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2024 Y11 Chapter 2
2024 Y11 Chapter 2
CHAPTER 2
The Operation of an Economy
An economy refers to the way in which a society is organised to solve the economic problem of the
scarcity of resources in relation to consumers’ needs and wants. Economies perform the important
function of co-ordinating economic activities such as resource allocation, production and distribution.
They also provide a framework of law and order for the operation of markets where goods and services
are exchanged. The economic organisation of economies has evolved into different forms with distinct
approaches to solving the economic problem. There are two broad types of economic system:
• The market or free enterprise economy is based on a system of markets and prices, which allocate
resources and allow private property rights, the profit motive and freedom of enterprise; and
• The planned economy is based on a system of government ownership of most resources, and the
allocation of these resources according to government or state planning priorities and targets.
Both types of economic system need to perform the three functions of production, distribution and
exchange. This involves answering the following four basic questions raised by the economic problem:
1. What to produce? This is a production question based on demand and society’s preferences
2. How much to produce? This is a production question based on consumer demand and
resource availability
3. How to produce? This is a production question based on resource availability, costs and
the level or state of technology or know how
4. To whom to distribute? This is a distribution and exchange question based on income, needs
and each person’s productivity and contribution to production
are guided by the incentive of profit maximisation and will attempt to minimise production costs by
producing the volume of output in the most efficient way. Producers will select a method of production
influenced by the availability and cost of resources; the nature of the goods and services to be produced;
and the state of technology. Resources which are scarce relative to others will command higher prices to
reflect that scarcity. Producers will only use those resources if individuals are willing to pay for the goods
and services they are used to produce. Since resources are relatively scarce, they will be allocated to their
most highly valued uses in production i.e. where the returns to the factors of production are highest.
The production methods used by firms also depend on resource availability. The most important
resources used in production are labour and capital. Labour intensive production will take place if
labour is relatively abundant and cheap to use. This is often the case in developing countries with low
per capita incomes such as India and China where labour intensive production methods are used for
example to grow wheat and rice, since unskilled labour is abundant and wages are low relative to the
cost of capital resources. In developed countries with high per capita incomes such as Australia and
the USA, more capital intensive production methods are used to grow wheat and rice because capital
is more abundant and cheaper to employ relative to the availability and higher cost of labour resources.
In market economies a system of private property rights provides the foundation for the operation
of the price system. Private property rights denote the private ownership of resources and entitle the
owner (under a system of law and order for protecting property rights) to enforce them in a court of
law; transfer them if they wish to sell them or buy them at an agreed price; and exclude non paying
users from using them if they do not have the income to pay the market price for the use of resources.
Prices are monetary indicators of the relative value of goods and services in an economy. Prices guide
the decision making process in an economic system in four main ways:
1. Prices match the output of goods and services by producers with the demand of consumers. For
example, an increase in demand will lead to a rise in the price of a good, helping to equate the
demand for that good with its available supply.
2. Prices ration the limited supply of resources and commodities. For example, if a resource becomes
scarce like oil, a rise in oil prices to reflect this scarcity will encourage careful consumption,
exploration for new oil reserves, and the development of alternative renewable sources of energy
such as solar, wind, geothermal and electric or battery power.
3. Prices help to prevent the wastage of resources by avoiding shortages and surpluses of production
in relation to demand, so that producers are encouraged to produce the exact amount of output to
satisfy demand (i.e. allocative efficiency) with the resources available so that demand equals supply.
4. Prices act as signalling devices to producers and consumers to adjust their economic behaviour (i.e.
through changes in demand and supply) in relation to changing market conditions.
In market economies exchange takes place in both factor and goods markets. Factor markets are where
the factors of production such as land, labour, capital and enterprise are bought and sold. Goods
markets are where final goods and services that are produced by businesses are sold to consumers.
REVIEW QUESTIONS
PRODUCTION, DISTRIBUTION AND EXCHANGE
1. Define an economic system. Discuss the four questions that an economic system must answer in order to solve
the economic problem.
2. Using examples, compare the characteristics of a market economy with a planned economy.
3. Complete the following table by explaining how the market and planned economic systems solve the
economic problem:
What to Produce?
How to Produce?
To Whom to Distribute?
The return to enterprise is called profit. Profit is equal to the positive difference between the total revenue
(TR) earned by a business and its total costs (TC) of production. Normal profit is the rate of profit
sufficient to keep the entrepreneur in business or the industry in which a firm operates. Supernormal
profit is profit over and above what is necessary to keep the entrepreneur in business or the industry
in which a firm operates and is usually earnt by businesses with a large degree of market power such as
monopolies (e.g. Australia Post) and oligopolies (e.g. oil companies such as BP, Shell, Caltex and Mobil).
The factor income returns paid to the owners of the factors of production (see Table 2.1) are determined
by the quantity and quality of the resources that are used in production. Essentially factor income
returns are influenced by the productivity of each factor of production. Income returns are paid to
households by firms for the use of productive resources. Gross income is subject to income taxation by
the Australian government. Disposable income is equal to gross income minus taxation. To calculate
final income, cash and non cash benefits (i.e. the social wage) paid by Australian the government are
added to disposable income, and indirect taxes (e.g. GST, excise and customs duties) are subtracted i.e.
Factor Markets
Factor Payments
Factor Incomes
Factor Payments
Resources
Resources
Resources
Transfers Transfers
Expenditure
Expenditure
Income
Goods Markets
Source: ABS (2023), Labour Force, Australia, Catalogue 6291.0.55.003, September. Table 04
Table 2.2: The Australian Labour Force 2017-2023 (total employed and unemployed persons)
The quality of life in an economy depends on the quantity and quality of both material and non
material goods and services in the economy and the community. Material considerations include the
level of income that individuals can earn, the types and nature of employment available, and people’s
access to a range of consumer goods and services. Non material considerations include access to a range
of collective goods and services such as health care, education, social welfare, public transport, housing,
defence, law and order and emergency services. Other quality of life indicators include access to safe
drinking water, a clean environment, and a safe community free from crime and civil disorder. Another
important consideration in the quality of life is the extent of personal freedom in the economy and the
ability of citizens to participate in the political process through democratic elections and voting.
In advanced market economies like Australia and the USA, per capita incomes averaged between
US$49,238 (Australia) and US$64,765 (USA) per annum in 2022 (World Bank), with the majority of
the population enjoying a high standard of living through access to a wide range of consumer goods and
services. Taxation revenue paid to governments in market economies, finances the provision of collective
goods and services such as social welfare, transport, education and health services. These services help
to increase life expectancy, reduce infant mortality and the incidence of endemic diseases, and improve
rates of educational literacy and labour mobility. Individuals are also free to elect governments of their
choice (democracies) and there is significant awareness of environmental issues, with resources allocated
to reducing environmental pollution and climate change. This helps to improve environmental quality,
raise living standards and the quality of life in advanced market economies like Australia and the USA.
In market economies, economic activity tends to occur in cycles. These cycles form the business or
trade cycle which is characterised by four main phases: upswings, booms, downswings and recessions.
Over time, the general trend is for economic activity to increase and for living standards, employment
and the quality of life to rise. The business cycle is represented in Figure 2.3, which shows the four
main phases of the business cycle, the length of the business cycle, and the attempts by the government
to smooth out the fluctuations in the business cycle by conducting counter cyclical or stabilisation
policies such as monetary and fiscal policies. In each stage of the business cycle, production, income,
employment and the quality of life may all be affected by changes in economic activity:
• In the upswing phase of the business cycle, expenditure, output, income and employment levels rise.
Higher levels of tax collections to governments may finance increased spending on infrastructure,
community services, welfare and environmental quality which can raise the quality of life.
• In the boom phase of the cycle, expenditure, output, income and employment levels reach a
maximum point as economic activity peaks. Shortages of labour and other resources may occur,
leading to inflation of the price level. The government may use contractionary policies to slow
down economic activity to a more sustainable level, including lower inflation and the preservation
of environmental resources to achieve ecological sustainability and improve the quality of life.
• In the downswing phase of the business cycle, expenditure, output, income and employment
opportunities begin to fall as economic activity decelerates. With less economic activity there
may be less demand for labour leading to some unemployment of resources in the economy and a
decline in the quality of life for some individuals and households because of falling incomes.
• In the recession phase of the business cycle, expenditure, output, income and employment
opportunities reach a minimum point as economic activity troughs. An excess supply of labour leads
to rising unemployment, and deflation may occur, as businesses attempt to clear unsold inventories
of goods and services by cutting prices. The government may use expansionary macroeconomic
policies to stimulate spending and activity during the recession stage of the business cycle.
REVIEW QUESTIONS
RESOURCES, INCOME, EMPLOYMENT AND QUALITY OF LIFE
1. How is the supply of resources linked to the provision of income in a market economy?
2. Refer to Figure 2.1 and explain how a market economy functions through a series of interdependent sectors
(households, firms and governments), goods markets and factor markets.
4. Refer to Figure 2.2 and Table 2.2 and discuss the pattern of employment in Australia in
2022-23 and how this has changed over time. What factors influence the quality of life in an economy?
5. Refer to Figure 2.3 and discuss the four main phases of the business cycle. How can governments use
macroeconomic policies (i.e. monetary and fiscal policies) to influence changes and extremes in this cycle
and maintain the quality of life for the community?
Figure 2.4: The Simple Two Sector Circular Flow of Income Model
Income (Y)
Resources
Households Firms
Output (O)
Expenditure (E)
In the simple two sector model represented in Figure 2.4, equilibrium is defined as a situation in which
there is no tendency for the levels of income (Y), expenditure (E) and output (O) to change i.e.
Y=E=O
This means that all household income (Y) is spent (E) on the output (O) of firms, which is equal in
value to the payments for the productive resources purchased by firms from the household sector.
The Three Sector Model: Households, Firms and the Financial Sector
If assumptions one to four in the two sector circular flow of income model are relaxed, and the financial
sector is included, this means that the leakage of saving (S) from households to the financial sector is
introduced, and also the injection of investment (I) from the financial sector to business firms. Saving
is that part of income not spent, and investment is defined as the process of capital accumulation by
firms. Figure 2.5 shows the three sector model consisting of the households, firms and finance sectors.
Saving is a leakage out of current income, since it represents money lent by the household sector to
the financial sector in return for interest payments. If saving occurs, not all of current output will
be purchased. Firms will cut back production and demand less resources from households, leading
to lower factor or household incomes. This process is represented in Table 2.3. In period one, all
household income of $2,000 is spent or consumed on available output. But if households decide to
save 10% of their income in period two, $200 is saved and only $1,800 worth of output is consumed.
Firms will react by cutting back production in period three by $200 worth of output. They will do this
by buying $200 less resources from households and so household incomes will fall by $200 to $1,800.
If households maintain their savings ratio at 10% of income, expenditure, output and income will
continue to fall in period four (from $1,800 to $1,620) and in period five (from $1,620 to $1,458).
If this process was to continue the economy would go into a recession leading to lower levels of expenditure,
output, income and employment. However if the leakage of saving is offset by the injection of funds
through investment (I) by firms, the circular flow will remain in equilibrium. Financial institutions
mobilise the savings of the household sector by lending money to firms wishing to undertake investment
in new capital equipment or new plant. For equilibrium to be maintained in the three sector model:
(1) Y=E=O
Since Y=C+S (Income = Consumption + Saving)
and O=C+I (Output = Consumption goods + Investment goods)
Therefore: S = I (Saving = Investment) Equilibrium condition (three sector model)
Disequilibrium will occur in the three sector model if S ≠ I (i.e. savings does not equal investment)
If S > I Y, E, O and employment will fall, leading to a recession and higher unemployment in
the economy. This represents a contraction in the circular flow of income since the
leakage of saving (S) exceeds the injection of investment (I) funds i.e. S > I and Y falls
If S < I Y, E, O and employment will rise, leading to a boom and higher employment in the
economy. This represents an expansion in the circular flow of income since the leakage
of saving (S) is less than the injection of investment (I) funds i.e. S < I and Y rises
Income (Y)
Resources
Households Firms
Output (O)
Leakage
Injection
Expenditure (E)
Saving (S) Investment (I)
Financial Sector
The Four Sector Model: Households, Firms, Finance and Government Sectors
With the relaxation of assumption five (i.e. no government sector), the government sector is introduced
into the circular flow of income model, leading to the leakage of taxation (T) and the injection of
government spending (G). Taxes are paid by households and firms to the government and are a leakage
out of current income, reducing the expenditure on current goods and services. Taxation therefore
reduces the levels of income, expenditure, output and employment in the circular flow of income model.
To offset the leakage of taxation (T), the government spends taxation revenue in providing collective
goods and services (e.g. health and education), infrastructure and transfer payments (e.g. pensions,
allowances, unemployment benefits and subsidies) to the household sector and the firms sector.
The government’s budget outcome is equivalent to the difference between government taxation revenue
and government spending (i.e. T - G). If the government budgets for a deficit (i.e. where G > T) this
will have an expansionary effect on economic activity. If on the otherhand the government budgets
for a surplus (i.e. where G < T) this will have a contractionary effect on economic activity. If the
government balances its budget (i.e. a neutral budget, where G = T) this will have a neutral effect on
economic activity. The four sector model of the circular flow of income is shown in Figure 2.6.
Equilibrium in the four sector model occurs when the sum of the two leakages of savings (S) and
taxation (T) equals the sum of the two injections of investment (I) and government spending (G) i.e.
S+T=I+G Equilibrium condition (four sector model)
Disequilibrium will occur in the four sector model if the sum of total leakages (S + T) does not equal
the sum of total injections (I + G), causing the levels of income, output, expenditure and employment
to fall or rise e.g.
If S + T > I + G Leakages exceed injections causing the levels of income, output, expenditure
and employment to fall, leading to a contraction in economic activity (i.e. a
downswing in the business cycle) and higher unemployment in the economy.
If S + T < I + G Injections exceed leakages causing the levels of income, output, expenditure
and employment to rise, leading to an expansion in economic activity (i.e. an
upswing in the business cycle) and lower unemployment in the economy.
Income (Y)
Resources
Households Firms
Output (O)
Expenditure (E)
Injections
Financial Sector
Government
Taxation (T) Spending (G)
Government Sector
The Five Sector Model: Households, Firms, Finance, Government and Overseas Sectors
By relaxing assumption six in the simple two sector circular flow of income model, and adding the
overseas sector, the leakage of imports (M) and the injection of exports (X) are added to the model.
This means that we are now dealing with an open economy model and not a closed economy model.
Imports (M), which represent spending by Australian residents on goods and services from the rest of
the world, are a leakage out of current income and reduce income, expenditure, output and employment
in the circular flow of income model.
Exports (X) of goods and services generate income for exporters from overseas residents who pay for
these exports. Exports are an injection of income into the circular flow of income model and increase
income, expenditure, output and employment. The five sector model is illustrated in Figure 2.7.
Equilibrium in the five sector open economy model of the circular flow of income will occur when total
leakages (S + T + M) are equal to total injections (I + G + X) i.e.
S+T+M=I+G+X Equilibrium condition (five sector model)
Disequilibrium will occur in the five sector model if the sum of total leakages does not equal the sum
of total injections, causing the levels of income, output, expenditure and employment to fall or rise e.g.
If S + T + M > I + G + X Leakages exceed injections causing the levels of income, output,
expenditure and employment to fall, and a recession or contraction in
economic activity and higher unemployment in the economy.
If S + T + M < I + G + X Injections exceed leakages causing the levels of income, output,
expenditure and employment to rise, and a boom or expansion in
economic activity and lower unemployment in the economy.
Income (Y)
Resources
Households Firms
Output (O)
Expenditure (E)
Injections
Financial Sector
Government
Taxation (T)
Spending (G)
Government Sector
REVIEW QUESTIONS
THE CIRCULAR FLOW OF INCOME MODEL
1. List the six assumptions of the simple two sector circular flow of income model.
3. Explain the concept of equilibrium in the simple circular flow of income model in Figure 2.4.
4. Refer to Figure 2.5 and Table 2.3 and explain what happens when the financial sector is introduced into the
circular flow of income model. What could cause disequilibrium to occur in the three sector model? How is
equilibrium regained?
5. Which leakage and injection occur in the circular flow of income model when the government sector is
introduced? What are the implications for the economy if the sum of S + T are not equal to the sum of I + G?
Refer to Figure 2.6 and the text in your answer.
6. Explain what the equilibrium condition is when the overseas sector is introduced into the five sector circular
flow of income model. Distinguish between the causes of a recession and a boom in economic activity in the
five sector model. Refer to the text and Figure 2.7 in your answer.
7. How could the government use macroeconomic policies to correct a disequilibrium situation in an open
economy that was experiencing a boom and higher inflation or a recession and higher unemployment?
8. Add the following terms to a glossary by finding out their correct definitions:
A B
Output
5 Investment
C
Taxation 6
D
7 Exports
E
The diagram above shows the five sector circular flow of income model for an economy. Marks
1. Name the sectors of the model that correspond to the following letters in the diagram: (2.5)
A B C
D E
2. Name the flows that correspond to the following numbers on the diagram: (2.5)
3 4 5
6 7
3. Explain the difference between a leakage and an injection in the five sector circular flow of (2)
income model by using an example of each.
4. Explain how equilibrium and disequilibrium may occur in the five sector circular flow (3)
of income model.
Society must decide to what extent it wants decisions made by individual businesses and consumers, each
acting in their own self interest, to determine their economic destiny and to what extent it wants to persuade
these businesses and consumers to act more ‘in the national interest’.”
Source: William J. Baumol and Alan S. Blinder (1985), Economics, Harcourt Brace Jovanovich, Orlando, USA.
Compare and contrast the ways that different economies deal with the economic problem of scarcity.
2. Explain the main forms of income and employment in a market economy like Australia. How are the levels of
income and employment influenced by changes in the business cycle?
3. Discuss the six main assumptions of the simple two sector circular flow of income model. Explain what
happens to the model when these assumptions are relaxed. How can disequilibrium arise in the five sector
circular flow of income model?
4. Analyse the main flows between the five sectors in the five sector circular flow of income model.
How is equilibrium established in the model? Explain how equilibrium is regained if disequilibrium occurs in
the model.
5. In a hypothetical economy, if S = 100, T = 150 and M = 50, and I = 200, G = 200 and
X = 100, explain how the process of equilibrium income is determined.
CHAPTER SUMMARY
THE OPERATION OF AN ECONOMY
1. An economy refers to the way in which a society is organised to solve the economic problem of the scarcity of
resources in relation to society’s needs and wants.
2. A market economy like Australia is characterised by freedom of enterprise, private property rights and the profit
motive. In a market economy, resources are allocated according to consumer demand, through a system of
product and factor markets based on the price mechanism.
3. In a planned economy like North Korea or Cuba resources are largely owned by the government and allocated
according to government planning priorities such as defence and heavy industry.
4. Both the market and planned economic systems perform the functions of production, distribution and exchange.
This involves answering the four basic questions raised by the economic problem of what to produce?; how
much to produce?; how to produce?; and to whom to distribute?
5. Goods and services produced by an economy involve the use of a combination of land, labour, capital and
entrepreneurial resources. The owners of these resources in the household sector are paid factor incomes for
their use such as rent, wages, interest and profit. Resources are bought and sold in factor markets, whereas final
goods and services are bought and sold in product markets.
6. Employment in a market economy is created by both the private and public or government sectors. The main
categories of industries which employ labour and other resources are threefold:
• Primary industry, which produces raw materials such as agriculture, mining, forestry and fishing.
• Secondary industry or manufacturing, which uses raw materials to produce finished goods for consumers
and other businesses.
• Tertiary or service industry, which involves the retailing, wholesaling and distribution of final goods and
services to consumers and businesses.
7. The quality of life of citizens in an economy depends on the level of per capita income, access to a variety of
consumer goods and services, as well as non material factors such as the extent of law and order, environmental
quality, life expectancy, access to health care, education and social welfare.
8. Market economies like Australia experience changes in the level of economic activity over time which are
known as business cycles. The business cycle has four main phases which are known as the upswing, boom,
downswing and recession.
9. The circular flow of income model is a simplified version of the workings of a market economy. In the five sector
circular flow of income model, there are household, firms, finance, government and overseas sectors, and the
flows of resources, output (O), expenditure (E) and income (Y) between these sectors. The three leakages in
the five sector model are savings (S), taxation (T) and imports (M), and the three injections are investment (I),
government spending (G) and exports (X).
10. Equilibrium in economics is a situation in which there is no tendency for change. In the five sector circular flow
of income model, equilibrium occurs when total leakages equal total injections i.e.
S+T+M=I+G+X
11. Disequilibrium occurs in the five sector circular flow of income model when total leakages are not equal to total
injections, causing either an expansion or boom or a contraction or recession in economic activity i.e.