Economics 1000 tutorial pdf

8/22/2019 Economics 1000 tutorial pdf

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ECO1000

Economics

Faculty of Business and Law

Study book


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Published byUniversity of Southern QueenslandToowoomba Queensland 4350

Australia

http://wwwus!eduau

" #ni$e%sity of Southe%n &ueensland' (01)(

Copy%i*hted mate%ials %ep%oduced he%ein a%e used unde% the p%o$isions of the Copyright Act1+,- as amended' o%as a %esult of application to the copy%i*ht owne%

.o pa%t of this publication may be %ep%oduced' sto%ed in a %et%ie$al system o% t%ansmitted in any fo%m o% by any

means elect%onic' mechanical' photocopyin*' %eco%din* o% othe%wise without p%io% pe%mission

%oduced by Lea%nin* esou%ces e$elopment usin* the 2CE ublishin* System


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3able of contents

a*e

Module 1 !ntrodu"tion to e"onomi"s 1Lea%nin* ob4ecti$es 1Lea%nin* %esou%ces 1

3e5t 1Essential 1

11 2nt%oduction 1111 3he economic way of thinkin* (11( 3he lan*ua*e of economics )

1( 3hinkin* like an economist )1(1 Economic models 6

1) #sin* *%aphs in economics 716 %oduction economics ,

161 Sca%city and oppo%tunity cost ,

Summa%y +

Module # $ow the mar%et wor%s 11Lea%nin* ob4ecti$es 11Lea%nin* %esou%ces 11

3e5t 11

Essential 11(1 2nt%oduction 11(( 3ools of analysis: demand 1(

((1 3he concept of demand 1(((( 3he demand cu%$e 1((() 3he downwa%d8slopin* demand cu%$e 16((6 9o$ements alon* and shifts of the demand cu%$e 16((7 easons fo% the demand cu%$e to shift 17

() 3ools of analysis: supply 17()1 3he concept of supply 17()( sin*le fi%m;s supply 1,()) 9a%ket supply 1eview @uestions (-(' at the end of chapter ) 5check youranswers with those from the tudy1esk6

&)& +nswer roblems and +pplications (, &, ), A, C, H, (', ((, (&, (), (A, (B,(C, (D, (I, (H, &' at the end of chapter ) 5check your answers with thosefrom the tudy1esk6

(7 Elasticity

(71 2nt%oduction

3n our development of the tools of analysis above, we have used a downward-sloping demand

curve and an upward-sloping supply curve hen changes in price or other economicvariables occurred, we focussed on the direction of the resulting effect on prices and

University of Southern Queensland


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ECO1000 Economics 21

quantities, rather than on the responsiveness of the dependent economic variable 3f we had ameasure of responsiveness of one economic variable to a change in another 5for example, theresponsiveness of quantity demanded to a price change6, we could take out analysis to the

next level and reach more useful conclusions

"lasticityis a measure of responsiveness 3n this section of the module, we introduce theconcept of elasticity, study the calculation and interpretation of various elasticity measures,and see how knowledge of elasticity can be used in market analysis

(7( 3he concept of elasticity

2lasticity is a measure of responsiveness 3t is a measure of the responsiveness in oneeconomic variable 5the dependent variable6 to a change in another economic variable 5theindependent variable6 0or example, consider the .own-price/ elasticity of demand; this is a

measure of the responsiveness in the quantity demanded of a good to a change in its priceOr, consider the price elasticity of supply; this is a measure of the responsiveness in quantitysupplied of a good to a change in the price of the good =learly, the responsiveness in eithercase could be high or low *he measure that we calculate for the elasticity indicates to us therelative si8e of the responsiveness *here are many measures of elasticity that we couldcalculate using appropriate economic variable !ere we focus on some of the most commonones

(7) %ice elasticity of demand

Price elasticity of demandis a measure of the responsiveness in quantity demanded of agood to a change in the price of that good *he calculation is straightforward, but theresultant elasticity does require correct interpretation

(76 C%oss8p%ice elasticity of demand

=ross-price elasticity of demand is defined as the responsiveness in the quantity demanded ofa good to a change in the price of another good *he value calculated for the cross-priceelasticity of demand may be positive or negative, and high or low 3f the value calculated is

positive, the goods are substitutes; if the value is negative, the goods are complementsNnowledge of cross-price elasticities may help in defining industries and seeing the strengthof the cross-price link between goods 0or example, the cross-price elasticity of demand

between *oyota four-wheel drives and 7itsubishi four wheel drives would be of interest tofirms producing those vehicles as they determine their pricing policy

(77 2ncome elasticity of demand

!ncome elasticity of demandis defined as the responsiveness in quantity demanded of agood to a change in money income *he value calculated for income elasticity of demandmay be positive or negative, and high or low *he sign for the calculated value tells whetherthe good is a normal one 5positive value6 or an inferior one 5negative value6 Nnowledge of



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22 ECO1000 Economics

this elasticity would be of use to business and governments seeking to cater for populationswith rising incomes

(7, %ice elasticity of supply

*he price elasticity of supply 5often 9ust the elasticity of supply6 is defined as theresponsiveness in quantity supplied of a good to a change in the price of that good *hiselasticity may be of high or low value, and various cases are distinguished in terms of thatvalue 3t is of interest to market analysts as they consider supply responses; for example, thechange in the quantity of oil supplied to the world market as the price of oil rises

eadin* acti$ity ((

tudy chapter A of the text 5!ubbard et al6

7ake sure that you can:

define and calculate .price elasticity of demand/

explain the midpoint formula for the calculation of price elasticity ofdemand

distinguish among elastic demand, inelastic demand and unit elastic demand

outline the determinants of price elasticity of demand

interpret calculated price elasticities of demand

explain why price elasticity of demand varies along a straight line demandcurve and the relationship between price elasticity and total revenue

define .cross-price elasticity of demand/

define the terms .complements/ and .substitutes/ in terms of the cross-priceelasticity of demand

interpret calculated cross-price elasticities

define .income elasticity of demand/

define the terms .normal/ and .inferior/ goods in terms of income elasticityof demand

interpret calculated income elasticities of demand

define price elasticity of supply

understand the determinants of the price elasticity of supply

distinguish and illustrate the various cases of elastic and inelastic supply

interpret calculated supply elasticities



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Lea%nin* acti$ity ((

?%: *his is the essential set of exercises 3f you have additional time, you

should practise the qui88es and tests in 7y2conlab

&D( +nswer >eview @uestions (-(& for chapter A 5check your answers withthose from the tudy1esk6

&D& +nswer roblems and +pplications (, &, ), A, B, C, D, I, H, (', (&, (), (B,(D, (I, (H for chapter A 5check your answers with those from thetudy1esk6

(, Economic efficiency and ma%ket failu%e?ow that we have developed a number of the tools used by economists, let us turn ourattention to the use of those tools 3n this section of the module, we explore the effects ofgovernment policy to control prices in a market, the economic impact of taxes and theinteresting question of why markets may fail to provide desirable outcomes in an economy%efore we go into all these applications, we introduce the concepts of consumer and

producer surplus first

(,1 Consume% and p%oduce% su%plus and economic efficiency

#onsumer surplusis the difference between the highest price a consumer is willing andable to pay and the price the consumer actually pays

Producer surplus is the difference between the lowest price a firm would have been willingand able to accept and the price it actually receives

hen equilibrium is reached in a competitive market, the marginal benefit from the last unitsold will equal the marginal cost of producing that last unit *his is an economically efficientoutcome

3f less than the equilibrium output were produced, the marginal benefit of the last unit bought

would exceed its marginal cost

3f more than equilibrium quantity were produced, the marginal benefit of this last unit wouldbe less than its marginal 5opportunity6 cost

"conomic surplusis the sum of consumer and producer surplus 2conomic surplus, or thenet benefit to society from the production of a good or service, is maximised at equilibriumin a competitive market 5when there are no externalities6

$ deadweight lossis the reduction in economic surplus resulting from a market not being incompetitive equilibrium



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"conomic efficiencyis a market outcome in which the marginal benefit to consumers of thelast unit produced is equal to its marginal cost of production, and where the sum of consumerand producer surplus is at a maximum

(,( %ice floo%s and p%ice ceilin*s

*hough the total benefit to society is maximised at a competitive market equilibrium,individual consumers would be better off if they could pay a lower than equilibrium price,and individual producers would be better off if they could sell at a higher than equilibrium

price=onsumers and producers sometimes lobby government to legally require a marketprice different from the equilibrium price *hese lobbying efforts are sometimes successful

+ price flooris a legally determined minimum price that sellers may receive

rice floors were established in agricultural markets in the J+, 2uropean Jnion 52J6 andin many other countries in response to pleas from farmers who could sell their product onlyat low prices

+ price ceilingis a legally determined maximum price that sellers may charge

3t is reported that Eene8uelan resident !ugo =have8$s policy of keeping a tight control onfood retail prices have caused severe food shortage in recent years

(,) 3he economic impact of ta5es

e are now in a position to return to market analysis and to see how knowledge of elasticityenables us to draw useful conclusions about market changes !ere we focus on the effects ofa tax 5such as a sales tax6 imposed on the sale or the production of goods and services

+ tax on the sale of a good or service also results in a reduction of economic efficiency 0orexample, if the federal government were to impose an additional tax on cigarettes of F(''

per pack, this would decrease the supply 5shift the supply curve of cigarettes to the left, orshift it up by F(''6 *he tax would result in a loss of consumer and producer surplus omeof the reduction of consumer and producer surplus becomes government revenue and the restis a deadweight loss, which is referred to as the excess burden of the tax

*he incidence of a tax is the actual division of the excess burden between producers andconsumers in the market *he tax incidence varies depending on how responsive producersand consumers are to the price change caused by the tax 5ie, elasticities of demand andsupply6



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eadin* acti$ity ()

tudy chapter B of the text 5!ubbard et al6


explain the concepts of consumer surplus and producer surplus

explain the concepts of marginal benefit and marginal cost

explain and illustrate the concept of economic efficiency

explain and illustrate the effect of the policy of setting a price floor in amarket

explain and illustrate the effect of the policy of setting a price ceiling in amarket

illustrate the effect of taxes on economic efficiency

define the term ta% incidence

use a supply and demand diagram to illustrate the tax incidence of a unit tax5tax placed on each unit of a good6 in terms of prices paid and received, andin terms of tax paid by buyers and sellers

discuss the importance of demand and supply elasticity for thedetermination of the tax paid by buyers and sellers when a unit tax isimposed

Lea%nin* acti$ity ()?%: *his is the essential set of exercises 3f you have additional time, youshould practise the qui88es and tests in 7y2conlab

&I( +nswer >eview @uestion (-(& at the end of chapter B 5check youranswers with those from the tudy1esk6

&I& +nswer roblems and +pplications (, &, ), A, B, D, I, H, (', ((, (A, (D,(H, &' at the end of chapter B 5check your answers with those from thetudy1esk6

Summa%y

3n this module, we introduced a number of important tools for use in economic analysis*hese were the concepts of demand, supply, market equilibrium, consumer surplus, producersurplus and elasticity Jse of these concepts, often in terms of graphical analysis, enables usto work out the effects of changes in a competitive market in terms of changes in prices,quantities, and revenues e are now able to use the economic way of thinking to analyse awide range of market situations



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9odule ) A Fi%ms and ma%ket st%uctu%e

Lea%nin* ob4ecti$es

On successful completion of this module, you should be able to:

explain the concepts of .explicit/ and implicit/ costs

use the law of diminishing returns to explain and illustrate the short-run productionfunction

explain the relationship between short runcosts and output in terms of total, average,and marginal cost curves

explain the relationship between marginal and average costand between marginalproductand marginal cost

explain the construction and shape of the firm/s long runaverage cost curve

explain the model of perfect competition

explain the model of monopoly

discuss the efficiency issues in both perfectly competitive market and monopoly market

Lea%nin* %esou%ces

3e5t

!ubbard et al &'(),Economics, chapters C, D and I

Essential

Study book:module )

)1 2nt%oduction

3n modules ( and &, we used the concepts of the production possibilities frontier, the supplycurve, and market equilibrium without going into much detail about the underlyingeconomics 3n this module, we will explore the economics of production, costs and themarket structuresof perfect competition and monopoly

Our earlier analysis of market equilibrium assumed a market structure of perfect competition:

one in which there are many buyers and sellers and in which no individual buyer or seller hasany market power over price



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3n this module, we add to our study of economic models by examining the model of perfectcompetition *his is the well-known model of the .free market/; a model which lies at theheart of much of the argument about the need to make actual markets more competitive

*o understand the operation of this model, we need to consider carefully the relationshipsbetween production and cost in both the short run time period and the long-run time periodOnce we know a typical firm/s short run and long run cost functions 5the relationships

between cost and output6, we can combine this information with information about therevenue function 5the relationship between output and revenue6 to work out how muchoutput a firm will be willing to supply 0rom this, we can deduce the shape of the marketsupply curve which is used in market analysis

+ monopoly is a firm that is the only seller of a good or service that does not have a closesubstitute 0or a monopoly to exist barriers to entering the market must be so high that noother firms can enter + monopolist will produce less and charge a higher price than would a

perfectly competitive industry producing the same good *he monopolist/s profit-maximisingprice exceeds marginal cost *he monopoly equilibrium is neither productively efficient norallocatively efficient

*here are a number of production, cost and revenue concepts to be understood in thismodule e begin with production and costs in the two time periods and then turn to theanalysis of the perfectly competitive firm and market

)( 3he concept of cost %e$isited

3n module one, we introduced the concept of opportunity cost Opportunity cost is animportant consideration when business decisions are made 7ost people would be familiarwith the basic idea of business costs, which would include wages for workers, materials,other production costs, and capital costs for buildings and equipment *hink of these asaccountingcosts, or the payments for actual things; that is think of them as e%plicit costs%usiness profit is calculated as:

>evenue 5or income6 < accounting costs M profit

udio: e5plicit costs

explicit costs

*his seems quite simple, but economists believe that such a simple calculation misleads thebusiness person *he economic question is: what has the business owner foregone in order tobe in a particular business4

uppose that ally earns F('' ''' a year as a corporate economist, but like many peopleshe wants to .be her own boss/ he buys a small business for F)'' ''', using funds sheinherited !owever, she realises the new business can only afford to pay her a managingdirector/s salary of FI' ''' ally is .paying/ an implicit costfor her decision to be an

owner operator *his implicit cost is the F&' ''' a year in her personal income 5F('' '''< FI' '''6 that she foregoes



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he also foregoes interest income by investing her funds in the business, rather than infinancial assets uppose that the current interest rateis (' *his is taken to be thereturn on the best alternative use of her funds ally could be earning F)' ''' a year

from a financial investmentof F)'' ''' at (' per year

3n total, the annual implicit costshe incurs by investing in the business is:

F&' ''' G F)' ''' M FB' ''' per year

*his cost should be added to the explicit accounting cost to give the economic costofchoosing the business option *hat is:

"conomic cost & accounting cost5explicit costs6 G implicit cost5implicit costs6

udio: economic costseconomic costs

udio: implicit costs

implicit costs

*his does not mean that business people should slavishly follow such a principle and alwayspursue the alternative yielding the highest return eople go into business for all sorts ofreasons, including 9ob satisfaction, the desire for independence and to create family assets 3naddition, in some years, profits will be down compared to other investments, so theopportunity cost will be higher, but you would not necessarily sell out to pursue always theshort term best option *here are costs in transferring assets and skills *here may also betaxation benefits in having a business which yields a better return than salaries, although thiscan be overestimated *he important point to note is that as a business person, you shouldknow what the options are and how much your choices really .cost/ !arsh as it may seem, ifyou stay in an enterprise that has a persistent negative economic profit, you might havedifficulty Over time, the temptation to pursue better options will increase

3n summary, in economics we measure costs as opportunity costs including explicit costs andimplicit costs 2xplicit costs are the payments to non-owners of a firm for their resources,eg, wages, lease payments, cost of materials, etc 3mplicit costs are the opportunity coststhat do not require an outlay of money by the firm, eg, the use of the owner$s time, moneyand car for production



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)) 3he sho%t %un p%oduction function

2conomists usually consider the economics of a firm/s production in two time periods *heshort run is that time period in which at least one of the firm/s inputs is fixed in quantity *helong run time period is that time period in which all of a firm/s inputs can be considered to

be variable in quantity *his leads to the classification of inputs as variable or fixed,depending on the time period in question

"iven this time period distinction, we can speak of the firm/s short and long run productionfunctions, where a production function refers to the relationship between the inputs used by afirm and the output it produces *hese production functions become the basis for the firm/scost functions in the long and short run time periods

3f we assume that labour and machine capital are the only two inputs for a firm and thenumber of machines is fixed *he marginal product of labour is the additional output thefirm produces as a result of hiring one more worker *he law of diminishing returns statesthat at some point, adding more of a variable input, such as labour, to the same amount of afixed input, such as capital, will cause the marginal product of the variable input to decline

*he average product of labour is the total output produced by a firm divided by the quantity

of workers hen the average product is rising, the marginal product is above theaverage product; when the average product is falling, the marginal product is belowthe average product *herefore, the marginal product curve cuts the average product curveat the point where the average product is at its maximum

)6 Sho%t %un cost functions

ith our knowledge of the short run production function, we can turn to a consideration of afirm/s short run cost function *his is the relationship between a firm/s output and costs *hecost function can be displayed in terms of its output and total costs 5 total fi%ed cost' totalvariable costand total cost6, or in terms of its output and its average costs 5average fi%edcost, average variable coast, and marginal cost6 e need to understand the shape of thetypical cost curves 5functions6 and to appreciate that there are geometrical relationships

between the various cost curves that need to be observed when we draw and interpret thecost relationships

arginal costis the change in a firm/s total cost from producing one more unit of a good orservice *he law of diminishing returns explains why the marginal cost curve is J-shaped*he relationship between marginal cost and average total cost can be explained as: when 7=is below +*=, +*= will fall; when 7= is above +*=, +*= will rise; 7= curve cuts +*=curve when +*= is at its lowest point; the +*= curve is J-shaped because 7= is J-shaped*he same reasoning applies to the relationship between 7= and +E=



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)7 Lon* %un a$e%a*e cost

3n the long run period, all inputs are variable =onsequently, all costs are variable as well0or this time period, economists use the concept of long run average cost to represent thelong run cost function *his cost function is typically J-shaped and is formed by the lowest

portions of the set of short run cost functions that enable production at least cost as output isincreased +s we explore the long run cost function, we need to note that the long run isessentially a firm/s planning period Once a decision has been made to build a certain si8e of

plant, the firm is operating in the short run

eadin* acti$ity )1

tudy chapter C of the text 5!ubbard et al6


understand the concepts of $short run$ and $long run$

define total cost, variable cost and fixed cost

define the terms .explicit/ and e%plicit cost

explain the concept of a .production function/

calculate average cost

explain the concepts of .marginal product/ and $average product$

state the law of diminishing returns

explain the relationship between marginal and average product define and calculate average marginal cost, fixed cost, average variable cost,

and average total cost

explain and illustrate the relationship between marginal cost and averagecost

interpret graphs showing either total cost curves, or average cost curves

explain and illustrate a firm/s long run average cost curvein terms of aseries of short average run cost curves

explain the typical shape of the long run average cost curve in terms of.economies/ of scale; .diseconomies/ of scale and .constant returns/ toscale



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Lea%nin* acti$ity )1



)A( +nswer >eview @uestions (-(' for chapter C 5check your answers withthose from the tudy1esk6

)A& +nswer the study questions and problems (, ), A, B, C, D, I, (', ((, (&,(), (A, (B, (I, &' for chapter C 5check your answers with those from thetudy1esk6

), 3he model of pe%fect competition

),1 2nt%oduction

*his is one of the most well-known models of the standard microeconomics literature 3tdeals with a market structure in which there are many buyers and sellers, and in which no

buyer or seller has any power over the price in the market #ike all models, there are anumber of assumptions made about this market structure "iven these assumptions, a numberof important conclusions about firm and industry pricing and production follow e will findthat, although it might be somewhat unrealistic in terms of typical market structures in

existence today, it still provides a very useful beginning to our study of the way in suchcompetitive forces work

3n our study of this model, we will look at the firm and the market 5industry6 in both the shortand the long run periods e will use our knowledge of cost functions for these periods tosee how firm/s decide on their choice of output, and how these choices flow into industrysupply *his will complete our understanding of the economics .beneath/ the market supplycurve that we have met already in the previous module

),( 3he pe%fecti$ely competiti$e model: in the sho%t %un

3n a perfectly competitive market, each individual firm is a price taker and its demand curveis hori8ontal, which is different from the downward-sloping market demand curve *heindividual firm cannot decide the market price, but it can decide its optimal output level

based on its marginal cost information to maximise the profit

*he profit is maximised at the output where the difference between total revenue 5*>6 andtotal cost 5*=6 is the largest 3t is equivalent to say that the profit is maximised at the level ofoutput where the firm$s marginal cost equals the market price

*he firm will make an economic profit if P +*= *he firm will break even if M +*=*he firm will experience a loss if Q +*=

3n the short run, the firm will stay in the business if P+E= *he firm will shut down ifQ+E= *here is no difference for the firm to shut down or to continue to operate if



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M+E= o the firm$s marginal cost curve is its supply curve only for prices at or aboveaverage variable cost *he market supply curve is the hori8ontal sum of the individual firms$supply curves

),) 3he ent%y and e5it of fi%ms in the lon* %un and efficiencies inpe%fect competition

hile entry into, and exit from, the industry is not possible in the short run 5firms ad9ust bychanging their output6, in the long run firms may exit the industry and new firms may enter3f a firm cannot make a normal profit 5a term that means 8ero economic profit or breakeven6, it will leave the industry 3f firms outside the industry observe that more than normal

profits are made within it, they will seek to enter the industry =onsequently, in the long runthere are both industry and firm ad9ustments to consider *his makes the analysis slightlymore complicated

+ long-run supply curve represents the relationship between market price and the quantitysupplied 3ts position is determined by the minimum point of the +*= curve 3n the long run,the +*= could increase, decrease or remain constant *herefore, the long-run supply curvecould be upward sloping, downward sloping or hori8ontal

erfect competition can be used as a benchmark to compare with other market structuressuch as monopoly 3n the absence of external cost or benefits a perfectly competitive marketcan achieve allocative efficiency in both short run and long run as the price is equal to themarginal cost5M7=6, meaning that the scarce resources are allocated in accordance with thewishes of consumers roductive efficiency also occurs when price equals the minimum ofaverage total cost 5Mmin+*=6 *his may not be achieved in the short run, but productiveefficiency is attained in the long run in perfect competition

roductive efficiency is the situation in which a given quantity of a good or service isproduced using the least amount of inputs 5Mmin +*=6

+llocative efficiency is a state of the economy in which production reflects consumerpreferences; in particular, every good or service is produced up to the point where the lastunit produced provides a marginal benefit to consumers equal to the marginal cost of

producing it 5M7=6

1ynamic efficiency is the ability for firms over time to develop and utilise technologicalinnovation, and to adapt their product to changes in consumer preferences and tastes!owever, it is debatable whether a firm in a competitive environment is more innovative or amonopoly firm tends to be more innovative



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eadin* acti$ity )(

tudy chapter D of the text 5!ubbard et al6


describe the characteristics of the market structure of perfect competition

explain why a perfectly competitive firm is a pricetakerand that itsdemand curve is perfectively elastic

explain and illustrate why a perfectly competitive firm maximises profit 5orminimises losses6 when marginal revenue is equal to marginal cost, or totalrevenue minus total cost is a maximum

explain why a perfectly competitive firm will .shut down/ if the price fallsbelow average variable cost

explain and illustrate the construction of perfectly competitive firm/s shortrun supply curve

explain and illustrate the construction of the perfectly competitive industry/ssupply curve

explain why a perfectly competitive firm in long run equilibrium makes 8eroeconomic profit 5normal profit6

explain why a perfectly competitive industry is in long run equilibriumwhen each firm is producing an output for which price is equal to short runmarginal cost, short run average total cost and long run average cost

explain productive, allocative and dynamic efficiencies

Lea%nin* acti$ity )(

?%: *his is the essential set of exercises 3f you have additional time, youshould practise the qui88es and tests in 7y2conlab

)C( +nswer >eview @uestions (-(& for chapter D 5check your answers withthose from the tudy1esk6

)C& +nswer roblems and +pplications (, &, ), B, C, D, I, H, (', ((, (&, (),(A, (C, (D, (I, (H for chapter D 5check your answers with those from thetudy1esk6

)< 9onopoly ma%kets

)


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be very useful +s with the perfect competition model, which provides a benchmark for howa firm acts in an industry where many firms supply identical product, monopoly provides a

benchmark for the other extreme, where a firm is the only supplier and faces no competition

from other firms

*here are higher barriers in the monopoly market which prevent other firms from entering*he barrier could be created by the government, for example, blocking the entry of more thanone firm into a market, or because the firm controls over a material necessary to produce a

product *he barriers could also result from important network externalities and economiesof scale

*he monopoly firm is a price maker %ut it is constrained by the downward-sloping demandcurve + monopoly firm/s demand curve is the market demand curve + monopoly firmmaximises profit by producing the level of output where marginal revenue equals marginalcost

lease note that profit is not guaranteed in a monopoly market 3f the demand is very lowwhile the firm$s +*= is very high, the firm could make a loss !owever, if the monopolist/s

price exceeds its average total cost at the output where marginal revenue equals marginalcost, it will earn an economic profit %ecause of high entry barriers new firms will not beable to enter the market, so if other things remain the same, the firm will be able to continueto earn economic profits, even in the long run

+ monopolist will produce less and charge a higher price than would a perfectly competitiveindustry producing the same good *he monopolist/s profit-maximising price exceedsmarginal cost 5P7=6 and the firm does not produce at the minimum point of +*= 5Pmin+*=6 *hus the monopoly equilibrium is neither productively efficient nor allocatively

efficient

)


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dynamic efficiency should be given the highest priority, followed by productive efficiency+s a result, allocative efficiency is said to be of less policy importance 5a normativestatementR6 !aving done this module, students should be able to formulate their own

argument on this issue

eadin* acti$ity ))

tudy chapter I of the text 5!ubbard et al6


explain entry barriers created by government action, control of keyresources, network externalities and natural monopoly

explain and illustrate how a monopoly firm determines its output and price

explain and illustrate consumer surplus, producer surplus and deadweightloss in a monopoly market

Jnderstand the concept of $market power$

explain why there is a need to regulate collusive behaviour and mergeractivities

Jnderstand the practices in regulating natural monopolies

Lea%nin* acti$ity ))



)C( +nswer >eview @uestions (-(& for chapter I 5check your answers withthose from the tudy1esk6

)C& +nswer roblems and +pplications (, &, ), A, D, I, H, (', ((, (&, (), (A,(B, (C, (D, (H, &' for chapter I 5check your answers with those from thetudy1esk6

Summa%y

3n this module, we have explored the concepts of short and long run production and costfunctions and used these in the analysis of two extreme market structures: perfectcompetition and monopoly e have seen how a firm/s short run cost curves may bedisplayed in terms of total or average costs and that there are definite geometric relationships

between the various cost curves *he long run cost curve was displayed in terms of the longrun average cost curve 3n the short run, the shape of the cost curves 5apart from the fixedcost curve6 reflects the operation of the law of diminishing returns 3n the long run, it is the

presence of economies and diseconomies of scalethat determines the shape of the averagecost curve



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=ombining our knowledge of short and long run costs with the revenue function of a firm inthe market structure of perfect competition, we developed the firm/s, and industry/s, shortrun supply curve and explored the long run ad9ustment of the firm and the industry *his

analysis of the perfectly competitive market has given us insight into the operation of acompetitive firm and the implications of this operation for the supply curve in a competitivemarket *his is the supply curve we used in module two when exploring market analysis interms of demand and supply e now know something about the economics of supply

3n a monopoly market, we have shown that deadweight loss is created as a result of higherprice and lower output than those in a perfectly competitive market *herefore, governmentplays an important role in safeguarding consumer welfare and promoting competition in animperfectly competitive market



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9odule 6 A 9ac%oeconomic Foundations

Lea%nin* ob4ecti$es


explain how total production in an economy is measured

discuss problems encountered in the measurement of economic activity

calculate nominaland real valuesof selected economic variables

understand how the economic growth rate is measured

discuss the importance of long-run economic growth and its impact on living standards

define and calculate the unemployment rate and the labour fore participation rate

explain the economic costs of unemployment

identify the types of unemployment and explain what factors determine the natural rateof unemployment

define the price level and the inflation rate, and understand how they are calculated

discuss the measurement and causes of inflation

Jnderstand the difference between demand-pull and cost-push

understand what happens during business cycles and their relationship to long-runeconomic growth

discuss the determinants of aggregate demand and aggregate supply

use the aggregate demand and aggregate supply mode to illustrate the difference betweenshort-run and long-run macroeconomic equilibrium

use the dynamic aggregate demand and aggregate supply model to analysemacroeconomic conditions

Lea%nin* %esou%ces

3e5t

!ubbard et al &'(),Economics, chapters H, (' and ((

Essential

Study book:module A



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61 2nt%oduction

3n this module, we swing our attention to the economy as a whole 3n the previous modules,we considered the activities of single markets that exist within a much larger set of marketsand associated economic activity *his is something like flying over a forest and looking atits wide extent, rather than being inside the forest and looking at the individual trees ?owwe are concerned with the overall si8e of the forest and at the rate at which it is changing insi8e !owever, we will speak of the rate of economic activity, and the rate of growth of thatactivity, rather than si8e and growth of a forest

*his field of economics is often called macroeconomics, to distinguish it from the fieldknown as microeconomics which deals with specific product, service or factor markets eneed to be aware, however, that this distinction is a modern one, and that the two fields ofeconomics are really different ways of considering the same economy 3t does not do to putthese fields into separate, never to be linked, compartments +fter all, the forest is made upof separate trees, and the separate trees are parts of a much larger whole

3n dealing with the economy as a whole, we have to think about the totality of economicactivity and to develop ways of making sense of it 3t is a rather sobering to be reminded that

prior to the (H)'s there were few measurements available of the si8e of an economy 3t isonly since then, and after the pioneering work of Sohn 7aynard Neynes 5The !eneralTheor" of Emplo"ment# $nterest and %one"(H)D6 that more refined tools of economicanalysis were available *oday, we speak of *Pand rates of growth of "1 with almostno appreciation of what these terms really mean and what pitfalls await the unwary as theyuse them very casually erhaps the protestors against globalisation have a point: what is the

purpose of trying to grow as fast as possible in terms of "1 growth4 3s the measure, and theunderlying concept of macroeconomic activity, valid4

e turn to an examination of key macroeconomic performance data and its potential use forthe design of macroeconomic policy in this module

6( = measu%es total p%oduction

6(1 9easu%in* the si>e of the total p%oduction

0ollowing the experience of the "reat depression of the (H)'s, when world economicactivity fell to very low levels and high levels of unemployment were widespread, the needfor macroeconomic data was obvious *his ushered in the development of nationalaccounting systems; systems which enabled the consistent measurement of macroeconomicvariables, such as "ross 1omestic roduct 5"16 3t was thought that if reliable measures ofthe si8e and growth of the economic activity were available, policy-makers would be able toensure that another great depression did not occur 1ata available today for many countries isthe result of the theoretical and statistical work in the field of macroeconomics hile therehas not been another great depression, there has been much debate on the question of theappropriate measurement of economic activity +s a result, we are in a much better positiontoday in our endeavour to .take the pulse/ of the economy



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3n this section of the module, we consider the components and the measurement of "1*hese are important building blocks for our later work in which we seek to explain how thesi8e of the circular flow changes over time

6(( 3he ci%cula% flow model of an economy

2arly economists talked about the idea of a .wheel of circulation/ erhaps they had in mindsomething like the great rotations of the planets, as did early viewers of the cosmos #atter-day economists have fashioned this idea into that of the circular flow of economic activity 3tis an intuitively appealing idea for we all have some appreciation of it e know that incomeis earned in various ways in various activities, and that income is spent in turn on a range ofgoods and services, themselves the output of countless other economic activities o, itmakes some sense to us to speak of a circular flow of activity within an economy with easilyrecognised boundaries e can sit back, close our eyes, and think of all the many activities

that go to make up the finished goods and services and make them available to finalpurchasers 3t is a very complex mosaic; but the idea of the circular flow helps to make senseof the overall activity that goes on every hour in any economy

*he circular flow is usually represented by a simple diagram that shows the ma9or, aggregateflows in an economy *hese diagrams can be made very complex; but that might defeat the

purpose of the exercise Our aim is to develop a workable understanding so that we canmeasure the si8e of the flow and its rate of growth e note that underlying this idea of theflow lies that of the economy as a system *hat is, of something that is characterised byinput-output relations *his is very convenient for mathematicians and modellers, and hasmuch to offer us !owever, we must ask at some stage about the validity of the mathematicalanalogy e might note that implied recognition of the environment as a .sink/, into which

waste is channelled, maintains this essential .input-output/ conception of overall economicactivity

*herefore, when we measure the value of total production in the economy by calculating"1, we are simultaneously measuring the value of total income "1 is the market value ofall final goods and services produced in an economy during a period of time *here are threemethods to calculate "1: the production method, the expenditure method and the incomemethod 3n this course, we place the emphasis on the expenditure method *here are fourma9or categories of expenditures: consumption, investment, government purchases, and netexports

"1 is not a perfect measure of total production, nor a perfect measure of wellbeing

!ousehold production and the black economy are excluded from "1 *he "1 measuredoes not give us the information of the distribution of the income and output among the

population *he value of leisure is not included in "1 3t does not contain the informationabout the level and quality of health care and education 0inally, "1 is not ad9usted for

pollution or other negative effects of production, changes in crime and other social problem

?ominal "1 grows over time not only as result of increases in output but also as a result ofgeneral price rises =hanges in nominal "1 that result from price changes do not tell usanything about the performance of the economy in producing goods and services *o get aclearer picture of how much an economy is growing over time, it is necessary to ad9ustnominal "1 so that it reflects only changes in output and not changes in prices *hisad9usted "1 allows meaningful comparisons of aggregate economic activity over time

when prices are changing and is referred to as real "1 >eal "1 is the value of all final



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goods and services produced during a given period based on the prices existing in a selectedreference year

6() Economic *%owth

#ong-run economic growth is the key to rising living standards *he issues of growth ratesand living standards are of considerable importance in the contemporary world ith muchof the world/s population in relative, if not absolute, poverty the need to understand thecauses of economic growth, and to implement effective growth policy, is urgent

7any economists have turned their attention to the causes of economic growth One of themost well-known models of economic growth is the .olow/ model, developed by >obertolow *his model focuses upon the roles of expenditure, saving, the capital stock andtechnological changein the determination of an economy/s rate of economic growth 3n this

section of the module, we explore the main causes of economic growth and consider theirimplications for economic policy to promote economic growth

3ncreases in real "1 per capita depend on increases in labour productivity #abourproductivity is the quantity of goods and services that can be produced by one worker or byone hour of work *wo key factors determine labour productivity: the quantity of capital perhour worked and the level of technology *herefore, economic growth occurs if the quantityof capital per hour worked increases and if technological change occurs

One important concept here is potential "1, which is the level of "1 attained when allfirms are producing at maximum capacity e will frequently use this concept in thefollowing chapters when we study macroeconomics

eadin* acti$ity 61

tudy chapter H of the text 5!ubbard et al6


define the term .*P/,

understand the three methods of measuring "1

understand the four components of "1 in the expenditure method

discuss limitations of "1 as a measure of total production and a measureof wellbeing

calculate nominal "1 to real "1

calculate the economic growth

calculate the "1 deflator

explain the determinants of the rate of long-run growth

use the economic growth model to explain why economic growth rates differbetween countries



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Lea%nin* acti$ity 61



A(( +nswer >eview @uestions (


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6)( 2nflation

e are all aware that the overall price level in an economy changes from time to time,

usually in an upward direction 5although declines are possible6 e recognise this when wespeak of the rate of inflation: an inflation rate of B means that the overall, or general, levelof prices is rising at B 2conomists have been interested for a long time in the developmentof measures of the change in the overall price level *oday, such changes are measured usinga price index 5several indices are usually published by a country/s statistics bureau6

*he most familiar price index 5in +ustralia and many other countries6 is known as the=onsumer rice 3ndex 5=36 !owever, =3 has some biases as a measure of inflation, whichinclude substitution bias, increase in quality bias, new product bias and outlet bias

+nticipated inflation does not reduce the affordability of goods and services to the averageconsumer, but it still imposes costs on the economy hen inflation is anticipated, its main

costs are that paper money loses some of its value and firms incur menu costs 7enu costsare the costs to firms of changing prices on products and printing new catalogues %ycontrast, when inflation is unanticipated, the actual inflation rate can turn out to be differentfrom the expected inflation rate +s a result, some people gain and some people lose3nflation affects the distribution of income, as some people will find their purchasing poweris rising while other people will find their purchasing power is falling

3nflation can be caused either by an increase in aggregate demand or by a decrease inaggregate supply 3n =hapter ((, we will use the +1-+ model to illustrate demand-pullinflation and cost-push inflation

eadin* acti$ity 6(

tudy chapter (' of the text 5!ubbard et al6


define the terms: unemployment rate, labour force; discouragedworker, and $labour force participation rate+,

discuss limitations of the unemployment rate as a measure of economicperformance

discuss the costs of unemployment

distinguish among the four types of unemployment identified by economists

discuss the concept of full employment

explain what factors determine the natural rate of unemployment

define the term: .inflation/

explain how inflation is calculated using a consumer price inde%

discuss limitations of using a consumer price index to measure inflation

use price indexes to ad9ust for the effects of inflation

discuss the costs of inflation to the economy

outline the cause of inflation in terms of .demand pull/ and .cost-push/theories of inflation



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Lea%nin* acti$ity 6(


AA( +nswer >eview @uestions (-(A for chapter (' 5check your answers withthose from the tudy1esk6

AA& +nswer roblems and +pplications (, &, ), A, B, C, D, I, (', (&, (), (A,(D, (I, (H, &' for chapter (' 5check your answers with those from thetudy1esk6

66 3he business cycle

2conomists refer to the concept of the business cycle when observing the short runperformance of an economy >esearch has shown that, typically, the economy traces out acyclical path of peaksand troughs separated by recessionand e%pansionperiodsNnowledge of the economy/s position in the cycle is important for the design ofmacroeconomic policy to .smooth/ the cycle

67 **%e*ate demand and a**%e*ate supply

3n this section we build a macroeconomic model of the economy which may be used formacroeconomic analysis *he purpose of such analysis is to explain the current performanceof the economy and to work through the effects on macroeconomic performance of possible

policy changes

e begin with some reflections on the (H)'s depression and the radical work of Neynes;Neynes suggested the policy-makers should focus on aggregate demand in the economy ifthey wished to .manage/ the business cycle e then move from the early Neynes/ model to

a more recent aggregate demand ($*)and aggregate supply5+6 model which capturessome of Neynes/ insights as well as those of other noted macroeconomists *his model

provides quite a powerful tool for macroeconomic analysis

*hree theories can be used to explain why the +1 curve is downward sloping: the wealtheffect, the interest-rate effect and the international-trade effect

e need to pay special attention to the variables that shift the +1 curve: changes ingovernment policies, changes in the expectations of households and firms and changes inforeign variables

3f there is an increase in resources such as workers, new mineral discoveries, quantity of

capital and advance in new technology, the long-run + will increase, shifting to the right*hese factors also increases short-run + Other variables that can shift >+ include



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expected changes in the future price level, ad9ustments of workers and firms to errors in pastexpectations about the price level, and unexpected changes in the price of an importantnatural resource

*he #>+ is vertical while the >+ is upward sloping because the wages and prices are$sticky$ in the short run

*he +1-+ model can be used to illustrate the effects of an decreaseKincrease in +1K+ onthe price level and real "1

eadin* acti$ity 6)

tudy chapter (( of the text 5!ubbard et al6


define the terms: .peak/, .recession/, trough, .expansion/

explain what happens during a business cycle

explain why the aggregate demand curve downward slopping

discuss the variables that shift the aggregate demand curve

discuss and illustrate the shapes of the long-run and short-run aggregatesupply curves

discuss the factors that shift long-run and short-run aggregate supply curves

understand why some firms and workers fail to predict accurately changes inthe price level

illustrate the difference between long-run and short-run macroeconomicequilibrium using +1-+ model

use +-+ model to illustrate recession, expansion and supply shock

use the dynamic +1-+ model to analyse macroeconomic conditions

Lea%nin* acti$ity 6)



A)( +nswer >eview @uestions (-(A for chapter (( 5check your answers withthose from the tudy1esk6

A)& +nswer roblem and +pplications (, &, ), A, B, D, I, ((, (&, (), (A, (B,(C, (D, (I, (H, &' for chapter (( 5check your answers with those fromthe tudy1esk6

Summa%y



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3n this module, we have explored the circular flow modelof the macroeconomy and used itto consider how economic activity might be measured +ny description or analysis of aneconomy relies upon a concept of the economy and on measurement of the economy/s rate of

economic activity *he circular flow model provides one way of thinking about the activitythat goes on in an economy 3t also provides suggestions as to how the flow of economicactivity could be measured *he concept of "1 5and related concepts6 enables us tomeasure changes in economic activity over time, to make comparisons among countries andto explore the outcomes of policies designed to affect the rate of economic performancehile suggestions for improved concepts are often discussed, the framework for nationalaccounting that is currently used provides a consistent method of measuring economicactivity

roduction, productivity of inputs, and economic growth are very important topics in thediscipline of economics and for the people of the world 1iscussion about economic growthinvolves issues such as the rate and type of growth that is desired, ways to achieve that

growth, and economic performance over a relatively long period of time #iving standardsare dependent on the rate of and type of growth =onsequently, it is important that there becareful analysis of the causes of growth and of policy to promote growth

*he +1-+ model enables us to work out the effects on the price level and "1 of changesthat affect either or both of the +1 and + curves *he +1 curve shows the relationship

between the price level and the quantity of real "1 demanded by households, firms and thegovernment, while the short-run + shows the relationship between the price level and thequantity of real "1 supplied by firms *he long-run + is vertical as in the long run, real"1 is always at its potential level and is unaffected by the price level *he short-runaggregate supply curve is upward sloping because the workers and firms fail to predictaccurately the future price level

Jnemployment remains a very important issue in most economies, though in some instancesit appears to be surprisingly low in the order of policy ob9ectives 1espite advances ineconomic understanding over the last century, there is considerable controversy over the

policy a government should pursue to achieve .full/ employment

%ecause of the existence of inflation 5and sometimes deflation6, it is necessary to distinguishnominal and real values of economic variables, such as "1 rice indices, such as the =3,are used for this purpose *hese are constructed to show changes in the general price levelfrom one period to another



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9odule 7 A 9oneta%y and Fiscal policy

Lea%nin* ob4ecti$es


understand the definition of money and its functions

understand the definitions of money supply

explain how financial institutions create money

describe the +ustralian financial system as an example of a typical financial system in

the &(st century explain monetary policy and the main goal of monetary policy in +ustralia

discuss how the >eserve %ank of +ustralia influences interest rates

explain fiscal policy and how the government can use it to stabilise the economy

explain the multiplier process

understand .automatic stabilisers/

demonstrate the effects of monetary and fiscal policy using the dynamic +1-+ model

Lea%nin* %esou%ces

3e5t

!ubbard et al &'(),Economics, chapters (&, () and (A

Essential

Study book:module B



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71 2nt%oduction

*he study of macroeconomic policy can be a frustrating experience for students 3t takessome time to understand the concepts because the operations of the economy are not easilyobserved and understood +t least with microeconomics, students can relate the relevantconcepts to specific markets they are familiar with, such as the market for =1s, or the

particular labour market in which they operate 3n addition, there is considerabledisagreement about how an economy works, let alone how it should be managed, or even if itshould be managed *hird, the relationships within the economy are highly interconnected,so that whenever one variable is changed to try and achieve a positive outcome there aremany potential side-effects, some of which in turn, have negative consequences for theeconomy 0inally, macroeconomic policy, and the politics associated with it, seems to be farremoved from the lives of students and working folk !owever, while micro economicfactors seem to have the most immediate effects on our lives, in relation to the cost of livingand our incomes, macroeconomic factors can have a great impact on us

"overnments of differing persuasions and in different time periods try to achieve differentthings but, in liberal democratic countries, there are some generally agreed policy goals*hese include:

keeping inflation down

keeping the growth rate up

keeping unemployment down

keeping the economy stable, so growth is relatively steady, rather than fluctuating wildly

encouraging an increase in net exports 5exports < imports6

3n addition to all that, some governments also want to:

assist the disadvantaged or, in some cases, to try and ensure a more equal distribution ofincome andKor wealth

maximise economic freedom within the economy 5a political principle6

provide opportunities for people to participate in the market economy

+s might be observed, many of these goals are potentially contradictory, and the pursuit ofone can compromise another

3n this module, we focus on the main types of macroeconomic policy: monetary and fiscalpolicy +lthough we will treat them separately, we need to note that they both operate at thesame time, although with different emphases e need to note, also, that there isconsiderable debate among economists about how the macroeconomy works and what are the

best policy settings for the purpose of achieving the policy goals



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7( 9oney' banks and the ese%$e Bank of ust%alian

3n modern economies, the financial sector, and the financial markets associated with it,provides an essential institutional structure for the operation of the economy *he financialsector includes the banking system, a number of financial markets 5such as the money marketand the stock market6, and a set of policy institutions 5such as the central bank6 3t isnecessary that we have a sound understanding of the nature and operation of the financialsector for our study of macroeconomic policy

7oney is any asset that people are generally willing to accept in exchange for goods andservices or for payment of debts hether an asset can be used as money depends on whetherit can fulfil the following A functions: medium of exchange, unit of account, store of value,standard of deferred payment

2conomists have developed several different definitions of the money supply *he narrowestdefinition of the money supply is 7(, which includes currency in circulation and demandaccount balances + broader definition of the money supply is -, which includes 7(, plusall other deposits with domestic and foreign-owned banks operating in +ustralia, includingcertificates of deposit, term deposits, and deposits with banks from building societies, creditunions and other authorised deposit-taking institutions %road money is the widest measureof +ustralia$s money supply, and includes 7) plus deposits into non-bank deposit-takingfinancial institutions less holdings of currency and deposits of non-bank depositorycorporations such as finance companies, money market corporations and cash managementfunds

+ bank balance sheet lists a firm/s assets on the left and its liabilities and stockholders/equity on the right >eserves and loans are assets and deposits are liabilities hen acommercial bank receives a deposit, it keeps a part of the funds 5say, (' which is calledreserve ratio determined by the central bank6 as reserves and loans out the remainder henthe loan borrower buys something with the loan, the seller will deposit the payment in a

bank *he seller$s bank will keep a fraction of the deposit 5say ('6 as reserves and loan outthe remainder *he process will continue until no banks have excess reserves 3n this way, thevolume of deposits is created and according to the definitions of money discussed above,money supply increases

*he financial system facilitates the flow of funds from savers to borrowers *he >eserve%ank of +ustralia 5>%+6 is the central bank of +ustralia 3ts main roles are to maintain theintegrity and stability of the financial system and to manage and implement monetary policy*he >%+ influences financial liquidity and interest rates through the use of open marketoperations



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eadin* acti$ity 71

tudy chapter (& of the text 5!ubbard et al6


define money and discuss its functions

discuss the definitions of the money supply

explain how financial institutions create money

understand the role of the >%+

explain the terms .simple deposit multiplier/, .cash rate/, and .open marketoperations/

Lea%nin* acti$ity 71


B(( +nswer >eview @uestions (-(' for chapter (& 5check your answers withthose from the tudy1esk6

B(& +nswer roblems and +pplications (, &, A, B, I, H, (', ((, (A, (B, (D, (I,(H, &' for chapter (& 5check your answers with those from the

tudy1esk6

7) 9oneta%y policy

+s noted earlier, monetary policy is implemented by a country/s central bank and isconcerned with the availability and price of money *he ma9or ob9ective of monetary policyin many countries is now seen to be the control of inflation *he actual implementation ofmonetary policy is a complex process, involving the monetary transmission mechanism in a

country, appropriate policy choices by the monetary authorities, and the actions and reactionsof consumers and firms to announced policy changes 3n this section of the module, we willexamine a number of key aspects of monetary policy

*he >%+ is responsible for carrying out monetary policy, which in +ustralia refers to theactions taken by the >eserve %ank of +ustralia 5>%+6 to affect interest rates to enable it totarget the rate of inflation *he >%+ and the federal government have agreed that the >%+will target an inflation rate in the range of &-) per annum on average over the businesscycle

7oney demand curve is downward sloping hen the interest rates fall, households andfirms switch from holding interest-bearing financial assets to holding money *he interest

rate is the opportunity cost of holding money hen the interest rates are high, firms and



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households will lose if they hold too much money *herefore, they will reduce the amount ofmoney and switch to financial assets

0actors that can cause the money demand curve to shift are real "1 and the price level +n

increase in real "1 and price level will shift the money demand curve to the right

3t was believed that the central bank could be able to control the supply and availability ofmoney !owever, these days, the money supply has become increasingly difficult to targetdue to financial innovation, the huge growth of credit and the growth of the private sector$sability to affect the money supply via private bonds, securities and loans *herefore, todaythe >%+ has given up targeting money supply and interest rate targeting is now used *he>%+ sets the cash rate on overnight loans in the money market Other interest rates in theeconomy are influenced by the cash rate 5usually move in the same direction6 =hanges ininterest rates affect aggregate demand through influencing consumption, investment and netexports

*he +1-+ model can be used to demonstrate the effect of expansionaryKcontractionarymonetary policy on the price level and real "1 +n expansionary monetary policy lowersinterest rates to increase =, 3 and ?T *his causes a rightward shift of the +1 curve, leadingto a higher level of price 5inflation rate6 and real "1 + contractionary monetary policyworks in the opposite direction

eadin* acti$ity 7(

tudy chapter () of the text 5!ubbard et al6


state the goals of monetary policy

describe how the >eserve %ank of +ustralia affects interest rates

understand the difference between nominal and real rates

use +-+ model to show the effects of monetary policy on real "1 andthe price level

understand the arguments for and against the independence of the >eserve%ank of +ustralia

Lea%nin* acti$ity 7(?%: *his is the essential set of exercises 3f you have additional time, youshould practise the qui88es and tests in 7y2conlab

B&( +nswer >eview @uestions (-(' for chapter () 5check your answers withthose from the tudy1esk6

B&& +nswer roblems and +pplications (


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76 Fiscal policy

*he other ma9or type of macroeconomic policy is fiscal policy *his is the responsibility ofthe *reasury in most countries and is most readily seen in the design and implementation ofannual budgets

0ollowing the work of Neynes, for some time it was thought that governments could usefiscal policy to maintain their employment, growth and price stability ob9ectives *his wasespecially so in the period immediately after the econd orld ar 5post (HAB period6!owever, subsequent economic experience showed that fiscal policy may not be as useful asoriginally thought for economic management *oday, many commentators see economicvirtue in a surplus budget !ere, we will examine the nature, implementation and possibleeffectiveness of fiscal policy

*iscretionary fiscal policystems from Neynes/ argument that a government could increaseaggregate demand in times of recession to stabilise the economy at a desirable level ofeconomic activity *his would involve the government running a deficit budget 5spendingmore than it received in revenues6 =onversely, it could dampen an .overheated/ economy byreducing aggregate demand by running a budget surplus 3n an attempt to develop successfulfiscal policy, economists have explored the economic impacts of deficit and surplus budgets,the role of expenditure multipliers, and the reliance on automatic stabilisers

2xpansionary fiscal policy involves increasing government purchases or decreasing taxes,while contractionary fiscal policy involves decreasing government purchases or increasingtaxes *he +1-+ model can be used to demonstrate the effects of the fiscal policy on pricelevel and real "1

*he multiplier effect amplifies the effect of an increaseKdecrease in government purchases ora cutKrise in taxes *he government purchases multiplier is the change in equilibrium real"1 divided by the change in government purchases *he tax multiplier is the change inequilibrium real "1 divided by the change in taxes *he larger the 7arginal ropensity to=onsume 57=6, the larger the multiplier

!owever, the multiplier effect might be offset by the crowding out effect ince thegovernment competes with other borrower for available savings, interest rates experienceupward pressure as the government seeks to borrow funds from the financial markets *heresult of this rise in interest rates may be lower consumption and business investment, whichwould act to offset the boost in +1 from the increased government spending

*he government may go into budget deficit during economic downturn and into budgetsurplus during economic expansion without taking any action because of the effects ofautomatic stabilisers *he former is caused by a drop in government tax revenue 5eg, fewerwages and profits mean fewer tax revenues for the government6 and an increase in transfer

payments 5eg, more people lose 9obs and apply for unemployment benefits6 *he latter iscaused by an increase in tax revenue and a decrease in transfer payments due to theeconomic expansion

ome fiscal policies have long-run effects by expanding the productive capacity of theeconomy and increasing the rate of economic growth *hese policies can shift the long-run+ curve to the right



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eadin* acti$ity 7)

tudy chapter (A of the text 5!ubbard et al6


define the term .discretionary fiscal policy/

distinguish between e%pansionaryand contractionary fiscal policies

explain the role of the .multiplier/ in fiscal policy

explain the role played by .automatic stabilisers/ in fiscal policy

discuss the long-run effects of fiscal policy

Lea%nin* acti$ity 7)?%: *his is the essential set of exercises 3f you have additional time, youshould practise the qui88es and tests in 7y2conlab

B)( +nswer >eview @uestions (


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Table 5*1+3he policy se!uence: fiscal policy

"%pansionary (loose) fiscal policy #ontractionary (tight) fiscal policy

( 3ncreased government spending andKortax cuts

( 1ecreased government spending andKortax increases

& 3ncreased consumption 5more disposableincome6

& 1ecreased consumption

) %usiness confidence increases ) %usiness confidence declines

A 3nvestment and output increase A 3nvestment and output decrease

B "1 increases 5assuming economy notat full capacity6

B "1 decreases

Possible second round effects on investment

(a 3ncreased demand for money, by

consumers and firms

(a 1ecreased demand for money

&a 3nterest rates rise &a 3nterest rates fall

)a ossible decrease in investment inresponse to higher interest rates U

)a ossible increase in investment inresponse to lower interest rates U

Aa 7ay partially offset benefits of increasedconsumption because investmentdecreases.5works against original

policy6

Aa 7ay partially compensate for decreasedconsumption because investmentincreases

/lowon effects related to the overseas sector

(b 7oney flows in to the country to takeadvantage of higher interest rates

(b 7oney flows out of the country to takeadvantage of higher interest rates

&b 1emand for domestic currency increases &b 1emand for domestic currency decreases

)b 2xchange rate increases )b 2xchange rate decreases

Ab Ealue of goods and services sold onoverseas markets increases

Ab Ealue of goods and services sold onoverseas markets decreases

Bb *otal quantity of exports sold declines Bb *otal quantity of exports sold increases

Cb Ealue of overseas goods decreases fordomestic buyers

Cb Ealue of overseas goods increases fordomestic buyers

Db =onsumption of imported goodsincreases

Db =onsumption of imported goodsdecreases

Ib ?et exports declines because of decrease

in exports and increase in imports

Ib ?et exports increase because of decrease

in exports and increase in imports*his leads to a further potential drop inexpenditure 5orks against original policy6

*his leads to a potential increase inexpenditure which may offset the cut inspending

U ?ote that investment is an inverse function of the rate of interest *hat is, if the interest rate is high,households and businesses would prefer not to invest *his is because households and businesses find thatborrowing for investment purposes is relatively costly

V *here is much debate about this second round effect Neynesians 5see +ppendix B(6 do not believe that firmsare so responsive to changes in interest rates *herefore, investment will not decrease that much On the otherhand, monetarists and other free market economists, tend to believe that there will be a drop in investment*his is known as the crowding out effect *he government .crowds out/ the private sector, by undertaking

activity that raises interest rates, thereby pushing aside investment by the private sector



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ith regard to international 5overseas6 effects, it is argued that smaller, open economies,such as the +ustralian and ?ew Wealand ones, are highly sensitive to overseas responses totheir domestic policies 5because of a high reliance on overseas investment and on income

from exports6

3n addition, currency traders engage in speculation; they may not always respond accordingto this theory *hey try to anticipate and even influence government policy

"overnments of these countries are very concerned about what international investors thinkabout the prospects for those countries 3n a sense, as globalisation increases, governmentslose some of their capacity to make independent policy *his is part of the reason why fiscal

policy has fallen out of favour *he expectation is that governments will keep a tight rein ontheir spending

On the other hand, monetary policy works on some of the same aspects of the economy, butin a different way *his is shown in table B&

Table 5*#+3he policy se!uence: moneta%y policy

"%pansionary (loose) monetary policy #ontractionary (tight) monetary policy

( =entral bank buys securities from tradingbanks and financial intermediaries

( =entral %ank sells securities

& 0inancial institutions can lend moneymore cheaply, 5lower interest rates6

& 0inancial institutions increase the cost ofborrowing 5higher interest rates6

) =onsumption increases ) =onsumption decreases

A 3nvestment and output increase A 3nvestment and output decrease

B "1 increases 5assuming economy notat full capacity6

B "1 decreases unless it was at fullcapacity

"ffects related to the overseas sector

(b 0inancial capital flows out of the countryin response to relatively higher interestrates overseas

(b 0inancial capital flows into the countryto take advantage of higher interest rates

&b 1emand for domestic currency decreases &b 1emand for domestic currency increases

)b 2xchange rate decreases )b 2xchange rate increases

Ab Ealue of goods and services sold onoverseas markets decreases

Ab Ealue of goods and services sold onoverseas markets increases

Bb *otal quantity of exports sold increases Bb *otal quantity of exports sold decreasesCb Ealue of overseas goods increases for

domestic buyersCb Ealue of overseas goods decreases for

domestic buyers

Db =onsumption of imported goodsdecreases

Db =onsumption of imported goodsincreases

Ib ?et exports increases because of relativeincrease in exports and decrease inimports

Ib ?et exports decrease because of decreasein exports and increase in imports

*his leads to a further potential increase inexpenditure 5works with original policy6

*his leads to a potential decrease inexpenditure 5works with original policy6



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ou can see from this how governments must try to anticipate the possible outcomes *hereare many variables, and responses will often depend on the situation

3n general, the theory and recent practice favours monetary policy !owever, there arepolitical pressures for governments to spend money, though not always 9ust to influence thestate of the economy *ax cuts are thought to be a popular policy, so there is always pressurefor some stimulation



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ppendi5 71 ?optional %eadin*' and not e5aminable@

Epilo*ue: b%ief %e$iew of selected schools of thou*ht in economics

3t has become apparent as we have progressed through the course that economists disagreeabout both theory and policy prescriptions 2ssentially, it is argued that they disagree

because:

at the most fundamental level, they disagree about the assumptions in economic models,including what motivates people and how economies work 3n other words, they disagreeabout what is really going on and, if you start with a different set of assumptions, thenyou are bound to finish with different conclusions about what .should be done/

like all of us, economists/ views of the world and advocacy for certain courses of action

are influenced by their fundamental values 0or example, someone who strongly believesin economic equity is going to have greater reservations about a market system, thansomeone who strongly believes in the principle of individual freedom

7uch of this course has been taught as if there is not too much disagreement about economictheories and it is fair to say that much of what has been taught is considered mainstreameconomics !owever, the reason for having limited discussion of the key debates ineconomics is not so much a commitment to the mainstream, as a problem of time andteaching restrictions 3n a relatively short course, the idea is to teach some ma9or principlesand models from economics; there is little time to critique them *he .opportunity cost/ oftrying to cover so many basic economic concepts is the incapacity to delve into the ma9or

economic debates ?onetheless, in this epilogue to the course, we do consider an area wherethere are some important debates going on *o better understand the origins of these debates,it is necessary to consider the diversity of opinion within economics

*he development of the economics discipline has been illuminated by the publication ofgreat and lasting works such as +dam mith/s, &ealth of 'ations5(DDC6, Narl 7arx/s,Capital5(IID6, +lfred 7arshall/s,rinciples of Economics5(IH'6, Sohn 7aynard Neynes/,Theor" of $nterest# Emplo"ment and %one"5(H)D6 and aul amuelson/s,)oundations of

Economic Anal"sis5(HAD6 *he ideas in texts such as these, and the results of newinvestigations, have led to the development of a diverse range of schools of thought ineconomics *hese include the: =lassical, 7arxian, ?eoclassical, Neynesian, ost-Neynesian,3nstitutional and >adical schools

+ttempts to explain the operation of economies in the &(st century and to find ways ofachieving countries/ economic ob9ectives draw on one or more of these schools of thought2conomic policy often reflects the temporary dominance of one of these schools; forexample, the drive for microeconomic reform in +ustralia is a reflection of the neo-=lassicalteaching that a free market system is more efficient than a highly regulated economy!owever, it is possible to see that modern economics is also heavily influenced by the ideasof the classical economists

3he classical economists



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#lassical economicswas a school of thought that emerged in estern 2urope, especially%ritain, in the late (C''s, and was influential until late in the (I''s *he classical economistsare considered the immediate forerunners of modern economics because they focused on the

outcomes from the sum of individual decisions, rather than thinking only about the actions ofthe rulers of nations *he classical economists included +dam mith 5(D&)


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*he mode of production in society provides the driving force of .dialectic/ and, therefore, thebasis for explaining the history of society 3ndeed, the material conditions of life 5theproduction system6 determine all aspects of life < social, economic and religious +s 7arx

notes, .the hand mill gives you society with the feudal land; the steam mill society with theindustrial capitalist/

1ialectical materialism/ comes to light as a linking of the dialectic sequence and the mode ofproduction =ontradictions 5negations of the thesis6 in this mode, such as those visible inclass conflict, bring about a new society 5synthesis6 via revolution and the sweeping away ofthe old modes and their social and political superstructures

7arx explained capitalism as a system of capital accumulation based on the generation ofprofit from the employment of labour by the resource owner 5capitalist6 0or 7arx, thecapitalist system was one of exploitation whereby those who generated the surplus value didnot retain it *he emergence of contradiction in the system would lead eventually, via the

operation of the dialectic process, to its overthrow and replacement by communism

3n the capitalist mode of production, the capitalist hires labour power 5the ability to work fora given number of hours6 and pays for it at a value given by the hours of labour 5labour time6needed to provide the sustenance of that labour power 0or example, a capitalist might hireten hours of labour power for the output produced by six hours of labour 3n doing so, shegains a surplus value of the output from four hours of labour < this is the source of thecapitalist/s profit

!ere is one of the many contradictions of capitalism noted by 7arx *he employer pays.correct/ value for the labour power, yet .cheats/ the worker by retaining the extra fourhours/ output < the system is one of .cheating/ and .not cheating/ +nother contradiction lies

in the capitalist/s desire to raise productivity 5through new technology6 *his has the effect ofreducing labour requirements, thereby reducing surplus value *o counter this, the capitalistwill seek to lengthen the working day

*hus, capitalism is a system characterised by a restless struggle for profit *his, according to7arx, inevitably leads to competition, unemployment and poverty =apitalism containswithin itself the seeds of its own destruction

7arx provides a very different explanation of the operation of capitalism to that presented inthe text *he scope of this work goes far beyond economics but has economic conditions asthe driving force in the history of society hile drawing on earlier economists/ ideas, 7arx

breaks completely from them and presents a radical account of society 7arx/s work, or at

least various interpretations of it, was to be adopted in much of 2astern 2urope, =hina andsome countries in outh 2ast +sia !is ideas now appear to be falling into the .dustbin ofhistory/, but they were influential

.eo8classical economics

0eoclassical economicsis the basis for the microeconomics you studied earlier in thecourse 3n the late (Hth century, illiam

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