11175 Introduction to Economics

Answers to exam review questions module 11

Compare your responses to those provided below.

Question 1
What are the costs of unemployment? Discuss the costs to the economy and to the individual.

The answers to this question can be found on pages 445 and 446 of the textbook under the
title costs of unemployment. Overall, the economic costs of unemployment include loss of
GDP, reduced income tax revenue to the government, reductions in firms' profits, the
budgetary and opportunity costs of unemployment benefit payments, deterioration of skills
of the unemployed, and loss of income to individuals when they become unemployed.
Unemployment also has social costs which may include crime, family problems and health
problems. [Please elaborate if you get this question in the exam].

Question 2
Explain the three main types of unemployment and outline the types of policies that can be used to
reduce each type.

There are three main types of unemployment: frictional, structural and cyclical.

Cyclical unemployment (also known as demand-deficient unemployment) occurs when the

economy moves into an economic contraction or recession. Many firms find their sales
falling, reduce production levels, and therefore do not require as many workers.
Expansionary fiscal and monetary policies can be used to try to reduce cyclical
unemployment (see Chapters 16 and 17) and effective stabilisation policy may be able to
prevent a recession from occurring.

Frictional unemployment is short-term unemployment that arises from the process of

matching workers with jobs. The process of job search takes time, so there will always be
some workers who are frictionally unemployed because they are between jobs and in the
process of searching for new ones. It also arises due to people entering the workforce for
the first time, such as school leavers and college and university graduates, together with
people re-entering the workforce after a period of absence (perhaps due to having children).
Policies that can reduce frictional unemployment focus on improving the efficiency of the
job-search process, such as more efficient job search agencies. Job Services Australia is the
result of a policy designed to do this. Greater use of the internet by job agencies has also
improved information flows.

Structural unemployment arises from a persistent mismatch between the skills or attributes
of workers and the requirements of jobs. Structural unemployment can last for long periods
because workers need time to learn new skills, and some may never learn these. In
Australia, the percentage of workers in manual jobs has been declining over several decades
with the decline in the manufacturing sector and increases in productivity in other
'industrial' areas such as utilities, telecommunications and agriculture. While some retrain,
others have been unable to find alternative work; particularly older men, since the skills in

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new jobs that have been created in the service sector do not match theirs. Some workers
lack even basic skills, such as literacy, or have addictions to drugs or alcohol that make it
difficult for them to perform adequately the duties of almost any job. These workers may
remain structurally unemployed for years. Retraining programs and apprenticeship
sponsorship by the government can help reduce structural unemployment or prevent it from
increasing.

Question 3
What are the biases that will make CPI (Consumer Price Index) overstate the true rate of inflation?

The CPI does not always produce an entirely accurate measure of prices in the economy.
Possible problems include: substitution bias—where people stop buying some goods and
services when their prices rise significantly (buying substitutes instead), but the CPI market
basket still bases its estimates on the same quantity and types of purchases; increase in
quality bias—where price increases may be due to quality increases; new product bias—the
CPI market basket is only revised every five years or so, and may therefore contain products
that are no longer commonly purchased or may not contain commonly purchased new
products; and outlet bias—where people buy goods and services from retailers outside of the
capital cities, at discount stores, or via the internet.

Question 4
What is the difference between demand-pull inflation and cost-push inflation?

[Please illustrate your answers to this question using a diagram as in the lecture slides. The
answers can also be found on pages 463 and 464 of the textbook]. Demand-pull inflation is
caused by an increase in aggregate demand when production levels are not able to meet
this demand. That is, there will be a shift in the aggregate demand curve to the right pushing
the price level up (and real GDP will increase above the potential GDP). It occurs when the
economy is near, at, or beyond full employment. Cost-push inflation is caused by anything
that decreases aggregate supply (i.e., shift aggregate supply to the left), such as an oil price
shock, natural disasters like flood or drought, increase in government taxes on businesses
or an increase in real wages that is greater than the corresponding increase in labour
productivity, etc.

Question 5
Explain how the rate of unemployment is measured and discuss the weaknesses of this method of
measurement.

The unemployment rate is measured based on the labour force survey conducted monthly by
the Australian Bureau of Statistics (ABS). People are considered to be unemployed if they
have not worked for one hour or more in the past week, are currently available to start work,
and have been looking for work for the past four weeks. The unemployment rate is then

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calculated as the number of people unemployed divided by the number of people in the
labour force, multiplied by 100.

Weaknesses with this method include: it does not take account of under-employment, that
is, people who are working less hours than they would like to; it does not include
discouraged workers; there may be reasons why people have not been looking for work or
are not available to start immediately, but they would still like a job; and some people do not
declare that they are working to avoid paying taxation because they are involved in illegal
work, or because they are receiving unemployment benefits when they are working and
think that telling this to the ABS will cause them to lose their benefits.

Question 6
What is the 'price level'? Discuss two examples of 'price levels'.

Price level is the average measure of prices of goods and services in the economy. GDP
deflator is one price level, and it gives us the average measure of goods and services
produced in an economy. CPI is another price level, and it gives the average measure of
goods and services consumed by a typical household in the economy. [Further discussion of
these two price levels and their formulas can be obtained from the lecture slides for week
11].