Unit 3, Area of Study 1 - Microeconomics

Question 1

Opportunity Cost

Answer 1

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.*

Question 2

Basic economic problem / Relative scarcity

Answer 2

The basic economic problem is “relative scarcity”

That we have unlimited needs and wants, however, only limited resources to satisfy these needs and wants.

As a result we are forced to make a decision about which needs/wants to satisfy.

Our resources (natural, labour and capital) are limited relative to our unlimited needs and wants.

Question 3

Demand

Answer 3

Demand is the willingness and ability of consumers to buy.

Question 4

Law of demand

Answer 4

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

Question 5

Microeconomic demand side non-price factors

Factors that cause the whole demand curve to shift left or right.

Answer 5

1. Changes in Disposable income (Disposable Income)
2. 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.
3. The price of complements – are goods and services that are usually consumed together, for example, cereal and milk.
4. Preferences and tastes.
5. Interest rates - cost of borrowing and the incentive to save.
6. Changes in population (i.e. population growth and demographic change)
7. Consumer confidence (sentiment) = consumer confidence in the future state the economy and their own job security

Question 6

Supply

Answer 6

Supply is influenced by the willingness and ability of suppliers to supply.

Question 7

Law of supply

Answer 7

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.

Question 8

Microeconomic supply side non-price factors

Factors that cause the whole supply curve to shift left or right.

Answer 8

1. Changes in cost of production such as: Labour costs (i.e. wages/salaries), Costs of capital equipment / technology, Costs of raw material, Operating costs (e.g. electricity, delivery costs etc), Level of government assistance or taxes and other charges (e.g. registration fees, rates),Indirect tax applied to goods and services (e.g. tobacco excise),Effect of changes in the value of the AUD
2. Technological change = e.g. NBN
3. Productivity growth = outputs from given level of inputs
4. Climatic Conditions (for example, positive climatic conditions can lead to increase yields for farmers, increasing the production of goods such as wheat.

Question 9

7 step response for explaining / describing a market adjusting to a new equilibrium

Answer 9

1. Explain the situation in your own words
2. Supply or demand
3. Increase or Decrease
4. Shift the curve left or right
5. If price were to remain at P₁ temporary shortage (demand exceeds supply) or surplus (supply exceeds demand) forms.
6. 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)
7. Overall impact on price & quantity.

Question 10

Price elasticity of demand

Answer 10

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”)

Question 11

Factors that influence the price elasticity of demand

Answer 11

1. The degree of necessity - the more you need it, the less elastic demand, e.g. water is inelastic in demand as it is a necessity to survival.
2. Availability of substitutes - if there are plenty of alternatives to the good or service, then demand is likely to be elastic as consumers will swap to the alternate with the smallest price change
3. Proportion of Income - the larger the proportion of income the price of the good or service, the larger the quantity demanded is likely to change to even a small change in price making demand elastic. E.g. the market for houses.
4. Time
   
   1. Short term – consumers continue to make buying decisions on a habitual basis.
   2. Medium to longer term – start to realise price changes, often occurs with products like telecommunications, gas, electricity (bill shock)

Question 12

Price elasticity of supply

Answer 12

Refers to the responsiveness of total quantity supplied of a product to a change in the price of that product.

Question 13

Factors affecting Price elasticity of supply

Answer 13

1. Spare capacity
   
   1. Elastic → if suppliers have plenty of spare capacity (e.g. their factories are only operating at 50% capacity), they can respond quickly to changes in price.
   2. Inelastic → if suppliers have limited spare capacity (e.g. their factories are operating at 95% capacity), they will find it very hard to respond to changes in price.
2. Production period.
   
   1. Elastic → Short time to produce as quick to respond
   2. Inelastic → Long time to produce as slow to respond
3. Durability of goods.
   
   1. Elastic → Last long time
   2. Inelastic → Short life (cannot be stored)

Question 14

Relative prices

Answer 14

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.

Question 15

Perfectly competitive markets

(4 pre-conditions)

Answer 15

Four pre-conditions required:

1. Consumer sovereignty exists - Consumer sovereignty is the ability of the consumer in a competitive market economy to direct or allocate resources
2. Large number of buyers and sellers and none have market power to influence price = all are price takers.
3. Products sold are homogenous meaning they are identical and easily substitutable.
4. Ease of exit and entry (i.e. low set up costs, regulations etc)

Question 16

Perfectly competitive markets

(based on 3 assumptions)

Answer 16

Perfectly Competitive Market based on following assumptions (there are three):

1. Buyers and sellers operate with full information
2. Resources are mobile
3. Behaviour is rational = Buyers and sellers seek to maximise their own wellbeing.
   
   1. Buyers = living standards
   2. Sellers = profits

Question 17

Allocative efficiency

Answer 17

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.

Question 18

Productive / Technical efficiency

Answer 18

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.

Question 19

Inter-temporal efficiency

Answer 19

How well resources are allocated over different time periods so the living standards of current generations are not jeopardising future generations living standards.

Question 20

Dynamic efficiency

Answer 20

How quickly an economy can reallocate resources to achieve allocative efficiency, entails firms being adaptive and creative in response to changing economic circumstances.

Question 21

Market failure

Answer 21

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 is 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.

Question 22

Public Goods

Answer 22

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

Question 23

Role and Effect of Government interventions in the market failure of provision of public goods.

Answer 23

1. 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)

Question 24

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!

Answer 24

O NOT SELECT PUBLIC GOODS AS THE OPTION AS THIS IS HARD TO REPRESENT IN A GRAPH AND STUDENTS GET IT WRONG!

Question 25

Common Access Resource

Answer 25

• 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”

Question 26

Role and Effect of Government interventions in the market failure of Common Access Resources

GOVERNMENT REGULATION

Answer 26

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.

Question 27

Role and Effect of Government interventions in the market failure of Common Access Resources

INDIRECT TAXATION

Answer 27

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.

Question 28

Role and Effect of Government interventions in the market failure of Common Access Resources

SUBSIDIES

Answer 28

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.

Question 29

Externality

Answer 29

An externality results when the well-being of a third party not involved in a transaction (or activity) is affected.

Question 30

Positive externalities

What are they? And how are they an example of market failure?

Answer 30

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: All positive externalities (in consumption or production) will eventually lead to an inefficient allocation of resources via an under-allocation of resources toward the production or consumption of a particular good or service that would generate a benefit for a third party.

Question 31

Role and Effect of Government interventions in the market failure of Positive Externalities

SUBSIDIES

Answer 31

Subsidies

e.g. Installation of solar panels

Subsidy is a payment made, usually to the producer of good or service that effectively reduces the cost of production and will incentivise the production or consumption of the good or service that produces the benefit for 3rd parties, addressing the under allcoation of resources that is the inefficiency allocation of resources.

Question 32

Role and Effect of Government interventions in the market failure of Positive Externalities

DIRECT PROVISION

Answer 32

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)

This addresses the under allocation of resources to the good or service that provides the benefits to third parties not involved in the transaction. For example, an educated individual is more likely to provide benefit to the community they live in.

Question 33

Negative externalities

What are they? And how are they an example of market failure?

Answer 33

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: All negative externalities (in consumption or production) will eventually lead to an inefficient allocation of resources via an over-allocation of resources toward the production or consumption of a particular good or service that imposes a cost on a third party that is not internalised by the producer or consumer.

Question 34

Role and Effect of Government interventions in the market failure of Negative Externalities

GOVERNMENT REGULATIONS

Answer 34

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.

In each instance, the regulation is designed to prevent the over allocation of resources toward the prodcution or consumption of the good or service that imposes the cost of the 3rd party not involved in the transaction.

Question 35

Role and Effect of Government interventions in the market failure of Negative Externalities

INDIRECT TAXES

Answer 35

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.

An indirect tax forces the producer or the consumer of the good or service that leads to the negative externality, i.e., the imposition of a cost on a 3rd party not involved in the transaction, incentivising them to change their behaviour.

Question 36

Role and Effect of Government interventions in the market failure of Negative Externalities

ADVERTISING

Answer 36

Government advertising

• Influence tastes and preferences by making consumers aware of negative aspects (e.g. health problems associated with smoking, excessive drinking or gambling).

Aims to correct the market failure by raising awareness of the negative aspects of the consumption or production of the good or service.

Question 37

ole and Effect of Government interventions in the market failure of Negative Externalities

SUBSIDIES

Answer 37

Subsidies

• To businesses and households that generate their electricity using solar panels

Aims to correct the over allocation of resources to production or consumption creating the negative externality (i.e. cost), by changing the behaviour of producers or consumers.

Question 38

Asymmetric Information

What are they? And how are they an example of market failure?

Answer 38

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.

Question 39

Adverse Selection (Type of Asymmetric Information)

Answer 39

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.

Question 40

Moral Hazard

Answer 40

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

Question 41

Role and Effect Government intervention – asymmetric information

Government Regulation

Answer 41

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.

Question 42

ROLE and Effect Government intervention – asymmetric information

Advertising

Answer 42

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.

Question 43

Contemporary example of the government intervention in a market leading to a decrease efficiency of resource allocation.

Answer 43

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 ($21.38 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.

Inefficient allocation of resources, as valuable labour not being utilised (as measured by the labour force underutilisation rate to be covered in Unit 3, Area of Study 2 = unemployment rate + underemployed rate.

Question 44

Evaluating the role of the market in allocating resources

Answer 44

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: