produced through similar methods (tax, policy, subsidies, restrictions etc.) For example the
government can encourage producers to compete through protectionist trade policies
● How to produce​: The cost of the FOP’s and how they are used in the production process, can
be changed through laws i.e. minimum wage, environmental protection acts.
● ​How to distribute production​: A government through their respective policies will change
the total share of production each individual receives, hence making it more equitable or the
converse; they regularly intervene with price mechanism and the factor market. For example
in Australia a progressive tax system is used.
Other things to consider​ (See Chapter 3.3 in ​The Market Economy​)
● Comparison of Australia against other OECD countries
● Global Financial Crisis
● Trade relationships with Asian Economies
● Living standards and quality of life in this region
● Distribution of income
● Environmental Sustainability
● Level of employment
● The role of the government
Topic 2: Consumers and Business 
The role of Consumers in the economy (Chapter 4)
● Consumer sovereignty; as said earlier consumers through their collective demand
(consumption patterns) ultimately determine what is produced by profit driven firms
● If there is high demand relative to supply, the price will rise and producers will notice that
higher profits can be made from such goods. Resultantly they will shift their production to
that good
● Consumer income → types of production that occurs → economic activity
Erosion of consumer sovereignty
1. Marketing​ exerts a power influence over the spending patterns of consumers, to alter the
behaviour of consumers, in satisfying their wants and needs.
2. Misleading or deceptive conduct​ occurs when consumers are deceived through dishonest
claims about a product, manipulative marketing etc.
3. Planned obsolescence​: Goods that are designed to break after a certain period of time
4. Anti-competitive behaviour​; Firms that operate in markets, in which there are few other
firms may diminish the ability of consumers to “choose what they really want”. Consider the
banking sector.
Decision to spend or save
In general an individual ​may either spend or save​ (deferred consumption) their income. Hence the
following Y = C + S can be made; where Y is disposable income, C is consumption and S is savings.
● Average propensity to consume​ is the total proportion of income spent on consumption and
is calculated as AP C = CY
● Likewise ​average propensity to save​ is the total proportion of income saved and is similarly
calculated as: AP S = YS
A variety of factors may influence the above decision including cultural factors, personality factors,
confidence, future expectations, income, age, tax policies and availability of credit etc.
● Marginal propensity to consume​ is the proportion of each extra dollar earned that is
ΔC
consumed and is calculated as M P C = ΔY
● Marginal propensity to save​ is the proportion of
each extra dollar that is saved and is calculated as
ΔS
M P S = ΔY
● As each extra dollar must either be saved or spent
the following M P C + M P S = 1 can also be made
We can also apply the following principles to a whole
economy, however there are some exceptions.
Life cycle theory of consumption
● Age plays the greatest role in savings and
consumption patterns, as our income stream and
propensity to consume or save are dynamic.
● Observe the beside diagram and consider how and why income varies with age.
Factors influencing individual consumer choice
There are ​endless ways​ an individual may spend their income, however economists assume that an
individual will ​attempt to maximise the utility​ of each purchase they make. However we find that
this is sometimes​ constraint by the market​ and products its creates, and the price at which they are
sold. These are the primary factors that affect the above:
1. The level of income​; as an individual earns a greater income they tend to spend more, as the
concept of utility may change for each person. Consider an investment banker vs a retiree.
2. The price of a good or service itself​; consumers must decide if they are willing to pay the
nominated price for an item, if it is a necessity this may bear a greater influence in
comparison to that of a want
3. The price of a substitute and complement goods​;
a. A substitute good​ is a good consumers may choose to use in place of another good,
they are considered as having a similar function
b. A complementary good​ is one that is used in conjunct with another.
4. Consumer tastes and preferences​; An individual will choose to purchase a good or service
that provides the highest level of personal satisfaction or utility. These preferences are
dynamic.
5. Advertising​; the individual consumer choice is altered by advertising which can make the
demand for goods and services less responsive to price increases, through building consumer
loyalty and can even remove price sensitivity.
Consumption and Saving expressed as a function
The Consumption function
● The consumption expresses consumption in terms of autonomous consumption (not related to
changed level of income e.g. rent, insurance) and induced consumption (related to direct
changes in the level of income e.g. electronics, cars etc.)
● Is calculated as C = C 0 + cY where C 0 is autonomous consumption, c is MPC, Y is
disposable income and C is total consumption
The Saving function
● The saving functions expresses saving as the sum of autonomous saving (not related to
changed level of income) and induced saving (related to direct changes in the level of income)
 ● Is calculated as S = − C 0 + sY where − C 0 is autonomous dissaving, s is MPS, Y is
disposable income and S is total saving.
Example calculation
● Both are calculated in a similar manner so here is an
example for the consumption function which can also be
applied to other calculations
1. Case 1 (Graph is given, and function must be determined)
a. Autonomous consumption is 200, as at 0 income
200 is still expended
ΔC
b. Finding the MPC, which is ΔY ; the most suitable
points to choose is when income is generally 0 as it
makes the calculation quicker, however for
demonstration we will choose when income is 400,
and 350.
c. M P C = 350−300
400−300 = 0.2
d. Plug these values into the consumption function,
which yields C = 200 + 0.2Y
2. Case 2 (Function is given and must be graphed)
a. Draw a 45 degree line (try doing this with the value
found in 1d and working in the opposite direction to
graph the line)
b. Determine autonomous consumption or saving, this is where the function intercepts
the y axis
c. Input random values for disposable income, and calculate the output value
d. Graph few values, and draw a straight line through them
Sources of consumer income
● Returns to FOP’s
○ Wage from labour (earned income)​: is the main source of income for consumer and
includes salaries, and wage payments given for input into the PP. It also includes
other non-wage income such as superannuation contributions and fringe benefits.
○ Rent from land (unearned)​: consumers may own a property, that provides rent.
○ Interest from capital (unearned)​: Bonds, shares, superannuation and other
investments provide interest as a return on a FOP.
○ Profit from entrepreneurial skills​: Individuals involved in the operation of a
business receive profit as a return for their entrepreneurial skill.
● Social Welfare
○ Assistance to the aged​; retired individuals
○ Family payments; ​families with children, who have a low income
○ Disability support payment​; not able to work due to physical or mental disability
○ Unemployment benefits​; those seeking work but unable to get.

The role of Businesses in the economy (Chapter 5)

The role of a business in the economy is to produce goods and services in order to satisfy consumers
wants while also maximising profit. In doing so, businesses employ the factors of production,
therefore creating opportunities for the labour force in primary, secondary and tertiary industries.
 ● A ​firm​ is an organisation which uses resources to produce goods and services to satisfy
consumers and make profit
● An ​industry​ is a collection of similar firms involved in production e.g. agriculture,
construction, mining, manufacturing.
The types of industries are the:
● Primary industry​: Involved in the extraction of raw materials e.g. meat
● Secondary industry​: Where the manufacturing of goods and services occur from the use of
raw materials e.g. electronics.
● Tertiary industry​: Concerned with the provision of services as well as the framework and
foundations of businesses e.g. banking, transport.
● Quaternary Industry​: Information and technology services provided by firms in the
information communications technology industry.
● Quinary industry​: Firms and Individuals who provide personal services to other firms and
individuals.
A firm’s production decisions:
Firms have similar ​production decisions​ to economies, which are:
● What to produce?​ Firms will only produce a product if it is profitable. The factors
influencing what to produce are:
○ The skills and experience of the business operator
○ Industries with strong consumer demand
○ Rapidly growing industries
○ Possibility of a niche (specific) market
○ Capital requirements in establishment
● How much to produce?​ This is based on:
○ Consumer demand
○ Ability to convert demand into sales
○ Break even point (BEP): The point in which revenue meets total costs. It shows the
minimum number of sales required to cover costs.
T otal f ixed cost
B EP = P rice per unit−average variable cost , where fixed costs don’t change with production
and variable costs increase with production.
○ All costs are variable in the long run
● How to produce?​ The production process involves combining resources to create products.
Factors influencing decisions on production methods include:
○ Comparing the cost of labour and production to determine if production should be:
■ Labour intensive - more use of employees
■ Capital intensive - more use of machinery and equipment
○ Firms make decisions to reduce production costs as much as possible. This will
depend on the relative efficiency of the factors of production.
Growing businesses are a source of ​economic growth​ and ​increased productive capacity​. Economic
growth occurs when an economy produces more goods and services than previously and will lead to
higher standards of living​.
Economic growth is measured by the percentage change in the amount of goods and services
produced a.k.a a countries ​real GDP​.
● Real GDP = Money GDP − The effect of inflation
Changes in real GDP
● E conomic Growth = P revious years GDP
The ​performance of firms​ has a major impact on economic performance.
 ● Firms do well → More tax paid → Increased Govt. Revenue → Increased Govt. Expenditure
→ Economy goes well → Increased quality of life
Growing business also ​reduces unemployment​, leading to an increase in the PPF.
Goals of the firm:
The ​goals of the firm​ reflect the preferences of owners, level of competition, legal structure and the
general economic environment. They include:
● Maximising Profits​: Maximising revenue & minimising expenses. The greatest positive
difference between total revenue and total cost.
● Maximising Growth​: Maximising market share at the expense of some profit
● Increasing Market Share​: Being the dominant firm in an industry.
● Meeting Shareholder Expectations​: Achieving customer satisfaction through ethical
behaviour
● Satisficing​: Balancing and satisfying all goals simultaneously.
Cost and Revenue theory:
Costs​ are the explicit monetary payments made by firms for the use/ownership of the factors of
production. All costs are variable in the long run. The five types of costs are:
● Fixed costs (FC)​: Costs that must always be paid and do not change with output.
● Variable costs (VC)​: Costs which vary with output. More output in the short run leads to
more variable costs e.g. raw materials, wages.
● Total costs (TC)​: Is equal to FC + VC
● Average cost (AC)​: The cost per unit of output. AC = TOC
ΔT C
● Marginal cost (MC)​: The change in total cost per extra unit of output. M C = ΔO
Revenue is earned money. The types of revenue are:
● Total revenue (TR)​: Total sales receipts from selling a given output. Equal to P rice × O
TR
● Average revenue (AR)​: The average price a firm receives for selling its output. AR = O
ΔT R
● Marginal revenue (MR)​: Change in total revenue per extra unit sold. M R = ΔO
Total Profit = TR－TC
Efficiency and the production process:
A firm’s goal is to provide their product at a minimal cost. In order to minimise cost, firms ​must be as
efficient as possible​ in the production process.
Productivity​ refers to the quantity of goods and services the economy can produce with a given
Output
amount of inputs such as capital and labour. P roductivity = Input
Multifactor productivity (MFP)​ is the productivity of all FOP’s combined to produce a given
Outputs
output. M F P = All inputs
Outputs
Single factor productivity (SFP)​ is the productivity of each FOP over time. S F P = Single inputs
The best way for firms to improve productivity in production is through ​increased specialisation of
the factors of production​ through:
● The ​division​ and ​specialisation of labour​: The acquisition of knowledge and skills by labour
through education and training, as well as division of tasks into specialised components.
● The ​specialisation​ or ​localisation of land​ or industry: Trend for firms and industries to locate
near each other, near suppliers or near customers to reduce production costs or access a larger
market.
● The ​specialisation of capital​ or ​large scale production​: The introduction of mass production
techniques to produce large volumes of output at a minimum cost by using specialised
machinery. It is often used along with specialised labour.
The ​increasing efficiency​ in the operation of firms ​benefits the economy substantially​ as more
output is possible with the same amount of input. In the long term, it would ​improve living
standards​ as there would be:
● Less wastage of resources
● Lower production costs
● Lower inflation
● Increased choice
● Higher real incomes
● Improved international competitiveness
● Economic growth and technological progress
However, increasing productivity may lead to:
● Structural unemployment​ due to the increased use of capital
● Higher rates of structural change in production, putting stress on employees
● Increased ​demand for reskilling​ and ​multi-skilling​.
Law of Diminishing returns:
Fixed factors of production​ are inputs that ​don’t vary with output​ e.g. land and capital
Variable factors of production​ are inputs that ​vary with output​ in the short term e.g. labour and
raw materials.
In the ​short term​, firms have a fixed scale of operation and ​both fixed and variable​ factors of
production. However, in the ​long run​, the scale of a firm’s operation may be increased, so ​all FOP’s
are varied​.
The ​law of diminishing returns​ states that: As a firm uses ​more of a variable​ input with a given
quantity of fixed inputs, the ​marginal product/output will eventually diminish​. The law of
diminishing returns goes by the assumption that:
● There are only two factors of production e.g. land and labour
● One factor is fixed (land) and the other factor is variable (labour)
● The level of technology and all other FOP’s are constant
The ​total physical product (TPP)​ is the total output of goods using the sum of fixed and variable
FOP’s.
The ​average physical product (APP)​ is the TPP divided by the number of units of the variable
TPP
factor: AP P = Labour .
The ​marginal physical product (MPP)​ is the change in TPP that occurs with each extra unit of the
ΔT P P
variable factor labour: M P P = ΔLabour .
The law of diminishing returns can be seen in the following example:
Increasing​ return TPP is ​increasing​ at an ​increasing rate
APP and MPP are both ​increasing
MPP>APP
Diminishing return TPP is ​increasing​ at a ​decreasing rate
APP and MPP are ​decreasing
Negative​ returns TPP is ​decreasing
APP and MPP are ​decreasing
MPP<0
The main constraint on a firm’s output in the short run is the fixed factor that can’t be used
indefinitely with increasing variable factors. Diminishing returns to the variable factor will eventually
occur if the marginal productivity of variable factors falls. The law of diminishing returns can guide
firms to use the most efficient combination of resources to produce output. ​As long as MPP is rising,
additional quantities of variable inputs can be used​ before diminishing returns occurs. ​In the long
run, a firm can avoid diminishing returns by varying all FOP’s​ e.g. increasing size of the plant.
This may also lead to economies of scale.
Economies of scale:
Economies of scale ​are factors that cause the ​average cost of production​ (cost per unit) to ​fall​ as the
volume of output increase​ e.g. it may cost $3000 to produce 100 toy cars but only $4000 to produce
1000 toy cars. In this case, the AC has fallen from $30 to $4.
A ​diseconomies of scale​ is an increase in the cost per unit of production. Economies/diseconomies of
scale can occur internally or externally:
● Internal​: Cost savings/dissavings within the firms control
● External​: Cost savings/dissavings outside of the firms control
An internal economies/diseconomies of scale can be represented on the following Long run average
costs (LRAC) curve:

The technical optimum (output Y) is the most efficient level of production for a firm:
● Any movement along the curve towards the technical optimum (X→ Y or Z→ Y) is an
internal economy of scale, resulting in a lower per-unit cost of production.
● Any movement along the curve away from the technical optimum (Y→ X or Y→ Z) is known
as an internal diseconomy of scale.
An external economies/diseconomies of scale can be represented on the following LRAC.
The technical optimum on the LRAC curve is shifting upwards or downwards:
● A downward movement of the LRAC curve ( LRAC 1 → LRAC 2 ) represents an external
economies of scale
● An upwards movement of the LRAC curve ( LRAC 1 → LRAC 3 ) represents an external
diseconomies of scale.
Returns to Scale​ refers to the relationship between a change in input and a change in output:
● Increasing returns to scale​ occurs when the increase in output is greater than the increase in
input.
● Constant returns to scale​ occurs when the change in output is equal to the change in input
● Decreasing returns to scale​ occurs when the change in output is less than the change in
input.

Topic 3: Markets 
The role of the market:
A market is a situation in which buyers and sellers are in contact for the purpose of exchanging. They
do not have to be a physical place, as exchange can occur over the telephone or on electronic markets.
Product markets​ refer to where and how final goods or services are bought and sold.
Factor markets​ refer to markets where the factors of production are bought and sold.
These exchanges are represented in:

Derived demand​ is the demand for productive resources, which is derived from the demand for final
goods and services or output e.g. if demand for computers increase, demand for metals will increase.
Relative price​ refers to the opportunity cost in consumption or production. They reflect the relative
opportunity cost of selecting one alternative relative to another alternative.
Demand (Chapter 6)
If an individual demands something, they:
● Want it
● Can afford it
● Have made a definite plan to buy it
The Law of Demand​ states that with all other factors being equal, an increase in the price of a good
or service increases, consumer demand for that good or service will decrease and vice versa. This is
due to the:
● Substitution effect​: As the opportunity cost of a good rises, the incentive to switch to a
substitute becomes stronger
● Income effect​: As prices rise, a larger proportion of income is used, resulting in less demand.
A ​giffen good​ is an exception to the law of demand, as it is a product that is consumed more as the
price rises.
Individual demand​ is the demand for a product by an individual in a market.
Market demand​ is the sum of all individual demands for certain products in a market.
On the demand curve:
A movement along the demand curve occurs when there is a
change in the price of the good itself​. If the price increases,
there will be a contraction of demand, and if the price lower,
there will be an expansion of demand.
When there is a ​change in a factor other than the price of the
product itself​, the demand curve shifts left (decrease) or right
(increase).
There will be a shift (increase/decrease) in the demand curve if:
● The price of a substitute changes​: If the price of a substitute falls, demand will decrease as
consumers would move towards cheaper substitutes for that product. If it rises, demand will
increase as the original product would be cheaper.
● The price of a complement changes​: Complements are usually purchased together, so if the
price of a complement increases, demand increases and vice versa.
● Expected future price changes​: If the price is expected to rise, current demand will increase.
If price is expected to fall, current demand will decrease as people will wait, then increase
when the price eventually falls.
● Income changes​: If income rises, demand increases due to more disposable income. If
income falls, demand will decrease as people will have less disposable income to spend.
● Income distribution changes​: For example, if the income is distributed towards higher
income earners, demand for luxury goods will rise.
● Expected future income changes​: It is uncertain what will happen if expected income
increases. However, if income is expected to fall, people will increase their APS and MPS,
hence leading to a decrease in demand
● Population decreases​: There will be less
individual demand, leading to a lower market
demand.
● Age distribution​: For example, a growth in
younger people will lead to more demand for
toys.
When there is an increase in demand, the curve shifts from D1 to D2 . Now at the same price, the
quantity demanded increases from Q1 to Q2 . When there is a decrease in demand, the curve shifts
from D1 to D3 . At the same price, the quantity demanded has decreased from Q1 to Q3 .
Aggregate demand (AD)​ refers to the total demand for goods and services within an economy. It is
comprised of Consumption (C), Investment (I), Government expenditure (G) and Exports (X) minus
Imports (M). ​An increase in AD​ will lead to an increased demand of output from firms. This forces
firms to increase their output and improve efficiency. This will lead to an increase in economic
activity. ​A decrease in AD​ forces firms to decrease price and therefore output so that they can still
gain sales revenue. This will lead to a decrease in economic activity.
Price elasticity of demand:
Elasticity of demand​ is a measure of the responsiveness of the quantity demanded of a good to a
change in its price when all other influences on buying plans remain the same. Elasticity (E) is a
%ΔQd
number calculated by the formula: E = %ΔP , where %ΔQd is the percentage change in quantity
demanded and %ΔP is the percentage change in price.

Price Elastic There is a strong response to a change in price. The percentage change in quantity
E>1 demanded is larger than the percentage change in price.

Unit Elastic There is a proportional response to a change in price. The percentage change in
E=1 quantity demanded is the same as the percentage change in price.

Price Inelastic There is a weak response to a change in price. The percentage change in quantity
E<1 demanded is less than the percentage change in price.
Perfectly elastic demand​ refers to demand in which consumers will demand an infinite quantity at a
certain price, but nothing at a price above this. No such situation exists in real life. E=∞
Perfectly inelastic demand​ refers to demand where consumers are willing to pay
any price in order to obtain a given quantity of a good. This can apply in some
situations such as a life saving drug. E=0
Firms need to know the elasticity of demand of their product. This is as:
● If demand is elastic, decreasing price will lead to much more sales, and
much greater revenue.
● If demand is inelastic, increasing price will increase revenue as the extra earning per unit
would cover the small amount of lost demand.
Governments need to know the price elasticity of demand:
● When pricing public/merit goods (these goods will be discussed in topic 6)
● To know the effect of a change in the level of indirect taxes
● So they can calculate the impact on revenue from the introduction of an
indirect tax
In the ​long run​, price elasticity of demand is higher than in the short run.
The elasticity of demand can also be calculated using the ​total outlay method​ by
looking at the effect of a change in price on the revenue of a product.

Elastic Demand When price and revenue move in opposite directions:

P rice ↑ and Revenue ↓ or P rice ↓ and Revenue ↑

Unit elastic demand When there is a price change but no change in revenue:
 P rice ↑ or ↓ and Revenue－

Inelastic Demand When price and revenue move together:

P rice ↑ and Revenue ↑ or P rice ↓ and Revenue ↓
Note that the slope of the demand curve should not be used as a measure of elasticity.
The factors affecting the elasticity of demand are:
● Necessities and Luxuries​: Necessities are generally inelastic e.g. water while luxuries are
generally elastic e.g. LV Handbag
● Existence of close substitutes​: A product with a large number of substitutes will usually be
elastic and a small amount of substitutes will be inelastic
● The proportion of income spent on the good​: A higher proportion of income spent will be
elastic and a low proportion will be inelastic
● Time since a price change​: Refers to a consumers responsiveness and awareness to a change
in price. If the price has increased, it will take time to seek alternatives, however when
alternatives are found, demand will become more elastic. Similarly, if the price has fallen, it
would take consumers time to become aware of the cheaper product but once they are aware,
demand becomes more elastic. The responsiveness to a price change also depends on the
durability of a good. After an initial price change, durable goods have more elastic demand as
consumers prefer to repair rather than buy. With time, elasticity will decline as durable goods
have to be replaced eventually e.g. a car.
● Whether a good is habit forming​: Habit forming goods tend to have inelastic demand as
people become addicted.
Supply (Chapter 7)
The law of demand​ states that with all other factors being equal , as the price of a good or service
increases, the quantity of products provided by suppliers will increase and vice versa.
If a firm supplies a good or service they:
● Have the resources and technology to produce it
● Can profit from producing it
● Plans to produce and sell it
Individual supply​ refers to the supply of a good or service by an individual firm or producer
Market supply​ is the sum of supplies from individual suppliers in a certain industry
Movements along the supply curve​ are motivated by
changes in price:
● An increase in price will lead to an extension of
supply
● A decrease in price will lead to a contraction of
supply.
Shifts in the supply curve​ are caused by factors other than a
change in the price itself. These factors include:
● The price of substitutes in production change​: The
quantity supplied of a good or service is affected by the prices of other goods and services.
E.g. if the price of good X remained the same but the price of good Y increases, firms will
supply more of good Y due to profitability
motives, decreasing supply of X.
 ● Price of complement in production changes​: Supply moves with the price of the
complement. If the price of a complement rises, supply rises and vice versa.
● Expected future price changes​: If the price is expected to rise, current supply will decrease
as firms will wait until the price rises. If expected price falls, current supply will increase.
● The state of technology​: Improvements in technology lower production costs and allow for
fast adjustments in production, leading to an increase of supply.
● The quantity of the good available​: For example, the quantity of oil is finite and is
constantly depleted, which would lead to less supply.
● The number of suppliers in an industry​: More suppliers will lead to an increase in supply
and vice versa.
● Changes in the costs of FOP’s​: This largely affects supply. A fall in the costs of FOP’s
would allow firms to use more FOP’s, hence increasing supply. If the price of FOP’s
increases, it will cost firms more to use FOP’s, hence decreasing supply.
● Climatic and seasonal influences​: Climate will affect agricultural production e.g. a drought
would decrease supply of most agriculture products. Seasons can impact on the supply of
products e.g. more ice-cream is supplied in summer than winter.
Aggregate supply (AS)​ refers to the total supply of goods and services in an economy, It is the total
productive capacity of an economy. It is comprised of supply from all of the factors of production. AS
is influenced by AD.
Price elasticity of supply:
The ​price elasticity of supply​ measures the responsiveness of the quantity supplied of a product to
changes in price. If the rise is the quantity supplied is proportionately greater than the increase in
price, then supply is relatively elastic. The supply of most goods is elastic due to profit maximisation
motives. If the change in quantity supplied is proportionately less than the change in price, then
supply is inelastic. If the change in quantity supplied is proportionate to the change in price, then
supply is unit elastic.
Perfectly elastic supply​ is when suppliers will supply an infinite quantity of a
product at a certain price, but nothing at a price below it. This is highly unlikely.
Perfectly inelastic supply​ is when firms will supply a certain quantity of products
at any price. An example of this is a unique artwork as only one of these may exist.
The ​factors affecting the elasticity of supply​ are:
● Time lags after a price change​: Generally, the longer after a price change,
the greater amount of time suppliers have to respond to a price change.
Following a price change, supply of most products is inelastic as producers can not quickly
alter the FOP’s much, however they may increase the number of employees or quantity of
inputs to make it less inelastic. In the long run, all FOP’s can be varied, so firms can alter
their FOP’s, hence leading to elastic supply.
● The ability to hold and store stock​: Firms are able to store some goods and not sell them
during economic downturns when prices are low. This inventory can be offered readily when
prices rise. Therefore, the more stock a firm can hold, the more elastic its supply will be and
vice versa.
● Excess capacity​: Excess capacity exists when firms are not fully employing their resources.
Firms with large excess capacity will have elastic supply, as they can readily employ their
unused resources. Firms with low excess capacity have inelastic supply, as all resources may
already be employed.
Market Equilibrium (Chapter 8)
Market Equilibrium
Equilibrium​ is a market situation in which there is no tendency for change of the price, quantity
demanded or quantity supplied. The market is cleared of any shortages or surplus’. This is based on
the assumption that there is pure competition and no
government intervention. This is represented in the
following diagram:
A disequilibrium can occur in two ways:
● Demand exceeds supply​: The price is below
equilibrium and there is a shortage of supply. Prices
will tend to rise to equilibrium. Demand will
contract and supply will expand.
● Supply exceeds demand​: The price is above
equilibrium and there is a surplus of supply. Prices
will tend to fall to equilibrium. Demand will expand and supply will contract.
This is the price mechanism in action. ​Changes in Equilibrium:
Changes in equilibrium​ can occur due to factors which lead to a shift in either or both the supply and
demand curves. The changes in equilibrium can happen in the following ways:
● An increase in demand with no change in supply will increase the equilibrium price and
quantity.
● A decrease in demand with no change in supply will lead to a lower equilibrium price and
quantity.
● An increase in supply with no change in demand will decrease equilibrium price but increases
equilibrium quantity.
● A decrease in supply with no change in demand will increase the equilibrium price and
decrease the equilibrium quantity.
● A decrease in supply and increase in demand will definitely increase the equilibrium price
however equilibrium quantity can remain unchanged, rise or fall.
● An increase in supply and decrease in demand will definitely decrease the equilibrium price,
however equilibrium quantity can remain unchanged, rise or fall.
● An increase in both demand and supply in definitely increase equilibrium quantity, but
equilibrium price can remain the same, rise or fall.
● A decrease in both demand and supply will definitely decrease the equilibrium quantity and
equilibrium price can remain the same, rise or fall.
In a market economy, the ​price mechanism​ (the interplay between supply and demand in determining
the equilibrium price) plays the most important role in determining the solutions to the economic
problem. Prices play an important role in markets as they:
● Reflect the relative scarcity of goods and services
● Help allocate resources in the production of goods and services
● Act as signals for producers and entrepreneurs to take risks in organising the factors of
production.
● Act as a rationing device in enabling markets to clear
● Are an equilibrating device in markets.
Any market will always try to achieve efficiency, such that goods and services are distributed in the
best manner. Economists find that there are different types of efficiency: (This is especially important,
given economics to an extent is all about efficiency) (Note: Some of these may have been mentioned
before)
 ● Allocative efficiency​ is when a​ ll goods and services are
distributed in accordance with consumer preferences​ and
tastes. In such a scenario, the price is always the same as the
marginal cost of production. This is as the price consumers
are willing to pay is a direct reflection of the satisfaction
they will receive. The equilibrium price is where marginal
costs equals marginal benefits.
○ This kind of efficiency is sometimes in perfectly
competitive markets , because there are a large
number of firms who have little to no bargaining
power. The only way they can survive is by
producing what consumers want. Comparatively monopolies are said to be inefficient
as they have a certain degree of market power, and undertake activities such as price
discrimination which affect prices.
● Productive efficiency ​occurs when a​ certain combination of inputs​ allows for the ​maximum
amount of output​ at minimal costs (this is where firms
operate at the lowest point of LRAC curve, or otherwise
where MC = AC). To achieve this kind of efficiency firms
must use the cheapest FOP’s available in the economy, the
best production processes and likewise the technology
available. Wastage must be minimized, and economies of
scale must also be achieved. We can diagrammatically see
this in a PPF (see the ​Nature of Economics)​ , where an
economy is operating along the curve.
● Dynamic efficiency ​references the p​ rocess of productive
efficiency​ changing of an economy ​over time​. It can be
achieved in the long-run through ​new innovation​ and​ technologies​, which allows an economy
to shift is long run (and short run) average cost curve down. Any factor that creates a level of
efficiency (competition and R&D as an example), will help assist achieve dynamic efficiency.
● Social efficiency​ is the case when goods and services are ​distributed simultaneously taking
into account externalities​. In reality this efficiency is rarely achieves, as whilst social welfare
is elevated, the cost of production will be too high. Hence in a free market, as producers do
usually not take externalities into account, the government intervenes through taxes and other
measures.
● X-efficiency​ is when a firm or economy has an ​incentive to maximize their output​ with a
given outpu​t. It is similar to productive efficiency, but differs in that it depends on
management incentives​ rather than technology.
○ This kind of efficiency is most likely experienced in highly competitive markets,
where management must produce as much as possible with as little as possible.
○ In a monopoly this kind of efficiency is lost, as the firm may increase profits by not
maximizing output.
We have also mentioned inflation a lot in this document, so here would be a good place to further
investigate it:
Inflation: What is it and why is it important?
The rise in the general cost of goods and services over time is what is known as inflation. Whenever
aggregate demand or supply rises we the price of goods or services will also rise, so at the most basic
level inflation is caused by supply and demand. However we can further categorise it into:
● Demand-pull inflation ​is when a r​ ise in aggregate demand​ for goods and services, occurs at a
greater rate than the increase in the productive capacity​ of an economy (supply increases
slowly or remains unchanged).
○ A case where this may occur is when a central bank increases the supply of money
rapidly. Individuals will demand more as there is a greater amount of money in the
economy, and in the short run businesses will not be able to achieve to match this
rising demand.
● Cost-push inflation​ occurs when the p​ rices of inputs​ in the
production process (FOP’s) ​rise​. This will reduce the supply of a
good or service, and hence cause an increase in the price level
○ A recent example of this is the rise in global oil prices
(volatility as well), following supply-shocks in Saudia
Arabia due to bombings on facilities.
While these two types of inflation may seem relatively simple, in practice
it is​ harder to distinguish between the cause of price changes in the
market​. So hence it is hard to isolate a single cause, as economies are
dynamic by nature.
Government Intervention in the marketplace:
Although markets are efficient, they are not ethical.​ The market price of a good or service may be
considered too high or too low, and some goods and services may not be provided.
Market failure​ is when markets do not produce the desired outcomes. This occurs as markets take
into account the private costs and benefits, but not the social costs or benefits.
The following graph provides a ​representation of a
market failure​. It shows the interaction of supply with
society’s supply curve (takes into account social costs) and
the private sectors supply curve (only private costs). From
the diagram, it can be seen that the actual equilibrium is at
the intersection of demand and the private supply curve.
Hence, the actual ​market price is below the socially
optimal price​, suggesting that the environment is
undervalued by the market. Additionally, the ​market
quantity is greater than the socially optimal quantity​,
suggesting that the environment is heavily overused by
suppliers.
Price intervention​ occurs when governments feel that
prices are too high or low. Therefore the government
implements:
● Price ceilings (price control schemes)​: Is where a maximum price for a good or service is
established below market equilibrium. This will create a shortage in the market. It is usually
implemented on basic needs to prevent prices from escalating due to scarcity.
● Price floors (price support scheme)​: Is where a minimum price for a good or service is
established above the market equilibrium. This will result in a surplus. These are usually
implemented to protect the incomes of specific suppliers.
However, due to these interventions causing disequilibrium, governments have moved to more
sophisticated means of intervention,
Quantity intervention​ occurs when the quantity supplied of some goods or services may be too high
or low because firms don’t take into account the social costs or benefits. These ​externalities​ are not
taken into account by the price mechanism. They can be:
● Negative externalities​: Costs faced by society due to the production process e.g. pollution
and environmental damage. Governments usually intervene by imposing ​taxes​ on businesses
to decrease supply, which increases equilibrium price and decreases equilibrium quantity.
● Positive Externalities​: Social benefits towards society that come with the consumption of
some goods and services e.g. parks and public transport. Goods and services that provide
positive externalities are known as ​merit goods​ but are usually undervalued. Governments
increase positive externalities through ​subsidies​ to increase supply, which decreases
equilibrium price and increases equilibrium quantity.
Some goods and services will not be provided as producers will not be able to exclude those not
willing to pay for it, leading to the free rider problem. These goods must be ​provided by the
government​ and are known as ​public goods​. They are funded by taxation revenue.
**This will be revisited in Topic 6**
Competition and market power
The degree of competition in an industry is primarily determined by the ​market structure​, which
refers to the number and relative size of the firms within an industry, the nature of the product being
sold, and the ease with which new firms can enter that industry. The market structures are:
● Pure/perfect competition​: Are faced with the following market conditions:
○ There are a large number of small firms who are not able to affect the market price
○ The products sold by firms is homogenous (same products). Buyers and sellers know
this as well as the prices which products are sold at
○ Buyers don’t incur any cost for moving from one supplier to another
○ There are no barriers to entry
○ Sellers can sell as much of the product as they like at the market price (perfectly
elastic demand)
Firms under these market conditions are ​price takers​ in that they must accept the market
price and cannot sell above it without losing all demand. They will not sell at a price below as
it wouldn’t add to sales. Advertising would be a waste of money as it wouldn’t help.
● Monopolistic competition​: A form of imperfect competition characterised by the following
conditions:
○ There are a large number of small firms
○ The products sold are similar but slightly differentiated in that they present their
products differently.
○ They have some degree of price setting power
○ There are small barriers to entry for new firms as there are existing firms with loyal
customers who believe certain existing firms to produce the best products.
Firms understand that there are many close substitutes to their product and competition is
fierce. Advertising plays an important role in attracting new customers and maintaining
existing ones. They also compete through price cutting. E.g. restaurants and hairdressers.
● Oligopoly​: This is the most common market structure in Australia. It is a form of imperfect
competition characterised by the following:
○ There are a few relatively large firms, each having a significant market share.
○ They sell similar but differentiated products.
○ There are significant barriers to entry
 The oligopolist constantly monitors the behaviours of rival firms in its industry. They must
carefully consider the reactions of their competitors whenever it decides to change its pricing
or output policies. As they do not want to start a price cutting war, they prefer to compete
through advertising campaigns. E.g. supermarkets, airline, banking.
● Monopoly​: A monopoly is a form of perfect competition characterised by the following
conditions:
○ There is only one firm selling the product, and there is no competition
○ There are no close substitutes to the product.
○ There are significant barriers to entry, preventing any potential competitors from
entering the market.
Monopolies have great power over the market. The monopolist is a price setter and can be set
at any price to maximise profit. Advertising is used to maintain product image. They tend to
be owned by the government to prevent misconduct and exploitation. E.g. Sydney Water.
 
Topic 4: Labour Markets 
Labour Demand and Supply (Chapter 9)
What is the labour market and why is it important?
● The labour market is where ​individuals seeking employment​ interact with​ employers​ who
want to ​obtain labour​ as an input into the production process.
● Labour is ​the most crucial resource​ available for use in the production process; if it does not
function well it will handicap an economy's ability to grow
● It is crucial for businesses to operate, and for individuals to find work and an income
● In reality ​there are many labour markets​, each having their own set wage price — there
might be thousands across a single occupation, industry or even nation
The demand for labour
● Labour is a ​derived demand ​that comes from the demand for goods and services
● High demand G&S → Firms increase production → Firms demand more labour
Factors influencing labour demand
● General economic conditions​; when economic conditions are more buoyant a firm will tend
to employ more labour to meet growing demand, and the converse. However firms often may
not react immediately to changes in economic conditions as tend to operate with excess
capacity. They also do not fully utilize their labour at any given time, and hence prefer to
retain labour and react to changes in the short-run, by creating changes in efficiency
(overtime, new training etc.). There is always a time-lag in between economic conditions, and
firms reacting to this change.
● Conditions in the firms industry​; factors such as the pattern of consumer demand & tastes,
barriers to entry, market competitiveness, level of regulation, contracts used in industry etc
may influence the need for labour.
● The demand for an individual firm’s products​; how much of the good being demanded, is
related to the effectiveness of selling that good, quality of the product, reputation, customer
service, marketing efforts etc. which will in turn affect labour as it is a derived demand
● The productivity of labour​; how much output is being created through labour input, and its
relative efficiency (affected skills, education, human capital etc.) of labour.
 ● The cost of other inputs​; a firm in general will either have a capital-intensive or
labour-intensive production process. They will determine what quantity of an input to use
based on the relative cost and efficiency of a FOP against other FOP’s.
Aggregate demand and labour productivity
Greater labour productivity​ does not always mean ​more labour should be employed​, in the
short-term​ hiring more productive labour may increase the output, but in the ​long term​ this will
change ​depending on the prevailing economic condition​s
● AD is increasing — higher demand for G&S; if this demand is rising faster than the increase
in productivity a firm will increase demand.
● AD is unchanged — labour productivity is rising, but demand for G&S is not, so a firm will
cutback on the amount of workers employed (they can still meet demand with less workers)
● AD is falling — labour productivity is rising, meaning workers are producing more. However
there is less demand for a G&S so a firm will lower demand to maintain profits
Labour vs Capital
● It is easy to substitute between labour and capital
● Labour costs are a relatively high proportion of a firm's total costs
● It is hard to pass on labour costs to consumers in the form of a higher price.
Hence a firm will consider
● What​ ​ratio of labour and capital​ to use, its relative costs and efficiencies
● Underlying costs of labour known as ​labour-on costs​; sick leave, fringe benefits, holiday pay,
long service leave etc.
● Underlying costs of capital​; ​the interest rate​ will determine how much it costs to borrow
funds to get capital production methods. If a firm is spending their own funds to finance a
capital project, interest is an opportunity cost, as it could have been earning a return. Other
special allowances — tax structures and subsidies.
● Domestic vs Foreign labour ​— developing economies have increasingly good infrastructure
and are in cases more competitive than domestic labour.
The supply of labour and what influences the supply
Individuals are the supply of labour in the economy
● Pay levels​ → The wage offered is an important factor in the determining of supply. In
general, the higher the wage, the more individuals are willing to work. (wage and non-wage)
● Working conditions​ → Attractive working
conditions encourage a higher supply of
labour. For example consider flexible
working hours or the working environment.
● Education, skills and experience
requirements​ → Elements of human capital;
higher human capital required in cases means
lower supply and the converse.
● The mobility of labour​ → Occupational
mobility refers to the ability of labour to
transfer their skills across jobs, whereas
geographical mobility refers to the ability of labour to move to different locations in response
to employment opportunities. In general terms:
○ H igh Geographical M obility = Less supply = H igher wage
○ H igh Occupational M obility = M ore supply = Lower wage
 ● The labour force participation​ → Anyone over the age of 15, included in the working age
population is a potential participant in the labour force. However not all people can work, so
by finding how many people want to work, or are working as a percentage of the total
working age population the “labour supply” can be gathered.
○ This may be affected by factors such as the state of the economy, if a population is
ageing, social attitudes and school retention rates
● Other factors ​→ Professional requirements, government policy and prestigious occupations
(consider the training required for a doctor or a lawyer).
The Australian Workforce
● Are those individuals in the ​working-age population​, whom are either seeking work or
employed.
● The most important aspects of a labour force are its ​size and quality​; the size of a labour
force will influence how much labour is available as an input, whereas the quality will affect
the productivity of the labour force as an input.
○ Consider the education patterns, age distribution and population size of an economy.
Calculation and definitions:
● Labour f orce = E mployed + U nemployed
Labour F orce 100
● Labour f orce participation rate = W orking age population × 1
● W orking age population = T otal P opulation − I ndividuals aged under 15
U nemployed 100
● U nemployment rate = Labour F orce × 1
● To be unemployed you must be actively seeking work, available to start work are unable to
find employment
● To be employed you must work one or more hours per week
○ NOTE: 1hr a week and you are considered employed, you cannot even meet your basic needs
on this income. A good statistic to show this would be the labour force underutilisation rate.
Labour market equilibrium
● Labour markets are complex​, and as such it does not function like a perfectly competitive
market; there is a high degree of intervention by many institutions. Here we will consider the
labour market in a “perfectly competitive” market
Determining Equilibrium
● The ​supply curve ​for labour slopes upwards
just like a ​normal supply curve​. However the
reasons for it sloping this way are different
○ As the wage rate increases, working for
that price becomes more attractive and
individuals are more likely to sacrifice
their leisure time (OP cost rises as well).
○ Individuals weigh up the utility they
derive from every aspect of life.
● The ​demand curve for labour​ also slopes
downwards like a ​normal demand curve​.
○ Using the law of diminishing returns, by
employing an extra unit of labour there is a point where this worker will contribute
less than the worker before
○ A profit maximizing firm will only employ a worker, if their wage rate is lower than
the marginal revenue that worker brings in. (Labour Output ＞ Wage rate)
 ● Equilibrium is achieved at the ​intersection between supply and demand​, where the wage
rate is equal to the quantity of labour (demanded and supplied)
● If there is an ​oversupply of labour​, individuals will work for less and if there is an
undersupply​ firms will compete more and increase the wage rate
Changes in equilibrium
● Any change in the conditions that determine the supply and demand for labour, will bring
about a change in the wage rate, and quantity of labour employed. Consider:
○ Ageing population
○ Aggregate demand
○ Increase in productivity
○ Labour vs Capital
○ Interrelation of labour markets
Labour Market Outcomes (Chapter 10)
What is a labour market outcome, and why are they important?
● Having looked at the supply and demand for labour, we will now consider what outcomes this
produces; this references aspects such as the wage-level, job growth, unemployment levels).
● The wage outcomes produced in a labour market, determine how income distributed across
the population, and will therefore have a flow on effect on the economy (see circular flow)
Measuring wages.
● Average total weekly earnings​ measures the average weekly gross rate of pay, before tax.
● Nominal wage​ measures the dollar input for the contribution to the production process, not
adjusted for inflation
● However in order to account for inflation (price rises in G&S) economists talk about the​ real
wage​ which is pay received by employees adjusted for inflation. It is a measure of the
purchasing power of a wage.
● Hence employers can afford an increase in the real wage, if productivity also rises
Differences in wage outcomes
● Differentials between different occupation​; some jobs require more skills, education and
experience and hence those employees are paid more. Consider the occupational mobility.
● Wage differentials in the same occupation​; Likewise more skilled and experienced workers
in the same occupation will be paid more. The geographical mobility of labour will also affect
this, as some jobs that are isolated will have to pay more. In addition to this the productivity
of labour and the capacity of the firm to pay will also influence the wage set.
● Age​; Income varies over the course of an individuals life
● Gender​; Discrimination across certain groups, often means some groups get paid less than
others; gender is a key example of such.
● Ethnic and cultural background​;
Trends in the distribution of income from work
● Income distribution refers to the way income is spread across an economy’s social and
socio-economic groups
● The labour market has become decentralised, with a move away from the award wages system
to firm level bargaining agreements. This has created considerable differences in income.
● The top 20% of earners, account for 40% of total income
● Decreasing union membership has created greater variation in wage.
Non wage outcomes
What is the difference between a wage and non-wage outcome
 ● A wage outcome is the distribution of monetary income to an employee as a return for their
input into the production process (wage and salary)
● A non wage outcome is the non-monetary benefits an employee receives for their
contribution to the production process
○ Desirable additions that increase workers satisfaction; they include benefits such as
salary packaging (getting a company car for example), performance bonus, flexible
working hours etc
● Non wage outcomes represent an additional cost to employers and do not appear in average
weekly earning statistics.
The costs and benefits of inequality
● In any economy there is always ​a tradeoff ​between either having a socially or economically
equitable distribution of income
● Some economists argue that inequality is a natural feature of the free market functioning, as
income is given in accordance with a worker's marginal productivity.
● However some argue that such systems divide society into different classes and each class has
certain restrictions imposed on them

Economic benefits of inequality Economic costs of inequality

Encourages the labour force to increase their
knowledge, skill and level of education
Individuals, with more education and skill receive
a greater income, so by working harder more
income is earned
Encourages labour force to work longer and
harder
The potential to earn a greater income drives
workers to give up their leisure time and work
longer and harder
Makes the labour force more mobile
Higher incomes incentivise labour to move where
its most needed, both occupationally and
geographically.
Encourages entrepreneurs to accept more risks
more readily
The prospect of earning profit encourages them to
undertake business ventures. Without this reward
economies would grow much slower, an economy
would be less productive and there would be less
jobs available
Creates the potential for higher savings and
capital formation
Consider the relationship between income and
saving. The greater the income the more that is
saved and the converse. Inequality creates more
income, and greater disparities hence making the
creating surplus funds that can be used for capital
Can reduce overall utility
People on higher incomes gain less utility from an
increase in income, as when individuals get richer
each dollar they earn means less to them
Can reduce economic growth
Not sure about this one, needs to be checked
Reduces consumption and investment
Low income earners have a higher average
propensity to consume if compared with rich
people and thus if there is a greater degree of
income inequality more funds will be saved than
spent.
Creates conspicuous consumption
Income inequality sometimes creates a ‘leisure
class’ in which funds are spent high class goods
or services, purely to display one’s wealth.
Creates poverty and social problems
Inequality in income distribution allows for
relative poverty to be created in distributed. As
those whom are more educated, skilled and
experienced receive a greater income, there is a
large degree of internal income disparity. This is
especially a problem for disadvantaged groups,
formation.
Social benefits of inequality
Creates more opportunities for individuals
An individual who works hard may receive
different kinds of opportunities. However those
who acquire wealth through inheritance, or do not
have access to the same networks of people may
also have a greater level of opportunity. Hence
this could also be placed into the the other
column.
and thus creates an undercurrent of low-income
earners
Increases the cost of welfare support
As income inequality makes an economy more
competitive, is simultaneously makes the job
market more competitive as those disadvantaged
people may require welfare.
Social costs of inequality
Wellbeing
Advanced economies experience a greater degree
of social problems such as mental health illness,
domestic violence, crime and lower levels of
social mobility. This is often a reflection of the
inadvertent impact market forces, and income
inequality creates in an economy
Social class division
Income inequality divides a society into distinct
set of classes, each of which has differing values
and attitudes. This may create tensions between
people of differing class, consider industrial
disputes.
Poverty
Income inequality induces relative poverty.

Unemployment
● A key aspect of the labour market is the level of unemployment, as individuals who are
unemployed represent an unused resources; as such policy-makers often try to reduce
unemployment to the greatest extent possible
● In any economy the amount of individuals unemployed can be calculated with some degree of
certainty (see ​The Australian Workforce​ above)
However there is more than one type of unemployment, as each individual’s reason for being
unemployed differs;
❖ Cyclical unemployment ​is caused by fluctuations in the business cycle, and changes in
aggregate demand
❖ Structural unemployment ​occurs when there is a mismatch between the skills supplied
(especially those of the unemployed) and demanded within a labour market.
❖ Long term unemployment​ is when an individual has been unemployed for a period of 12
months or more
❖ Seasonal unemployment ​is due to jobs which are by nature, only viable for certain periods of
time (ski-resort employee, or tour-guide as an example)
❖ Frictional unemployment ​occurs when individuals are in between jobs, and references
‘frictions’ such as taking job interviews, searching for opportunities etc.
❖ Hard core unemployment ​references those individuals unemployed as a result of a personal
characteristics; such as a mental or physical disability.
 ❖ Hidden unemployment ​speaks to those unemployed individuals whom are not counted in
official statistics (this is especially important during prolonged periods of economic
downswing)
❖ Underemployment ​is when individuals are employed but want to work more hours.
NAIRU and the Phillips Curve​ (Optional read)
What is the Phillips Curve?
● It is an ​economic concept​ stating that ​inflation​ and ​unemployment ​have an ​inverse
relationship​ (however it is not always true, as seen by periods of STAGFLATION)
● The belief that any fiscal stimulus package would increase aggregate demand and cause
effects such as an increase in labour demand, employment and wage rates was the basis for
this theory.
● If inflation went up,
unemployment would go
down and the converse
● Hence many governments
implemented fiscal and
monetary policies aimed at
either expanding or
contracting the economy, to
achieve their target inflation
rate.
● However these policies failed,
when during the 1970’s there
was a period of high
unemployment and high inflation (STAGFLATION), directly contradicting this theory.
● Economists discovered that because workers and consumers can change their expectations
about inflation and unemployment, this relationship could only hold in the short run
● So when a central banks seeks to increase inflation in order to reduce unemployment it may
cause an initial shift along the SRPC (Short Run Phillips Curve), but as expectations about
inflation will change the SRPC will move outwards.
● So if expectations can adapt, then the LRPC (Long Run Phillips Curve) is where
unemployment will be after market expectations have worked themselves out (the natural rate
of unemployment). And monetary policy simply raises or lowers the inflation rate after the
market has worked itself out.
● This all goes to say that in the long run there is no well defined relationship between
unemployment and inflation
What is NAIRU?
● The ​Non Accelerating Inflationary Rate of Unemployment​ is the specific level of
unemployment that does not cause inflation to rise.
● Economy performs poorly​ → Businesses cannot increase prices due to a lack of consumer
demand → Price of product falls → Less people employed → ​Unemployment goes up​ →
Inflation goes down
● Economy performs well​ → Businesses raise prices to match demand → More goods bought
and sold → Inflationary pressures → More individuals employed → ​Unemployment goes
down​ → ​Inflation goes up
● Think of it as the tipping point between unemployment and rising or falling prices.
 ● This crucial moment is represented at point (A), as when an economy tries to reduce
unemployment past that point, inflation rises.
What is the natural rate of unemployment?
● The natural rate of unemployment is the minimum unemployment rate resulting from real or
voluntary economic forces. It reflects the number of people whom are unemployed due to the
structure of the labour market; such as frictional and structural unemployment. It does not
include those whom are unemployed due to fluctuation in economic activity.
● Hence full employment occurs when cyclical employment is zero; as the natural movement of
labour deems that at any time irrespective of economic growth, employment will persist due
to other factors.
The movement away from full-time work
There are in general, the following types of employment in Australia
Full-time employees
They work at least 38 hours per week, on a predefined basis.
Hours of work are defined by an agreement between their employer, additionally they may also be
set by an award or registered agreement.
They are entitled to following types of leave: long service, parental, bereavement, annual, personal,
sick, and carer’s.
Part time employees
are similar to full time employees but less than 38 hours per week on average
they work on a pro rata (proportional) basis and are paid by how many hours they work.
Casual
Employed on an hourly basis
Lacking entitlements received by other kinds of employment.
Compensated through loading in addition to their hourly rate.
They work on an irregular basis in order to meet business demands and have: no expectation of
ongoing work, no obligation to accept work offers, no sick or annual leave pay, no obligation to
provide notice of ending of employment unless specified by an award, agreement or contract.
Fixed term and contract
Employers can employ individuals under contract, if a certain task needs to be performed, or if the
contract is time based.
Have the same entitlements as permanent staff, but on a pro rata basis.
Apprentices and trainees
Employees working towards gaining a national qualification
Payment is set by an award or registered agreement.
Parties involved their contract include the registered training provider, the employer and the
employee.
Commission and piece rate
Performance based employment type.
The employer may compensate good performance through the distribution of a commission or piece
rate. However this may only be given if an awards stipulates that such compensation is applicable, or
if a set agreement allows for it.
Volunteer and Unpaid work
The provision of services and products, without financial compensation.
Over the past decade, the structure of employment in the Australian labour market has changed
significantly:
● Shift away from full-time employees to part time and casual employees
● Growing use of arrangements of contractors, outsourcing and
subcontracting arrangements; creates greater efficiencies in production
process
● Casualization of the workforce;
○ Advantages: Flexibility for employers to increase and reduce
staff, avoid paying non-wage costs, flexibility for employees etc.
○ Disadvantages: Erosion of job security, difficulty for employees to plan for the future
and carry out financial transactions (home loan), less staff loyalty etc.
The Changing Australian Labour Market (Chapter 11)
An outline of the labour market
The ​relationship between employers​ (demand) and ​employees​ (supply) is a crucial part of how the
economy functions. Employers want labour costs to be kept as low as possible, whereas employees
want the highest wage as it is their largest source of income
It is this relation that is known as ​industrial relations​ which can further be defined as ​“the laws,
institutions and processes established to manage the relationship between employers and employees; it
determines wages and conflict resolution within the workplace”
Australia has a unique industrial relation system. Over the past century our system has ​moved away
from a traditionalist structure​ to guarantee​ fair outcomes​ for both the employer and employee. As a
result, there are many special laws, policies and institutions that operate within the labour market, and
moreover negotiate things such as wages, contracts and industrial disputes etc.
Because of this the Australian labour market is​ far from a perfectly competitive market​, as
market-operations are significantly impacted by ​institutional forces​ that seek to ​improve labour
market outcomes
The role of trade unions ​is simply to represent the interests of its members by negotiating
improvements in their wages and working conditions.
● Occupational unions ​are formed with members who possess a similar occupational skill/s
● Industry-based unions ​include members in a particular industry
● Enterprise-based unions ​represent the workings of one specific enterprise
● General unions ​cover a broad range of workers with different skills, across different industries
Note that in recent decades union membership has declined significantly, due to microeconomic
reform, specifically the decentralisation of the labour market.
How do unions influence wage outcomes for its members?
By coordinating the bargaining power of all its members (employees), unions have a greater collective
bargaining power in negotiations.
● Representing employee interests​; unions provide
a collective voice for their members when
attempting to promote change (improving safety
standards, work environment etc
● Exercising their bargaining power in
negotiations with employers​; when employees
join together and go on strike, their collective
bargaining power will have a substantial
influence (variable input of labour is being
 unproductive), as they can negotiate a wage price above equilibrium.
○ At this point (see beside diagram) although the wage will be higher, there will also be
an oversupply, meaning there will be less employment.
● Restricting the supply of labour;​ unions can impose restrictions on the supply of labour
through imposing both macro and micro restrictions. They will essence say that they will not
work, unless their demands are met
○ In this case labour supply is outright shifted to the left, with the wage rate similarly
being pushed up, as well as the quantity employed also being lessened.
The role of employer associations
Employer associations were ​formed in direct opposition to unions​, however they are not as well
coordinated as their members also​ compete with each other​. In general employer associations do not
deal with unions, as employers prefer to deal with them themselves. Their main roles are:
● Represent and promote the interests of their members through lobbying the government on
industrial relations policies.
● Manage industrial relations issues by representing their members at industrial tribunals and
settling industrial disputes
● Provide advice, training and direct assistance to employers.
● Assist members in negotiating wage agreements (sometimes)
Through lobbying the government for protection from foreign competition, for tax exemptions,
industry assistance etc. employer associations are able to secure a larger share of the domestic
market for its members.
Australia’s current industrial relations framework
The Australian industrial relations system has slowly evolved from ​one of central wage
determinations​, to one that allows for ​greater variations​ and ​flexibility​ in the way work arrangements
are made. The current systems is governed by the ​Fair Work Act 2009,​ which replaced the Workplace
Relations Act 1996.​
The current system has established ​three main streams​ in the labour market that ascertains the pay and
conditions of employment — ​industrial awards​,​ collective agreements​ and​ individual employment
contracts
This system is overseen by the ​Fair Work Commission​ which is a government agency that regulates
industrial relations in Australia. Its functions include:

dealing with unfair dismissal claims ​dealing with anti-bullying claims ​dealing with general protections and unlawful termination claims
setting the national minimum wage and minimum wages in modern awards ​making, reviewing and varying modern awards
assisting the bargaining process for enterprise agreements ​approving, varying and terminating enterprise agreements
making orders to stop or suspend industrial action ​dealing with disputes brought to the Commission under the dispute resolution procedures
of modern awards and enterprise agreements ​determining applications for right of entry permits

National employment standards (NES) ​— Australian employees must receive these ten guarantees
under the NES from employers if they are employed (may vary for casuals). These provisions are:

Maximum weekly hours Requests for flexible working arrangements

Parental leave and related entitlements Annual leave
Personal/carer’s leave, compassionate leave and Community service leave
unpaid family and domestic violence leave
Long service leave Public holidays
Notice of termination and redundancy pay Fair Work Information Statement

As said earlier there are three main ways of wage determination in the Australian industrial relations
system, they are:
● Industrial awards (Modern awards) ​establish the minimum wage and working conditions
for employees. They set the absolute minimum wage and
working conditions for a type of employment with
respect to a work or industry sector. They often extend
the basic guarantees outlined the NES, to be more
industry specific. All the other types of wage
determination in both the formal and informal system,
must provide conditions in excess of the relevant modern
award.
● Enterprise agreements​ are negotiated between
employers and employees, and are the most common
method of wage determination; were introduced when
the labour market became decentralised. They must
provide conditions in excess of a relevant industrial
award and are subject to the “Better Off Overall Test”, and are usually negotiated between a
union and employee. They are also known as enterprise bargaining agreements, and were
previously called collective agreements.
○ Single-enterprise are made between ​a single employer​ (or ​two or more single interest
employers​) and​ employees​ employed at the time
the agreement is made, and who will be covered
by the agreement. Single interest employers are
employers that are in a ​joint venture or common
enterprise​ or are ​related corporations​.
○ Multi-enterprise are ​created by ​two or more
employers​ as well as the​ employees of those
different enterprises​. These agreements differ
from single enterprise agreements in that the
employers ​do not need to prove that they have a
single interest​ in the bargaining process
○ Greenfields are ​made between an employer and
their employees ​before the business has started
and ​before anyone has been employed.​ Made through an employer and an employee
association
● Common law contracts​ is at its​ most basic level, an employment relationship between an
employer and an employee is a civil contract where the employee agrees to perform work for
the employer in exchange for monetary or other payment. They are part of the informal
system and are also known as “individual unregistered agreements”, as they are specific to
one person or enterprise. They also must provide conditions in excess of a modern award.

Topic 5: Financial Markets 

Types of Financial Markets (Chapter 12)
Understanding the Global Financial Crisis (Optional but good read)
What is the Global Financial Crisis and why is it important?
● The real economy ​where goods and services are exchanged​ are connected to the ​financial
markets​ where ​financial securities​ are ​exchanged​. Whilst these securities has enabled for
greater efficiencies in transactions and increased the level of surplus funds in an economy (for
capital projects), there is also a ​degree of uncertainty​ when​ trading in securities​. We see
that these securities reflect the prevailing business conditions, risk, uncertainty and
expectations of future returns.
● Even though the financial markets are expected to have ​substantial levels of volatility​, there
are sometimes periodic bursts of abnormally high volatility; we see when this occurs market
participants ‘run for cover’ as the ​value of their investments depreciate significantly​. The
resulting liquidation of assets, is the method through which the market will attempt to​ restore
balance​. This is what occurred during the GFC.
● Hence the global financial crisis refers to the​ financial crisis that occurred in 2008​, which was
traced to the collapse of the housing market in the USA.
● It is through this crisis through which the importance of the financial market arises; it has the
potential to ​enable economic growth​ but also to cause​ severe instability​ in the global market.
What caused the Global Financial Crisis?
● We can trace the financial crisis back to what occurred in the US housing market in 2007.
During this time, the realisation that house prices in America had fallen substantially and
mortgage default rates were increasing — especially in sub-prime mortgages (loans to
borrowers who cannot repay them) — began a liquidation of positions in the mortgage
market.
● Uncertainty about the value of assets, posted collateral and the solvency of financial
institutions flowed through the financial system — as banks could not fund their activities
through their usual streams and were subjected to ‘runs’ in which customers demand all their
money back from an institution at one time. The lack of availability of repurchase agreements
(a dealer would sell a financial security to a person, and agree to buy it back later at a higher
price) further meant that banks could not continue to run.
● However the ​inappropriate issuing of loans​ was not the ​only cause​. In addition to this banks
usually had engaged in the ​issuing of complex financial securities​ in the housing market,
where they​ essentially traded​ and ​structured the debts​ of homeowners (Think about how crazy
this is, you own a home and you can't afford to repay it, and your debt is being traded. If
everyone withdraws their money from a bank, and they call their money back from you, what
will happen to the value of your home and these financial securities. Using basic supply and
demand, we see that a drop in demand for these houses and securities, will erode the value of
that asset completely).
● For example one of these complex financial securities was a ‘Collateralized debt obligation
CDO’s’, in which cash flow generating financial assets were packaged together into discrete
tranches, which could be sold to investors — in the GFC home loans were packaged by risks.
Buyers of the CDO’s were also engaged in ‘Credit default swaps’ which shifted the credit
exposure of the buyers of these tranches. Basically a seller of a CDS issuer would say to the
buyer in a case of default (of the asset being traded), that they would reimburse the buyer on
the condition that they continue to pay a premium for the CDS.
The Eurozone crisis
● It was the second installment in the GFC; namely in Greece when the government announced
that sovereign debt was 113% of the country’s national income, and 220% of GDP. There was
 a high probability that the government would be unable to meet their repayments (bonds), and
hence the european bond market panicked as investors lost confidence
● Economic indicators in Greece deteriorated as other european economies, who had loaned and
been loaned funds from European countries such as Greece & Italy lost money, as the assets
through which these loans had been made were depreciating.
● This created major instability in the overall international market, as banks who had trillions of
dollars held and loaned to other countries were now losing money, due to a lack of
confidence.
What about Australia?
● Australia averted the broader effects of the GFC to an extent due to implementation of a
guarantee on money held with financial institutions by the federal government. This allowed
for confidence to be maintained in the financial system and prevent ‘runs’
● Furthermore in late 2008 and early 2009, the Australian government implemented two fiscal
stimulus packages totalling more than $50 billion, to stimulate aggregate demand and prevent
a recession
● However these were not the only contributing factors to Australia’s relative well navigation
through the GFC; for example the trade relation between Australia and China also helped
maintain a healthy Current Account, and lesser exposure to exotic financial instruments.
Lessons to be learnt from the GFC
● The importance of stable financial sector, and how it affects the overall health of an economy
● The need for strong regulatory reforms, and regulation in the financial market
● Greed, irrationality, fraud, the instability of capitalism, the disproportionate size of the ‘real
economy’ to the ‘financial sector’, shadow banking, lax lending models, misguided central
bank policy, unrestricted financial innovation, poorly designed mathematical models in
measuring risk etc in causing instability.
● The interrelated nature of all markets, and the ability of one economy to affect other
economies within the global economy
The role of financial markets in the economy:
Financial Markets​ play a crucial role in the operation of an economy. They ​provide returns​ for those
that have ​excess funds​, while
making those ​funds available​ to
those in need for additional
money. We can define a financial
market in broad terms as ​where
the trading of securities​ occurs.
They are the ​factor markets for
capital​. The financial sector is
one of the fastest growing areas
of the Australian economy, with
the finance and insurance
industry contributing over $150 Billion to GDP.
Financial Intermediaries​ are firms that receive the funds of individuals or firms, and then loan these
funds to other individuals or firms. They channel the excess savings (from the net savers) in the
economy to those who wish to borrow funds (the net borrowers). This is shown in the flow of funds in
the Australian financial system:
The types of financial institutions include: Consumer banks, Investment banks, Finance companies,
Credit unions, Permanent building societies, Mortgage originators, Superannuation funds.
​savings are classified as a leakage​ as they detract from AD, while ​investments are classified as an
injection​ as they contribute to AD.
There are various sources and reasons for saving and borrowing:
Sources & Reasons for saving Reasons for borrowing
Individuals Source/s:​ The proportion of income that is When their demand for products exceed
not spent. capacity to pay for them.
Reasons:​ Future spending, backup money
Businesses Source/s​: Undistributed profits To fund the expansion of the business.
Reason/s:​ Funds can be retained in financial
markets until needed, can be reinvested into
the business.
Governments Source/s: ​Government revenue, budget The government becomes a borrower when
surplus they budget for a deficit.
Reason/s:​ Pay debt
International Source/s:​ Australians can borrow money Australian Financial institutions can lend
from overseas to access foreign savings money overseas.

Primary and secondary financial markets

● Primary financial markets​ facilitate the ​creation​ of financial assets (securities) that can be
sold in the economy. If a firm wants to raise funds, they can borrow money by issuing debt
securities or selling new shares. The income received from investors goes directly to the
company.
● Secondary financial markets​ involve the exchange of financial assets that have previously
been issued in the primary market. This is where most financial market transactions occur.
The companies do not
receive income from
these transactions, but
the owner does.
● Primary and
secondary market
transactions can be
seen in the beside
diagram:
There are four types of financial markets:
● The share or equity market​: Where ownership shares in companies are issued or exchanged
● The debt market​: Where debt securities (e.g. bonds) are exchanged, or cash is lent or
borrowed
● The derivatives market​: Where people buy and sell financial assets whose value is based on
the value of other financial assets
● The foreign exchange (forex) market​: Where financial assets defined in one country’s
currency are exchanged for assets defined in another country’s currency.
There are a variety of ​financial market products​ to meet the needs of lenders and borrowers. They
vary in risk, return and liquidity:
● Consumer credit​: Allows consumers to purchase products in advance of actual payment. The
most common type is the credit card, which charges interest on the use of credit.
 ● Housing loans​: Long term loans used to purchase property, requiring periodic repayments
with interest e.g. mortgage. They are offered by banks and mortgage originators.
● Business loans​: A form of debt that allows businesses to invest in their operations with
borrowed money e.g. debt financing. Small businesses generally pay higher interest due to the
risk factor
● Short term money market​: Connects individuals and firms with temporary shortages or
surpluses of funds. Those with surplus funds e.g. banks issue forms of debt securities to those
in need, and have a maturity date of less than one year e.g. bank bills, promissory notes..
● Bonds market​: Issuing of long term debt securities from governments, banks and some
companies. Lenders receive regular fixed payments (coupon payments) from the issuing
institution, and receive the face value (original value) of the bond at the end of the maturity
period.
● Financial futures and options​: Contracts to trade in financial instruments (shares or bonds)
at a later date for a certain price. It provides protection from adverse movements in interest
rates, currency fluctuations, or share prices. The investor agrees on the current price and
currency for which the financial assets will be bought or sold at a later date.
● The FOREX market​: The market for buying and selling foreign currencies . Investors and
businesses require foreign currencies when they do business with people overseas.
The share market
The ​share market​ is where investors buy and sell shares. A share is a type of financial asset that
when purchased, provides the investor with part ownership of a business. For a firm to issue shares, it
must be an incorporated company (private, public). Shares of a public company are listed on the
Australian securities exchange (ASX)​ - the largest primary and secondary financial market in
Australia that provides a regulated environment for investors to buy and sell shares, by matching
sellers with a desired selling price with buyers who are willing to pay that price The transaction
process is as follows:

There are various reasons for purchasing shares:

● Gain stake in a company​: Shareholders are able to vote for the board of directors
● Capital Gain​: Profit from the sale of a property or investment.
● Dividends​: A proportion of the company’s profit is returned to shareholders on a per share
basis.
However, many share purchases are ​speculative​ - meaning shares are bought with the intention of
being sold within a short period of time, in the hopes of making short term capital gains.
A ​float​ or Initial Public Offering (​IPO​) occurs when a company decides to list itself on the stock
exchange and offer its shares for the first time.
Individual share performance can be measured in two main ways:
Annual Dividend per share
● Dividend yield​: The return on investment is calculated by: P rice per share . The higher
the percentage or dividend yield, the higher the return on investment will be.
 ● Price to Equity (P/E) ratio​: Is a measure of how expensive it is to purchase a company’s
Share price
shares. It is calculated daily in the ASX by Earnings per share . A higher value means a
company’s shares are expensive to hold, as the earnings per share a relatively low. A lower
value indicates a cheap share, as earnings per share are relatively high.
Share prices change​ due to the forces of supply and demand, and reflects factors such as confidence
in management, previous earnings, expected earnings and general economic conditions.
The sharemarket performance and the relationship with general economic conditions can be measured
by the:
● All Ords​: A measure of the overall performance of the Australian sharemarket at any given
time. It measures the changes in the overall value of the top 500 companies on the ASX.
● Standard & Poor’s (S&P) index​: Provides the index calculation services for the ASX. It is
now the most popular index and is recognised as the investable benchmark for the Australian
equity market.
A ​global market​ refers to the integration of the financial systems of all nations and include FOREX
markets and global debt and equity markets. Australia’s debt and net Australian equity have been
increasing over the past 30 years. Global markets are analysed and somewhat regulated by:
● The ​Bank of international settlements​: Aids central banks e.g. RBA in promoting financial
stability
● The ​International Monetary Fund​: Overseas the general stability of the international
financial system.
Superannuation
Superannuation is the compulsory payment by employers of ​9.5%​ of the gross income of employees
into a nominated superannuation fund to build retirement savings for employees. Total superannuation
assets was ​$2.9 Trillion​ at the end of June 2019. Super Funds operate by pooling money from all
members and investing it into various mediums. There are also self managed super funds, in which the
members invest their super money themselves.
Superannuation is important for the Australian government as it allows individuals to save for
themselves. It also removes a large burden on the government by ​reducing government expenditure
on welfare​. These spare funds can then be spent in other areas by the government.
Regulation of Financial Markets
There are five regulators for financial markets:
● Council of Financial Regulators (CFR)​: The CFR is a coordinating body for financial
market regulation that provides for cooperation and collaboration among its fours member,
the RBA, APRA, ASIC and the Treasury. It is an informal body that allows for sharing of
information and coordination of advice, but has no function other than the functions of its
members.
● The Reserve Bank of Australia (RBA)​: The RBA is Australia’s independent central bank.
Its primary purpose is the overall management of the financial system by overseeing its
stability and conducting monetary policy. It is not influenced by the political process, but is
accountable to the Parliament for its actions. The RBA will be further examined in the next
chapter. Some other roles of the RBA include:
○ The RBA is the sole ​issuing authority for the Australian currency​. The volume of
notes and coins varies depending on the demand for cash.
○ They are also responsible for the payments system, by ​ensuring the efficiency of
payment methods​ including: credit cards, electronic cash, travellers’ cheques, and
 stored value cards. They promote stability in the clearing and settling of large
transactions in financial markets.
● Australian Prudential Regulation Authority (APRA)​: They provide prudential regulation
for all authorised deposit taking institutions (ADI’s). ADI’s include banks, superannuation
funds, insurance companies, credit unions and building societies. Their two main regulatory
roles are to:
○ Encourage behaviour by institutions to ensure they meet their obligations to the
people who place money with them e.g. ensuring deposit holders can withdraw their
money. APRA requires ADI’s to maintain certain levels of funds to manage risks.
○ For ADI’s experiencing financial trouble, APRA intervenes by sorting out their
financial position, and ensuring deposit holders receive as much of their funds as
possible.
● Australian Securities and Investments Commission (ASIC)​: ASIC aims to improve the
performance of the financial system by regulating Australian companies and financial markets
to protect investors and consumers. They lift the standards of corporate behaviour, and if any
companies are found to participate in bad behaviour, ASIC will take legal action. Their roles
have been expanded to regulate consumer credit (home loans, credit cars) as well as
supervising the ASX.
● Australian Treasury​: The treasury is the main source of economic policy advice to the
government. They can influence how governments devise budgets, allocate expenditure, and
implement other policies such as monetary policy, labour market policy and market
regulations.
The Money Market (Chapter 13
The ​money market​ is the market for borrowable funds:
● Borrowers​ are the consumers who demand funds.
● Lenders​ are the producers who supply funds.
The ​price of money​ on the money market ​is the interest rate​. However, the interest rate is not set
solely by the forces of supply and demand, but it is influenced by the RBA.
The types of borrowers can be seen in the following table:
Type Borrowers - Demanding funds Lenders - Supplying funds

Individuals Individuals borrow money for personal
use. They borrow for short term
purposes e.g. travel, education, credit
cards and also borrow in the long term
e.g. mortgages.
Individuals who hold wealth and do not
wish to spend can: Invest it in assets,
shares and interest bearing deposits.
When they place money in deposits, they
are lending money.

Businesses Businesses do the most borrowing.
They need access to funds for
expansion, investment and
development.
If a business has a strong cash flow and
good profits with no immediate plan for
expansion, they may deposit funds into
ADI’s, especially when interest rates are
high.

Governments Governments may need to borrow When governments are in surplus, they
funds to increase economic activity or can: Pay off outstanding debt or maintain
fund a rise in debt or government positive financial balances by lending
expenditure. money through the financial sector.
 International Other countries may need to borrow International lenders provide funds for
from Australia to meet their goals and domestic borrowers. Australia relies quite
obligations. heavily on international savings to fund
domestic consumption and investment.

Factors affecting the demand for funds

Individuals with surplus funds must decide what form to keep them in. The choices are to:
● Hold it as money (currency and bank deposits)
● Purchase financial assets (bonds or shares)
The benefit of holding money is ​liquidity​, allowing for the easy use of funds when necessary. The
benefit of holding financial assets is the possibility of earning a return, however, they carry risks due
to fluctuations in their value.
The reasons for holding money rather than purchasing financial assets are:
● Transactions motive​: People have day to day transactions which include making regular
payments for goods and services.
● Precautionary motive​: There are numerous unpredictable circumstances and emergencies
(e.g. sickness) for which people need liquidity.
● Speculative motive​: Buying financial assets carries the possibility of making capital losses.
Individuals try to avoid capital losses, so if the value of financial assets is expected to fall,
they will liquidate their financial assets.
Financial innovation (e.g. ATMs and EFTPOS) have led to the decrease in demand for holding liquid
funds.
Financial Aggregates
Money plays a crucial role in the functioning of an economy. This is as the value of products in
product markets and all resources in factor markets can be expressed in terms of money. The four
characteristics of money are that it is a:
● Medium of exchange
● Measure of value
● Store of value
● Method of deferred payment​ - allows the system of lending and borrowing
Money is not just notes and coins. The money supply can be measured in the following ways which
are each called financial aggregates (in decreasing order of liquidity):
● Currency: Notes and coins held by the private non-bank sector
● Money Base​: Currency + banks’ holding of notes and coins + deposits of banks with the RBA
+ RBA’s liabilities to the private non-bank sector.
● M1: Currency + current (cheque) deposits of the private non-bank sector with banks.
● M3​: Money base + All bank deposits. This is the RBA’s definition of the money supply
● Broad money​; M3 + Deposits in non bank financial intermediaries (e.g. credit unions,
building societies) minus their holdings of bank deposits.
Note: Another monetary aggregate is ​credit​ which allows payments to be deferred. However, credit is
not a store of value so is not counted as a measure of the money supply.
Macroeconomic Policy
Macroeconomic policy​ refers to policies directed at stabilising the level of economic activity or
Aggregate demand (AD). The two policies are:
● Fiscal Policy​: Changes in the level and composition of government spending and taxation. It
is directly controlled by the government.
 ● Monetary policy​: Involves changes in the cash rate which influences other interest rates.
These policies operate on the demand side of the economy and impact on the growth of AD which is
the total spending in the economy (C+I+G+X-M). Note that consumption (C) makes up 57% of AD.
The ​goal​ of macroeconomic policy is to provide a stable economic environment that is conducive to
fostering strong and sustainable economic growth, on which the creation of jobs, wealth and improved
living standards depend.

Stabilisation of AD:

Monetary Policy
As stated earlier, an interest rate is the price of money. The two types of rates are the:
● Borrowing rate​: Rate of interest offered by financial institutions if you put money with them
● Lending rate​: Rate of interest charged by financial institutions if you use their money
Financial institutions work in the following way:

Inflation​ is the rate of increase for goods and services over time. It is measured by the Australian
Bureau of Statistics (ABS). Its measurement is the CPI.
The RBA conducts monetary policy, works to maintain a strong financial system and issues the
nation's currency.
Monetary involves ​setting the interest the interest rate on the overnight money market​. Other
interest rates in the economy are influenced by these, so monetary policy affects the behaviour of
borrowers and lenders.
The RBA derives its powers from the ​RBA Act 1959,​ which sets the goals of the:
● Economic prosperity and welfare for the people of Australia
● Maintenance of full employment
● Stability of the currency
The RBA has found that maintaining an average inflation rate of 2-3% on average per annum over the
business cycle will allow them to achieve their goals.
The RBA meets 11 times a year on the first tuesday of every month except January. At the meeting
they can either decide to:
● Decrease the cash rate (​loosening stance​)
● Increase the cash rate (​tightening stance​)
● Leave the cash rate (​neutral stance​)

The impacts of monetary policy on AD are as follows:

● Consumption (C)​: An expansionary stance aims to increase consumption. This would result
in lower interest rates on loans from ADI’s, meaning that the cost of borrowing is cheaper.
This would increase disposable incomes for individuals and reduce expenses for businesses. A
larger disposable income for individuals will increase the levels of consumption within the
economy. This is a major factor in increasing AD as C makes up 57% of the total AD.The
opposite of this will happen in a contractionary stance, which aims to decrease consumption.
A neutral stance aims to maintain consumption.
 ● Investment (I)​: An expansionary stance aims to increase investment, as there would be an
increase in both property and share investments due to higher disposable incomes and more
attractive share investment (as deposit and bond rates will be lower), hence increasing I.
Firms will also undertake investment projects. The opposite of this will happen in a
contractionary stance, which decreases I. I is unchanged in a neutral stance.
● Net Exports (X-M)​: Businesses would be able to acquire more funds due to more investment
and fewer expenses, making them more likely to undertake investment and innovation. This
would lead to an increase in X. The cash rate also impacts the exchange rates. As the cash rate
decreases in an expansionary stance, foreign investment will decrease lower interest rates in
Australia compared to other developed nations. This would reduce the demand for Australian
funds, hence reducing the Australian exchange rate. Australian exports will become more
globally competitive and imports will become more expensive, leading to an increase in X
and decrease in M. The opposite of this will happen in a contractionary stance. X-M will be
unchanged in a neutral stance.
Note that there are​ time lags​ of 6-12 months on AD and 12-18 months on inflation as households and
businesses take time to adjust.
Implementation of Monetary Policy
Who does it target, and what does it attempt to do?
So we have already mentioned monetary policy involves influencing the ​interest rate (price of
money) on money​, but how do central banks specifically achieve this. So in general in an economy,
money can either ​be saved​ with a financial institution or ​be borrowed​ from a financial institution, with
in both cases interest being either paid or received. Further, we find these institutions are largely
banks as they conduct these transactions the most. Hence monetary policy targets banks (and other
institutions), by influencing the interest rate they offer to consumers on savings, and the interest they
charge on loans. By doing this they can achieve their goals as described above.
What does the RBA specifically do?
They undertake transactions in the ​Australian Cash Market​,
which is the market for overnight loans between financial
institutions (note that this definition of the cash market is
specific to the australian system) . It is the overall availability of
cash (surplus ESA balances, see later) in an economy; as this is
where banks see to borrow or lend money.
To understand monetary policy, we must first understand what
an exchange service account is. As the RBA defines it, an
exchangement service account (ESA) is “​the means by which
providers of payments services settle obligations that have
accrued in the ‘clearing process’ (settling transactions) ”. Everyday banks undertake transactions with
other banks; for example Westpac may owe ANZ for taking a loan, or Commonwealth may have lent
Suncorp etc. The point being, that that if these banks and ADI’s are constantly undertaking
transactions, how are these obligations fulfilled. Say we had five banks. They could each sit around
the table and pay each other in cash, however in doing so this would be very inefficient, as interbank
transactions are usually very large and if cash is used, it is more risky (robberies, hijacking etc). This
is where an exchange settlement account comes in. In essence they are interest bearing accounts held
by financial institutions at the Reserve Bank; they contain the RBA’s electronic currency. The reasons
for holding ESA’s with the RBA are outlined below:
(​this section is the most incomplete section of the whole document, head to the RBA’s website for
more info​)
The RBA sets the interest rate on the overnight money market, which is the market for Authorised
Deposit taking Institutions (ADI’s) to exchange funds so they can maintain a positive Exchange
Settlement Accounts (ESA) balance. Consumer banks hold (​ESA’s​) with the RBA, and must have a
positive liquidity at the end of each day to ensure they meet obligations. ESA’s allow banks to settle
and create debts with each other and the RBA. The RBA can also buy and sell government securities
through ESA’s. Banks with an ESA in deficit must:
● Borrow from banks with surplus ESA’s​. Banks who leave money in their ESA’s receive
interest at 0.25% below the cash rate.
● Borrow from the RBA​. Banks who borrow from the RBA have to pay interest of 0.25%
above the cash rate.
In overnight money markets, the interest rate is unchanged in a neutral stance, the interest rate is
lowered in an expansionary stance and in a contractionary stance, the interest rate is increased. The
corridor for the money market is at ±0.25% of the cash rate. The interest rate on the overnight money
market influences the interest rates which ADI’s use. Once a stance and cash rate is decided, ​the cash
rate is maintained through Open Market Operations (OMO’s)​ which can be seen in ​Figures 1 &
2​. OMO’s involve changing the level of liquidity in the overnight money market by changing the
supply of funds through the sale and purchase of Government bonds. In Figure 1, the cash rate is
below target ( R1 ), so the RBA decreases the level of liquidity from Q1 to Q2 by selling government
bonds to move the rate up to R2 . In Figure 2, the cash rate is above target ( R1 ), so the RBA increases
liquidity from Q1 to Q2 through the purchase of Government bonds to decrease the rate to R2 .
Figure 1 Figure 2

OMO’s can
occur in
three ways:

● Bond Purchases or sales​: The RBA buys or

sells bonds in exchange for ES balances. As a result, these transactions change the supply of
cash in the market.
● Repurchase Agreements (Repos)​: Repurchase agreements are the most common OMO used
by the RBA as it allows them to manage liquidity on two different days with the one tool..
These occur in two parts. In the first part, the RBA might lend a bond to a bank and receive
ES balances, draining the supply of money on that day. The second part is pre-arranged, and
involves the RBA receiving the bond back at an agreed price and date, leading to an injection
of ES balances on that day. A ​Reverse​ ​Repo​ is when the RBA initially borrows a bond,
 supplying ES balances on that day, and at an agreed price and date, the RBA later returns the
bond to the bank and removes ES balances.
● Foreign Exchange swaps​: This is similar to a repo. (Don’t really need to know this one)

Topic 6: Government and the Economy 

The Limits of Markets (Chapter 14)
Under the free operation of market forces, the most ​desirable economic​ and​ social outcomes​ is not
always achieved​. This is as although markets are very effective in deciding the key economic
concerns:
{What to produce} — {How much to produce} — {How to produce} — {How to distribute}
they often fail to consider the underlying social effects and byproducts of market decisions;
nevertheless markets are still the​ best system of economic coordination​ in promoting innovation,
efficiency, growth and satisfying our material wants
Thus governments intervene in the market so that both our broader economic and social interests are
met. So the challenge is ​finding the right balance​; too much intervention can stifle innovation, and
too little may make a society very inequitable in its outcomes
Market failure; an overview
As said earlier the government intervenes in the market in cases of ​market failure​ which can be
defined as a ​situation in which the allocation of goods and services is inefficient, often leading to
undesirable economic and social outcomes
Given this there are both benefits and costs, on society and the private individual when market forces
set an equilibrium price.
● Private costs​ refer to the expenditure of producers on resources to produce output, whereas
for consumers it represents the costs incurred through the consumption of a good or service,
which in turn reduces their income
● Private benefits ​are the profits made by producers in selling goods and services in markets,
and likewise for consumers this benefit is the utility gained through the consumption of goods
or services in satisfying their needs and wants.
● Social costs ​are the costs imposed upon or borne by society as a result of private actions in
the production process
● Social benefits ​are the positive spillover effects of private production on the overarching
community.
We can thus say that any action in the ​production process​ will often affect people whom are not
directly involved with such; as supply and demand rarely takes into account​ side-effects from a
transaction​. Because these consequences affect those on the ‘outside’ we call them ​externalities​;
which are the external costs and benefits that private agents do not consider in their decision making
process​. Further, externalities are a form of market failure, as they represent a situation in which ​price
mechanism​ had not shown the ​true social costs or benefits of production​. An externality can either
be
1. Negative​: the adverse ‘spillover’ effect on the economy and society (we often use this in the
context of the environment).
a. Consider when land is cleared for commercial buildings or when water is polluted
from industrial output
2. Positive​: the beneficial ‘spillover’ effect on the economy and society.
a. Eco-tourism business cleans the river to offer rafting expeditions
This relationship between social and private costs and benefits can be represented diagrammatically
(​see the beside Figure )​ , observe that;
● For a negative externality ​the social cost is at a higher market price, and a lower quantity
whereas the for ​the private cost the market quantity is greater and a lower market price​.
As a result a good or
service is supplied at
the market price,
which means the in
between triangle is
the cost on society
● For a positive
externality the
private benefits is at
the market quantity
and price, which is
below where the
private cost and social benefit intersect. ​The good or service is supplied at the socially
optimal price and quantity which is above the private benefit and below the private
costs​. Similarly the in between triangle represents the benefit for society
Market failure in the provision of goods and services
A market may fail to provide certain necessary goods or services, or it may be desirable that the
provision of a good not be left to the market. Because of this there a several types of goods that
deserve special attention:
● Public good​; a commodity or service provided to all members of a society either by a
government or sometimes an organization. They are usually not constrained in supply, and are
funded by general taxes
○ National defence, public parks, street lighting, air-traffic control etc.
● Merit good​; are a commodity or service that is regarded by society as deserving public
finance, the market may sometimes produce an inadequate quantity of this good. They usually
have benefits that go beyond the individual who enjoys them directly. They have a positive
marginal costs (producing more costs more).
○ Sydney opera house, education,
● Demerit good​; a good that has a harmful effect on society. Their productions and sale often
comes under heavy government scrutiny, due to their negative effects
○ Tobacco, alcohol, illicit drugs, gambling etc.
● Monopoly goods​; are goods that have an inherent advantage of production in the natural
monopoly structure, as this good will only be profitable if it is supplied by one or few
suppliers.
○ Consider a rail network. It requires huge amounts of infrastructure to setup, and is
capital heavy. Smaller firms would not be able to do this, and if many firms tried to
produce this it would not be profitable; as there would be many disconnected rail
networks and different card systems (Imagine having to have more than one bus card)
Classifying the types of goods and services
Any good or service can be classified using the following parameters
● Rival ​➣ Consumption of goods by individual, restricts quantity available for consumption by
other individuals
 ● Nonrival​ ➣ Consumption of goods by individual, does not change the quantity available for
consumption for others
● Excludable ​➣ It is possible to prevent someone from enjoying its benefits
● Nonexcludable​ ➣ It is impossible to
exclude someone from enjoying its
benefits
Note that there are major overlaps between
each of the four quadrants; some goods may
be classified as more than one type, but for
the purpose of an exam try not to get hung up
on these small differences
Privatization and corporatization
Public enterprises (or government business
enterprises, GBEs) have been an important
part of the government, however in recent times there has been a major shift in reducing the
government's direct role in the economy, and the production process to ensure free-market efficiency.
GBE’s can either be:
● Privatised​; the process of transferring a GBE from the public sector to the private sector
○ For example the provision of electricity has largely been privatised, with previous
GBE’s and infrastructure such as ​Transgrid​ and ​Ausgrid​ being sold off either
completely or in stakes. Whilst this has brought in hundreds of billions of dollars,
electricity prices have risen significantly; the government can no longer do anything
in such cases.
● Corporatisation​; when the government encourages GBE’s to operate independently from the
government to increase efficiency and profitability
○ Statutory authorities such as ​Transport for NSW​, have become corporatized as they
act largely independently from the government. Whilst they are still under
government jurisdiction they in effect have their own management structure and their
day-to-day runnings are not intervened in by the government.
Market failure in the abuse of market power
● There are ​heavy costs associated​ with making a business to produce a good, distribute it
and market it requires a large amount of ​human capital
● Hence there are some industries in which there is a ​high concentration of imperfect
competition​ the market structure may consist of either one firm or a few large firms
sometimes there may be many medium sized firms.
● When there is a ​monopoly​, a ​smaller quantity of goods and services​ will be produced at a
higher price​, to maximize profits
● Similarly oligopolists will not engage in price competition but will rather try to​ differentiate
their product​ through instruments such as marketing, advertising and packaging.
● All this means is that the consumer will have little real benefits
We find that in highly concentrated industries in which firms have substantial market power, firms
exercise their market power through activities such as:
● Monopolisation​ is when a firm uses its dominant market power to eliminate existing
competition and prevent new firms from entering the market
● Price discrimination​ occurs when a firm sells the same good in different markets at different
prices. They may sell a good for a greater price to a group is richer, and the converse.
 ● Exclusive dealing ​occurs when a firm sets conditions for supply that exclude retailers from
dealing with other competitors
● Collusion and market sharing ​is when firms get together and agree on a pricing and
marketing arrangements that reduces the level of competition in a market, and inhibits the
entering of new firms into that market
The law instituted by acts of parliament prevent such arrangements in theory (they are civil and
criminal violations), however in reality it is very hard to completely eradicate abuse of market power.
Examples include:
● The ACCC blocked the Vodafone and TPG telecommunications merger as if these two firms
united they would have a substantial market share; lessening competition. Moreover, TPG is
the“b​ est prospect Australia has for a new mobile network operator to enter the market”.
● In 2012 the ACCC conducted an investigation into the petrol industry due to “p​ etrol price
sharing arrangements that allow for the private and very frequent exchange of comprehensive
price information between the major petrol retailers”. Although petrol is under close scrutiny
by both the government and its institutions, it is very hard to prove any form of collusion, and
abuse of market power.
● In 2005 the ACCC began proceedings against the Visy Group for engaging in a cartel with
Amcor for entering into illicit arrangements wherein price and price rises were jointly
negotiated. At the time these two companies were the only ones who provided corrugated
fibreboard packing, and collectively they held 90% of the market share. Because all goods at
some stage undergo packaging, this illegal deal had the potential to damage the cost of
packaging as a cost in the PP. They were fined $36 million and later a class action was
undertaken by affected businesses who also later received $95 million.
Market failure in income distribution
● Left to operate without government intervention, market forces tend to produce a substantial
amount of ​inequality​ (this was explored in labour markets)
● Once an individual earns wealth, they ​continue to accumulate wealth​ which takes more than
just a form of money, it also encapsulates opportunities to develop their skills and more.
● In direct opposition to this. disadvantaged groups are ​more susceptible to inequality​ and
poverty as they have less education and opportunities
● This can easily become entrenched an economy; if a child is born into a low class family they
may struggle to gain the same opportunities as a richer child. Without further education they
may risk being stuck in this same situation for the rest of their life
Even though income inequality can not be eradicated completely; as it is preferable to have inequality
from an economic perspective, governments do intervene in this matter in several ways:
● Free education helps promote equal opportunity for all
● Living allowances for students
● Helping mature age workers find employment etc.
When looking at income inequality, economists look at relative poverty and absolute poverty
● Absolute poverty​ is when an individual only has enough income to survive
● Relative poverty ​is the living standards of an individual in comparison to the rest of the
population.
Market instability: the business cycle
The ​largest market failure​ that occurs across the​ whole economy​ is the ​boom-bust behaviour​ of
economic activity. Without intervention a free market economic system will experience​ heavy
fluctuations​ in the business cycle, and overall economic activity.
If market forces bring about a ​growth in economic activity​, demand for goods and services will go
up, as well as inflation. Whilst this is considered normal, it is the ​magnitude of the fluctuations​ that
is considered as market failure
[Free market without intervention] [Economic Growth] [High inflation] [Reduce consumer PPP]
[Increase interest rates] [Cause a recession]
So all economies want ​strong and stable economic
growth​, not volatile and unstable. Due to this the
government intervenes with its ​economic stabilization
policies​, which aim to maintain a sustainable rate of
economic growth.
These policies are macroeconomic policies (whole
economy) and microeconomic policies (individuals and
firms).
The aim of macroeconomic policy is to provide provide a
stable economic environment that is conducive to fostering
strong and sustainable economic growth, on which the
creation of jobs, wealth and improved living standards
depend. It targets aggregate demand. The government has
two instruments for doing this:
● Monetary policy ​is the use of ​interest rates to influence aggregate demand, employment and
inflation in the economy and stabilize overall economic activity.
○ Other aims include stability and confidence in the financial system; especially the
payments system
● Fiscal policy ​is the use of government
spending and taxation policies to influence
aggregate demand, employment and inflation in
the economy and stabilize overall economic
activity.
○ An outline of government spending is
released each year in the ​Budget
Hence macro economic policy provides some
counterbalance to the business cycle as to stabilize
economic activity. In doing so the government can
promote long term sustainable economic growth.
● Microeconomic policy is designed to increase productivity and efficiency in the allocation of
resources (especially capital and labour) in the long term. It targets aggregate supply, and is
specific to the workings of the product and factor market. It necessitates structural change in
an economy for it to be effective, and hence is a long-term strategy. Some examples of
microeconomic policies and reforms include:
○ Trade Liberalization
○ Deregulation of markets
○ Decentralisation of the labour market (Industrial relations reform)
○ Environmental policies
○ Reduction in protectionism
These will be studied in greater depth in the ​HSC Global Economy ​course, where each of the above
reforms will be unpacked and understood.
The Role of Government in Australia (Chapter 15)
The structure of government
Australia has a three tiered structure of government since it became a nation in 1901:
● The Commonwealth (federal) Government​: Has overall responsibility for the economy and
has the most influence on economic performance.
● State governments​: They have important roles in developing infrastructure, delivering
government services (e.g. health, education), and fostering regional development
● Local governments​: Have a relatively minor role, mainly relating to community facilities and
roads

The ​constitution​ is the set of rules by which Australia is governed. It:

● Establishes the composition of the Australian parliament
● Describes how parliament works
● Sets out the powers that parliament has
● Describes how federal and state parliaments share power
● Sets the roles of the executive government
● Determines the roles of high court
The ​public sector​ consists of all levels of government as well as public enterprises (e.g. Sydney
water, RailCorp, Australia Post).
The reallocation of resources
When governments reallocate resources, it changes the pattern of production in the economy. It
directs resources towards the production of some goods and services that it considers desirable and
away from others that are considered less desirable. It also promotes efficient use of scarce resources.
Governments affect the allocation of resources in two ways:
● By influencing the way businesses and consumers behave in the market through taxation or
spending measures
● By producing goods and services itself
The government can influence the price of goods and services through taxes and thus, influence
consumer demand. Taxes can also divert resources away from certain types of economic activity.
Conversely, reduced tax can attract more resources towards a specific sector.
The amount of taxation raised by the government depends on the:
● Tax base​: What is being taxed (e.g. income, capital gains)
● Tax rate​: The percentage of tax being paid
The two types of tax are:
● Direct tax​: Taxes paid by individuals or firms on which they are levied e.g. personal income
tax
● Indirect tax​: Tax levied on individuals and business firms, but can be passed onto someone
else. Indirect taxes are attached to goods and services e.g. Goods & Services tax (GST).
The government also considers the:
● Impact of a tax​: ​the immediate result of or original imposition of the tax; the impact of a tax
is on the person on whom it is imposed first
● Incidence of a tax​: ​The incidence of a tax is upon that person who cannot shift the burden
any further, so he has to himself bear the direct money burden of the tax. It emerges when the
tax finally settles or comes to rest on the person who bears it (so basically it is who it actually
affects, and who actually pays it)
Governments place taxes on those items that produce negative externalities, to divert production and
consumption e.g. cigarettes, carbon tax.
Government spending​ can be used to directly reallocate resources to a particular sector of the
economy, or to influence the decisions of consumers and businesses. This can occur through funding,
grants, subsidies and cash payments. For example, government spending may encourage consumers to
buy certain goods by reducing an industry’s costs, and therefore, reducing prices.
Government provision of goods and services​ occurs when governments themselves are directly
involved in the production process to achieve a better allocation of resources. These play an important
role in the economy, with governments providing infrastructure such as roads, railways, public
transport, electricity services, postal service and telecommunication networks.
The redistribution of income
The main way in which governments redistribute income is through the ​taxation system​ and ​social
welfare payments​. Tax plays an important role in redistributing income. This is achieved through
taxing individuals at different rates. The:
● Average rate of tax (ART)​: Is the proportion of total income earned that is paid in the form
of tax.
● Marginal rate of tax (MRT)​: Is the proportion of any increase in income that must be paid as
tax.
How the ART changes as an individual's income increases indicates whether the tax is a:
● Progressive tax​: Higher income earners pay a greater proportion of their income as tax. ART
rises e.g. personal income tax.
● Regressive tax​: Higher income earners pay a smaller proportion of their income as tax than
lower income earners. ART falls e.g. GST.
 ● Proportional tax​: All income earners pay the same proportion of their income as tax. ART is
constant e.g. company tax.
The progressive personal income tax known as(PAYG is the main instrument of redistributing
income. Tax payments are regularly deducted from employee’s wages. The tax brackets are as
follows.
The government redistributes its taxation revenue to lower income earners via ​social welfare
payments​ a.k.a income support payments. These payments account for approximately one third of
government expenditure each year. Payments are ​means tested​ meaning than eligibility is examined
in order to receive these payments. The largest area of social welfare payments is for age pensions.
Fiscal policy​ plays an important role in economic stability, and will be discussed in chapter 16.
Environmental Protection
Government intervention deals with the impact of economic activity on the environment to ensure
environmental sustainability. They have become a more significant issue for governments recently. A
main issue in the environmental debate concerns the use of ​renewable and non-renewable
resources​. The industrialised and developing nations are rapidly depleting the world's stock of
renewable resources. This facilitates the move to renewable resources. Australia has also had a
response to climate change e.g. when labour introduced a carbon tax of $23 per tonne of emissions on
the top 500 emitters of carbon.
Government in Action (Chapter 16)
What is the budget?
The Budget​ is the tool of the government for the implementation of fiscal policy, it outlines its
planned expenditure and revenue for the current financial year and three forward years.
● As outlined earlier, it aims to influence resource allocation, redistribute income and reduce the
fluctuations of the business cycle
● It is released once a year in May by the commonwealth government.
● We see in the circular flow of income that through varying its intended expenditure (G for
government expenditure) and revenue (T for taxation), the government can influence the
overall level of economic activity, and achieve its economic outcomes
Revenue and expenditure
Commonwealth revenue comes from a variety of resources, however the main sources of income are
(from the 2019 budget):
● Individual income tax​ is the amount of money the government takes from a person’s income
($234.1 billion)
● Company and resource rent taxes ​is tax paid by companies ($101.9 billion)
● Sales taxes ​are the tax paid by in the retail sector on the sales of goods ($71.4 billion)
● Non-tax revenue​ ​is the recurring income earned by the government from sources other than
taxes such as profit from GBE’s and dividends ($37.2 billion)
● Fuels excise ​is tax paid on the purchase of fuel ($20.5 billion)
● Customs duty ​is taxes paid on imported products ($21.1 billion)
● Superannuation taxes ​arise at three stages; when an employer (or employee) makes a
contribution, when your superannuation grows and if you make a withdrawal before the age
of 60 ($9.8 billion)
● Fringe benefits tax ​is paid on the non-monetary benefits given to employees ($4 billion)
● Other taxes ​encapsulates a broad range of miscellaneous taxes, charges, fees and fines
imposed by the government ($10.2 billion)
● Other excise ​are other miscellaneous taxes levied on G&S
Similarly the government spends money on various types of G&S, they mainly include (again listed
from the 2019 budget):
● Social security and welfare ​($180.1 billion)
● Health ​($81.8 billion)
● Education ​($36.4 billion)
● Defence ​($32.2 billion)
● General public services ​($23.6 billion)
● All other functions ​($48.5 billion)
● Other purposes ​($98.3 billion)
The impact of budget outcomes
The ​budget outcome ​is the net budgetary position in terms of revenue and spending and include:
● Budget surplus​: A positive balance that occurs when revenue (T) exceeds expenditure (G)
i.e. T>G.
● Budget deficit​: A negative balance that occurs when expenditure exceeds revenue i.e. G>T
● Budget balance​: A zero balance that occurs when expenditure equals revenue i.e. G=T.
The change in the budget outcome from year to year may also indicate a change in the government
policy stance; there are three types of fiscal stances:
● Expansionary fiscal policy stance​: A government will either reduce taxation revenue or
increase government expenditure (keeping more money in the economy), creating either a
smaller surplus or bigger deficit than before. An expansionary policy aims to increase the
level of aggregate demand and the level of economic activity
● Contractionary fiscal policy stance​: The government would plant to increase taxation
revenue or decrease government expenditure (keeping less money in the economy), creating
either a smaller deficit or larger surplus than before. This should decrease the level of
aggregate demand and the level of economic activity.
● Neutral fiscal policy stance​: Occurs when government does not change its outcome from the
previous year; there should be no effect on the level of economic activity and aggregate
demand.
When economists talk about the stance of fiscal policy being either expansionary, contractionary or
neutral they are usually comparing the previous years outcome to this years.
● [Surplus -˃ Balanced] = Expansionary (expenditure has risen in relation to revenue)
● [Deficit -˃ Balanced] = Contractionary (expenditure has fallen in relation to revenue)
So just remember economists are speaking in relative terms, rather than the absolute figure.
There are two main components of the budgetary outcome:
● The ​structural (discretionary)​ component refers to deliberate changes in government
spending and/or taxation policies that affect the budget outcome
● The ​cyclical (non-discretionary)​ component refers to changes in the budget outcome caused
by changes in the level of economic activity or national income.
Changes in government expenditure and/or revenue due to economic conditions are called ​automatic
stabilisers​. They are built into the budget and are activated by certain changes in the economy; they
counterbalance trend in the level of economic growth and stabilize the economy. The two main
stabilisers are unemployment benefits and the progressive tax system. Their operation can be
illustrated in the following:
● Rise in economic activity​: {Income rises} {Taxation rises} {Revenue from tax rises}
{Unemployment falls} {Unemployment benefits fall} {Less money in the economy}
{Smaller deficit or larger surplus} {AD falls}
 ● Decrease in economic activity​: {Income decreases} {Taxation decreases} {Revenue
from tax decreases} {Unemployment rises} {Unemployment benefits rise} {More
money in the economy} {Smaller surplus or larger deficit}{AD rises}
Therefore changes in the actual budget are the result of two aspects;
1. Cyclical component ​is the automatic feature brought about by stabilizers acting with respect
to the level of economic growth
2. Structural component ​is the deliberate revenue and expenditure changes initiated by the
government. This component is the key driver of fiscal policy.

There are three ways in which a government can use its surplus;
● Pay debt incurred with the private sector​: Debts accumulated from past borrowings are
repaid, reducing future debt obligations. This is the most preferred method of using a budget
surplus. It involves the purchase of old government securities previously sold to the private
sector. Debt interest will be reduced.
● Finance future expenditure or fund tax cuts​: Governments can accumulate surplus and use
it to fund future expenditure. It can also be used to fund tax cuts, or be spent on productive
assets e.g. infrastructure.
● Repay overseas debt​: This would occur if the RBA used its foreign currency reserves on
behalf of the Aus government, and debited the equivalent amount of AUD from the
governments account with the RBA. The advantage of this is that it reduces net external or
foreign debt owed by the Australian government. This reduces interest payable overseas and
the size of the net primary income deficit, and increases Australia’s external stability.
The three ways in which a government can ​finance a deficit​ to meet its spending commitments are to
borrow funds from the:
● Private sector​: By selling commonwealth government securities in domestic financial
markets. This is known as bond or debt financing. It requires the government to pay the
money back in the future with interest. The ​advantages​ are: The government is certain that
they can fully service the debt, there is no change in the money supply, and there is no
increase in net foreign debt. However the ​disadvantages a​ re: Accumulation of public debt, a
rise in interest rates due to crowding out of private investment (interest rate offered must be
competitive), rise in the exchange rate.
● RBA​: The government instructs the RBA to print money to cover the shortfall in budget
revenue. This is known as monetary financing. The government sells securities to the RBA
which they must buy. This has not occurred since 1982. The ​advantages​ are: no change in
interest rates, no accumulation of public debt. The ​disadvantages​ are: An increase in the
money supply, risk of rising inflation, reduction in confidence.
● Overseas financial markets​: The RBA sells new government securities in return for foreign
currency. They hold the foreign currency and credits the AUD equivalent of the loan to the
governments account. The ​advantages​ are: No increase in domestic interest rates. The
disadvantages​ are: The accumulation of foreign debt, adding to the current account deficit.
Influences on government policies in Australia
Government policies are influenced by:
● Political parties​: Political parties form governments. Economic reform must be supported by
the government in power, meaning that it must be approved by Cabinet.
● Businesses​: Successful and growing businesses are crucial for a nation’s prosperity
● Unions​: They represent the interests of employees
 ● Environmental groups​: They advocate for environmental protection
● Welfare agencies​: They represent the most disadvantaged people in society
● The media​: They determine which issues will receive coverage
● Other interest groups​: People with concerns, interest or expertise relating to specific issues
work together towards common ends.
● International​: Markets have become increasingly interrelated and interdependent in the
current global economy, as a result other economies have the potential to affect Australia’s
economy so it is important Australian policy stance takes this into consideration.

Statistics (2019): 
● Cash rate: 1%
● Inflation: 1.6%
● Consumption is 57% of total AD
● Economic Growth: 1.4%
● Wage growth: 2.3%
● Unemployment rate: 5.2%
● Underemployment rate: 8.4%
● Employment Growth: 2.6%
● Participation Rate: 66.1%
● Budget has been in deficit since the GFC 2008, until
● 2019/20 FY Budget Surplus Projection: $7.1 Billion
● Government debt at: $361 Billion
● Government Expenditure at: $501 Billion
● Government Revenue at: $514 Billion
● Income tax: 45% of government revenue
● Company tax: 20% of government revenue
● Health: 16% of government expenditure
● Social security is 36% of government expenditure
● Education: 7% of government expenditure
● Current account : $5.85 billion surplus
● GDP: 1432.20 billion US dollars (2018)
● Business investment as a share of nominal GDP: 12%
● Consumer sentiment index: fell 4.1% from august to 95.5 in september
● Household saving rate: 2.30%