VCE 3/4 Economics Past Paper PDF

UNIT 3 AOS1 - MICROECONOMICS Key knowledge Introductory concepts: The two main branches of economics: microeconomics and macroeconomics Microeconomics: It's about the decisions of individuals and businesses, focusing on how they allocate resources and prices of goods and services. Macroeconomics: It looks at the entire economy, dealing with issues like inflation, unemployment, and economic growth. The two main forms of economic analyses: positive economics and normative economics Positive economics is about objective facts and what 'is' — describing how the economy works. Normative economics is about subjective values and what 'ought to be' — expressing opinions on economic policies. Resources (factors of production such as land, labour, and capital) are used to satisfy needs and wants, and essential inputs are used to produce goods and services to satisfy human needs and wants. Land: Natural resources available without human intervention, such as minerals, forests, and water, are used for production. Labour: Human effort, both physical and mental, contributed to the production process. Capital: Man-made tools, machinery, and buildings used to create goods and services. Perfectly competitive market: - Many buyers and sellers - Homogenus goods - A high ease of entry - Price takers as they compete on price - Highly competitive Explain the nature of, and conditions for, a perfectly competitive market. 3 marks 1 mark) identify and explain some of the key conditions required for the The nature of a perfectly competitive market is one where no buyer or seller has the existence of a perfectly competitive capacity to be a price maker (ie no individual firm has market power). This is a market and then connect these to the consequence of the existence of several hypothetical conditions or characteristics, such nature of the market as a large number of sellers fighting for market share and the existence of homogenous 1 marks) condition of a perfectly products that prevent sellers from differentiating their products from those of competitors. competitive market Other conditions include perfect information, mobility of resources and no barriers to entry 1 marks) condition of a perfectly or exit which all help to maintain downward pressure on prices. competitive market Describe what is meant by a perfectly competitive market. 2 marks 1 mark) identify a characteristic of A perfectly competitive market is one where there are many buyers and sellers fighting such a market over the market share and the existence of homogeneous goods that prevents sellers 1 mark) identify a characteristic of from differentiating their products from competitors. Therefore, in this highly competitive such a market space in order to remain profitable and in operation producers must be price takers. The basic economic problem of relative scarcity and the need for economic decision-making we have finite resources but infinite wants and needs. This disparity forces individuals and societies to make decisions about how to allocate limited resources like land, labour, and capital most effectively to meet the greatest number of needs and wants and derive the most profit gain. The concept and applications of opportunity cost Opportunity cost is the value of the next best alternative forgone when making a choice, highlighting the trade-offs inherent in every economic decision. - It’s used to ensure resources are directed to their most efficient use. - Value of benefit that is ascribed to the foregone choice The production possibility model to illustrate the concepts of scarcity, choice, opportunity cost, efficiency and under-utilisation of resources The Production Possibility Curve represents different combinations of two goods that an economy can produce using all its resources efficiently Scarcity: The PPF shows that we can’t have unlimited amounts of both goods due to limited resources. Choice: Selecting a point on the PPF indicates a choice of which combination of goods to produce. Opportunity Cost: Moving along the PPF shows that producing more of one good incurs the cost of producing less of the other. Efficiency: Points on the PPF curve represent the maximum efficient use of resources. Under-utilisation: Points inside the curve show resources are not fully used. The need for trade-offs and cost-benefit analysis and their relationship to opportunity cost Trade-offs require choosing between options, and cost-benefit analysis helps evaluate these choices by comparing their costs and benefits, directly linking to opportunity cost as the cost of the foregone alternative Types of efficiency: Allocative: ensuring the resources are used in areas of production that best satisfy society's needs and wants - one point on PPF Technical/productive: extracting the maximum output from resources - all points along PPF Dynamic: being adaptive/innovative in resource allocation - e.g. updating technology, relocating resources to once again achieve allocative efficacy Inter-temporal: Balancing the use of resources between current and future Provide two possible reasons for a shift left in the PPF/C. Discuss why this may not 1 Mark) explain - quality and necessarily result in a decrease in production across the economy. 4 marks quantity 1 Mark) one reason + example A shift left in the PPF means that there is a reduction in the quantity or the quality of resources. If 1 Mark) one reason + there was a decrease in the quality of resources produced due to factors such as decreased example education of labour the resource of labour would decrease due to a decline in skills and productivity 1 Mark) Why wouldn't it result thus shifting the PPF left. Additionally, if there was a decrease in the quantity of a resource due to in a decrease in production across the economy factors such as climatic conditions fewer resources would be available thus shifting productive capacity inwards. However, this may not necessarily result in a decrease in production across the economy of a firm that is already operating inside the PPC they will not be affected by the loss of resources unless they are using them Distinguish between allocative efficiency and dynamic efficiency. 3 marks 1 Mark)Explain allocative 1 Mark)Explain dynamic Allocative efficiency occurs when resources are used to produce the combination of goods and 1 Mark) providing a services that best satisfies society’s needs and wants so that society’s well-being is maximised. distinguishing feature of each Dynamic efficiency refers to the speed at which resources are reallocated from one area of type of efficiency production to another in response to a change in consumer preferences or tastes. Dynamic efficiency promotes the achievement of allocative efficiency and it involves improving allocative efficiency over time. How do relative prices affect the allocation of resources in a perfectly competitive market of 1 Mark) Explain relative pumpkins and potatoes when there is a rise in popularity for pumpkins as opposed to prices in a competitive market potatoes? 4 marks 1 Mark) An increase in popularity leads to an When a market is operating under perfectly competitive conditions, relative prices (which refer to increased relative price the price of one good relative to another good set by forces of demand and supply) determine the 1 Mark) Producers receive a allocation of resources. If there was an increase in the popularity of pumpkins relative to potatoes, signal to produce more consumers would demand more pumpkins over potatoes thus the upward demand pressures will 1 Mark) Relative scarcity - cause its relative price to rise. This sends a signal to producers to produce more pumpkins than must reallocate to produce potatoes. However, due to relative scarcity, there is only a finite number of resources thus to more increase production producers will need to reallocate resources from the production of potatoes 1 Mark) Link to allocative towards pumpkins thus increasing allocative efficacy as resources are allocated to best meet efficacy society's needs and wants. What is the opportunity cost of drinking alcohol. 2 marks 1 mark) Define opportunity cost Opportunity cost refers to the next best alternative foregone when deciding between two options. 1 mark) explain the The benefit that is foregone when deciding to drink alcohol is the ability to think clearly. opportunity cost In a competitive market, explain how an increase in demand for a product might result in a 1 mark) a clear change in relative prices, and explain how this would influence resource allocation and understanding of the meaning and importance of relative living standards. 5 marks prices in the context of the In a competitive market, an increase in demand for a product lead to upward pressure on its price question. compared to other products, such as the price of a substitute. This is due to the creation of a 1 mark) clarify how the shortage in the market which causes producers to raise price in order to eliminate the shortage. change in relative prices ultimately sends important This sends a signal to the producers that higher profits can be made by producing this particular signals to product and they then allocate more resources, including labour and capital, to its production. For producers/consumers example, during 2020, the demand for facemasks increased relative to other products which 1 mark) explain how this causes resources to move encouraged producers to allocate more resources to the production facemasks. The change in from the production of one relative prices and the ability for competitive markets to adjust can improve living standards good to another because consumers demands will readily be met. This means that markets will only produce the 1 mark) how does this goods and services that consumers want and changes in relative prices are an important part of influence resource allocation 1 mark) Impact on LS this process will help to ensure that allocative efficiency is achieved. 1 mark) examples The three basic economic questions: what and how much to produce, how to produce, and for whom to produce The three basic economic questions every society must answer are: 1. What and how much to produce? This question addresses which goods and services should be produced and in what quantities, based on society's needs and wants. 2. How to produce? This pertains to the methods and resources utilized in the production process, determining the most efficient and cost-effective way to create goods and services. 3. For whom to produce? This final question decides who will receive the produced goods and services, involving the distribution of income and wealth within the society to determine access. How different economic systems, including market economies, planned economies, mixed economies and traditional economic systems, may answer the three key economic questions Different economic systems answer the three key economic questions as follows: Market Economies: Choices are made by individuals and businesses based on supply and demand. Planned Economies: The government decides what, how, and for whom to produce. Mixed Economies: Combines elements of market forces and government decisions. Traditional Economies: Relies on customs and traditions to make these decisions. The three-sector circular flow model of the economy, including consumers/households, producers/businesses and government The three-sector circular flow model illustrates the economy: households offer labour to businesses and receive wages, businesses produce goods and pay for labour, and the government collects taxes and provides public services, creating a continuous flow of money and resources. The law of demand and the theory of the law of demand, including the income effect and the substitution effect Law of Demand: ○ States that there is an inverse relationship between price and quantity demanded. ○ As price increases, quantity demanded decreases, and vice versa. Theory of the Law of Demand: ○ Income Effect: When the price of a good decreases, consumers have more real income (purchasing power), allowing them to buy more of the good. ○ Substitution Effect: As the price of a good decreases, it becomes relatively cheaper compared to other goods, leading consumers to substitute it for more expensive alternatives. The inverse relationship between the quantity demanded and the price Inverse Relationship: ○ Definition: The law of demand describes an inverse (negative) relationship between price and quantity demanded. ○ Explanation: When the price of a good or service increases, the quantity demanded by consumers generally decreases, and when the price decreases, the quantity demanded increases. ○ Rationale: This occurs due to the income effect (higher prices reduce purchasing power) and the substitution effect (higher prices make alternatives more attractive). The demand curve, including movements along and shifts of the demand curve Movements Along the Demand Curve: ○ Expansion of demand: Occurs when there is a decrease in price, leading to an increase in quantity demanded (movement down the curve). ○ Contraction of demand: Occurs when there is an increase in price, leading to a decrease in quantity demanded (movement up the curve). Shifts of the Demand Curve: ○ A shift to the right indicates an increase in demand at all price levels. ○ A shift to the left indicates a decrease in demand at all price levels. Non-price factors likely to affect demand and the position of the demand curve ○ Changes in Disposable Income: Higher disposable income generally increases demand (shift to the right). Lower disposable income generally decreases demand (shift to the left). ○ Prices of Substitutes and Complements: Substitutes: An increase in the price of a substitute increases demand for the good (shift to the right). Complements: An increase in the price of a complement decreases demand for the good (shift to the left). ○ Preferences and Tastes: Positive changes in consumer preferences or tastes increase demand (shift to the right). Negative changes decrease demand (shift to the left) ○ Interest Rates: Higher interest rates can decrease demand (shift to the left) as borrowing costs rise. Lower interest rates can increase demand (shift to the right). ○ Population Demographics: An increase in the population, particularly in specific demographic groups, can increase demand (shift to the right). Changes in demographics, such as aging populations, can affect demand for certain goods and services. ○ Consumer Confidence: High consumer confidence leads to increased demand (shift to the right). Low consumer confidence leads to decreased demand (shift to the left). The law of supply and the theory of the law of supply, including the profit motive Law of Supply: ○ States that there is a direct relationship between price and quantity supplied. ○ As the price increases, the quantity supplied also increases, and vice versa. Theory of the Law of Supply: ○ Profit Motive: Higher prices incentivize producers to supply more of a good or service because they can achieve greater profits. As prices rise, the potential for higher profits motivates businesses to increase production, leading to a greater quantity supplied. The supply curve, including movements along and shifts of the supply curve Movements in the Supply Curve: Expansion of supply: This occurs when there is a price increase, leading to an increase in quantity supplied (movement up the curve). Contraction of supply: Occurs when there is a price decrease, leading to a decrease in quantity supplied (movement down the curve). Shifts of the Supply Curve: A shift to the right indicates an increase in supply at all price levels. A shift to the left indicates a decrease in supply at all price levels. Non-price factors likely to affect supply and the position of the supply curve Changes in the Costs of Production: Higher production costs (e.g., wages, raw materials) decrease supply (shift to the left). Lower production costs increase supply (shift to the right). Number of Suppliers: An increase in the number of suppliers in the market increases supply (shift to the right). A decrease in the number of suppliers decreases supply (shift to the left). Technology: Technological advancements typically increase supply (shift to the right) by improving production efficiency. Productivity: Higher productivity, often through better technology or processes, increases supply (shift to the right). Lower productivity decreases supply (shift to the left). Climatic Conditions: Favourable climatic conditions (e.g., good weather for agriculture) increase supply (shift to the right). Unfavourable conditions (e.g., drought, natural disasters) decrease supply (shift to the left). The effects of changes in supply and demand on equilibrium prices and quantity traded ○ Equilibrium occurs when the quantity demanded equals the quantity supplied. ○ Increase in Demand: Raises both equilibrium price and quantity. ○ Decrease in Demand: Lowers both equilibrium price and quantity. ○ Increase in Supply: Lowers equilibrium price but increases quantity traded. ○ Decrease in Supply: Raises equilibrium price but decreases quantity traded. ○ Simultaneous Changes: The overall effect on price and quantity depends on the relative magnitude of the shifts in demand and supply. The meaning and significance of price elasticity of demand and supply Price elasticity of supply Meaning and Significance: ○ Definition: Measures the responsiveness of quantity demanded to a change in price. ○ Significance: Helps businesses and governments understand how changes in price affect total revenue and consumer spending. Price elasticity of supply Meaning and Significance: ○ Definition: Measures the responsiveness of quantity supplied to a change in price. ○ Significance: Important to understand how quickly producers can respond to changes in market prices. Factors affecting price elasticity of demand, including degree of necessity, availability of substitutes, proportion of income and time Degree of Necessity: Necessities have inelastic demand (PED < 1); consumers will buy them even if prices increase. Luxuries have more elastic demand (PED > 1). Availability of Substitutes: Goods with many substitutes have elastic demand, as consumers can easily switch to alternatives. Fewer substitutes lead to inelastic demand. Proportion of Income: Goods that take up a large proportion of income have more elastic demand, as price changes significantly affect purchasing decisions. Goods that take up a small proportion of income have inelastic demand. Time: In the short term, demand is often inelastic as consumers need time to find substitutes or adjust consumption habits. In the long term, demand becomes more elastic as consumers adapt to price changes. Factors affecting price elasticity of supply, including spare capacity, production period and durability of goods Spare Capacity: Firms with spare production capacity can increase supply quickly when prices rise, leading to elastic supply. Limited spare capacity results in inelastic supply. Production Period: Goods that can be produced quickly have elastic supply. Goods with long production times have inelastic supply, as it takes longer to increase output. Durability of Goods: Durable goods have more elastic supply because they can be stored and sold later when prices increase. Non-durable goods are less elastic because they must be sold quickly before they perish or become obsolete. The role of relative prices in the allocation of resources Relative Prices: Definition: The price of one good or service compared to another, expressed as a ratio or in comparison to other goods/services. Significance: Relative prices signal where resources (such as labor, capital, and raw materials) should be allocated in the economy to maximize efficiency and meet consumer demand. Resource Allocation: Price Signals: Higher relative prices for a good or service indicate greater demand or scarcity, encouraging producers to allocate more resources towards its production. Incentives: Producers are incentivized to move resources to areas where they can achieve higher returns, based on the relative prices of goods and services. Consumer Influence: Changes in consumer preferences or incomes alter the relative prices of goods and services, leading to reallocation of resources to match these changes. Market Efficiency: The constant adjustment of resources based on relative prices helps to achieve an efficient allocation of resources, where they are most valued by society. The role of free and competitive markets in promoting an efficient allocation of resources and improved living standards Free and Competitive Markets: ○ Definition: Markets where prices are determined by supply and demand, with minimal government intervention, and where multiple firms compete freely. Efficient Allocation of Resources: ○ Price Mechanism: In free and competitive markets, prices adjust based on supply and demand, guiding resources to their most valued uses. ○ Competition: Firms strive to offer better products at lower prices to attract consumers, leading to innovation, cost reduction, and more efficient production methods. ○ Consumer Sovereignty: Consumers have the power to influence what is produced through their spending choices, ensuring that resources are allocated to meet the most urgent needs and wants. Improved Living Standards: ○ Lower Prices: Competition drives down prices, making goods and services more affordable, which increases consumers' purchasing power and overall welfare. ○ Innovation and Variety: Competition encourages innovation, leading to the development of new products and technologies, enhancing consumer choice and quality of life. ○ Productivity Gains: Efficient allocation of resources through competitive markets increases productivity, leading to economic growth and higher incomes. ○ Economic Growth: As resources are efficiently used to produce more goods and services, the economy grows, raising living standards across society. Explain one way that free and competitive markets promote an efficient allocation of resources and improved living standards. (3 marks) Free and competitive markets are those without government intervention with that are 1 – explain free and competitive markets characterised by a level of competition whereby firms are more likely to compete on - Pick a characteristic price (price takers) and produce homogeneous products. The high exposure to 1 – link to one type of efficiency competition forces firms to be low-cost producers and allocate resources to 1 – link to living standards areas in which they have a comparative advantage. This means that firms are likely to achieve technical efficiency (maximising outputs from inputs) and lead to lower prices. This will help to increase MLS as people will be able to buy more G+S with the same level of income. Types of market failure, including public goods, externalities, asymmetric information and common access resources 1. Public Goods: ○ Definition: Goods that are non-excludable (cannot prevent people from using them) and non-rivalrous (one person’s use doesn’t reduce availability to others). ○ Market Failure: Private markets often underproduce public goods because they cannot easily charge users, leading to under-provision. ○ Examples: National defense, public parks, street lighting. 2. Externalities: ○ Definition: Costs or benefits of economic activities that affect third parties who are not involved in the transaction. ○ Types: Negative Externalities: Occur when a third party suffers a cost (e.g., pollution from a factory affecting nearby residents). Positive Externalities: Occur when a third party gains a benefit (e.g., vaccinations reduce disease spread to others). ○ Market Failure: Markets tend to overproduce goods with negative externalities and underproduce those with positive externalities because these costs or benefits are not reflected in market prices. 3. Asymmetric Information: ○ Definition: A situation where one party in a transaction has more or better information than the other. ○ Market Failure: This can lead to adverse selection (e.g., in insurance markets where only high-risk individuals purchase insurance) or moral hazard (e.g., insured individuals taking more risks because they are protected). ○ Examples: Used car markets, health insurance. 4. Common Access Resources: ○ Definition: Natural resources that are non-excludable but rivalrous, meaning they are accessible to everyone but can be depleted through overuse. ○ Market Failure: Overuse and depletion occur because individuals acting in their own interest consume more than is sustainable, leading to the "tragedy of the commons." ○ Examples: Fisheries, forests, clean air, and water. Given that vaccinations are generally regarded as beneficial for society, explain why they are treated as a form of market failure in a free and unregulated market. (3 marks) A free and unregulated market means that there is no government regulation. In this 1 - Explain market failure and positive scenario, vaccinations can create market failure which refers to a sub-optimal externalities allocation of resources that reduces living standards. - Define MF and free and Vaccinations are a form of positive externalities in consumption where a benefit unregulated market. spills onto a third party not involved in the transaction. Because the social benefit - Refer to vaccinations as a outweighs the private benefit people will choose not to consume vaccinations knowing positive externalities they can consume the benefit of immunity without getting the vaccine. The lower 1 – link to underconsumption and levels of consumption signal producers to slow the production of vaccines and allocate underproduction of vaccinations fewer resources towards vaccines. This creates market failure as there is a suboptimal 1- link to underallocation of LLK and allocation of resources and as fewer people are vaccinated overall health levels will reduction in living standards decline educating society's living standards. Explain the specific characteristic that leads to the free rider problem. (2 marks) The free-rider problem relates to public goods as it is a scenario whereby consumers 1 – explain free rider problem and link to will not choose to consume a specific good if they can consume it without paying. Due public goods to the non-exclusivity of public goods, consumers will choose to not pay for a good 1 – link to non-excludable nature while still consuming it creating the free rider problem. Producers who are profit-driven will not produce public goods as they don't receive profits. Explain why adverse selection results in a market failure. What is one way that the government can rectify this issue. (4 marks) Adverse selection refers to a situation where a consumer unknowingly makes a 1 – explain adverse selection, decision that does NOT increase their living standards. This occurs when a buyer asymmetric information, market failure does not have access to all information, i.e when the seller has more information than - the buyer which is known as adverse selection. 1.5 – explain why adverse selection is a This is a market failure which is a suboptimal allocation of resources that decreases market failure living standards as consumers pay a price that is above fair value. When consumers - Living standards spend too much money on a good or service that doesn't satisfy their needs and - Sub-optimal allocation wants their material living standards decline. Additionally, as the price is higher than 1.5 – explain how government the product, producers will find it profitable to produce and thus will over-allocate intervention addresses the issue resources towards it production. To rectify this issue the government can introduce regulations such as section 18 of the Australian Consumer law which stipulates that firms cannot engage in behaviour that is deceiving or misleading regarding a product whereby the consumer much have all the information. This means that the price will likely fall closer to the true value which reduces profitability, production and allocation of resources to a good. This should lead to higher living standards. The role and effect of indirect taxation, subsidies, regulations, advertising and direct provision as forms of government intervention in the market to address market failure Indirect Taxation: Role: Imposed on goods and services to correct negative externalities by increasing the cost of production or consumption. Effect: ○ Reduces consumption of goods with negative externalities (e.g., tobacco, alcohol) by raising prices. ○ Internalizes external costs, making producers and consumers bear the full social cost Subsidies: Role: Financial assistance provided to encourage the production or consumption of goods with positive externalities. Effect: ○ Lowers production costs for producers, increasing the supply of beneficial goods and services (e.g., renewable energy). ○ Reduces prices for consumers, encouraging greater consumption of goods with positive externalities (e.g., education, vaccinations). ○ Helps in addressing underproduction positive externalities Regulations: Role: Government-imposed rules and standards to correct market failures, particularly where externalities or asymmetric information exist. Effect: ○ Limits harmful activities (e.g., pollution controls, safety standards) by setting legal requirements. ○ Protects consumers from risks due to asymmetric information (e.g., food labeling, quality standards). ○ Can lead to improved public health, environmental quality, and safety, but may increase costs for businesses. Advertising: Role: Government campaigns to inform or persuade the public, particularly to correct asymmetric information or promote positive externalities. Effect: ○ Increases public awareness of the benefits or harms associated with certain goods (e.g., anti-smoking campaigns, energy-saving initiatives). ○ Influences consumer behavior towards more socially desirable choices, reducing negative externalities or increasing positive externalities. ○ Can lead to healthier lifestyles and better environmental practices. Direct Provision: Role: Government directly supplies goods and services, particularly public goods or where markets fail to provide adequately. Effect: ○ Ensures availability of essential goods and services (e.g., public healthcare, education, infrastructure) that might be underprovided by the market. ○ Addresses free-rider problems associated with public goods by ensuring everyone has access, regardless of ability to pay. Explain why an indirect tax such as an excise tax would not solve the market failure associated with common access resources. 2 marks) 1. Explain the type of market failure Common access resources is an example of market failure. CARs are For CARS: Non excludable and non rivalrous non-excludable (non-payers can’t be prevented from consuming the product) but rival (one person’s consumption will diminish another person’s ability to 2 – overall quality of explanation of answer consume it). This leads to an overconsumption of CARs. An indirect tax on which should include some information on the production of CARs won’t work as they can’t be taxed as they are not market failure associated with CARs and an produced and thus don’t have a market price. It would not address the explanation that supply-side tax can’t solve the overconsumption of CARs. overconsumption of CARs (that don’t have a market price) One example of a government intervention in markets that unintentionally leads to a decrease in one allocative, productive, dynamic or intertemporal efficiency Minimum wage: Type of Efficiency Affected: Productive Efficiency Government Intervention:The minimum wage of $23.23 per hour in Australia is designed to ensure that people have access to essential G+S to improve their MLS. Unintended Consequence: The government has set a price floor above the equilibrium market wage. - This will see a contraction in demand for labour and an expansion in supply of labour. This creates an oversupply of labour, otherwise known as unemployment. This reduces technical efficiency = an economy’s ability to maximise outputs from inputs as the economy will have idle resources and not be operating on the PPF Explain one type of government intervention in markets that unintentionally leads to a decrease in one type of efficiency. (3 marks) The minimum wage is an example of where governments have intervened to improve 1 – explanation of government living standards but have unintentionally decreased living standards. The minimum intervention and wage of $23.23 per hour in Australia is designed to ensure that people have access to essential G+S to improve their MLS. 1– explanation of how But the unintended consequence is the government has set a price floor above government intervention the equilibrium market wage. This will see a contraction in demand for labour and an unintentionally reduces one type expansion in supply of labour. This creates an over supply of labour, otherwise known of efficiency as unemployment. This reduces technical efficiency (an economy’s ability to maximise outputs from inputs) as the economy will have idle resources and not be operating on 1 - explanation of how the PPF. government intervention unintentionally reduces living standards The economic agents: Economic agents and the concept of the public and private sectors of the economy Economic agents are individuals, businesses, and governments that make decisions about resource allocation, production, and consumption within an economy. The economy is divided into two sectors: The public sector is government-controlled, serving the collective need; The private sector is individual or business-controlled, aiming for profit. The traditional economic viewpoint of consumer behaviour: self-interest, maximisation of utility, rationality, informed decision-making and marginal benefits from consumption Self-Interest: Consumers aim to fulfill personal desires and needs. Maximization of Utility: They strive to get the highest satisfaction from goods and services. Rationality: Choices are made logically to optimize well-being. Informed Decision-Making: Decisions are based on available information and understanding. Marginal Benefits: The additional gain from consuming an extra unit of a good. The ways consumers and workers might respond to incentives and disincentives, including taxes and tax rebates, subsidies and regulations Taxes: Higher taxes on goods or income can lead to reduced consumption or labor supply as they decrease the net benefit of these activities. Tax Rebates: By returning part of the taxes paid, tax rebates can increase disposable income, thus encouraging spending or investment. Subsidies: Providing financial support for certain goods or activities lowers their cost to consumers and producers, thus increasing demand and supply. Regulations: Government-imposed rules can restrict or guide behaviour; they can discourage undesirable activities or encourage beneficial practices. The traditional economic viewpoint of business in the economy: profit maximisation The traditional economic viewpoint holds that businesses aim to maximize profits by increasing revenue while minimizing costs, driving their decisions and actions in the economy. The ways businesses might respond to incentives and disincentives, including taxes and tax rebates, subsidies and regulations reducing after-tax profits, leading businesses to cut costs, possibly by reducing output or workforce. Tax Rebates: Businesses might use tax rebates to reinvest in operations, expand production, or explore new markets, as these rebates effectively lower their tax liability and increase capital available for growth. Subsidies: By receiving financial assistance, businesses often increase the production of subsidized products, as the effective cost of production is reduced, making those goods or services more competitive. Regulations: While they may introduce additional compliance costs, regulations can also create predictable market conditions, ensuring fair competition and protecting against market abuses. The traditional economic viewpoint of the government in the economy: maximisation of living standards The traditional view holds that the government's role in the economy is to maximize living standards through policy measures that ensure economic stability, redistribute income, and provide public goods and services. U3 AOS1: Microeconomics 1. How does a free and unregulated market answer the basic economic questions? A free and unregulated market is one in which there is no government intervention and where all economic agents are price takers. The first of the basic economic questions is “what and how much to produce,” which is determined by consumer sovereignty and sellers through the interaction of the forces of supply and demand, which then sends a price signal to producers through relative prices and as producers are profit driven, they will respond to the price signals. The second question which is “how to produce” is determined by profit-driven producers who are influenced by the relative costs of production methods and their benefits to determine if the firm takes a labour intensive or capital-intensive production process. For example, if the cost of labour relative to capital increases, producers will employ capital such as technology to replace human capital to a greater extent to reduce their cost of production. The third question which is “for whom to produce”, that is the distribution of goods and services, is determined by who can afford the certain good at the equilibrium price, as there is no government to ensure equity. 2. Explain one factor that affects the elasticity of demand for weet-bix? Price elasticity of demand refers to the responsiveness of the quantity demanded to a change in price. Weet-bix has a low price elasticity of demand and thus an inelastic demand curve (PED1) as there is a great availability of substitutes. Thus, as there are many substitutes such as nutri grain, consumers will quickly change to buying a substitute when the price rises reflecting that a change in its price will lead to a more than proportional change in the quantity demanded and an elastic demand curve. 3. How would an excise tax on cigarettes affect the efficient allocation of resources? Excise tax is an indirect tax levied on the manufacture of specific goods and services. An excise tax on cigarettes would raise the cost of production which decreases the profitability of firms who supply cigarettes. Hence profit driven producers will be less willing to supply cigarettes at each price point which will decrease supply shifting the supply curve for cigarettes left. Supply decreasing will lead to a rise in price for cigarettes and will signal to consumers to buy less cigarettes. So, they will demand more of a cheaper substitute item (the substitution effect) which will lead to higher prices of the substitute and send a price signal back to producers to producers more of the substitute and less cigarettes. As producers are profit driven, they will respond to this price signal by producing less cigarettes thus resources (L,L,K) will be directed away from cigarettes and towards substitutes. This will allow for allocative efficiency to be achieved which is an allocation of resources that maximises living standards as less production of cigarettes will increase people's health as smoking will reduce and the health of the society as passive smoking will decrease thus improving the quality of life beyond tangible value and non material living standards. 4. Evaluate the role of free and competitive markets in achieving an efficient allocation of resources. In a free and competitive market, there are many buyers and sellers, selling homogenous products. In such a market, the forces of demand and supply interact determine relative prices and resource allocation. Consumer sovereignty ensures that in a free and competitive the needs and wants of society are responded to by producers. Assume the demand for good A increases due to a change in tastes and preferences for example, this will increase its relative price. This sends a price signal to producers. As producers are profit driven, they realise that good A is underproduced and therefore produce more of it. This means more resources (L,L,K) are allocated to the production of good A. This helps to achieve allocative efficiency as resources are allocated according to the needs and wants of consumers which should in turn improve living standards. In addition, free and competitive environments can also help achieve technical efficiency (maximising outputs from inputs). Due to the low barriers to entry and many buyers and sellers selling homogenous products suppliers are price takers and have low price setting ability. This imposes a discipline on firms, forcing them to be efficient and low-cost producers to lower prices and attract customers to gain market share. As firms improve their productivity and efficiency, existing resources or potentially fewer resources can produce higher production volumes thus maximising outputs from inputs and helping to achieve technical efficiency. However, sometimes free and unregulated markets fail which is known as market failure where there is a suboptimal allocation of resources where living standards are not maximised. For example, public goods which are non-rivalrous in nature (one’s consumption doesn’t limit the ability for another to consume) and non-excludable (firms cannot stop non-payers from consuming) are a type of market failure. The resulting ‘free rider’ problem means that people will choose not to pay but can still derive the benefit such as streetlights. As people do not pay profitability for firms that produce public goods will decrease, resulting in an under allocation of resource towards public goods which goods and services that would benefit society. Thus, consumers are not able to access good and services that maximise their living standards preventing allocative efficiency from being achieved. 5. Explain the market failure associated with public goods. Market failure is the suboptimal allocation of resources where living standards are not maximised. Public goods refer to goods and services in a market that are both non-rivalrous in nature which is where one’s consumption does not lead to a reduction is the amount available for others and non-excludable, where producers cannot stop non-payers from consuming, such as streetlights. As public goods are non-excludable (non-payers can’t be excluded) the ‘free rider’ problem arises where consumers will consume the product without paying for it. Hence, producers are less profitable and will decrease production of public goods which will allocate resources (L,L,K) away from the production of public goods. Thus, in a free market where there is no government intervention, there will be an under allocation of resources towards public goods. Thus, living standards are not maximised because consumers cannot access beneficial goods and services. For example, without streetlights, the community may feel less safe, thus decreasing nonmaterial living standards (quality of life beyond the tangible value). 6. How could government intervention address the market failure associated with asymmetric information? Asymmetric information refers to the market failure in which one party has access to more information than the other party involved in the transaction. In the case of sellers having more information that buyers such as in the market for second hand cars, the government can intervene by implementing regulations such as consumer laws which prevent suppliers from engaging in misleading or deceptive conduct, such as section 18 of consumer laws stating that consumers require full disclose when purchasing, as regulated by the ACCC. Thus, the government attempts to ensure both parties have equal information and ensures the price more accurately reflects the value of the good which decreasing the profitability of second-hand goods for example compared to when there was no intervention and decrease production leading to resources allocated away from goods and services with asymmetric information. This improves the material living standards of consumers as buyers are not being over charged or making adverse selections increasing access to goods and services. Thus, rectifying the overallocation of resources and helping to achieve allocative efficiency and improve living standards. 7. What is one contemporary example of government intervention in markets that unintentionally leads to a decrease in the efficiency of resource allocation? This year, the government raised minimum wage from $23.23 to $24.10 which is setting price floor in the labour market, where the price of labour is prohibited from falling below a certain value. This aims to improve material living standards for those who are employed and particularly low-income earners as they will earn more money per hour and thus have greater access to goods and services particularly as inflation is quite high. However, as the price floor is above equilibrium price, it adopts the unintended consequence of creating a labour surplus. This is because holding a job has become more lucrative so supply of labour elands, but simultaneously, higher wage costs increase costs of production so the demand for labour contracts. as supply exceeds demand an increase in unemployment unintentionally occurs. This causes a movement away from productive capacity as the economy operating further inside the PPF. As such, technical efficiency (maximising outputs from inputs) is jeopardised as more idle labour resources exist in the economy. UNIT 3 AOS2 - DOMESTIC MACROECONOMIC GOALS The purpose of economic activity LIVING STANDARDS 1. Material Living Standards Definition: Refers to the economic well-being of individuals based on their ability to access goods and services. Measured by: Indicators like income levels, GDP per capita, and access to consumer goods. Factors Affecting Material Living Standards: ○ Income: Higher incomes increase access to goods and services. ○ Employment: More jobs increase household income and purchasing power. ○ Prices and Inflation: Low inflation improves purchasing power, boosting material living standards. 2. Non-Material Living Standards Definition: Refers to quality of life beyond income, including well-being, happiness, and satisfaction. Measured by: Indicators like health, education, and environmental quality. Factors Affecting Non-Material Living Standards: ○ Environmental Quality: Clean air, water, and sustainable use of resources enhance overall well-being. ○ Physical and Mental Health: Good health improves quality of life and the ability to enjoy leisure and work productively. ○ Crime Rates: Lower crime rates lead to safer communities, improving well-being. ○ Literacy Rates: Higher literacy improves access to information, better employment opportunities, and overall societal progress The five-sector circular flow model of income, including the role of households, businesses, government, financial institutions and the external sector in an open contemporary macroeconomy The five-sector circular flow model outlines the flow of income in an open economy, showing interactions between 1. Households: Supply resources (labour, capital) to businesses and receive income (wages, rent). They consume goods and services (C) and save. 2. Businesses: Use household resources to produce goods and services. They invest in capital (I) and supply goods to households and other sectors. 3. Government: Collects taxes (T) and spends on public goods and welfare (G), influencing resource allocation and economic stability. 4. Financial Institutions: Facilitate savings (S) and investment (I), directing funds from savers to borrowers. 5. External Sector: Engages in trade. Exports (X) bring income, while imports (M) are a leakage. Net exports (X - M) impact economic growth. UNIT 3 AOS2 The business cycle and its causes The business cycle refers to the fluctuations in economic activity over time, typically moving through four phases: expansion, peak, contraction, and trough. Expansion: Increasing GDP, employment, and income, with rising demand and investment. Peak: Maximum economic output, often accompanied by high inflation and full employment. Contraction: Decreasing GDP, rising unemployment, and lower consumer spending. Trough: The lowest point, with weak economic activity, often followed by recovery. 2. Causes of the Business Cycle: 1. Changes in Aggregate Demand (AD): ○ Consumer Confidence: High confidence boosts spending and investment, leading to expansion, while low confidence leads to contraction. ○ Government Policy: Fiscal and monetary policies (e.g., interest rates, taxes) can influence AD and trigger expansions or slowdowns. 2. External Shocks: ○ Global Demand: Changes in demand for exports or global economic crises can cause fluctuations in economic activity. ○ Commodity Prices: Fluctuations in prices for key exports (e.g., iron ore, oil) can impact national income and the business cycle. 3. Technological Innovation: ○ New technologies can drive productivity and investment, causing periods of growth. 4. Supply Shocks: ○ Events like natural disasters or supply chain disruptions can reduce aggregate supply, leading to economic contractions. The meaning and importance of aggregate demand and the factors that may affect the level of aggregate demand in the economy 1. Meaning of Aggregate Demand (AD) Aggregate Demand (AD) is the total value of all goods and services demanded in an economy over a given period. It is represented by the formula: AD = C + I + G + (X − M) C = Consumption I = Investment G = Government Spending (X - M) = Net Exports (Exports minus Imports) UNIT 3 AOS2 2. Importance of Aggregate Demand Economic Growth: AD drives production and investment, leading to higher GDP growth. Employment: Higher AD increases demand for labour, reducing unemployment. Inflation: Excessive AD can lead to demand-pull inflation, where too much demand pushes prices up. Factors Affecting Aggregate Demand 1. Disposable Income: ○ Higher disposable income increases consumer spending (C), boosting AD. ○ Lower disposable income reduces consumption, slowing AD. 2. Interest Rates: ○ Lower interest rates make borrowing cheaper, encouraging spending and investment (C and I), increasing AD. ○ Higher interest rates discourage borrowing and spending, reducing AD. 3. Consumer Confidence: ○ When consumers feel optimistic about the economy, they spend more (C), raising AD. ○ Low consumer confidence leads to more saving and less spending, lowering AD. 4. Business Confidence: ○ High business confidence encourages firms to invest in capital (I), increasing AD. ○ Low confidence reduces investment, slowing AD. 5. Exchange Rate: ○ A weaker exchange rate makes exports cheaper and imports more expensive, increasing net exports (X - M), boosting AD. ○ A stronger exchange rate reduces export competitiveness, lowering AD. 6. Overseas Economic Growth: ○ Strong economic growth overseas boosts demand for exports (X), increasing AD. ○ Weak global growth reduces export demand, slowing AD The meaning and importance of aggregate supply and the factors that may affect the level of aggregate supply in the economy 1. Meaning of Aggregate Supply (AS) Aggregate Supply (AS) refers to the total quantity of goods and services that producers in an economy are willing and able to supply at a given price level over a specific period. 2. Importance of Aggregate Supply Economic Growth: AS determines an economy's capacity to produce, influencing GDP growth. Inflation: Increases in AS help to control inflation by meeting rising demand without pushing up prices. Employment: Higher AS increases production, leading to greater demand for labour and reducing unemployment. Factors Affecting Aggregate Supply 1. Quantity and Quality of Factors of Production: ○ Quantity: More resources (labour, capital, land) allow for higher production capacity. ○ Quality: Improved education, skills, or technology increases efficiency, enhancing AS. UNIT 3 AOS2 2. Costs of Production: ○ Lower production costs (e.g., wages, raw materials) increase firms' willingness to produce, boosting AS. ○ Higher costs reduce profitability and AS. 3. Technological Change: ○ Technological advancements increase efficiency, reduce production costs, and boost AS by enabling firms to produce more with the same resources. 4. Productivity Growth: ○ Increases in labour productivity (output per worker) lead to more efficient production, boosting AS without needing more resources. 5. Exchange Rates: ○ A stronger exchange rate makes imported inputs cheaper, lowering production costs and increasing AS. ○ A weaker exchange rate raises the cost of imports, potentially reducing AS. 6. Climatic Conditions: ○ Favourable conditions (e.g., good weather for agriculture) enhance production, increasing AS. ○ Adverse conditions (e.g., droughts, floods) reduce the ability to produce, lowering AS. 7. Government Regulations: ○ Supportive policies (e.g., tax incentives, deregulation) can reduce business costs and encourage higher production, increasing AS. ○ Restrictive regulations may add costs to production, limiting AS. 8. Disruptions to International Supply Chains: ○ Disruptions (e.g., pandemics, geopolitical tensions) can lead to shortages of inputs, increasing costs and reducing AS. The domestic macroeconomic goals The meaning of the goal of strong and sustainable economic growth 1. Meaning of the Goal The goal of strong and sustainable economic growth (SSEG) aims to achieve a growth rate that increases the production of goods and services (GDP) while avoiding environmental degradation, inflationary pressures, or unsustainable levels of debt. This type of growth supports higher living standards by generating employment, increasing incomes, and improving government revenues for public services. Growth is currently at 1% Measurement of the rate of economic growth using growth in real Gross Domestic Product (GDP) Economic growth is measured by the growth rate in real Gross Domestic Product (GDP), which adjusts for inflation to reflect the real increase in the value of goods and services produced. The target range for sustainable growth is generally 3-3.5% per year. This level supports job creation and income growth without leading to significant inflationary pressures or environmental strain. UNIT 3 AOS2 Consequences of Not Achieving Strong and Sustainable Economic Growth 1. Growth Is Too Low High Unemployment: ○ Low or weak growth reduces the demand for goods and services, leading to lower production and job cuts. This increases unemployment, reducing household incomes and access to goods and services, lowering material living standards. ○ Rising unemployment also increases reliance on welfare, which may strain government budgets and reduce funding for public services, negatively affecting non-material living standards (e.g., increased stress, reduced social well-being). Reduced Income and Government Revenue: ○ Low growth means slower income growth for households and lower profits for businesses. This reduces consumer spending and investment, further weakening economic activity. ○ Government revenues fall due to lower tax receipts, limiting the ability to fund essential services like healthcare and education, which can impact overall living standards. 2. Growth Is Too High High Inflation: ○ When growth is too rapid, demand for goods and services may exceed the economy’s capacity to supply them, leading to demand-pull inflation. ○ High inflation erodes the purchasing power of households, as goods and services become more expensive. This reduces material living standards, particularly for those on fixed incomes. ○ Persistently high inflation can also create uncertainty, making it harder for businesses to plan and invest, which may slow future growth. External Pressures: ○ Strong growth often leads to increased imports to meet rising demand. This can worsen the trade balance and lead to current account deficits, placing pressure on the exchange rate. ○ A weaker currency can make imported goods more expensive, worsening inflation and affecting households’ ability to purchase necessary goods, impacting both material and non-material living standards. 3. Environmental Degradation Unsustainable Growth: ○ If growth is achieved without considering environmental sustainability, it can result in environmental degradation (e.g., deforestation, pollution, resource depletion). ○ This has long-term consequences for non-material living standards by reducing the quality of life through poorer air and water quality, loss of biodiversity, and increased health problems. ○ Degraded natural resources can also affect future economic productivity, particularly in industries like agriculture and tourism, potentially slowing long-term growth and worsening material living standards. UNIT 3 AOS2 Impact on Living Standards Material Living Standards: Both high inflation and high unemployment reduce households' ability to access goods and services, lowering overall economic well-being. Unemployment reduces income, while inflation erodes purchasing power. Non-Material Living Standards: High unemployment leads to increased social issues such as stress, anxiety, and reduced well-being, while environmental degradation worsens public health and quality of life. The meaning of the goal of full employment, including the NAIRU (natural rate of unemployment) 1. Meaning of Full Employment The goal of full employment refers to achieving the highest possible level of employment in the economy where the government is achieving its goal for SSEG without running into cyclical unemployment due to low AD Full employment is achieved when the unemployment rate is at or near the NAIRU, typically around 4-4.5%. Full employment aims to minimize cyclical unemployment, which occurs during economic downturns. It also seeks to maintain employment levels consistent with economic growth while avoiding high inflation. 2. The NAIRU (Non-Accelerating Inflation Rate of Unemployment) Refers to the lowest level of unemployment that an economy can sustain without causing inflation to rise. At this level, cyclical unemployment (unemployment caused by insufficient demand) is zero, but structural, frictional, and seasonal unemployment still exist. In Australia, the NAIRU is generally estimated to be around 4.25 Classifications within the labour force 1. Employed: ○ Definition: Individuals who are working for at least one hour per week in paid employment or in their own business. ○ Includes: Full-time, part-time, and casual workers. 2. Unemployed: ○ Definition: Individuals who are actively seeking work and are currently available to start a job but are not employed. ○ Criteria: Must be actively searching for employment and available to start immediately. 3. Hidden Unemployed: ○ Definition: People who are not actively seeking work (and therefore not classified as unemployed), often because they have become discouraged and believe no jobs are available. ○ Impact: These individuals are excluded from official unemployment statistics, potentially understating the true unemployment rate. 4. Long-Term Unemployed: ○ Definition: Individuals who have been unemployed and actively seeking work for 12 months or more. ○ Significance: Long-term unemployment can lead to skill deterioration and social and psychological impacts. UNIT 3 AOS2 5. Underemployed: ○ Definition: People who are working part-time or casually but would prefer to work more hours, or full-time workers whose skills are underutilized. ○ Example: A person working part-time but seeking full-time work, or an overqualified worker in a lower-skilled job. 6. Frictional Unemployment: ○ Definition: Temporary unemployment that occurs when individuals are between jobs or are entering the labour force for the first time. ○ Cause: This type of unemployment is a normal part of a dynamic economy and reflects the time taken for people to find new employment. Measurement of the labour force 1. Labour Force: ○ The labour force includes all individuals aged 15 and over who are either employed or unemployed (actively seeking and available for work). 2. Participation Rate: ○ The participation rate measures the percentage of the working-age population (aged 15 and over) that is actively participating in the labour market (either employed or unemployed). Importance: A higher participation rate indicates more people are engaged in the labour market, either working or seeking work. 3. Unemployment Rate: ○ The unemployment rate represents the percentage of the labour force that is unemployed (actively seeking work but not currently employed). Significance: A key indicator of economic health, reflecting how many people in the labour force are without a job. 4. Labour Force Under-utilisation Rate: ○ The labour force under-utilisation rate includes both unemployed individuals and the underemployed (those who are employed but want to work more hours). Importance: Provides a more comprehensive view of labour market slack by including those who are not fully employed, capturing the true extent of underused labour. UNIT 3 AOS2 The difference between cyclical and structural unemployment Cyclical Unemployment: ○ Caused by economic downturns (recessions). ○ Linked to reduced aggregate demand and job losses. ○ Temporary and improves with economic recovery. Structural Unemployment: ○ Caused by long-term changes in the economy (e.g., technology, industry shifts). ○ Results from a skills mismatch between workers and available jobs. ○ Requires retraining and education for workers to find new opportunities. Cyclical is temporary, while structural is long-term and requires adaptation. The consequences of not achieving the goal of full employment and its effect on living standards, including the impact on GDP and tax revenue if unemployment is too high and the effects on inflation if unemployment is too low 1. High Unemployment Impact on GDP: ○ High unemployment leads to lower production and output, as fewer people are working and contributing to the economy. This reduces GDP, slowing economic growth. Impact on Tax Revenue: ○ With more people unemployed, tax revenues decrease because fewer individuals are paying income taxes. Additionally, government spending on welfare and unemployment benefits increases, straining public finances. Effect on Living Standards: ○ High unemployment reduces household incomes, limiting access to goods and services, which worsens material living standards. Non-material living standards also decline as joblessness often leads to stress, anxiety, and social problems. 2. Low Unemployment (Below the NAIRU) Impact on Inflation: ○ When unemployment falls below the NAIRU (Non-Accelerating Inflation Rate of Unemployment), the labour market becomes tight. This increases demand for labour, pushing up wages. ○ Higher wages can lead to demand-pull inflation (rising consumer demand) and cost-push inflation (rising production costs), which erodes purchasing power and reduces living standards. Effect on Living Standards: ○ While more people are employed, rising inflation can reduce the real value of wages, limiting access to goods and services and lowering material living standards over time. The meaning of the goal of low and stable inflation (price stability) The goal of low and stable inflation, also known as price stability, refers to ensuring the stability of the Australian currency over time. This ensures that inflation remains within the target range of 2-3% per year, on average, over time. - Currently at 3.8% which is a rise from 3.6% at the beginning of 2024 UNIT 3 AOS2 The distinction between inflation, disinflation and deflation Inflation: Definition: The sustained increase in the general price level of goods and services in an economy over time. Effect: Reduces the purchasing power of money, meaning consumers can buy fewer goods and services with the same amount of money. Example: Prices rise at 3% annually. Disinflation: Definition: A slowing down of the rate of inflation, meaning prices are still rising, but at a slower rate than before. Effect: Prices continue to increase, but the pace of price rises decelerates. Example: Inflation falling from 5% to 2% annually. Deflation: Definition: A decrease in the general price level of goods and services, leading to a negative inflation rate. Effect: Increases the purchasing power of money, but can lead to reduced consumer spending, business investment, and economic stagnation. Example: Prices falling by 2% over a year. Measurement of the inflation rate using the Consumer Price Index (CPI), including the difference between the headline and underlying (core) rate of inflation 1. Consumer Price Index (CPI) The Consumer Price Index (CPI) measures the average change in prices of a fixed basket of goods and services typically purchased by households over time. CPI calculation: Prices of goods and services are tracked quarterly, and the percentage change in the index over time reflects the inflation rate. 2. Headline Inflation Definition: Headline inflation reflects the total change in the CPI, including all items, such as volatile components like food, fuel, and energy. Significance: It represents the broad measure of inflation that captures price changes in the entire economy. Limitation: Since it includes volatile items, headline inflation can be more subject to short-term fluctuations. 3. Underlying (Core) Inflation Definition: Underlying inflation excludes the most volatile items (e.g., food and fuel) that can cause short-term spikes or drops in prices. Types of Measures: ○ Trimmed Mean: Excludes the largest and smallest price changes from the CPI to provide a more stable measure of inflation. ○ Weighted Median: Takes the price change at the middle of the price distribution, giving a clearer view of the central tendency of price changes. UNIT 3 AOS2 Significance: Core inflation provides a more stable and accurate reflection of long-term inflation trends, often used by central banks like the Reserve Bank of Australia (RBA) for policy decisions. Causes of inflation, including demand inflation and cost inflation 1. Demand Inflation (Demand-Pull Inflation) Definition: Inflation caused by an increase in aggregate demand (AD) that exceeds the economy’s productive capacity. Causes: ○ Higher consumer confidence: Leads to increased spending. ○ Low interest rates: Encourage borrowing and investment. ○ Government spending: Expansionary fiscal policy increases demand. ○ Strong overseas demand: Increased demand for exports boosts AD. Effect: When aggregate demand outpaces aggregate supply, producers raise prices to manage the excess demand, causing inflation. 2. Cost Inflation (Cost-Push Inflation) Definition: Inflation is driven by an increase in production costs that firms pass on to consumers in the form of higher prices. Causes: ○ Rising wages: Higher labour costs increase the price of goods and services. ○ Increased raw material prices: For example, oil price hikes increase transport and production costs. ○ Depreciation of the exchange rate: Makes imported goods more expensive, increasing production costs. ○ Supply chain disruptions: Shortages or delays in getting materials can drive up prices. Effect: Producers pass higher input costs on to consumers by raising prices, leading to inflation even if demand has not increased. Consequences of not achieving the goal of low and stable inflation (price stability) 1. Erosion of Purchasing Power: ○ Impact: When inflation is too high, the value of money declines, meaning households can buy less with the same income. This reduces material living standards as the cost of living rises, affecting access to goods and services. 2. Wage-Price Spiral: ○ Impact: High inflation can lead to a wage-price spiral. Workers demand higher wages to keep up with rising prices, but this increases costs for businesses, which pass them on by raising prices further, perpetuating inflation. 3. Distortion of Spending and Investment Decisions: ○ Impact: High inflation causes uncertainty, making it difficult for households and businesses to plan for the future. Consumers may rush to buy goods before prices rise further, while businesses may delay long-term investments due to unpredictable costs. UNIT 3 AOS2 4. Lower Returns on Investment: ○ Impact: High inflation erodes the real value of savings and returns on investment. Investors may demand higher interest rates to compensate for inflation, which increases borrowing costs and reduces investment, slowing economic growth. 5. Loss of International Competitiveness: ○ Impact: If domestic inflation is higher than that of trading partners, the prices of locally produced goods rise, making exports less competitive. This can lead to a decline in export revenue and a worsening trade balance, reducing economic growth and employment in export sectors. 2. Consequences of Low or Deflationary Inflation 1. Delayed Consumption: ○ Impact: When inflation is too low or there is deflation (falling prices), consumers may delay spending in expectation of even lower prices in the future. This reduces aggregate demand, which slows economic growth. 2. Unemployment: ○ Impact: Low inflation or deflation can lead to weak demand for goods and services, reducing business revenues. Firms may respond by cutting production and laying off workers, increasing unemployment and reducing living standards. Effects on Living Standards High Inflation reduces purchasing power, distorts economic decisions, and lowers returns on investments, negatively affecting both material and non-material living standards. Low Inflation or Deflation can lead to reduced consumption and higher unemployment, undermining economic growth and further damaging living standards. Aggregate demand and aggregate supply factors that have affected the level of achievement or non-achievement of the goals Factors Type SSEG FULL EMP LOW INFLATION Disposable AD Low disposable income due to Lower consumer spending Low spending helped moderate Income inflation and rising interest rates reduced demand for labour, inflationary pressures, but reduced consumption, slowing slowing employment growth. inflation remained above target. GDP growth. Interest AD Rising interest rates (RBA policy) Higher borrowing costs Helped contain inflation by Rates reduced household spending and discouraged business reducing demand, but inflation business investment, slowing expansion, limiting job remained high due to supply-side growth to ~1%. creation. pressures. Consumer AD Low consumer confidence (89.8 Lower demand for goods and Slowed demand-driven inflation, Confidence points) reduced consumption, services limited job creation, though cost-push factors kept further slowing growth. preventing further inflation above target. unemployment reduction. UNIT 3 AOS2 Business AD Lower business confidence Discouraged firms from hiring, Lower investment in supply-side Confidence reduced investment, limiting impacting job creation and capacity limited the economy's growth in capital expenditure and slowing reductions in ability to meet demand, production. unemployment. contributing to inflation. Exchange AD/ Depreciation of the AUD Mixed effects—boosted Increased the cost of imported Rate AS increased costs of imports, slowing export demand, supporting goods, contributing to (Depreciati growth due to higher input costs employment in export sectors, cost-push inflation. on) for businesses. but higher import costs hurt import-reliant sectors. Global AD Slow global growth reduced Slower global demand Lower global demand moderated Economic demand for Australian exports, reduced job opportunities in demand-pull inflation, but Growth limiting GDP growth. export-driven industries. domestic supply issues kept inflation elevated. Costs of AS Higher costs of production, Increased costs led to fewer Cost-push inflation occurred as Production including rising wages and input new hires and restrained job businesses passed on higher (Labour, prices, limited businesses’ ability to creation, keeping costs to consumers, contributing Inputs) expand, reducing growth. unemployment at 4.2%. to rising prices. Productivit AS Slower productivity growth Limited productivity gains Lack of productivity gains y Growth limited increases in output, restricted labour market contributed to rising production constraining economic growth efficiency, slowing job costs, leading to cost-push potential. creation. inflation. Climatic AS Adverse weather conditions Reduced agricultural Supply shocks from climatic Conditions disrupted agricultural output, production led to job losses in conditions contributed to (Droughts, slowing overall economic growth. affected regions. cost-push inflation, especially Floods) for food prices. UNIT 3 AOS2 EXAMPLER QUESTIONS: 8. Explain how low levels of consumer confidence would affect the circular flow model of income. Consumer confidence refers to the degree of optimism consumers feel about the state of the economy. Consumer confidence is currently low at 89.8 points as it is below its neutral value of 100 points. As consumers are more pessimistic about the future state of the economy this means there will be lower levels of consumption in the economy and therefore, likely to be high levels of saving. A higher level of savings will indicate an increase in leakages from the financial sector. Thus, with increased leakages this means there is a decrease in expenditure from households into the business sector, causing a decrease in production from the business sector. Therefore, causing less demand for resources of land, labour and capital to enter the business sector, causing a decrease in incomes to the household sector. 9. What is one aggregate demand and aggregate supply factor currently contributing to slower economic growth in Australia? Consumer confidence, which refers to the degree of optimism consumers feel about the state of the economy is currently contributing to slower economic growth. Consumer confidence is low at 89.8 points which is below the neutral value of 100 points indicating that consumers are quite pessimistic about the future state of the economy potentially as inflation has remained high. This suggest that households are more likely to save their money them spend. Therefore, this will decrease consumption which will contribute to a decrease in aggerate demand. Producers will respond to the fall in aggregate demand by producing less which will decrease production as measured by GDP, thus contributing to slower economic growth in Australia with the annual GDP rate at 1%. Cost of production in the form of labour costs are an aggregate supply factor that is contributing to slower economic growth. Recently, minimum wage has increased from $23.23 to $24.10, meaning firms will need to pay their workers more per hour. This causes a rise in labour costs for businesses, increasing their cost of production. A rise in cost of production will decrease firms' profitability which will decrease their willingness to supply and aggregate supply. A decrease in aggerate supply will mean producers will produce less causing a decrease in production as measured by GDP. This, contributing to the slow rates of economic growth which annual GDP at 1%. 10. What are 2 consequences of not achieving each of the government’s macroeconomic goals? SSEG: The goal of strong and sustainable economic growth is the highest growth rate possible consistent with strong employment growth without running into environmental, external and inflationary problems. A consequence of not achieving this goal, and economic growth being “too strong” is high inflation. This will erode individuals purchasing power as each good and services takes up a larger proportion of their income, decreasing individuals' material living standards as they have less access to goods and services An addition goal of not achieving the goal of SSEG with economic growth being “too weak” ,is high unemployment, as if economic growth is weak, derived demand for labour decreases, causing a rise in unemployment. Therefore, decreasing non-material living standards as with high unemployment, more people will experience stress and anxiety over supporting themselves Low and stable inflation: If we don’t achieve the goal of low and stable inflation which is 2-3% CPI on average over time, if we are higher than this that means prices are rising at a high rate thus this will erode peoples UNIT 3 AOS2 purchasing power, as there disposable income has a lower real value as each good and service takes up a higher proportion of income, this hence would reduce peoples access to goods and services reducing material living standards. If inflation is over the goal this also means our exports now become more less competitive as the general level of prices are higher, and our tradeable sector becomes less competitive as it is less able to compete on price and quality with overseas. Full Employment: The goal of full employment is the level of employment that is consistent with achieving the goal of SSEG whilst avoiding the existence of cyclical unemployment, approximately occurring at the NAIRU at 4.25% If we overachieve the goal of full employment that is below the NAIRU of 4.25% this indicates a “tight” labour marking. Meaning as there are low levels of unemployment, more people have factor incomes that are higher than transfer incomes this means consumption may increase. This contributes to an increase in and AD, and if we are at or near capacity, likely due to the tight labour market with unemployment at 4.2%, means inflation may increase due to high demand. Another consequence if unemployment is above the target of 4.25% this means cyclical unemployment is present means more people are relying on transfer incomes which are low and thus reducing peoples access to goods and services hence material living standards would decrease. 11. Evaluate whether Australia is currently achieving domestic economic stability (the achievement of each of its 3 goals)? LOW AND STABLE INFLATION: The goal of low and stable inflation is to stabilise the Australian currency in relation to purchasing power. It has a target of 2-3% CPI on average over time. Currently, this goal is not being achieved as inflation has been stubbornly above the target range with the June quarter reporting headline inflation at 3.8%. However, in the same quarter in 2023 the figure for inflation was 6% thus reflecting a promising downwards trend of inflation which is optimistic for the future achievement of the goal of low and stable inflation. FULL EMPLOYMENT: The goal of full employment is to achieve strong employment consistent with the government's goal of strong and sustainable economic growth and avoid the existence of cyclical unemployment. It has a target at the NAIRU (non-accelerating inflation rate of unemployment) which is approximately 4.25% unemployment where it is said to be the lowest without contributing to inflationary pressures. Australia's current rate of unemployment at 4.2% is very close to the NAIRU reflecting a successful UNIT 3 AOS2 achievement of this goal. It is obviously desirable for MLS and NMLS to have a situation with low unemployment, where people who want a job, are able to find one. However, this statistic sitting just below the NAIRU which indicates a slight overachievement of the goal and a tight labour market as there is not much spare capacity. This is likely contributing to problematic inflationary pressures within the economy as workers have more bargaining power. Hence, the goal of full employment is being achieved in terms of the NAIRU but may still be contributing to some inflationary pressures within the economy. SSEG: The goal of strong and sustainable economic growth is to achieve the highest growth rate possible consistent with strong employment but without running into external, environmental, or inflationary problems. It has a target of 3% - 3.5% GDP. Australia is currently not achieving the goal of strong economic growth as economic as well below target with GDP being sluggish at 1%, despite this strong employment is occurring with unemployment at 4.2%. Similarly, the economy is experiencing inflationary pressures reflected by the cost-of-living crisis due to persistently high inflation currently at 3.8% which fell from its peak of 7.8%. Hence sustainable economic growth also is not being achieved. Ultimately the goal of strong and sustainable economic growth is not being achieved. UNIT THREE AOS3 - AUSTRALIA AND THE INTERNATIONAL ECONOMY Gains from International Trade 1. Lower Prices: Trade allows countries to import cheaper goods, reducing prices for consumers and increasing competition. 2. Greater Choice: Consumers have access to a wider variety of goods and services from other countries. 3. Access to Resources: Nations can import resources they lack and specialise in what they produce best. 4. Economies of Scale: Access to larger markets enables firms to produce more efficiently and reduce costs. 5. Increased Competition and Efficiency: Trade pressures firms to innovate and use resources efficiently, boosting productivity. The balance of payments and its components The Balance of Payments (BoP) records all economic transactions between a country and the rest of the world over a period. It has two main components: Credits: Inflows of money, which increase the country’s foreign currency reserves (e.g., exports). Debits: Outflows of money, which decrease the foreign currency reserves (e.g., imports). 1. Current Account: Records trade in goods and services, income, and current transfers. ○ Goods: Exports and imports of physical goods (e.g., machinery, food). ○ Services: Trade in services (e.g., tourism, financial services). ○ Primary Income: Earnings from investments and wages from abroad. ○ Secondary Income: Transfers such as foreign aid, and remittances. 2. Capital and Financial Account: Records financial flows related to investment and transactions in assets. ○ Capital Account: Transfers of capital (e.g., foreign aid for capital projects). ○ Financial Account: Transactions in financial assets like foreign direct investment (FDI), portfolio investment, and reserve assets. The BoP should theoretically balance, meaning any deficit or surplus in the current account is offset by corresponding flows in the capital and financial account. Cyclical and structural influences on Australia’s current account balance 1. Cyclical Influences Cyclical factors are short-term and driven by the economic cycle, affecting Australia’s current account balance as follows: Commodity Prices: The fall in commodity prices reduced Australia’s trade surplus from AUD 15.9 billion in Q1 to AUD 11.8 billion in Q2 2024, lowering export revenues. Import Growth: Rising imports of goods also contributed to the shrinking trade surplus. Global Economic Conditions: Fluctuations in overseas economic growth impact demand for Australia’s exports, further influencing the current account. 2. Structural Influences Structural factors are long-term and reflect deep-seated features of the economy: Net Primary Income Deficit: Australia has a persistent net primary income deficit, which widened to AUD 22.5 billion in Q2 2024. This is largely due to higher interest payments on Australia’s foreign debt. Commodity Dependence: Australia’s heavy reliance on commodity exports makes its current account sensitive to changes in global demand and prices for these goods. 3. Long-Term Trends Australia has a history of current account deficits, averaging around -3.1% of GDP since 1959. While it saw a surplus in 2021, defi

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