Unit 3, Area of Study 1 - Microeconomics Flashcards
Opportunity Cost
The value of the next best alternative that is foregone whenever a choice or decision is made.
- Examples:*
- You have $50 in your pocket, you decide to go out for dinner with some friends, instead of buying a new shirt for summer = opportunity cost is the new shirt*
- Free pizza is being offered on Enderly lawn, however there is a long queue, what is the opportunity cost of consuming a piece of pizza? = opportunity cost is the time spent in line.*
Relative scarcity
(basic economic problem)
Refers to the basic economic problem where resources are limited in supply relative to the unlimited wants and needs of individuals, businesses, and governments.
How does relative scarcity lead to an opportunity cost?
Relative scarcity leads to opportunity cost because, in a world of limited resources and unlimited wants, choices must be made about how to best allocate our scarce resources. When a decision is made to use resources to satisfy a need or want, the next best alternative foregone represents the opportunity cost.
Demand
Demand is the willingness and ability of consumers to buy.
Law of demand
As the price increases, the quantity consumers are wiling and/or able to demand decreases
As the price decreases, the quantity consumers are wiling and/or able to demand increases
Income effect
A reduced consumption of a good or service whose price has increased that is due to the reduction in the consumers purchasing power or an increase in consumption of a good or service whose price has decreased that is due to the increase in the consumers purchasing power.
This factor contributes to / influences consumer willingness and/or ability to consume, and helps explaining why the demand curve slops downwards.
Subsitution Effect
Refers to the way consumers react to changes in the prices of goods by substituting one good for another. When the price of a good increases, consumers will seek out an alternate product to consume in place of the good in focus. When the price of a good decreases, then consumers are likely to consumer more of this good in place of alternates.
This is a key component of the law of demand, which states that as the price of a good or service decreases, the quantity demanded increases, and as the price increases, the quantity demanded decreases.
Microeconomic demand side non-price factors
Factors that cause the whole demand curve to shift left or right.
- Changes in Disposable income (Disposable Income)
- The price of substitutes – a substitute is a good or service that can be consumed in place of another, for example, a hot chocolate is an substitute as a hot drink for hot tea.
- The price of complements – are goods and services that are usually consumed together, for example, cereal and milk.
- Preferences and tastes. - refer to the individual desires, likes, and choices of consumers that influence their demand for goods and services.
- Interest rates - cost of borrowing and the incentive to save.
- Population demographics - refer to the statistical characteristics of a population (i.e. population growth and demographic change)
- Consumer confidence (sentiment) = level of optimism or pessimism in the future state the economy and their own job security
Supply
Supply is influenced by the willingness and ability of suppliers to supply.
Law of supply
As the price increases, the quantity that suppliers are willing and/or able to supply increases.
As the price decreases, the quantity that suppliers are willing and/or able to supply decreases.
Profit Motive (influences the law of supply)
As the price of a product rises, producers have a greater incentive to increase production because they can potentially earn higher profits.
In addition, it attracts new suppliers into the market through the operation of relative prices.
Microeconomic supply side non-price factors
Factors that cause the whole supply curve to shift left or right.
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Changes in cost of production Refers to the costs incurred by a business/producer in the process of producing goods or services.
These can include:
Labour costs in the form of wages or salaries
Costs of raw materials
Costs of equipment used in the production process
Costs of land and premises required to produce
Can include indirect taxes, for example, a carbon tax - number of suppliers - literally how many producers/suppliers produce the good or service in the market.
- Technology = e.g. NBN or AI
- Productivity = the level of outputs that are produced from given level of inputs
- Climatic Conditions (for example, positive climatic conditions can lead to increase yields for farmers, increasing the production of goods such as wheat.
7 step response for explaining / describing a market adjusting to a new equilibrium
- Explain the situation in your own words
- Supply or demand
- Increase or Decrease
- Shift the curve left or right
- If price were to remain at P1 temporary shortage (demand exceeds supply) or surplus (supply exceeds demand) forms.
- Market forces put pressure on upward/downward pressure on price to adjust to new equilibrium (including whether there is an expansion or contraction along the curve)
- Overall impact on price & quantity.
Price elasticity of demand
The price elasticity of demand (PED) refers to the responsiveness of total quantity demanded** of a product to a **change in the price of that product.
Elastic = high price elasticity of demand
Inelastic = low price elasticity of demand (curve looks like an “I”)
Factors that influence the price elasticity of demand
- The degree of necessity - refers to how necessary the good or service is essential for survival or daily life a good that is necessary for survival or daily life must be purchased so the quantity purchased will not change a lot no matter what the change in price (PED is inelastic), if the good or service is not essential, then quantity can change a lot (PED Is elastic)
- Availability of substitutes - refers to the number of products available that can be consumed in place of the product (substitutes) a lot of substitutes means consumers can easily change the quantity they demand (PED is elastic), however, if there are not a lot of substitutes they cannot (PED is inelastic)
- Proportion of Income refers to the percentage of a consumers income required to purchase the product if it is a large proportion or percentage then consumers will change quantity demanded a lot (PED is elastic) and if it is a small proportion or percentage the change is likely to be small. (PED is inelastic)
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Time
refers to the amount of time that passes and how this can impact on PED. PED is often inelastic in the short term as consumers have limited flexibility to change their spending habits, however, is demand can become more elastic in the longer term due to greater flexibility.
Price elasticity of supply
Refers to the responsiveness of total quantity supplied of a product to a change in the price of that product.
Factors affecting Price elasticity of supply
- Spare capacity - refers to the level at which a producer’s productive resources (natural, labour and capital) are being under-utilised* If all resources are not being fully utilised, then a producer can respond quickly by increasing production levels (PES is elastic), however, if resources are already being fully utilised, they cannot (PES is inelastic)*
- Production period - how long does it take to produce the good or service if the production period is short then the producer can respond quickly and increase production (PES is elastic), however, if production period is long then the producer cannot response quickly (PES is inelastic)
- Durability of goods - how long can the good be stored if the product is durable and can be stored, then a producer can respond quickly as they will have an inventory to draw on, e.g., tinned peaches (PES is elastic), however, if the product is not durable and cannot be stored, then a producer cannot respond quickly as they will not have an inventory to draw on (PES is inelastic)
Relative prices
Scenario: Prices increase in Market A relative to Market B this:
- Price Mechanism describes how the forces of demand and supply influence prices of goods and services and in turn relative prices, the price of one good relative or compared to another,
- An increase in relative prices send price signals to producers that a shortage has formed in the market.
- producers investigate to determine the reason
- If the increase is the result of a increase in demand = profit making opportunity due to unmet consumer demand
- Producers will reallocate resources into Market A to meet the increase in consumer demand (upholding consumer sovereignty) and maximise profits.
Free and Perfectly competitive markets
(4 pre-conditions)
Conditions required:
- Consumer sovereignty exists - Consumer sovereignty is the ability of the consumer in a competitive market economy to direct or allocate resources
- Large number of buyers and sellers and none have market power to influence price = all are price takers.
- Products sold are homogenous meaning they are identical and easily substitutable.
- Ease of exit and entry (i.e. low set up costs, regulations etc)
- Buyers and sellers operate with full information
- Resources are mobile
Allocative efficiency
The most efficient allocation of resources occurs when living standards and welfare are maximised and it is not possible to further increasing living standards by changing the way resources are allocated.
Productive / Technical efficiency
When it is not possible to increase output without increasing inputs (resources). Achieving productive or technical efficiency means maximising the output from a given level of inputs.
Inter-temporal efficiency
How well resources are allocated over different time periods so the living standards of current generations are not jeopardising future generations living standards.
Dynamic efficiency
How quickly an economy can reallocate resources to achieve allocative efficiency, entails firms being adaptive and creative in response to changing economic circumstances.
Market failure
When an unregulated market is unable to allocate resources efficiently or where resources are allocated in such a way that national living standards or welfare are not maximised. It will result in an over-allocation of resources to the production (or consumption) of some goods and services and/or an under-allocation to others.
Types of Government Intervention in Market Failure
The role of government intervention is to address or correct the market failure.
Indirect taxation – an indirect tax is a tax paid by economic agents via the purchases of goods and services (such as the GST or an excise tax).
Subsidies – a subsidy is a payment or concession of a producer or consumer that is designed to increase consumption/production of a good or service by covering some of the costs involved.
Government regulations - a set of rules and policies established by governmental authorities to direct and manage various activities within a society or economy.
Government advertising - is a communication strategy used by government entities to inform, educate, and engage the public about policies, programs, services, and important initiatives.
Public Goods
Public goods have two defining characteristics
Non-excludable – you cannot exclude non-payers from enjoying the benefits that the good or service provides, which gives rise to the free rider problem
Non-depletable/non-rivalrous in consumption – one person’s consumption does not diminish the ability of another person to enjoy the same consumption, so all benefit equally
A public good is a good or service that is socially desirable and important to all, it is non-excludable (all can use them) and non-depletable / non-rivalrous in consumption (consumption by one person does not reduce the amount available to another).
Example: Street Lights/Public Transport/Free to Air TV/Fireworks display/Defence
Role and Effect of Government interventions in the market failure of provision of public goods.
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Government subsidies
* Subsidy: a payment or concession of a producer or consumer that is designed to increase consumption/production of a good or service by covering some of the costs involved.*
Subsidies can take the form of:
- cash payment to private suppliers to cover costs incurred in the provision of public goods.
- Low or no interest loan
- Subsidised costs (e.g., access to tax-free petrol)
2. Direct Government Provision
Remember, the government intervention to a market failure, in general, should always address the inefficiency in resource allocation (which will be an under or over allocation of resources to the production or consumption of a good or service)
Public Goods can be the subject of a short answer question, however, if asked to construct a graph to illustrate the government intervention in a market – DO NOT SELECT PUBLIC GOODS AS THE OPTION AS THIS IS HARD TO REPRESENT IN A GRAPH AND STUDENTS GET IT WRONG!
DO NOT SELECT PUBLIC GOODS AS THE OPTION AS THIS IS HARD TO REPRESENT IN A GRAPH AND STUDENTS GET IT WRONG!
Common Access Resource
- Common Access Resources are ones that are not owned by anyone and usually do not have a market price making them available to anyone, (i.e., non-excludable), however, they are depletable / rivalrous as consumption by one person reduces the amount available to another.*
- Two key features:*
- Non-excludable
- Depletable
Lack of excludability and the absence of price leads to excessive production or consumption of goods that use up valuable common access resources. (over allocation of resources toward consumption / production).
Remember, sometimes referred to as “Tragedy of the Commons”
Role and Effect of Government interventions in the market failure of Common Access Resources
GOVERNMENT REGULATION
Government regulations
- Environmental regulations / laws limiting use of common access resources*Legislation used to reduce consumption of Common Access Resources through requirement of permits or licenses or setting and monitoring quotas.
- Permits: fishing or hunting licenses
- Quotas: Fishing / Abalone
- Production techniques: Victorian government has placed a ban on commercial net fishing in Port Phillip and Corio Bays
These address the over-consumption of common access resources (CAR) by limiting access to the CAR through restricting access such as through permits and quotas limited how much can be used or outright bans preventing use all together.
Role and Effect of Government interventions in the market failure of Common Access Resources
INDIRECT TAXATION
Indirect taxes
Carbon tax / ETS or Emissions Trading Scheme
These address the over-consumption of common access resources (CAR) by placing a price on their consumption of the CAR.
These address the over-consumption of common access resources (CAR) by placing a price on their consumption, for example, an emissions trading scheme increases production costs incentivizing producers to adjust their production methods for more cleaner options such as renewable energy generation.
Role and Effect of Government interventions in the market failure of Common Access Resources
SUBSIDIES
Subsidies
- Subsidy: a payment or concession of a producer or consumer that is designed to increase consumption/production of a good or service by covering some of the costs involved.*
- Can be used to encourage development of “clean” technologies
These address the over-consumption of common access resources by making alternatives more attractive through subsidization of costs involved, reducing the use of CAR (over-allocation)
Externality
An externality results when the well-being of a third party not involved in a transaction (or activity) is affected.
Positive externalities
What are they? And how are they an example of market failure?
A positive externality occurs when the third party receives a benefit from the production or consumption of a good or service.
Production:
- Research and development conducted by businesses
- Beekeeper assists any nearby food producers
Consumption:
- Vaccinations (think CoVid, you get a vaccination, you protect the community.)
- Education
Market Failure: Because the benefits of a good or service extend beyond the individual consumer or producer, but the unregulated market does not account for these external benefits, so the consumer or producer do not gain from this benefit. This leads to underproduction and underconsumption compared to the socially optimal level.
Role and Effect of Government interventions in the market failure of Positive Externalities
SUBSIDIES
Subsidies
e.g. Installation of solar panels
How?: The subsidy or payment reduces the cost of producing or consuming goods considered to result in positive externalities (i.e., social benefit for 3rd parties), making them more affordable and accessible, thereby increasing consumption to a socially optimal level, addressing the under allocation of resources.
Role and Effect of Government interventions in the market failure of Positive Externalities
Government Regulation
Government regulation
e.g., Education and Training Reform Act 2006, which mandates that children aged6 to 17 yearsmust be enrolled in and attend a registered school or be registered for homeschooling.
How?: Government regulations can mandate certain behaviours, such as attending school, ensuring that production and/or consumption of goods or services that provide social benefits to 3rd parties are produced or consumed ensuring there is an allocation of resources toward these areas of the economy.
Role and Effect of Government interventions in the market failure of Positive Externalities
DIRECT PROVISION
Direct provision
- Health and Education
- Research and development (e.g., The Commonwealth Scientific and Industrial Research Organisation (CSIRO) is the federal government agency for scientific research in Australia)
How?: By directly supplying goods and services such as education, healthcare, and public infrastructure, the government ensures they are available in sufficient quantities. This leads to greater consumption, maximizing social benefits and correcting the underproduction caused by the market.
Negative externalities
What are they? And how are they an example of market failure?
A negative externality occurs when a cost is imposed on a third party not involved in the transaction, from the production or consumption of a product.
Production
- Pollution (noise / air)
- Consumption*Smoking
Market Failure: because the production or consumption of the product imposes costs on third parties who are not involved in the economic transaction, but these costs are not internalised or paid for by the producer or consumer. As a result, there is an over allocation of resources toward their consumption or production.
Role and Effect of Government interventions in the market failure of Negative Externalities
GOVERNMENT REGULATIONS
In general, the role of government intervention is to ensure the consumption and production of the negative externalities does not takes place or is minimised.
Government regulations:
- 1987 – CFCs were banned by governments around the world
- 2007 – Victorian government banned smoking of cigarettes in an enclosed public environment.
- Illegal to light fires and burn off materials in your own backyard.
How?: Imposing rules and restrictions that force producers and consumers to account for the external costs they impose on society and providing the incentive to change their behaviour (for example production processes with high emission levels), reducing the allocation of resources towards goods or services that impose the cost on 3rd parties.
Role and Effect of Government interventions in the market failure of Negative Externalities
INDIRECT TAXES
Indirect tax
- Excise taxes (on cigarettes – e.g. 12.5% per year for 4 years)
- Excise taxes on petrol – 40 cents per litre.
- This is the government intervention that can be used if a question requires you to illustrate using a graph the effect of a government intervention on a market to correct a market failure.
How?: Placing an indirect tax on the good or service creating the negative externality forces producers and consumers to account for the external costs they impose on society and providing the incentive to change their behaviour (for example production processes with high emission levels), reducing the allocation of resources towards goods or services that impose the cost on 3rd parties.
Role and Effect of Government interventions in the market failure of Negative Externalities
ADVERTISING
Government advertising
- Influence tastes and preferences by making consumers aware of negative aspects (e.g. health problems associated with smoking, excessive drinking or gambling).
How?: By informing consumers about the harmful effects of certain goods or behaviours increasing public awareness, advertising shifts consumer behaviour away from consumption harmful goods and services, reducing the overallocation of resources toward their consumption and leading to a more efficient allocation of resources in society.
Role and Effect of Government interventions in the market failure of Negative Externalities
SUBSIDIES
Subsidies
- To businesses and households that generate their electricity using solar panels
How?: By lowering the cost of eco-friendly alternatives by covering some of the costs associated, subsidies shift production and consumption toward less harmful activities, reducing the impact of negative externalities by addressing the over allocation of resources toward production processes that cause high emissions and leading to a more socially efficient allocation of resources
Asymmetric Information
What are they? And how are they an example of market failure?
A type of market failure where one party has greater information than the other in a transaction, leading to an inefficient allocation of resources / over or under allocation of resources to production or consumption of certain goods or services over time.
Ultimately this does not maximise the nations living standards or well being.
Adverse Selection (Type of Asymmetric Information)
Adverse Selection: an economic outcome that does not maximise well being for at least one of the parties to a transaction due to one party having more information than the other.
One example is in the marketplace is that of used car sales. A car dealership might be aware that a car they are selling has a major flaw, one that is not immediately apparent to buyers. The dealership may fail to divulge this information and sell the car for more than it is worth, resulting in the consumer over allocating valuable resources to the purchase of the car and also to any repairs required in the future, reducing theirs and the nations well-being and standard of living.
Moral Hazard
Moral hazard: occurs when economic agents adjust their behaviour, without the other party being aware, to one that is less efficient or favourable from society’s point of view after a transaction has occurred meaning.
For example: Insurance à buyer has more knowledge about their probability of making a claim. Can lead to some buyers/consumers engaging in high risk activity, raising premiums for all consumers including low risk consumers requiring them to over allocate value resources toward their insurance, and even not purchasing insurance reducing theirs and the nations well-being and living standards
Role and Effect Government intervention – asymmetric information
Government Regulation
Government regulation:
- Asymmetric information (misleading information) à Legalisation: Australian Consumer Law which makes it illegal for businesses to engage in conduct that misleads or deceives consumers or other businesses.
- ACCC – Australian Competition and Consumer Commission, primary responsibility is to ensure that individuals and businesses comply with Australian competition, fair trading, and consumer protection laws - in particular the Competition and Consumer Act 2010.
- Regulations to ensure seller provides greater level of meaningful information to the consumer, e.g., food labelling.
In each instance the inefficiency is addressed by attempting to ensure all parties to the transaction have the same information.
ROLE and Effect Government intervention – asymmetric information
Advertising
Government awareness (advertising):
- Campaigns about benefits of eating fresh food and vegetables
- Campaigns about smoking, drinking, gambling
Inefficiency is addressed by attempting to ensure all parties to the transaction have the same information.
Contemporary example of the government intervention in a market leading to a decrease productive, dynamic, allocative and technical efficiency.
Minimum wage
An example of a price floor set, and the price of labour cannot go below this preventing the market from establishing an equilibrium.
At the minimum wage level ($24.10 per hour), the labour supply is greater than the labour demand (a surplus) = a number of people who are willing and able to work at the going wage, cannot.
Productive efficiency – labour resource underutilised, therefore not all inputs being used, meaning outputs are not maximised.
Dynamic efficiency – By artificially raising wages for low-skilled work, minimum wage laws may reduce incentives for workers to invest in developing new skills or pursuing education that could lead to greater creativity and innovation in the economy.
Allocative efficiency – due to high wages, low skilled work off-shored (sent overseas to countries with lower wages) or alternatively producers’ resort to capital resources to replace the labour resources even if it is not going to lead to improved output, reducing the living standards of portions of the economy.
Evaluating the role of the market in allocating resources
A competitive market is one in which there are …
The high levels of competition that result ensure that all sellers are …
So …
In addition, this allows the price mechanism (forces of supply and demand) to operate freely in determining both prices and relative prices, this ensures that consumer sovereignty is the driving force behind decisions on resource allocation. So …
However, there are occasions where a competitive market is unable to allocate resources efficiently or where resources are allocated in such a way that national living standards or welfare is not maximised, known as a market failure. For example,
Judgement:
Price Ceiling as a form of a price control
Price Ceiling – where the sellers of the good or service are banned from raising prices above a certain level, this distorts the price mechanism as it prevents the market from establishing an equilibrium.
Price ceiling leads to shortages and creations of black markets = action by government reducing society’s well-being as black market leads to higher prices and organised crime can become involved.
Price Floor as a form of a price control
Price floor – where the price offered in a market is prohibited from falling below a certain level, distorting the price mechanism and preventing the market from establishing an equilibrium.
A surplus of the good or service is created, which represents a waste of resources or inefficient allocation of resources.
Result is significant wastage of resources when surplus or oversupply occurs.
3 fundamental economic questions
- What and how much to produce?
* Decides which goods and services should be produced and in what quantities, based on factors such as consumer demand, government priorities, and available resources. - How to produce?
* Determines the methods of production, including the choice between labour-intensive or capital-intensive production, as well as considerations of efficiency and sustainability. - For whom to produce?
* Addresses how goods and services are distributed among individuals and groups in society, influenced by factors such as income, government policies, and market structures.
These questions are central to economic systems, as different systems (market, planned, mixed) answer them in different ways – In Unit 3 and 4, we only consider a Market Capitalist Economy.
