Preliminary Topic One Introduction to Economics

THE NATURE OF ECONOMICS

Background
Economics is the study of how societies allocate scarce resources in order to satisfy their unlimited material wants.
This means how our societies solve the economic problem. The focus for this topic is the need for choice by
individuals, businesses and governments. Their decisions determine the nature of the economy and create the
diversity of economies across the globe.
Since we cannot satisfy all our wants with our limited resources, we must choose between them. Therefore we need
to rank our preferences we will choose our highest preference wants first, and leave some wants unsatisfied. The
study of economics is a study of choices, in which each choice we make involves choosing one option but deciding
against choosing an alternative option.
The Economic Problem Wants, Resources, Scarcity
Wants the material desires of individuals or the community. They are items that provide some pleasure or
satisfaction when they are consumed. E.g. expensive clothing, iPad.
Utility broadly means satisfaction or pleasure.
Needs something essential to a persons existence. E.g. food, clothing, shelter.
Resources something that is used to satisfy a want. An economic resource must be know, accessible, capable of
being used in production and useful. E.g. land, labour, capital, enterprise.
Scarcity the state of being scare or in short supply.
Individual wants are the desires of each person. Individuals who have low incomes are affected by the economic
problem more severely than those on higher incomes. The less income that a person has, the fewer wants they will be
able to satisfy.
Collective wants are the desires of a whole community. Collective wants are usually provided by the government. In
Australia, local government proves collective wants of a local nature, such as parks, libraries and local sporting
facilities. State governments provide most wants for a wider community, such as hospitals, schools and a police
force, while the federal (commonwealth) Government satisfies the wants of the entire nation, such as a defence
force. Governments provide collective wants by using taxation revenue collected from the community.
Recurrent wants are the wants that will need to be satisfied over and over again in the future e.g. food, newspaper,
clothes and petrol.
Complementary wants are the wants that naturally follow the initial satisfaction of another want e.g. a car and
petrol, cd player and cds.
An economy refers to the consumers, business and government in a society that interact in the process of buying,
producing and selling goods and services.
The questions all economies must answer to solve the economic problem are:

What to produce? It must decide which wants it will satisfy first and which it will leave unsatisfied.
How much to produce? By producing too much of a good, resources will be wasted and by producing too
little, the wants of some individuals will be left unsatisfied.
How to produce? An economy must look for the most efficient method of production that uses the least
amount of an economys resources so that the greatest number of wants are satisfied at any one point in time.
How to distribute production? Each economy must decide whether it wants a more equitable (even)
distribution of production or a more inequitable (uneven) distribution. This is a difficult question because
there is often a conflict between equity and efficiency more efficient systems may produce less equitable
outcomes.

The Need for Choice by Individuals and Society

Individuals and the societys needs to make choices due to limited supply of resources available to any economy.

Preliminary Topic One Introduction to Economics

Opportunity Cost and its Application through Production Possibility Frontiers
Opportunity cost is the loss of potential gain from other alternations when one alternative is chosen. It can be
demonstrated using a graph called a production possibility frontier or curve. (PPF or PPC)
A PPF shows the different output combinations a producer or economy can achieve if they are producing 2 goods or
services at a specific point in time. It is a simple way of explaining opportunity cost. Assuming that only two goods
are produced, it shows that producing more of one good requires us to produce less of the other.
Note: Economic theory often uses the concept of ceteris paribus which is latin for other things being equal or if
other things dont change.
The output combinations shown on the PPF are achieved when all resources are fully employed. Therefore to
increase the output of one of the goods, resources must be removed from producing one good and used to produce
the other goods. As a result to increase the output of one good, the output of the other must fall. (That is, there is an
opportunity cost.)
X: is a level of output where the economy is not operating to its full
capacity and thus some resources are unemployed resulting in goods
being produced at a level below its PPF, because it is located inside
the PPF.
A: is a point where the economy is operating to full capacity
producing a greater quantity of Product A than Product B.
B: is a point where the economy is operating to full capacity
producing a greater quantity of Product B than Product A.
C: is a point where the economy is operating in full capacity
producing an equal amount of both Product A and Product B.
Y: is where an economy is operating beyond the PPF and thus is impossible and will only become achievable with
an increase in technology or the discovery of new resources.

An outward movement in the PPF similar to this means an

improvement in resources and technology involved in Product B
only.

An outwards movement in PPF parallel to the old curve means an

improvement in technology that has affected both goods equally.

An inwards movement in the PPF means there are less resources

available due to natural disaster, war, disease etc.

The PPF (also known as the Production Possibility Curve) is used to demonstrate how opportunity costs arise
when individuals or the community makes choices. With the application of new technology there may be an increase
in production, which would cause an outswing of the PPF. This might allow us to produce a higher quantity of a
good with the same resources. Also, with the discovery of new resources the PPF will experience a shift.

Preliminary Topic One Introduction to Economics

There are four assumptions of the PPF model:
All resources are fully employed
All resources are in fixed supply but easily transferred from one product to another.
The level of technology is constant.
The economy produces only 2 goods.
Future Implications of Current Choices by Individuals, Businesses and Governments
Todays economic choices affect tomorrows economic outcomes. If we choose to satisfy a want today, we may not
be able to satisfy a want in the future.
Individuals current spending decisions reflect desire to maximize satisfaction by buying goods and services. They
make decisions about:
What they buy
How much they save
Their type of employment
Their retirement
Businesses make decisions about
What to produce
For whom are you producing
Who to employ (labour/machines)
What price they charge consumers
Governments make decisions about:
Its spending and taxes
Laws
What goods and services it produces
Budget for a deficit (Government expenditure > Investment) in the present may face higher debt levels and
lower spending in the future
Budget for a surplus (Government expenditure < Investment) in the present will allow the government to
repay current debt and spend more in the future
How may the following choices impact on the economy?
Individual consumers decide to spend more of their income:
Less saving
More spending Shortages of goods Higher prices Inflation
Higher rates of employment or lower rates of unemployment
More tax revenue to the government and less spending on unemployment benefits higher budget surplus
or lower budget deficit
Individuals decide to retire earlier:
Less spending lower living standards
Retirees may have less income in future
Shortage of workers
Less experienced works
Unemployment may fall
Less tax revenue for Government
Government needs to pay more pensions therefore raises taxes
Increase in skilled migration
Businesses moving their factories to cheap labour countries such as Asia:
Higher unemployment in country where business closes
Increased imports to Australia from not producing goods
Decreased exports to Asia from not producing goods
Cheaper imported goods from Asia in Australia

Preliminary Topic One Introduction to Economics

Less tax revenue for Government

The Government reducing taxes on imports:

Increase in imports because they are cheaper for Australians to buy
Higher unemployment in import competing industries in Australia
More competition for Australian firms Lowered prices
Economic Factors underlying Decision-Making
Individuals will be influenced by factors such as their:
Ability to spend or save high income earners have greater choices than low income earners.
Work/Education and retirement the longer you work the more income received and as a result the more
wealth you accumulate to spend during retirement.
Voting/Participation in the political process decisions on areas such as health care, education and taxation
will all influence your quality of life and choices you are able to make.
Future expectations
Future plans
Personality/Personal Preference
Present family circumstances
Advertisement
Businesses will be influenced by factors such as:
What will be the most profitable seeking profit maximisation.
Production and resource use aim is to produce efficiently at minimum cost.
Industrial relations relationship between employers and employees
Consumer Demand
Business ethics
OHS/Laws
The Government will be influenced by factors such as:
Voter reaction
Economic conditions e.g. recession
Taxation policies
Legislation
The Constitution

THE OPERATION OF AN ECONOMY

Production of goods and services from resources natural, labour, capital and entrepreneurial resources
The operation of an economy includes the functioning of the production process and its flow on effects through the
circular flow of income. The level of efficiency an economy is able to operate at will affect the economys
unemployment levels, economic growth and quality of life.
The production process is defined as mechanical or chemical steps used to create an object, usually repeated to
create multiple units of the same item. Generally involves the use of raw materials, machinery and manpower to
create a product. The outcomes of the production process are tangible goods and intangible services which are used
to satisfy our wants and needs.
There are four main resources used in the production process to produce goods and services;
Resources
Expanded
Natural Resources/Land
Any resource that is provided by nature
Labour
Human effort, both physical and mental. The availability of labour;
which depends on population size, availability and quantity of
resources, the leaving school age, retirement age and social attitudes
towards the workforce, will largely affect the production process and
thus the quantity and quality of production which in turn will affect
economic growth and employment.

Return
Rent
Wages

Preliminary Topic One Introduction to Economics

Capital

Entrepreneurial Resources

Produced means of production; includes machinery, tools, factories,

computers and infrastructure. The amount of capital available can
have a significant effect upon the future earning capacity of an
economy as it can largely affect the production process.
Managing and organizing production, which has a considerable risk
of failure.

Interest

Profit

Each of the four resources is limited in its supply, reflecting the problem of scarcity:
Natural Resources
Availability
Renewable resources take long periods of time to renew themselves
Non-renewable resources need to be used in a sustainable way so that our current
societys use does not affect the use of future generation (sustainability)
Labour
Population size the larger the population the greater amount of labour available
Skills depending on the level of skills (both physical skills and educational levels)
this will limit supply of labour needed in particular sectors
Willingness to work the social attitude towards employment will affect peoples
willingness to work
Capital
The private sector and governments willingness to invest
Entrepreneurial
There may be a limited amount of people willing to take risks associated with
Resources
entrepreneurship
Population size
Provision of Employment and Quality of Life through the Business Cycle
The business cycle is a graphical representation of economic growth within an economy. It is a cycle of ups and
downs in market economies. Refers to fluctuations in the level of economic growth due to either domestic or
international factors.

The level of economic growth is measured by the percentage change in GDP (Gross Domestic Product total
production)
An upswing in the business cycle is when economic growth is growing at a faster rate than it previously was and
occurs when injections are greater than leakages. When an upswing peaks this is known as a boom, as is where the
growth rate of economic growth peaks. This rise in economic growth will have many beneficial effects on the
economy. A boom in economic growth is associated with increased investment and production.
A downswing in the business cycle is when economic growth is growing at a declining rate than it previously was
and occurs when leakages are greater than injections. When a downswing reaches its lowest point this is the trough
of the business cycle. This decline in economic growth can have many negative effects on the economy. A recession
is the stage of the business cycle where there is decreasing economic activity, defined as two consecutive quarters
(six months) of negative economic growth i.e. a fall in GDP.

Preliminary Topic One Introduction to Economics

Impacts of the Business Cycle
Recession
Falling production of goods and services
Falling levels of consumption and investment
Rising unemployment
Falling income levels
Falling quality of life

Boom
Increasing production of goods and services
Rising levels of consumption and investment
Falling unemployment
Rising income levels
Rising quality of life

The Circular Flow of Income

The circular flow of income is a theoretical model showing how money moves around an economy between the
different sectors of that economy.
The economy can be classified into five different sectors:
Individuals or Households

Businesses
Financial Institutions

Government

International Flows

Made up of Australias population which includes more than 20 million

people
Consists of all types of firms or suppliers who make and deliver goods
Consists of organisations that borrow household savings from individuals
and lend credit to businesses wanting to expand
Includes the activities of federal, state and local governments; taxes and
expenditure
Involves the importation and exportation of goods and services to and from
Australia

The circular flow of income is an economic model that in a very simple way explains how the economy operates. It
assumes the economy has five sectors that interact with each other to ensure goods and services flow through the
economy.

Leakages are flows of money out of the two-sector economy (individuals and businesses). Leakages include:
Savings (S)
Taxation (T)
Imports (M)
Injections are flows of money into the two-sector economy (individuals and businesses). Injections include:
Investment (I)
Government Expenditure (same as spending) (G)
Exports (X)
Investment in the economic sense refers to spending on capital equipment such as machinery, factories or any goods
used to make an income.

Preliminary Topic One Introduction to Economics

An economy is in equilibrium when total leakages equal total injections. When this occurs income in the economy
is stable and there is no change in economic conditions.
An economy is in disequilibrium when total leakages exceed injections (I+G+X < S+T+M), the level of income in
the economy will fall, unemployment may rise and the standard of living will decrease. When injections exceed
leakages, the opposite occurs and the economy will grow.

ECONOMIES: THEIR SIMILARITIES AND DIFFERENCES

Economies tend to fall somewhere on the following flow diagram:

Market
Economy
(e.g. USA)

Mixed
Economy
(e.g.
Australia)

Planned
Economy
(e.g. North
Korea)

Economic System
Market Economy
(e.g. USA)

Ownership of Resources
Private ownership of
resources

Role of the Market

Market allocation of
resources

Role of the Government

Limited government
intervention

Mixed Economy
(e.g. Australia

Private ownership of
resources

Market allocation of
resources

Substantial government
intervention

Planned Economy
(e.g North Korea)

Government ownership of
resources

Limited role of markets

Government planning of
resource allocation

Market Economy
In a pure market economy, all major economic decisions are made by individuals and private firms. Under this
system, most economic resources are owned by the private sector and people are able to seek wealth without the
government intervening or affecting their business activities.
Other names used to describe a market economy are capitalist, free enterprise and laissez-faire. Laissez-faire means
an almost complete absence of government intervention in economic activity. It can be translated to let things be.
The essential features of a market economy are:
Emphasis on private ownership of property and private enterprise. Private enterprise is the system by
which privately owned (rather than community-owned or government-owned) resources are used in
production.
The price mechanism in the market is the basis of the economic system.
A monetary system operated by private enterprise, but regulated by the government.
A high degree of specialization and interdependence (dependent on each other) at all levels
Consumer sovereignty refers to the manner in which consumers collectively through market demand determine
what is produced and the quantity of production.
Freedom of Enterprise individuals have the right to use their resources as they choose. This means that
entrepreneurs are free to set up profit-making activities and have the right to determine what goods and services they
produce and how they will undertake that production. Workers are free to choose their occupations or, for that
matter, whether they work or not.
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. The price that consumers are willing to pay for goods
indicates their preferences.

The price mechanism has shown what to produce. The lower price will reduce the suppliers profits so they
will use the resources to produce other goods which consumers prefer and for which they will pay more.

Preliminary Topic One Introduction to Economics

Producers decide how to produce, or which combination of resources to use to get the output they want, by
comparing prices of the various resources. To prevent the increase of the producers cost, producers will try
to substitute a more plentiful, and therefor less expensive resource. In this way, the prices of resources
indicate the most efficient combination of resources.
The price mechanism has shown how much to produce.
Prices also provide the means of distributing the goods in a free enterprise economy. The price mechanism
is one of rationing the limited number of goods among those who want to consume them.

Mixed Economy
A mixed economy is an economic system where the decisions concerning production and distribution are made by a
combination of market forces and government decisions. The government intervenes in production because the free
market does not always provide the most efficient allocation of resources for the economy as a whole. There are
three considerations here:

Some necessary goods and services may not be provided under a pure market system. Governments provide
those goods that are beneficial to the whole community and for which it would not be practical to charge on
an individual basis (e.g. railway system, parks, roads, national defence)
It is sometimes better for essential goods and services to be provided by government, rather than being left to
private individuals. For example, for reasons of security and internal stability, it is safer to have a defence
force in the hands of the government than to have a system of private armies.
The government provides regulations to prevent producers from exploiting consumers with misleading
information or by agreeing to raise prices. The government may also legislate to ban the production of
undesirable goods and services (e.g. illicit drugs) and ensure adequate safety standards for all products sold
on the market.

The government intervenes in the distribution of output (income) because the free market will not necessarily
provide a socially desirable or fair distribution. The government intervenes in two ways:

Social Welfare Payments under the price mechanism alone, there would be no income earned by those
who did not contribute to the production process. In other words, there would be no provision made for the
elderly, the unemployed and the chronically sick. In Australia, the government overrides the market forces
and redistributes income by taxing people on higher incomes more heavily, and making social welfare
payments to the members of society who do not contribute to the production process (the economically
weak old, disabled, unemployed). Examples of social welfare payments include disability pensions, age
pensions and unemployment benefits.
Progressive Income Tax The government also causes an overall redistribution of income in order to
achieve a more equitable (even) sharing of produced output. It does this though the use of a progressive
income tax system. Under such a system, high-income earners pay proportionally more tax than low-income
earners. This leads to a more even distribution of income.

Centrally Planned Economy

Under a centrally planned system, government planners make economic decision and there is little scope individual
choice to influence the economy. Public ownership of factors of production allows the government to allocate
resources as it sees fit. A planned economy promotes:
The government decides how to use and distribute resources.
The state regulates prices and wages.
In the past, Russia, Eastern Europe and China followed the planned economy model, but it is no longer pursued by
any major economy except for North Korea.