Economics for Decision Making

ECO10250 Economics for Decision

Making

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Study Guide

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Contents

Introduction ………………………………………………………………………………………………………………………………………………………………………….. 7

Topic 1 Introduction to economics …………………………………………………………………………………………………………………………………. 9 Introduction…………………………………………………………………………………………………………………………………………………………………… 9 Objectives ………………………………………………………………………………………………………………………………………………………………………. 9 Microeconomics and macroeconomics………………………………………………………………………………………………………………………. 10 Fundamental economic concepts………………………………………………………………………………………………………………………………… 10 Opportunity cost………………………………………………………………………………………………………………………………………………………….. 11 Economics in practice …………………………………………………………………………………………………………………………………………………. 12 Economic theory………………………………………………………………………………………………………………………………………………………….. 12 Economic models ………………………………………………………………………………………………………………………………………………………… 12 Markets and trade………………………………………………………………………………………………………………………………………………………… 13 Economic systems ……………………………………………………………………………………………………………………………………………………….. 14 Summary ……………………………………………………………………………………………………………………………………………………………………… 14 Review activities…………………………………………………………………………………………………………………………………………………………… 14 Feedback to activities …………………………………………………………………………………………………………………………………………………… 15

Topic 2 Markets: Demand and supply …………………………………………………………………………………………………………………………. 16 Introduction…………………………………………………………………………………………………………………………………………………………………. 16 Objectives …………………………………………………………………………………………………………………………………………………………………….. 16 Demand ……………………………………………………………………………………………………………………………………………………………………….. 16 Supply …………………………………………………………………………………………………………………………………………………………………………… 17 Equilibrium price…………………………………………………………………………………………………………………………………………………………. 18 The free-market economy ……………………………………………………………………………………………………………………………………………. 19 Summary ……………………………………………………………………………………………………………………………………………………………………… 19 Review activities…………………………………………………………………………………………………………………………………………………………… 20 Feedback to Activities ………………………………………………………………………………………………………………………………………………….. 21

Topic 3 Markets: Elasticity……………………………………………………………………………………………………………………………………………….. 25 Introduction…………………………………………………………………………………………………………………………………………………………………. 25 Objectives …………………………………………………………………………………………………………………………………………………………………….. 25 Price elasticity of demand ……………………………………………………………………………………………………………………………………………. 26 Calculating price elasticity of demand………………………………………………………………………………………………………………………… 26 Investigating elasticity along the demand curve…………………………………………………………………………………………………………. 27 Determinants of price elasticity of demand………………………………………………………………………………………………………………… 28 Income elasticity of demand (denoted by ηy) …………………………………………………………………………………………………………….. 29 Cross price elasticity of demand (denoted by ηx) ………………………………………………………………………………………………………. 30 Price elasticity of supply ………………………………………………………………………………………………………………………………………………. 30 Short-run and long-run demand ………………………………………………………………………………………………………………………………… 31 Markets where prices are controlled …………………………………………………………………………………………………………………………… 31 Consumer surplus, producer surplus & total surplus ………………………………………………………………………………………………… 31 Summary ……………………………………………………………………………………………………………………………………………………………………… 32 Review activities…………………………………………………………………………………………………………………………………………………………… 33 Feedback to Activities ………………………………………………………………………………………………………………………………………………….. 33

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Topic 4 The supply decision …………………………………………………………………………………………………………………………………………… 37 Introduction…………………………………………………………………………………………………………………………………………………………………. 37 Concept review ……………………………………………………………………………………………………………………………………………………………. 38 What is a firm? …………………………………………………………………………………………………………………………………………………………….. 38 Economic profit……………………………………………………………………………………………………………………………………………………………. 39 Economic efficiency …………………………………………………………………………………………………………………………………………………….. 39 Markets and the competitive environment …………………………………………………………………………………………………………………. 40 Short-run cost ……………………………………………………………………………………………………………………………………………………………… 40 Long-run production and cost ……………………………………………………………………………………………………………………………………. 42 Excess capacity and over-utilisation ……………………………………………………………………………………………………………………………. 43 Profit and revenue ……………………………………………………………………………………………………………………………………………………….. 44 The firm’s decisions ……………………………………………………………………………………………………………………………………………………… 45 Profit-maximising output ……………………………………………………………………………………………………………………………………………. 46 The firm’s short-run supply curve ……………………………………………………………………………………………………………………………….. 46 Profit and losses in the short and long-run…………………………………………………………………………………………………………………. 47 Summary ……………………………………………………………………………………………………………………………………………………………………… 48 Review activities…………………………………………………………………………………………………………………………………………………………… 48 Feedback to activities …………………………………………………………………………………………………………………………………………………… 48

Topic 5 Market structure: Perfect competition & monopoly ………………………………………………………………………………….. 56 Introduction…………………………………………………………………………………………………………………………………………………………………. 56 Concept review ……………………………………………………………………………………………………………………………………………………………. 57 Objectives …………………………………………………………………………………………………………………………………………………………………….. 57 What is perfect competition? ………………………………………………………………………………………………………………………………………. 58 Short- and long-run equilibrium ………………………………………………………………………………………………………………………………… 58 Monopoly …………………………………………………………………………………………………………………………………………………………………….. 59 Summary ……………………………………………………………………………………………………………………………………………………………………… 61 Review activities…………………………………………………………………………………………………………………………………………………………… 62 Feedback to activities …………………………………………………………………………………………………………………………………………………… 62

Topic 6 Market failure and government policy …………………………………………………………………………………………………………. 66 Objectives …………………………………………………………………………………………………………………………………………………………………….. 66 The economic theory of government ………………………………………………………………………………………………………………………….. 67 Externalities …………………………………………………………………………………………………………………………………………………………………. 68 Public goods…………………………………………………………………………………………………………………………………………………………………. 68 Monopoly …………………………………………………………………………………………………………………………………………………………………….. 69 Government intervention ……………………………………………………………………………………………………………………………………………. 70 Property rights …………………………………………………………………………………………………………………………………………………………….. 70 External costs: The environment…………………………………………………………………………………………………………………………………. 70 Progress in microeconomic reform …………………………………………………………………………………………………………………………….. 71 Trade practices legislation …………………………………………………………………………………………………………………………………………… 72 Summary ……………………………………………………………………………………………………………………………………………………………………… 74 Review activities…………………………………………………………………………………………………………………………………………………………… 74 Feedback to activities …………………………………………………………………………………………………………………………………………………… 74

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Topic 7 Introduction to macroeconomics…………………………………………………………………………………………………………………… 79 Introduction…………………………………………………………………………………………………………………………………………………………………. 79 Objectives …………………………………………………………………………………………………………………………………………………………………….. 80 Economic growth ………………………………………………………………………………………………………………………………………………………… 81 Jobs and unemployment ……………………………………………………………………………………………………………………………………………… 82 Inflation ……………………………………………………………………………………………………………………………………………………………………….. 83 Governments and deficits ……………………………………………………………………………………………………………………………………………. 84 The circular flow of economic activity ………………………………………………………………………………………………………………………… 85 Australia’s national accounts ……………………………………………………………………………………………………………………………………….. 87 The price level and inflation ………………………………………………………………………………………………………………………………………… 89 Real GDP and associated limitations ………………………………………………………………………………………………………………………….. 91 Labour market indicators and unemployment definitions ………………………………………………………………………………………… 91 The labour market ……………………………………………………………………………………………………………………………………………………….. 93 Summary ……………………………………………………………………………………………………………………………………………………………………… 95 Review activities…………………………………………………………………………………………………………………………………………………………… 95 Feedback to activities …………………………………………………………………………………………………………………………………………………… 95

Topic 8 Gross domestic product ………………………………………………………………………………………………………………………………….. 100 Introduction……………………………………………………………………………………………………………………………………………………………….. 100 Aggregate demand……………………………………………………………………………………………………………………………………………………… 101 Aggregate supply………………………………………………………………………………………………………………………………………………………… 102 Macroeconomic equilibrium …………………………………………………………………………………………………………………………………….. 104 The multiplier …………………………………………………………………………………………………………………………………………………………….. 104 Fluctuations in economic activity resulting from shocks …………………………………………………………………………………………. 104 Summary ……………………………………………………………………………………………………………………………………………………………………. 105 Review Activities………………………………………………………………………………………………………………………………………………………… 105 Feedback to Activities ………………………………………………………………………………………………………………………………………………… 105

Topic 9 Money, interest rates & inflation …………………………………………………………………………………………………………………… 108 Introduction……………………………………………………………………………………………………………………………………………………………….. 108 Money markets…………………………………………………………………………………………………………………………………………………………… 109 Types of inflation ……………………………………………………………………………………………………………………………………………………….. 111 Inflation policy …………………………………………………………………………………………………………………………………………………………… 113 Summary ……………………………………………………………………………………………………………………………………………………………………. 114 Review activities…………………………………………………………………………………………………………………………………………………………. 114 Feedback to activities …………………………………………………………………………………………………………………………………………………. 114

Topic 10 The global economy………………………………………………………………………………………………………………………………………. 116 Introduction……………………………………………………………………………………………………………………………………………………………….. 116 Global interdependence and the gains from trade……………………………………………………………………………………………………. 117 Arguments for restricting trade…………………………………………………………………………………………………………………………………. 117 Trading blocs ……………………………………………………………………………………………………………………………………………………………… 118 The balance of payments ……………………………………………………………………………………………………………………………………………. 118 Foreign exchange markets and the dollar …………………………………………………………………………………………………………………. 119 Exchange rate determination: Flexible exchange rates……………………………………………………………………………………………… 120 Summary ……………………………………………………………………………………………………………………………………………………………………. 121 Review activities…………………………………………………………………………………………………………………………………………………………. 122 Feedback to activities …………………………………………………………………………………………………………………………………………………. 122

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Topic 11 Fiscal and monetary policy ………………………………………………………………………………………………………………………….. 123 Introduction……………………………………………………………………………………………………………………………………………………………….. 123 The Commonwealth Government budget ………………………………………………………………………………………………………………… 124 The effectiveness of fiscal policy ………………………………………………………………………………………………………………………………… 125 The Reserve Bank and monetary policy ……………………………………………………………………………………………………………………. 125 The relative effectiveness of fiscal and monetary policy …………………………………………………………………………………………… 126 Summary ……………………………………………………………………………………………………………………………………………………………………. 127 Review activities…………………………………………………………………………………………………………………………………………………………. 128 Feedback to activities …………………………………………………………………………………………………………………………………………………. 128

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Introduction

This is an introductory course in economics which concentrates on explaining and examining those influences on the level of economic activity in economies such as Australia. It is concerned with the micro and macroeconomic issues which affect us all, such as production decisions, market structures, interest rates, inflation, growth, unemployment and the international sector. Current events are used to illustrate the purposes and conduct of policies by individual companies and governments as they wrestle with some of the micro and macro domestic and international economic problems that confront Australia.

The unit systematically develops an understanding of the main determinants of economic activity in Australia, the problems that face policy makers in regulating the level of economic activity, and the effectiveness of the instruments used by governments in addressing these problems. The order of treatment of topics has been chosen so that the fundamentals of the economy are progressively introduced and new concepts build upon ones previously discussed. It is very important that you have a good understanding of each topic before moving on to the next since each topic builds on the previous topic.

The unit begins by examining the foundation economic principles and then moves to looking at how the microeconomic market is developed through an analysis of product decisions and the various markets which these products are sold in. The next microeconomic step is to investigate why markets fail and offer theories as to how reform can assist. The first macroeconomics topic examines the main indicators of economic performance in the economy and the model which illustrates the impact of changes in these variables. Australia’s international economic relationships complexities are then considered. The unit concludes with some consideration of the complexities of economic management and an evaluation of them in the light of current economic events.

There are eleven topics in this unit. As a guide you should spend about one week on each topic. Your rate of progress in this unit will depend upon your interest in the material, the speed with which you can study, and any outside commitments you might have. You might also find that some topics can be completed much more quickly than others. As a general rule it is suggested that you spend at least 12 hours a week on most topics – 3 hours going through the study learning materials including those on MySCU; 4 hours carefully reading the textbook and taking notes; 2 hours reading the supplied readings and other relevant material; and 3 hours undertaking activities and review activities.

The study guide begins each topic with a brief introduction that outlines broadly what is going to be covered followed by the learning objectives for the topic. The learning objectives should direct your study activity since they identify the expected outcomes from your study of each topic. When you have completed each topic you should check to see that each of the objectives has been achieved.

The leaning objectives are followed by information about the principal reference(s) for the topic. Each topic in the study guide is broken into subsections to make it easier for learning. Follow the directions contained in each section. Throughout the topic you will be given learning activities which test your understanding of the concepts covered. You should try to answer each learning activity before you move on to the next section. Answers to (or feedback on) the learning activities are provided at the end of each topic. We recommend that you attempt the learning activity before consulting the solution. If your answer differs from the one given and you are still confused, then go back through that section again.

At the end of each topic there is a summary which wraps up what we have covered.

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The text – Sloman, J, Norris, K ∓ Garratt, D (2014) – follows the topics fairly closely but there will be times when it doesn’t but these will be pointed out in the guide. We recommend that when you have worked through a topic you undertake the MyEconLab activities from the relevant chapter/s. Again you should attempt your own answer before you look up the answer provided. You are also strongly encouraged to keep up to date with the current economic issues by reading newspaper articles regularly.

For additional important information please refer to the Unit Information document associated with this unit. The Unit Information document provides you with material about assessment, study timetable and additional references.

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Topic 1

Introduction to economics

Introduction This first topic introduces you to the discipline of economics and discusses some of the main concepts that underpin the economic method of analysis. We begin by considering the nature of microeconomics and how it differs from macroeconomics.

Some fundamental economic concepts are introduced in this topic and they will form an essential foundation to the rest of your work in this unit. The basic economic problem is how best to use scarce resources to meet the needs of human beings and involves concepts such as scarcity, choice and opportunity cost.

In its function in the real world, economics concerns itself with theory, models and the use of graphs to depict and analyse economic data. This topic considers all of these areas and introduces the important assumption of ceteris paribus, which enables economists to focus on individual variables or small models which are abstractions from the total economy.

Building upon the earlier concept of opportunity cost, the next concept examined is the production possibility frontier and the circular flow of the economy.

Many of you will have had previous exposure to a number of these concepts and will be able to refresh your knowledge relatively quickly. Those of you who have never studied economics or graphical analysis may need to take more time with the material. It is very important that you have a good understanding of each topic before moving on to the next since each topic builds on the previous topic.

Objectives On completion of this topic you should be able to:

Study materials The time you need to spend studying Topic 1 will depend upon your previous experience in the study of Economics. Topic 1 sets the foundation for further study in this unit.

distinguish between macroeconomics and microeconomics

describe the basic economic problem and explain why scarcity forces people to make choices

outline the role and uses of economic theory and models and the assumptions underlying their use

describe the operation of markets as coordinating mechanisms

explain opportunity cost and illustrate its use graphically through the production possibility frontier concept.

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Textbook Sloman, J., Norris, K. & Garratt, D., 2014, Chapter 1.

Readings

Microeconomics and macroeconomics This unit ECO10250 is a specialisation of the broad discipline of economics. The prefix micro means that we are studying economics at a base level of individual consumers, firms or industries, rather than from the broader view of the total economy which is covered in macroeconomics. The first six topics of this subject focus on microeconomics with Topics 7 to 11 focusing on macroeconomics. Microeconomics focuses on the efficient allocation of scarce resources, between alternative competing uses. Macroeconomics, on the other hand, concentrates on the economy as a whole, for example employment, national income, trade, inflation etc.

In microeconomics we examine how consumers will be trying to maximise the satisfaction they can obtain from consuming products and firms will be trying to maximise profits (total revenue minus total costs). A market is defined as an arrangement that facilitates buying and selling. Note that a market does not have to be visible or occupy a space, for example, an interface between buyers and sellers may be achieved electronically.

Markets do not always allocate resources efficiently. This could mean that consumers are not able to buy products for a price which reflects the true costs of production or society may be incurring additional costs such as pollution of the environment, where producers are not held accountable for their production costs. Costs passed on externally to society are called externalities. Hence we need a market supervisor such as the government, whose role might be to provide some goods and services to households, redistribute income and manage the economy in such a way as to maximise the welfare of the constituents, particularly when the markets fail to share wealth efficiently.

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