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Chapter 1: An introduction to economics

Chapter 1An introduction to economics

1.1 What is economics?1.2 Thebasiceconomicproblemofrelativescarcityandtheneedforeconomic

decisionmaking1.3 Theconceptandapplicationsofopportunitycost1.4 Theproductionpossibilitycurve(PPC)anditsapplications1.5 Thebasiceconomicquestions1.6 Thepurposeofeconomicactivityandtheinfluenceonlivingstandards1.7 Theneedfortrade-offsandcost-benefitanalysis1.8 Multiplechoicereviewquestions1.9 Chaptercrosswordpuzzle1.10 Chaptersummary

1.1 What is economics?

Onyourwaytoschoolthismorning,youwillhaveundertakensomeformofactivityintheeconomy.Youmayhaveconsumedbreakfastcerealthatwaspurchasedfromasupermarket;youmayhavepurchasedaticketforabus,trainortram;youmayhavebeendriventoschoolinacarusingfuelanddrivingonroadsprovidedbythegovernment;oryoumayhavewalkedthroughgardensthataremaintainedbyyour localcouncilormunicipality. Atschool,youwillbeprovidedwithaservice(education)thatisproducedbyeitherthegovernmentoraprivateorganisation.Indeed,youmayevenbeconsumingtelecommunicationservicesasyoutextafriendordownloadanAppduringoneofyourclasses!!

Alloftheseactivities,andnumerousothersthattakeplaceeverysingleday,canbedescribedaseconomic activity. This isactivitythattakesplaceinordertomakeourlivesmoreenjoyableand/oractivitythatisdesignedtohelpusachieveourgoalsortocompleteourdailychores.Theeconomicactivitythatweengageinwillinvolvenumeroustransactions–whichtypicallyinvolvetheexchangeofmoneyforsomethinginreturn.Forexample,thebusridetoschoolwillhaverequiredapaymenttothebusoperatorandtheuseofSMStextingservicesrequiresapaymenttothetelecommunicationsprovider.

Sometimestheformornatureofanytransactionintheeconomyismuch lessobvious–suchasyouwalking throughaparkonthewaytoschool.Youmightask,howisthisanexampleofaneconomictransactionwhenIhaven’tpaidanything?Theansweristhattheserviceprovidedbytheparkhasindeedbeenpaidfor,butindirectly,bythosepayingtaxestogovernmentsorratestocouncils.

All transactions that we undertake, or indeed all economicactivity,naturallytakeplaceinaneconomy.Aneconomyexistsinanyplaceorregionaroundtheworldwhereproductionofgoodsandservicestakesplace,expenditureonthosegoodsandservicesoccursandincomeismadefromthesellingofthosegoodsandservices.

Atthisintroductorystage,thinkaboutproductionastheprocessofmakingagoodorservices,suchasproducingacar;incomeasthemoneygiventothoseinvolvedintheproductionofgoodsandservices,suchaswages;andexpenditure asthespendingofincomeongoodsandservices.

Withrespecttoaneconomy,itismostcommonlydefinedbyaregion.Forexample,inAustraliaalone,wehaveseveraleconomies:theAustralianeconomy,theVictorianeconomy,theNSWeconomy,andsoon.Alternatively,aneconomycanbedefinedbythesystemusedtodeterminehowdecisionsaboutproduction,incomeandexpendituretakeplace.Forexample, later,wewillexplorethedifferencesbetweena“marketcapitalist”economyanda“plannedsocialist”economy. So,yourdecisiontobeatschool,consumingeducationservices, isanexampleofeconomicactivitythatistakingplaceinboththeVictorianandAustralianeconomies.Theproductionoftheserviceismadebyyourschool,expenditureismadebyyourparentseitherdirectly(viafees)orindirectly(viataxes),andtheincomeisearnedbytheschoolanditsteachers.TheprovisionofthiseducationserviceisalsoanexampleofatransactionthatisoccurringinAustralia’smarketcapitalisteconomy.

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Economics from the ground up (3rd ed)

Positive and normative economics?

Inyourstudyofeconomics,youwillencountermanystatementsorclaimsaboutvariouseconomicrelationships.Somewillbebasedonfact,andarethereforeobjectiveinnature,whileotherswillbebasedonopinions,andarethereforesubjectiveinnature.Fact-basedeconomicstatementscomeunderthebannerofpositive economics andtheycanbeverifiedortestedtobeeithertrueorfalse,usingevidence.Toillustrate,thestatementthattravellingtoschoolonabusisanexampleofeconomicactivityisonebasedonfact.Evidencecanbegatheredtoprovewhetherornotastudenttravellingtoschoolonabusinvolvesexpenditure(spending)thatcreatesproductionandincome.

Incontrast,statementsorclaimsthatarebasedonopinionorvaluejudgementscomeunderthebannerofnormative economics.Giventheirsubjectivenaturetheycannotbeverifiedortestedtobeeithertrueorfalse.Toillustrate,thestatementthattravellingtoschoolonabuscontributestotheeducationalandsocialdevelopmentofstudentsisonebasedonopinion.Itisvirtuallyimpossibleforthisclaimtobeverifiedwithcertainty.

Thisdistinctionbetweenpositiveandnormativeeconomicscansometimesbeafineone.Itisparticularlyimportanttoknowthedifferencegiventhatwemakeeconomicdecisionsthatareinfluencedbyjournalists,politicians,economists,teachersandmanyothers.Oncewearebetterabletoseparatefactfromopinion-positivefromnormative-willwethenbeinabetterpositiontomakeaccurateandinformeddecisionsovertime.Eventhenitwon’tbeeasy,giventhatthebulkofeconomiccommentaryisnormativeinnature,highlightedbythefactthateconomistsdisagreeonawiderangeoftheoriesabouthoweconomieswork.Thisincludesdisagreementaboutthebestwaytouseourpreciousandscarceresourcesduetothecoreproblemfacedbyalleconomies:theproblemofrelative scarcity.

Review questions 1.11. Explainwhatismeantbyeconomicactivity.2. Defineatransaction.3. Distinguishproductionfromexpenditure.4. Distinguishincomefromexpenditure.5. Explainhowgrowthinproductionislikelytoaffectincome.6. Explainhowgrowthinincomeislikelytoaffectexpenditure.7. Explainhowgrowthinexpenditureislikelytoaffectproduction.8. Definetheterm‘economy’.9. Describehoweducationservicescanbeusedasanexampleofeconomic

activitythatistakingplaceintheAustralianeconomy.10. Distinguishpositivefromnormativeeconomics.11. Classifythefollowingtermsaccordingtowhethertheyrelateto‘positive’or‘normative’economics:basedonfact,

opinion,tested,evidence-based,classifiableastrueorfalse,objective,subjective,verifiable,valuejudgements.12. Explainwhyitisimportanttoknowthedifferencebetweenpositiveandnormativeeconomics.

Application Exercise 1a1. In your workbooks, make a list of the five most recent transactions you have undertaken today.2. For each transaction, identify the person or group that is undertaking each of the following:

• Production of the good or service• Expenditure on the good or service• Income earned from the production of the good or service

3. In the table below, classify each transaction as either production, income or expenditure by ticking the relevant box (note that it is possible for more than one box to be ticked in each row)

Transaction Production Income Expenditure1.Janeearns$100fromheremployer,7-Eleven

2.Dylan,acouncilemployee,prunesrosesinthelocalpark

3.BrittanybuysanewcarfromKia

4.Mingsendsatexttohisgirlfriend

5.Tianreceivestutoringfroma1styearuniversitystudent

6.Afarmerharvestshercropofapples

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Chapter 1: An introduction to economics

1.2 The basic economic problem of relative scarcity and the need for economic decision making

Economics primarily concernswhy and how individuals or groupsmake decisions about the transactions theywillundertakeonadailybasis. Asconsumers,weneedtomakedecisionsaboutthetypesandquantitiesofgoodsandservicestoconsume.DowebuyanAppleiPadoraMacBook?Askateboardorascooter?AcanofCokeorabottleofwater?Dowetraveltoschoolonabusorrideabike?Doweattendagovernmentorprivateschool?Asproducersweneedtomakedecisionsaboutthematerials,machineryorequipmentweusetoproducethegoodorservice,aswellastheworkerstoemploy.Inaddition,asincome earners,weneedtodecidehowbesttouseourlabourorskillsinordertoderivethemaximumpossiblebenefit.

Alleconomic agents -whicharedefinedasanyindividual,grouporbodyinvolvedineconomicactivity-arerequiredtomakedecisionsforthesimplereasonthattherearenumerousalternativeoptionsavailable.Inotherwords,thereareanumberofchoiceswearerequiredtomakefrommanypossibleoptions.Wemayaskwhycan'twehaveitall.Whycan’twehavetheMacBook,theiPad,theCoke,bottleofwater,skateboard,scooterandalltheotheritemsonourwishlist?Theanswerliesinaneconomicconceptknownasrelative scarcity.Asacommunity,andacrosstheeconomy,wewantanunlimitednumberofgoodsandservicesandourabilitytosatisfythesewantsdependsonourcapacitytoproducegoodsandservices–which,inacountrylikeAustralia,isquitelarge,butnotlimitless.Wearethereforelimitedbythephysicalconstraintsplacedonusbytheamountofresourcesatourdisposal.

WhileinacountrylikeAustraliawehaveanabundanceofresourcesavailabletoproducegoodsandservices,suchasland,machineryorworkers,theseresourcesarelimitedwhencomparedtotheunlimiteddemandsweplaceuponthoseresources.Relative scarcityisthereforethecoreproblemdeterminingdecisionmakingineveryeconomyaroundtheworld:thefactthatthewantsandneedsofsocietiesarelargerthantheresourcesavailabletosatisfythosewantsandneeds.

Relative scarcity = Wants & needs > resourcesRelative scarcity = Wants & needs > resources

Transaction Production Income Expenditure7.JanesignsuptoaSpotifysubscription

8.BazildownloadsanEconomicsAppfromiTunes

9.Anitacallshermotherusinghermobilephone

10.Zaynabbuysapiefromthecanteen

Application Exercise 1bIn the table below, classify each statement as either a positive or normative statement and be prepared to justify your decision.

Economic statement Positive Normative1.Companytaxcutsshouldincreaseeconomicactivity

2.TheAustraliangovernmentisspendinganinsufficientamountoneducation

3.Australiaisoneofthewealthiestcountriesintheworld

4.Australia’sminimumwagesaretoolow

5.Legalisingmarijuanaformedicalpurposeswillincreasetherateofillegaldruguse

6.Anoversupplyofcrudeoilcontributedtolowercrudeoilpricesover2015-16

7.Carbonemissionsarecontributingtoglobalwarmingandclimatechange

8.Thebestwaytoaddressclimatechangeistoprohibittheproductionofcoalfiredelectricity

9.Spendingonsmartphonescreatesemploymentandgeneratesincome

10.The increaseduseof socialmediabychildren isharmful to their long termwell-being

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Economics from the ground up (3rd ed)

Needs versus wants

The needsofindividualsorhouseholdsinsocietiescanbedefinedasthebasicgoodsandservicesthatarenecessaryforoursurvival.Ourcoreneedsarefood,clothingandshelter.However,inawealthycountrylikeAustralia,somewouldextendthelistofneedstootheritems,suchasacar,mobilephone,digitaltabletorcomputer. Indeed,somecouldmounttheargumentthatsomeindividualsdon’trequireclothingtosurvive,citingthoselivinginwarmclimates. Incontrast,awantisconsideredtobesomethingwedesiretohavetoimproveoursatisfactionorqualityoflife,butthatisnotnecessaryforoursurvival.Regardlessofwhetherweclassifysomethingasawantoraneed,itisstilltruethatrelativescarcitywilloccur.

Why do economists argue that our wants areunlimited?Surely,oncewehaveenoughtoprovidefor a good standard of living, wouldn’t we slowdownourrateofconsumptionorspending?Whilstthismightbetrueforsome,economistsarguethatit is humannature to alwayswantmore. As ourincomesgrowandwebecomewealthier,productsthatwereonceconsideredwants,becomeneeds,and products that were previously ‘out of reach’become wants. This is largely due the inherentgreedofhumans,ourcompetitiveinstincts(wantingmore than our neighbours or trying to keep upwiththeconspicuousconsumptionofothers)andourmaterialisticsocietymoregenerally. Thepervasivemarketingandadvertisingundertakenbybusinessesincreasesourwantsfurther,helpingtomakerelativescarcityanimpossibleproblemtosolve.Inotherwords,nomatterhowmanyneedswefulfil,morewantswillspringupintheirplace,meaningourwantsandneedswillalwaysoutstriptherelativelyscarceresourcesavailabletosatisfythem.

Ifyouhaveanydoubtsaboutthisidea,consideryourownideaaboutyour“needs”comparedtothoselikelytohavebeenexperiencedbyyourgrandparentswhentheywereyourage.Itislikelythatmanyoftheitemsyoucurrentlyconsider“needs”wouldnothaveevenbeenconsideredaspossiblewantsbyyourgrandparentswhentheyweregrowingup.

Resources

Resourcesarethosethingsthatareusedtoproducegoodsandservices;theyarealsoreferredtoasfactors of production. Theyexistinmanydifferentforms,includingmachinery,equipment,workers,managers,factories,forests,andsoon.However,resourcesallhavetwoimportantcharacteristicincommon:theyareallkeyinputsintheproductionprocessandtheyallhavepossiblealternativeuses.Everyorganisationinvolvedinproductionmusthaveexamplesof‘factorsofproduction’thatfitintoeachofthefourcategoriesbelow:

Land or natural resources refers toall those resources thatoccurinnature.Thesecanbeusedintheproductionprocessto generatemoreelaborateproducts, or consumed in theirrawform.Examplesofsuchresourcesinclude:water,forests,minerals, land, animals, fruit and vegetables. It may seemobvious,butallproductiondependsonnaturalresources.

Labourreferstothementalandphysicaleffortbyhumansintheproductionprocess.Itprimarilyincludesalloftheworkersemployedbybusinessesorgovernmentsinreturnforincomeintheformofawageorasalary.

Capital refers to those resources that have been made bycombining labour and natural resources to create a moresophisticated input in theproductionprocess.Capitalgoodsare made with the intention of making more goods andservices in the future and generally these will increase theefficiencywithwhichresourcescanbeconvertedintoproductsforfinalconsumption.Examplesofacapitalresourceincludemachinery,factoriesandequipment.

Entrepreneurship(orenterprise)referstotheskillsofthoseindividualswhocombineourresourcestoproducegoodsandservices.Theytakefinancialriskstoestablishenterprises(businesses)andareextremelyimportanttowealthcreationforeverynation.TheyincludenotonlyhighprofileentrepreneurslikeBillGates,ElonMusk,

Study tip

Whether items are considered to be ‘capital’ in nature depends on how they are used. For example, a car or computer used by a household for private purposes is considered to be a consumer good. However, if they were used by a business they would be considered to be

capital goods.

Study tip

Processed materials used in the production of goods and services, such as chemicals, fuels, or plastics used to manufacture many goods are not resources as defined earlier. Instead they

are simply referred to as inputs.

Application exercise 1cCreate a list of five goods or services that, over time, have gone from being “wants” to “needs”. Justify your choices.

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Chapter 1: An introduction to economics

JeffBezos,RichardBransonorMarkZuckerberg,butincludeallbusinessowners.Inreturnforprovidingtheirexpertiseorskillstothebusinesssectoroftheeconomy,entrepreneurswillreceiveincomeintheformofaprofit.

How relative scarcity affects decision making

Earlier, the concept ofeconomic activity was introduced and described as the process of production, income andexpenditurethattakesplaceineveryeconomy.Eachgroupresponsibleforthedecisionmaking-producers,incomeearnersandconsumers-willexperiencetheproblemofrelativescarcityinuniqueways.However,eachgroupwillneedtomakeeconomicdecisionsthatareultimatelydefinedbythefactthattheycannotsatisfyalloftheirwantsorneedswiththeresourcesattheirdisposal.

The producersinvolvedindecisionmakingfacetheproblemofrelativescarcityby determining the best way to combine resources in order to best satisfyconsumersandthereforemakethemostprofit. Thinkabouttheproductionof a simple product like a banana. It involves theuseof farming land (thebananaplantation),machinery(tractors),workers(farmhands)and,ofcourse,the entrepreneur (the owner/farmer). All of these factors of productionare required to produce the bananas that end up in the fruit shops andsupermarkets around the country. Theproducer or the entrepreneur needstomakeeconomicdecisionsonadailybasisdue to theproblemof relativescarcity.Thefarmerwillmakedecisionssuchas:

• Do I continue to use all ofmy land for banana production or do Iconsiderusingsomeorallofitforsomeothercrop,suchasguavas,orindeedforsomenon-farmingactivity,suchaseco-tourism?

• HowmuchlabourdoIemployonthefarm?• ShouldIusemoremachineryinsteadoflabour?• WhattypesofmachineryorfarmequipmentshouldIemploy?

With respect to income earners,whichincludebothworkersandentrepreneurs,theyneedtodeterminehowbesttousetheirincomeearningcapacity,ortheirskillsandlabour,inordertoachievethebestpossibleoutcome.Anindividualworkercanworkinanumberofdifferentareasorindustries,meaningthattheirskillsareoftentransferableorthatlabourskillshavealternativeuses.Forexample,atruckdriverinvolvedinthetransportationofbananasandotherfruitaroundthecountrywillneedtomakedecisionssuchas:

• DoIcontinueofferingmylabourservicestothefoodtransportationindustry?ShouldIrelocatetoaminingstateandoffermyservicesasatruckdriveronaminingsite,wherethewageissignificantlyhigher?

• DoIretrainorenrolinacourseofstudythatenablesmetoworkinanotherindustry?• DoIwithdrawmylabourservicesandusemywealthtobecomeanentrepreneurbycreatingatransportation

(orsomeother)businessofmyown?

With respect to consumersweneedtomakedecisionsabouthowwe can best use our income orwealth to gain satisfaction fromspendingorconsumption.Ultimately,weallmakedecisionseverydayonhowbesttouseourmoneyinordertomaximiseourwellbeingorlivingstandards.Thismeansthatmoneyisrelativelyscarceandanotherwayofviewingtheproblemofrelativescarcityistosaywedon’thaveenoughmoneytosatisfyallofourwantsandneeds.

Review questions 1.21. Distinguishthetypesofeconomicdecisionsmadebyconsumersandproducers.2. Defineeconomicagent.3. Definethetermrelativescarcity.4. Distinguishaneedfromawant.5. Discusswhetheranationcansolvetheproblemofrelativescarcity.6. Definethetermresourcesandexplainwhyresourcesarealsoreferredtoasfactorsofproduction.7. Discusshowonedecisionmadebyaproducercanbelinkedtotheconceptofrelativescarcity.8. Discusshowonedecisionmadebyanincomeearnercanbelinkedtotheconceptofrelativescarcity.9. Discusshowonedecisionmadebyaconsumercanbelinkedtotheconceptofrelativescarcity.

Study tip

Note that money is not a resource in itself. While it has important functions, such as a store of value and a means of exchange, in itself, it cannot be of use in the production process as it is only a piece of paper or a coin. Therefore, in Economics, it is incorrect to argue

that money is a scarce resource.

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Economics from the ground up (3rd ed)

1.3 The concept and applications of opportunity cost

Theuseofourscarceresourcesinoneeconomicactivitymeansthatthosesameresourcescannotbeusedinanother.Forexample,assumethatafarmerhasaplotof land, let’ssay1,000acres,fromwhichshecouldproducebananas,guavasoranyothercrop.Itmaybethat500acresisdevotedtobananaproductionand500acrestotheproductionofguavas.Alternatively,someothercombinationforthelandusecouldbedetermined.Regardless,thefactremains,thatoncethefarmermakesadecisionabouthowthelandwillbeusedinproduction,itinvolvesasacrifice.Itmeansthatthefarmerissacrificingtheopportunitytousethelandforalternativecropsoruses.Thenatureofthesacrificeisdefinedbytherangeofalternativelandusesavailabletothefarmer,suchasmelonorpineappleproduction,orawildlifesanctuary,nature reserveorevena tourist facility. This ideaof therebeingacost involved inalleconomicdecisionmaking isreferredtoasopportunity cost.Theopportunitycostofusingthe1000acresforaparticularpurposeis,specifically,thevalueofthenextbestalternativeforwhichthelandcouldbeused.Thisrequiresajudgementontherelativemeritsofeachalternative.Theoptionconsideredtobethenextbestalternativebecomestheopportunitycost.

Opportunitycostisthereforethebenefitsacrificed(economistsspeakaboutthebenefit“foregone”)whenchoosingonealternativeoverothers.Itismeasuredbythevaluethatwouldhavebeencreatedbyusingtheresourcesintheirnextbestalternativeuse.Thefactisthatwheneverwedecidetouseourresourcesinsomeway,itnecessarilyinvolvesusgivinguptheopportunitytousethosesameresourcesinsomeotherway.

All rational economic agents will seek to minimise theiropportunity costs when making decisions or undertakingeconomictransactions.Thismeansthattheoverallnetbenefits(thebenefitsgainedminusthecostsincurred)fromanydecision(or transaction) will be the highest possible. Assume that thefarmerwith1000acresoflandhasconductedextensiveresearchanddeterminedthatthelandwillyieldthefollowingbenefitsindollarterms:

• $100,000ofannualincomeifusedforbananaproduction;• $80,000ifusedforguavaproduction;and• $60,000ifusedforpineappleproduction.

Ifthefarmerispurelymotivatedbyprofit,therationaldecisionwouldbetousethelandforbananaproduction,withtheopportunitycostbeingthe$80,000ofguavarevenuethatwillbesacrificed.Thedecisionisrationalbecausethe$100,000ofrevenuegainedfromproducingbananaswillbegreaterthanthe$80,000ofrevenuethatwouldhavebeengainedifthefarmerusedthelandforguavaproduction.

Study tip

In Economics, it is necessary to assume that economic agents are rational in their decision making. This means economists assume that economic decisions are made with a view to maximising benefits and minimising costs. Without this important assumption, the predictions made by economists become

much less reliable.

Application Exercise 1eIn the table below, classify each of the resources as either natural, labour, capital or entrepreneurship and be prepared to justify your decision.

Item Natural Labour CapitalTractorComputerusedathomeTeacherMineralsandsComputerusedatAustraliaPostGreatBarrierReefAcomputerprogrammerThePrimeMinisterofAustraliaAmotorcarusedasataxiFarmland

Application Exercise 1dIn the table below, classify each item as either a want or a need and be prepared to justify your decision.

Item Want Need

HouseTelevision

Mobile phone

Motorvehicle

Trainservices

FoodandwaterHouseUnderwear

Dinnersuit

Digitaltablet

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Chapter 1: An introduction to economics

However,assumenowthatthefarmerdecidedtousethelandforguavaproductionandexpectstoreceive$80,000peryear.Thisisclearlyanirrationaldecisionforafarmerwhoissolelymotivatedbyprofit.Theopportunitycostofguavaproductionisnowthe$100,000ofrevenuethathasbeensacrificed.Inthiscase,thefarmerhasnotminimisedopportunitycostsbecausetheopportunitycostofthedecisionis$100,000(themoneythatcouldhavebeenearnedfromthe“nextbestalternative”)whenitcouldhavebeen$80,000.

Further applications of opportunity costs

Eachofusexperienceopportunitycostseverydayofourlivessimplybecausewemakeeconomicdecisionsonadailybasis.Adecisiontoleaveschoolattheageof17maycomewithfinancialbenefits,suchasafull-timeincome,aswellasotherbenefits,includingfreedomfromtherulesandconstraintsexistingateducationalinstitutions.However,itwillcomeatanopportunitycostwhichislikelytobethebenefitsthatmightbeprovidedbyatertiaryeducation,suchasapotentiallylargerincomeinthefuture,orpossiblyimprovedstatusinthecommunity.

Onceinemploymentasincomeearners,individualswilloftendecideonachangeofemployerorevenacareerchange.Clearly,thesedecisionsaremadeonthebasisthattheopportunitycostsofstayingwiththeirexistingemployerhavebecome too great. To illustrate, theWestern Australia andQueenslandmining boom that occurred in recent yearsmarkedlyincreasedtheopportunitycostsofremainingemployedinotherareas,particularlyforthoselivinginWAandQueensland. Theshortageofmining labour resulted in thewagepaid tominers increasing to relativelyhigh levels.SomeoneemployedinWesternAustraliaorevenVictoria,asatruckdriverwithLinfoxforexample,earning$75,000peryear,realisedthatthenextbestalternativeuseofherlabourskillswouldhaveyieldedanincomeintheorderof$150,000ononeofthemines.Astheminingwagecontinuedtoincrease(inordertoattractworkerstomines),the

Application Exercise 1f: Smoking and opportunity costsConsumersarebombardedwithdifferentmessagesinfluencingtheirdecisionmaking,manyofwhicharedeliberateattemptsbybusinessestocreateademandfortheirproductthroughmarketingandadvertising. Ultimately,thedecisiontopurchaseanyparticulargoodorservicewillcomeatbothafinancialcost(thecostoftheproduct)aswellasanopportunitycost(foregoingthevalueofthenextbestalternative).Formostpurchases,theopportunitycostsarequitetransparent.Thepurchaseofanapplefor$1meansthatweforegotheopportunitytousethatsame$1topurchaseapear.Thebenefitsthatareforegonewhennotpurchasingthepeararesimilartothebenefitstobeenjoyedfromconsumingtheappleandtheseareeasilymeasured(suchassatisfiedhungerandahealthierdiet).

This is not the casewith a decision to purchase a packet of cigarettes. Formany years tobacco manufacturers have been able to employ sophisticatedmarketingstrategies toattractyoungsmokers,hopingtocreatebrand loyaltyandcapturethemascustomersforlife.Thedecisiontotakeupsmokinginvolvesopportunity costs,manyofwhicharedelayed,making itmuchmoredifficultforconsumerstomakearationaldecision. Whenayoungpersondecidestopurchasecigarettestheywillequatethecostofapacketofcigarettes,perhaps$20,withthepotentialbenefits,includingtheperceptionofbeingcool,toughorindependent.Butthelongtermcostsintermsofdamagetohealthandwell-beingaredelayedsofarintothefuturethatmanyyoungconsumersgenerallydon’ttakethisintoaccountwhenevaluatingthenetbenefits(i.e.thebenefitsminusthecosts)ofsmoking.

Intermsofopportunitycosts,thebenefitthatcouldbederivedfromusingthat$20inthenextbestalternative(whichmightbehealthfoodorevensavinginthebank)isclearlysuperiortothenetbenefitsthataregainedfromsmoking.Accordingly,theopportunitycostsofsmokingarehigherthanopportunitycostsofusingthatsame$20tobuymostothergoods.Inotherwords,whenconsumersdecidetospend$20onapacketofcigarettes,alltheevidencesuggeststhattheyarenotminimisingtheiropportunitycosts. Butwhydopeoplestillsmoke?Aretheirhiddenorunknownbenefitsofwhichonlysmokersareaware?Areconsumerssimplymakingirrationaldecisions?Oraretobaccomanufacturerssuccessfullyblindingconsumerstothelongtermdamagethatsmokingcauses,makinganirrationaldecisionappearmorerational?

Questions1. Define the term ‘net benefits’ and discuss how it might influence the decision making of consumers.2. Illustrate one way that tobacco manufacturers seek to persuade consumers to purchase their product.3. Outline some possible alternatives to spending $3000 on cigarettes in a given year.4. Determine the opportunity cost of spending $3000 on cigarettes over a one year period.5. Discuss why the consumption of cigarettes may not be the most rational decision, using the concept of

opportunity cost in your answer.

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Economics from the ground up (3rd ed)

opportunitycostsincreasedfortruckdriversinthetransportindustry,andmanytruckdriversmovedfromthetransportindustrytotheminingindustry.Thiswasarationaldecisionbytheseeconomicagentswhowerekeentominimisetheopportunitycostsassociatedwithemployment.Ofcourse,sincetheendoftheminingboom,theprocesshasworkedinreverse,asminingwageshavefallenrelativetonon-miningwages.

Governmentshavesubstantial(butlimited)fundsattheirdisposal touse for society’sbenefitand these fundsarecollectedthroughtaxes.Ifthefederalgovernmentchoosestospend$2billiononbuildingafastrailwaylinebetweenGeelongandMelbourne(aspromisedin2019),itforegoesor sacrifices theopportunity touse that same$2billionfor investment inhealth,educationorpublicparks. Theopportunity cost in this example is the benefit thatcouldbederived froma$2billion investment inhealth,educationand/orpublicparks,whicheverisconsideredtobethenextbestalternativeforthegovernment.

Review questions 1.31. Defineopportunitycost,usingtheexampleofafarmerwithacreagetoillustrate.2. Explainhowtheconceptofopportunitycostcanbeusedtoillustratehowproducerswilltendtomakerational

decisions.3. Discusshowthegovernmentfacesopportunitycostswhendecidingtospendtaxpayers’money.4. Discusstheopportunitycostsofayoungpersondecidingtodiscontinuefurthereducationafterreachingthe

ageof17.

Application Exercise 1hAssumethatyourunasmallsurfshopsellingsurfgearandmakingrepairstoboardsandequipment. Yourelectricitybill isquite substantialandyou seekwaystoreduceit.Youdiscoveradevicecosting$1,000thatwilldecreaseyourelectricitybillby$50everyyear.Youfigurethatyoucouldtakethemoneyoutofyourcashbalancetopurchasethemachineandthereforesave$50peryear.Alternatively, you coulddecide to invest the$1,000 ina termdepositwithabank,earning10%perannum.Thefinalalternativeisthatyoucouldleavethe$1,000 in thebusinesschequeaccount,where itearnsa low1% interestperannum.

Questions1. Make a list of the competing uses for the $1,000.2. Determine the opportunity cost of purchasing the machine.3. Assuming that your business does not experience cash flow problems,

explain why the business should not leave the cash in the business cheque account. In your answer, refer to opportunity cost.

4. Explain why it might be a rational decision not to purchase the machine. In your answer, refer to opportunity cost.

Application Exercise 1gFill the gaps in the paragraph below: Economics is all about how peoplemake ___________ about the use of resources. These decisionsmust bemadebecauseeverynation’s___________are__________whencomparedtothedemandsplaceduponthose____________.Thisisreferredtoastheproblemof_____________________.Whenwedecidetouseourresourcesinsomeway,itnecessarilyinvolvesusforegoingthe______________tousethosesame___________insomeotherway.Thisisbecausetheavailabilityofresourcesis__________andtheyhavealternativewaysofbeing_____.Theopportunity______ofdecisionmakingcanbedefinedasthe________thatcouldhavebeengainedifthenext_______alternativewaschosen.

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Chapter 1: An introduction to economics

1.4 The production possibility curve and its applications

Aproductionpossibilitycurve(PPC)isalsoreferredtoastheProduction Possibility Frontier (PPF).Itisanabstracttoolusedbyeconomiststohighlightanumberofdifferentconcepts,includingtheconceptsofscarcity,choice,opportunitycost,underutilisationofresourcesandefficiency.

ThePPCinvolvesarepresentationoftheproductionalternativesavailabletoaneconomyproducingonlytwogoodsorservices,intheformofadiagram.Whileitisnotstrictlyrealistic,becausealleconomiescanproducemorethantwogoodsorservices,itdoesdemonstratesomeusefulpointsandhelpsustomakebettereconomicdecisions.ThePPCreliesonanumberofsimplifiedassumptions,thekeyonesbeing:

• onlytwogoods(orservices)arebeingproducedinaneconomy;• allresourcesorfactorsofproductioncanbeusedintheproductionofeithergood(orservice),andso

theyareeasilyabletobeswappedbetweenproductionofthetwogoods(orservices);and• allresourcesarefullyandefficientlyemployed.

Assumethataneconomycandecidetouseitsresourcestoproduceeithermilitarygoods,suchastanksandgrenades,orconsumergoods,suchasfoodandclothing.Theproductionpossibilitiescouldbeasfollows:

Table 1.1Combination Militarygoods(000) Consumergoods(000)

A 120 0B 115 20C 100 40D 75 60E 35 80F 0 90

Whenweplotthisontoatwodimensionaldiagramwegetaproductionpossibilitycurve(PPC)asfollows:

0

10

20

30

40

50

60

70

80

90

100

0 20 40 60 80 100 120 140

Cons

umer

good

s (00

0)

Military goods (000)

Figure 1.1 Production possibility curve

A

G

H

B

C

D

EF

How the PPC illustrates economic concepts

Theway thePPC isdrawnclearlyhighlights the conceptof relative scarcity. Given thatwehave limited resourcesrelativetothedemandsplacedonthoseresources,wemustmakechoicesaboutthebestwaytouseourscarcefactorsofproduction(suchaslabourandcapital)intheproductionofgoodsandservicesforsociety.Intheaboveexample,ourchoiceisbetweenconsumerandmilitarygoods-achoicefacedbyeverynationintheworld.Whichisthebestchoiceis a normative consideration that ultimately depends on value judgements. Those countrieswith valuable naturalresourcesandwhoalsofeelunderthreatfrompowerfulneighboursmightprefertochooseproductioncombinationsCorB.Incontrast,thosecountrieswithoutfearofforeignexploitationormilitaryinterventionmightpreferproductioncombinationsEorF.

AmovementfromonepointtoanotheralongaPPCmeansthatacountryisallocatingmoretotheproductionofonegoodandlesstoanother.Intheaboveexample,astheeconomyproducesmoremilitarygoodsitinvolvesasacrificeintheproductionofconsumergoods,clearlyanexampleofopportunity cost. IfweassumethattheeconomywasinitiallyoperatingatpointF,producingnomilitarygoodsand90,000consumergoods,thenadecisiontoproduce35,000militarygoodswill involveanopportunitycostexpressedintermsoftheproductionofconsumergoodsthatwillbeforegone–inthiscase10,000consumergoods.

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Economics from the ground up (3rd ed)

Allpointsalongthecurverepresentthemaximumproductionpossibilitiesachievableatthatparticularpointintime.Pointsoutsidethecurve(likepointG)arenotachievabletoday,butareachievableinthefuturethroughanincreaseinthequantityorqualityorresources.Forexample,ifthenationimprovesitsproductivity(orefficiency),whichmeansthatitcanproducemoreofbothgoodswiththesamevolumeofresources,thenthewholePPClinewillshiftouttotheright.

Points insidethePPC(likepointH) indicatethattheeconomy isnotefficientlyusing itsresources intheproductionofmilitaryandconsumergoods. Inotherwords,therewillbeanunderutilisation of resources,meaningthatsomeavailable resources are not being fully utilised in production. Better ormore efficient use of the nation’s existingresourceswouldthereforeincreaseproduction.ProducingwithinthePPCisalsolikelytoreflectsomeunemploymentorunderemploymentofthenation’sresourcesandeveryeconomyiskeentoensurethatproductionoccursonitsPPC.

TheconstructionofaPPCisnotlimitedtotheproductionoftwogoodsorservicesforaneconomy.Itcanbeusedtoillustratetheproductionpossibilitiesavailabletoanyeconomicentity,suchasthefarmerreferredtoearlierwhocanproduceeitherguavasorbananas.Alternatively,itcanbeusedtoillustratethetrade-offs/opportunitycostsassociatedwithsavingsandconsumptiondecisions,wherethemoreofourmoneywedevotetoconsumption,thelesswecandevotetosavings.

Application Exercise 1iUsingthedataintheadjacenttable,constructaPPCforhealthfoodsandjunkfoodsandanswerthequestionsthatfollow.Youshouldusegridpaper,orsomeothermethodtoensureyourPPCisaccurate.

Questions1. Discuss the implications for the economy if it

produces at point F. 2. Discuss the implications for the economy if it

produces at point A.3. Discuss the implications for the economy if it

decides to reallocate its resources and move from production point F to D.

4. Identify the opportunity costs associated with a change in production from point A to E.5. Assume that the economy produces 130,000 items of health food and 100,000 items of junk food. Label this

point G on your diagram and discuss its implications.6. Label a point H on the outside of your PPC diagram and provide two examples of changes that could occur in

the economy for this point of production to be achieved in the future.

Combination Health foods (000)

Junk foods (000)

A 200 0B 190 40C 170 80

D 140 120E 100 160F 0 200

Efficiency and the PPCThePPCwasusedtohighlighttheopportunitycostsassociatedwiththeproductiondecisionsforaneconomy.Itcanalsobeusedtodistinguishdifferenttypesofefficiencythatexistineconomies.Ingeneralterms,efficiency refers to the extenttowhicheffortorresourcesarewellusedfortheirintendedtaskorpurpose.However,therearetwomajortypesofefficiencythathelptodeterminehowwellaneconomyisfunctioning–productiveandallocativeefficiency.

Productive/technical efficiency

GiventhatthePPCisdefinedasthemaximumproductionpossibilitiesavailable when all resources are fully and efficiently employed, bydefinition, it represents one measure of efficiency – productive (or technical)efficiency.Productive(technical)efficiencyisdefinedasthatsituationwhereanation’sresourcesareproducingthemaximumamountpossible (and at the lowest cost). This type of efficiencymeans thatproductivitylevelsinaneconomyareattheirpeak,whereproductivityisdefinedastheratioofoutput(orproduction)tothetotalinputsusedinproduction.Inthiscase,theinputsincludeourfactorsofproductionplusotherinputssuchasmaterials.

AllpointsalongthePPCareproductivelyefficient. Thevaluessocietyplaces on the goods in question is irrelevant when the focus is onproductiveortechnicalefficiency. So longasproductionoccursalongthePPC,thenationisefficient inaproductivesense– ithasachievedproductive(technical)efficiency.ThisishighlightedinFigure1.2.

Figure 1.2 Technical/productive e�ciency

Goo

d A

Good B

1

2

3

5

4

All technically e�cient

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Chapter 1: An introduction to economics

Allocative efficiency

However,economistsarealsoconcernedaboutadifferenttypeofefficiency, allocative efficiency,whereresourcesneedtobeallocatedorusedintheeconomyincombinationsthatprovidethemaximumpossiblebenefitsforconsumersandthenation.Aneconomycanhavethehighestlevelsoftechnical(productive)efficiencyimaginable–whereoutputisashighaspossible,atthelowestcost-butthisisoflittlevalueifthegoodsbeingproducedinthiseconomyareeithernotthegoodswantedbysociety,orgoodsthatarenotinsociety’sbestinterests.Toillustrate,assumethataneconomycanproducehealthfoodsorillicitdrugs.ItsPPCmightlooksomethinglikethathighlightedinFigure1.3.

Despite all combinations of production being technically efficient (i.e.points 1-3), there is onlyone combination that is in the national bestinterest. This ispoint1. Thismeans that if theeconomymoved frompoint 1 towards point 2, itwould be allocating fewer resources to theproductionofhealthfoodandmoreresourcestotheproductionofillicitdrugs.Thiswouldclearlynotbeinthenation’sinterestsasitswelfareorlivingstandardswoulddecline.

The most efficient allocation of resources (i.e.allocativeefficiency)canthereforebedefinedasonewhereallofthenation’sresourcesarebeingused to produce the best possible combination of goods and servicessuch that nationalwelfare or living standards ismaximised. This thenimpliesthatanychangeinthewayresourcesareallocatedfromthispointwillresultinadeteriorationofnationallivingstandards.

Whatis,orisn’t,consideredtobethemostefficientallocationofresourcesforanyparticularnationlargelydependsonthevaluesitplacesonvariousgoodsandservices.Forexample,anationthatishighlymaterialisticislikelytovaluethehighestpossibleproductionlevels,regardlessoftheimpactontheenvironment.Comparedtoanothercountrythatismoreenvironmentallyconscious,itwillthereforetendtoproducemorecarbonintensiveformsofenergy(creatinggreater levelsofC02 emissions) relative tomoreenvironmentally friendlyenergyproduction (suchas solarorwindenergy).

Review questions 1.41. Defineproductionpossibilitycurve(PPC)andlisttheassumptionsunderpinningtheconstructionofaPPC.2. UsingTable1.1,identifytheopportunitycostofthenationincreasingitsproductionofmilitarygoodsfrom35,000

to100,000.3. Using Table 1.1, identify theopportunity cost of thenation increasing its productionof consumer goods from

20,000to60,000.4. DiscussthepossibilityofproducingatapointoutsidethePPC,suchaspointGinFigure1.1.5. OutlinetheimplicationsforaneconomythatproducesinsidetheboundaryofitsPPC,suchaspointHinFigure1.1.6. ExplainhowthePPCcanillustratetheconceptsofscarcity,choice,opportunitycost,underutilisationofresources.7. Defineproductivity.8. Definetechnical(productive)efficiency.9. Distinguishtechnicalefficiencyfromallocativeefficiency,usingaPPCtoillustrate.10. Explainhowanimprovementintechnicalefficiencymightnotbeaccompaniedbyanincreaseinallocativeefficiency.11. Explainwhatismeantbythemostefficientallocationofresources.12. Discusswhyanation’svaluesdeterminewhatitconsiderstobethemostefficientallocationofitsresources.

Application Exercise 1j Efficiency, efficiency, efficiency.......1. Assume that an economy is achieving technical efficiency and it achieves a boost to

productivity as a result of new technology. Explain how this is likely to affect both technical and allocative efficiency. Use a PPC to illustrate.

2. Assume that an economy is not achieving technical efficiency and it achieves a boost to productivity, illustrate how this is likely to affect its PPC.

3. Assume that an economy is achieving technical efficiency. Explain how it could achieve a more efficient allocation of resources without pushing out its PPC.

4. Assume that two countries had exactly the same quality and quantity of resources. Explain why the most efficient allocation of resources as depicted by a point on their respective PPCs is unlikely to be the same.

5. Discuss whether the most efficient allocation of resources, as determined by the ‘best’ production point on the PPC, is more closely related to normative economics or positive economics.

Hea

lth fo

ods

Illicit drugs

1

2

3

Allocatively e�cient combination

Figure 1.3Allocative e�ciency

Health foods versus illicit drugs

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Economics from the ground up (3rd ed)

1.5 The basic economic questions

What and how much to produce?

Thisisconcernedwithhowweallocateourscarceresources.Shouldweproducebananasorguavas?Capitalgoodsorconsumergoods?Coalfiredelectricityorsolarelectricity?Militaryweaponsorbetter-resourcedschools?Oncewedeterminethetypesofgoodsandserviceswewillproduce,preciselyhowmuchshouldbeproduced?

Australiahasamarket capitalist economy,withthemajorityof Australia’s resources privately owned and with theallocation of resources being determined primarily by the market. Thismeans that thegoodsand servicesproducedwill ultimately be determined by the wants and needs ofconsumers. Providing businesses can make a profit fromproducing thesegoodsand services,amarketwill develop,wherebuyersandsellerscometogethertoexchangegoodsandservicesatanagreedprice.Inthiscontext,‘themarket’will determine how the nation’s resources are allocated inproduction.Inotherwords,‘themarket’willdeterminewhatgoodsandservicesareproducedandinwhatquantitiestheywillbeproduced.

It isusefultonoteatthis introductorystageofthecoursethatamarketdoesnotinvolveasinglebodyorauthoritydictatingtheprocess.Insteaditinvolvesconsumersandproducers,guidedprimarilybyself-interest,determiningthetypeandquantityofgoodsandservicestobeproducedintheeconomy.[TheroleandoperationofthemarketintheAustralianeconomywillbeexploredinChapter3.]

Whilemarketsplay theprimary role indeterminingwhat is produced,Australian governmentsensure that there issomedegreeofgovernmentinterventiontoprotectagainsttheproblemsinherentwithunregulatedmarkets.These‘problems’arecommonlyreferredtoasmarket failuresandincludetheunder-productionofessentialservices,suchaspublichousing,prisons, schools,hospitalsandemergencyservices,aswellas theover-productionofundesirablegoodsandservicessuchasillicitdrugs,someweapons,alcoholandtobacco.Inthisrespect,governmentswillnotonlyinfluencewhatgoodsandservicesareproduced,buthowmuchproductionwillbetoleratedincertaininstances.Forexample,thegovernmentprovidesdefenceandnationalsecurityservicesitselfbecauseamarketwouldfailtodevelopfortheseservices.Thisisbecauseitwouldbetoodifficultforproducerstoextractpaymentfromconsumers,resultingin insufficientprofitto justifythe investment. Inother instances,governmentsallowamarkettodevelopforgoodsandservices,butwillbekeentolimittheamountofconsumptionandproductionthattakesplace.Commonexamplesincludedirtyenergy (suchascoalfiredelectricity), tobacco,alcoholandgamblingservices. Governmentswillusearangeofmeasurestolimittheconsumptionorproductionofcertaingoodsandservices,suchasoutrightprohibition,taxes,regulationsandadvertising.

Overall,whilegovernmentsdoplaya role, it is themarket thatultimatelydetermineswhatgoodsandserviceswillbeproducedand inwhatquantities. It is thereforeconsumerswhoare ‘inthedrivingseat’andexperiencewhat iscommonlyreferredtoas‘consumer sovereignty’.ThismeansthatconsumersprimarilydeterminewhatwillbeproducedinAustralia.

How to produce?

Thisisalsoanallocationquestionandaskswhatcombinationoffactorsofproductionwillbeusedtoproducegoodsandservices. Do we use more labour than capital (i.e. morelabour intensive formsofproduction)ormore capital thanlabour(i.e.morecapitalintensiveproductionmethods)?

In Australia, most of the decisions about how goods andservicesareproducedisalsodeterminedbythemarket. Aminingcompany,suchasBHP,havingalreadydecidedthatitwillproduceironore,willthenneedtodeterminethebestmixofresourcestouseinitsdrillingandminingoperations.Itsdecisionwillbedeterminedbywhatitconsiderstobethemostcostefficientmethodofproduction,whichinturndependsuponhowefficientorproductiveeachfactorofproductionisrelativetoitscost.Giventherelativedifficultyofextractingoredepositsfromtheearth,miningcompaniesareheavilycapital intensive–meaningtheyusemostly

13

Chapter 1: An introduction to economics

machinery-becauseitisthemostcostefficientandprofitmaximisingmethodofproduction.Inthisrespect,theoverallcostoflabouristoohighrelativetothecostofcapital,resultinginmorecapitalemployedrelativetolabour.

Governmentsdoinfluencehowgoodsandservicesareproducedtoalimitedextent.Forexample,governmentsprovidetaxationandotherincentivesforbusinessestospendmoreonresearchanddevelopmentintonewtechnologiesandinnovation.Thishelpsthebusinesssector to increase efficiency over time and reduces costs for consumers.Governmentsalsoinfluencethecostoflabourforbusinessesbyintroducinglaws thatensureminimum wages arepaid,occupationalhealthandsafetystandardsarehighandequalopportunityandanti-discriminationmeasuresareenforced.Inaddition,thegovernmenthaslawsinplacethatrestricttheabilityorfreedomofforeignlabourtooffertheirservicesinAustralia.

For whom to produce?

This is really concernedwith how the goods and services are allocated ordistributed to society. If left to freemarkets, thosewithgreatereconomic power (suchasthewealthiermembersofsociety)willhavegreateraccesstogoodsandservicesandsomemembersofsociety(e.g.thoseearningminimalincomes)will be unable to purchase some essential goods or services likehealth care or education. As a consequence, in a freemarket, only thosepeoplewithsufficientfundswouldbeabletoaffordthecostofeducationfortheirchildren.Similarly,somelowincomeearningfamilieswouldbeunabletohaveaccesstoevenbasichousingservices.

InAustralia,itisthemarketoncemorethatdetermineswhogainsaccesstothemajorityofgoodsandservices.Incomeearners in Australia generate the bulk of national income from their contribution to the production of goods andservices.Generallyspeaking,thosewithhigheroruniqueskillsearnbiggerincomesandwillhavethegreatestaccesstogoodsandservices.However,thisisinfluencedbygovernmentattemptstoachieveamoreequitabledistributionofincomeandwealth.Thesegovernmentactionsincludetheimplementationofaprogressiveincometaxsystemthatredistributesincometolowerincomeearners,aswellasthedirectprovisionofgoodsandservicesforlowerincomegroups,suchaspublichousing.

Review questions 1.51. DiscusswhatismeantbythethreebasiceconomicquestionsfacingtheAustralianeconomy.2. ExplainhowAustraliadecides‘what’and‘howmuch’isproduced.Inyouranswer,makereferencetotheroleof

marketsandwhygovernmentinterventionisneeded.3. ExplainhowAustraliadecides‘how’goodsandservicesareproducedandoutlinehowthegovernmentinfluences

howgoodsandservicesareproduced.4. Explain how Australia decides who receives the goods and services that are produced and outline how the

governmentinfluenceswhogainsaccesstogoodsandservicesthatareproduced.

Application Exercise 1k1. Explain how changes in technology have changed ‘what’ and ‘how’ goods and services have been produced

over the past 10 years. Use at least one example from the Australian economy to illustrate your response.

2. Discuss how the government can reduce the consumption and production of products like alcohol and tobacco.

3. Discuss why and how the government supports the production of certain goods or services. Use at least one example from the Australian economy to illustrate your response.

4. Outline how the Australian government can influence the private sector to employ more labour when producing goods and services.

5. Explain how ‘the market’ was ultimately responsible for mining companies replacing labour with driverless trains and trucks.

6. Explain how minimum wages laws can affect a firm’s decision about how to produce goods and services.

7. Explain how a person earning zero income from wages can still have access to goods and services in the Australian economy.

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Economics from the ground up (3rd ed)

1.6 The purpose of economic activity and the influence on living standards

Earlierwe introduced the term ‘economicactivity’ in thecontextofdiscoveringwhateconomics isabout. Wesaidthateconomicactivity refers toproduction, incomeandexpenditure that takesplace inaneconomy. Wesaid thatproductionistheprocessofmakingagoodorservices;incomeistherewardgiventothoseinvolvedintheproductionofgoodsandservices;andexpenditureisthespendingofincomeongoodsandservices.

Overtime,thetotalvalueofproduction,incomeandexpenditureinaneconomyshouldbeequal.Thisshouldmakesensebecausealloftheproductiontakingplaceismeasuredinmonetarytermsandmusteventuallybereturnedtofactorsof production (such asworkers andowners) in the formof income. Inotherwords, thosewhoprovide thefactorsofproductionreceivepaymentforthosefactorswhentheyareusedintheproductionprocess.Allofthisincomewilltheneventuallybespent(i.e.expenditure)atsometimeinthefuture.Thisspendingwillbeonvariousgoodsandservices(i.e.production).Thisprocessisoftencharacterisedbyacircular flow diagramasshowninFigure.1.4.

Figure 1.4Circular �ow of income

Production

Expenditure

Income

Economic activity and a two sector circular flow sector model of the economy

Thecircularflowofproduction,incomeandexpenditurecanalsobedemonstratedbyincludingthetwokeysectorsintheeconomythatareresponsibleforeconomicactivity-the business sectorandthehousehold sector.ThisisshowninFigure1.5below.

Household sector Business sector

Flow 1: Resources/factors of production provided to the business sector

LabourLand

CapitalEntrepreneurship

Wages & salariesRent

InterestPro�ts

Flow 2: Income returned to household sector for providing resources/factors of production

Flow 3: Expenditure on goods and services

Flow 4: Production of goods and services

Figure 1.5 Two sector circular �ow model of the economy

Figure1.5showsthattheflowsofproduction,incomeandexpenditureoccurasaresultoftransactionsbetweenthebusinessandhouseholdsectors.Thehouseholdsectorprovidesthebusinesssectorwithresources(suchaslabour)and

15

Chapter 1: An introduction to economics

thisishighlightedbyFlow 1inthediagram.Inreturn,thebusinesssectorprovidesthehouseholdsectorwithincome(suchaswages),whichishighlightedbyFlow 2.Thisincomeisthenspentbythehouseholdsectoronthepurchaseofgoodsandservices(i.e.expenditure),whichformsFlow 3 andthis expenditurenecessarilyresultsintheproductionofgoodsandservicesbythebusinesssector,whichishighlightedinFlow 4.

Whilethissimplemodelignoresotherimportantsectors(e.g.thegovernmentandexternalsectors)andflows(e.g.thepossibilityofsavingsandtaxes)itremainsusefulbecauseithelpsustogainabetterunderstandingofthecoreinfluencesaffectingeconomicactivity.Forexample,itshouldbeobviousthatanydecisionbythehouseholdsectortocontributemoreresourcestothebusinesssector(e.g.providingmorelabour)willultimatelyresultinmoreincome,expenditureandproduction(i.e.economicactivity)takingplaceintheeconomy.Thisboostineconomicactivityisthereforeheavilylinkedtothedesireofthehouseholdsector(individualsandfamilies)toimprovetheirstandardofliving.

Economic activity and living standards

Ultimately,economicactivitytakesplacebecauseithelpstoimproveourindividualandcollectivestandards of living,both in material andnon-material terms. Thismeans thatmost people are keen to improve their enjoyment andqualityoflifeovertime,whichusuallytakestheformofthembeingmoreabletopurchasegoodsandservices.Inthisrespect,thereistypicallyapositivecorrelationbetweeneconomicactivityandlivingstandards,suchthatanincreaseineconomicactivityleadstoanincreaseinlivingstandards.Thisisbecausetheearningofincomeleadstoexpenditureongoodsandservicesthatprovidespeoplewithadditionalsatisfaction.However,livingstandardsarenotonlyrelatedtotheabilitytoconsumegoodsandservicesandwilldependonbothmaterialandnon-materialfactorsthatdetermineouroveralllivingstandards.

Material living standards

Australian governments are keen to stimulate growth inproduction as measured by growth in real gross domestic product,orrealGDP,overtime.[RealGDPwillbecoveredmorefully inUnit2butatthisstagesimplyrememberthat it isthemainstatisticalmeasureofproduction.]GrowthinrealGDPisalso referred toaseconomic growth and itmeans that therehasbeenan increase intherealvaluesofproduction, incomeandexpenditurefromoneperiodtoanother. Any increase inrealGDPoreconomicactivitywillhelptoraisematerial livingstandards, on average, for Australian households. Higherproductionlevelsleadtomoreincomesand/oremployment,enablinghouseholdstopurchasemoregoodsandservices,therebyincreasingtheirmaterialprosperity.Thisisreferredtoasanincreaseinmaterial living standards,andismostcommonlymeasuredbyincreasesinreal GDP per capita.[RealGDPpercapitawillalsobecoveredinUnit2.]

Non-material living standards

Clearly,there ismoretoour livingstandardsthantheabilitytopurchasegoodsandservices. Inotherwords,thereexistsawiderangeoffactorsthatinfluenceourwell-beingbeyondourabilitytopurchaseanewercarorhouse,morefashionableclothes,orthe latesttechnologicalgadgetry. These influencesareoftenreferredtoas ‘non-material’or‘qualityoflife’factorsthatimpactonouroveralllivingstandards.Theseincludethefollowingtypesoffactors:

• Accesstocleanair,waterandothernaturalresources• Accesstohealthandeducationservices• Congestionorpollutionlevels• Depletionofresources• Exposuretocrime• Jobsatisfactionlevels• Leisuretime• Stresslevels• Lifeexpectancy• Freedomofexpression• Incomeandwealthinequality• Generalhappinesslevels• Qualityofgoodsandservicesavailable• Levelsofgenderequality• Lackofsocialconflict.

Study tip

The term ‘real’ in real GDP means that the impact of inflation or rising prices has been removed from the calculation of GDP. This ensures that any growth in the value of (real) GDP has occurred because there has been a genuine increase in production (or economic activity) rather than an increase caused by

higher prices.

16

Economics from the ground up (3rd ed)

Someof the factorsabove relate to thenon-materialbenefitsattached toanygrowth ineconomicactivity, suchasthesatisfactiongainedfromemploymentorthereducedstresslevelsassociatedwithearninganincomeandbuildingastockpileofwealth.However,anumberofthefactorsonthelistarenon-materialcostsassociatedwitheconomicgrowth.Thisincludescongestion,pollutionanddepletionofresources.Thebenefitsofeconomicgrowthwillalwaysneedtobeweighedupagainstthecostsofeconomicgrowthwhendeterminingtheoverallimpactonlivingstandards.Governmentpoliciesthatseektotakeintoaccountthechangestooverall living standardswillbeexploredmorefullyinUnit2.Butfirst,itwillbeusefultofirstexaminethenatureofboth‘trade-offs’aswellascost-benefitanalysis.

Overall living standards

Material factors Non-material factors

Review questions 1.61. Outlinetherelationshipbetweenproduction,incomeandexpenditureusingfigure1.4toillustrateyourresponse.2. RefertoFigure1.5anddescribetheflowsthatrepresenteconomicactivity.3. Explainafactorthatcouldcontributetoariseineconomicactivity.Usethetwosectormodeltoillustrate.4. Describethegenerallinkbetweeneconomicactivityandlivingstandards.5. Distinguishbetweenthematerialandthenon-materialfactorsthatimpactonlivingstandards.6. Identifytwoseparatefactorsthatcouldcontributetogrowthinmateriallivingstandards.7. Identifytwoseparatefactorsthatcouldcontributetogrowthinnon-materiallivingstandards.8. Discusswhetheranincreaseineconomicactivitywillleadtoanincreaseinoveralllivingstandards.

1.7 The need for trade-offs and cost-benefit analysisAseconomicagents,anydecisionwemakewilltypicallybemadewithaviewtomaximisingoursatisfaction,andthesedecisionswillalwaysinvolvetrade-offs.Thismeansthattogainsomethingofvaluewithourtimeormoney,wenecessarilyforegotheopportunitytodoarangeofotherthingswiththattimeormoney.Forexample,adecisiontospend$1,000onjewelleryinvolvestrade-offsintermsofwhatwecouldhavebeenpurchasedwiththat$1,000,suchaspurchasingaholiday,anewsmartphone,ordonatingthemoneytocharity.Alternatively,adecisiontospendexcessivelylonghoursatworkmightinvolveatrade-offintermsofone’shealthinthelongterm.Thesetrade-offsarenecessarybecause,tovaryingdegrees,wehaveafiniteamountofmoneytospend(orresourcestouse)andaninfinitenumberofusesforthatmoney(orresources).Thisisofcoursetiedtothecoreproblemofrelative scarcityandopportunity coststhatweexaminedatthestartofthistext:our resourcesare scarce relative to theunlimiteddemandsplaceduponthoseresources.Itthereforebegsthequestion:‘whatisthedifferencebetweentrade-offsandopportunitycosts?’

Relative scarcitywill necessarily result in one ormore trade-offsbeingmade,suchastheholiday,thesmartphoneorthedonationbeing traded-off for thepurchaseof the jewelleryworth$1,000.However, the existence of the trade-offs creates an opportunitycost that is quite unique in terms of the value of the next bestalternative that has been foregone. For example, if your next best choicewas a $1,000 donation to charity, thenthisbecomestheopportunitycost,despite itbeingoneof threethingsbeingtraded-offwhenpurchasing jewellery.Accordingly,opportunitycostismorespecific,narrowingthefocustoonlyoneofthetrade-offs:thetrade-offthatwasconsideredtobemostvaluableandthereforemostdifficulttoforego.

Therearenumerousexamplesofspecifictrade-offsthataremadeatbothamicroeconomiclevelandamacroeconomic level.Forexample,trade-offsexperiencedatthemicroeconomiclevelmightinclude:

17

Chapter 1: An introduction to economics

• Thetrade-offbetweenspendingandsaving• Thetrade-offbetweenworkandleisure.

Trade-offsexperiencedatthemacroeconomiclevelmightinclude:

• Thetrade-offbetweeneconomicgrowthandtheenvironment• Thetrade-offbetweenefficiencyandequity.

[Acloseranalysisofthemacroeconomictrade-offswilloccurlaterinthetextwhencoveringUnit2.]

Thetwotrade-offswewilllookatincloserdetailarerelativelygeneralinnatureandcanbeexaminedatbothamicroeconomicandmacroeconomiclevel.Thesearethetrade-offsbetweenthecurrent and the futureaswellasthetrade-offbetweenthelong run and the short run.

Current versus future trade-offs

This is perhaps themost common formof trade-off experienced by economic agents. Given that time is arguablyendless,andmostofusliveforarelativelylongperiodoftime,oureconomicdecisionswillneedtobalanceourcurrentneedsagainstourfutureneeds.Insimpleterms,trading-offcurrent consumption for future consumption means that ourlivingstandardswillbelowertodayandhigherinthefuture.Thistypeoftrade-offwilltypicallyinvolvesaving more ofourcurrentdayincomeforuseinthefuture.Itiseffectivelytransferringconsumptionthroughtime,fromtodaytosomefuturedate.Conversely,anydecisiontoborrowmoneytodaytosupportcurrentconsumptioninvolvestrading-offfutureconsumption.Inthiscase,itisonceagaintransferringconsumptionthroughtime,butthistimefromthefuturetotoday.

The trade-offsandopportunity costsassociatedwithdelayingornotdelaying current consumptionwill varyoveraperson’s lifecycle. Generally,asweage,wearemore likely tohaveresponsibilitiesandbecloser toretirement. Asaconsequence,ourwillingnesstothinkaboutthefuture increasesand itbecomesmucheasiertotrade-offcurrentconsumptionforfutureconsumption.Thiscontrastswithyoungpeople,whoaregenerallylessconcernedaboutthefutureandfind itmoredifficult toenvisage retirement. Thismeans that theopportunity costs forolderpeopleofdelayingconsumptionwillbelowercomparedtoyoungerpeople,whoarenotonlylesswilling,butlessabletosaveforthefuture.

Thetrade-offbetweencurrentandfutureisalsoonethatisregularlyfacedbybusinessesandgovernments.Theendofthemining boominAustraliaover recentyearssawminingcompaniesslowdowntherateofspendingoncapitalequipmentandproductivecapacityandinsteadfocusonsavingsomeofthegainsthatwereearnedduringtheboomyears.Theydecidedthat continued spending and expansion today would ultimately resultinexcesscapacity in the future. Incontrast,whentheminingboomwasat its peak, with very high prices being received for Australianminerals,companiesdecidedtospendheavilyoncapitalexpansion (e.g.expandingminecapacity)inordertotakeadvantageofthegrowingdemandthatwasexpectedtocontinueintothefuture.

With respect to governments, their decisions constantly balance the needs of the futurewith the demands of thepresent.Currently,thisisparticularlyevidentgivenourageing populationandthenegativeimpactthisisexpectedtohaveonourfuturelivingstandards.WithanincreasingproportionoftheAustralianpopulationnearingretirementage,thelargeexitofworkersfromthelabourforcewillcausetherateofgrowthineconomicactivity(i.e.economicgrowth)toslowandgovernmentexpendituretorise(asmoreretireeswillrequiretheagedpensionandhealthcarecostswillaccelerate). Thiswillhavemajornegativeimplicationsforthegovernment’sfinances(i.e. itsbudgetposition) inthefuture,withincomefromtaxesexpectedtofallandexpenditureonhealthandwelfareexpectedtorise.Withoutactingtodaytoprotectagainstthepossibilityofamuchhigherbudgetdeficit(governmentspendingexceedingincome),futuregenerationsofAustralianswillbeforcedtofacetheburdenofsupportingolderAustralians.Inessence,failuretoacttodaymeansthatwewouldbetrading-offfutureprosperityforcurrentconsumption.

Asaconsequenceoftheneedtotrade-offthecurrentforthefuture,recentgovernmentshavedevelopedpoliciesthatseektoaddressthetrade-off. This includesmeasurestoexpandthesizeofthefuturepopulation,byencouragingahigherbirthrateand immigrationofyoungerpersons,aswellaseffortstoreducethebudgetdeficitandreturnthebudgettosurplusinthemediumterm.

Study tip

Microeconomics focuses on the decision making or performance within specific areas or sectors of the economy. The analysis is ‘micro’ in nature, meaning that it involves an examination of the smaller parts that make up the entire economy, such as the spending or production decisions within households, or specific businesses. In contrast, macroeconomics relates to aspects or performance of the entire economy that are ‘macro’ in nature. For example, national production, income and expenditure are macroeconomic terms because they relate to activity of the entire economy, and not activity within specific sectors or sections of the economy.

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Economics from the ground up (3rd ed)

Short run versus long run trade-offs

Tradingofftheshort run for the long runisverysimilartotradingoffthecurrentforthefuture.Similarly,tradingoffthelongrunfortheshortrunisverysimilartotradingoffthefutureforthecurrent.Butwhatistheshortruncomparedtothelongrun?Thedistinctionbetweenthetwoisnotalwaysclearcut.Ingeneralusage,theshortruntypicallyreferstoaperiodoftimethatiscloseenoughtoheavilyinfluencedecisionmakingtoday,whereasthelongrunisthatperiodoftimethatisfarenoughawaytohaveasmallerinfluenceontoday’sdecisionmaking.Theshortrunisthereforelooselydefinedasthenextsixmonthstoayearwhereasthelongrunisaperiodbeyondoneyear.Often,thefuturetimehorizonisbrokenupintotheshortterm(shortrun),mediumtermandlongterm(longrun),asdepictedinFigure1.6below.

Time1 year 3 years 4 years 5 years2 years

Figure 1.6A general guide:

short term vs long term

Short term[up to 1 year]

Medium term[1 - 3 years]

Long term[3+ years]

Decisions made with long term bene�ts in mind will often involve a trade-o� in the form of short term bene�ts that are

necessarily sacri�ced.

Decisions made with short term bene�ts in mind will often involve a trade-o� in the form of long term bene�ts that are

necessarily sacri�ced.

Asageneralrule,decisionsmadewithshorttermbenefitsinmindwillofteninvolveatrade-offintheformoflongtermbenefitsthatarenecessarilysacrificed.Forexample,adecisionbyayoungpersontoleaveschoolandcommenceworkbeforecompletingyear12isoftenmadewithshorttermbenefitsinmind,suchasearningincometoachieveabetterqualityoflife.However,thisinvolvestrade-offsintermsofthelongtermbenefitsthatcouldhavebeenprovidedbyfurthereducation,suchasahigherincomeearningcapacityinthefutureandthepossibleprestigeattachedtoatertiaryqualification.Similarly,decisionsmadewithlongtermbenefitsinmindwillofteninvolvetrade-offsintheformofshorttermbenefits thatarenecessarily sacrificed. Forexample, adecisionbyahousehold to invest$20,000 installingarenewableenergysystemathome(e.g.solarpanels)ismadewithlongtermbenefitsinmind(e.g.cheaperenergybillsinthefuture).However,itinvolvestradingofftheshorttermgainsthatcouldhavebeenenjoyedbyusingthat$20,000onanewcarorfamilyholiday.

ItisimportanttonotethatthetimelineshowninFigure1.6isaonlyageneralguide.Thereisbynomeansagreementabouthowtimeisbrokenupintotheshortandlongrun.Itwillmostlydependupontheindividualsorgroupsmaking

Application Exercise 1l: Consume now or save for the future?Incomethatweearncaneitherbeconsumed(i.e.spentonconsumptiongoodsandservices)orsaved(e.g.deposited in thebank). Giventhatsavingsshouldaccumulate (and becomewealth), theywill eventually be spent sometime inthefuture. Inthisrespect,savingsrepresentfutureconsumptionor‘deferred’consumption.Thismeansthatanygivenlevelofincometodaycaneitherbespentoncurrentorfutureconsumption.Itisinthisrespectthatsavingmoneyisoftenreferredtoas‘aninvestment’-becauseitresultsinfuturebenefitsforthesaver.Accordingly, themoreof our income that is devoted to current consumption,thelessthatisdevotedtofutureconsumptionandviceversa.Thismeansthatour decision to consumeor save necessarily involves a trade-off. To become wealthier in the futureweneed to trade-off current consumption in order tocreateroomforsavings,whichcanthenbeinvestedforwealthcreation.Overall,ifwe‘party’toohardtoday,wemayhavelessopportunityto‘party’tomorrow,andifwepreparetoomuchfortomorrow,wemaynotenjoytodayasmuchaswecould.Thetrade-offbetweencurrentandfutureconsumption(orconsumptionandsavings)isclearlyapersonalchoiceandultimatelydependsonone’sabilityorwillingnesstothinkbeyondtheshortterm.

Questions1. Explain why savings is also referred to as ‘deferred’ or ‘future’ consumption.2. Discuss how a decision to save more today involves a trade-off.3. Discuss how a decision to save less today will impact on your living standards over time.4. Outline two ways that a person can increase their wealth over time.5. Discuss what is meant by the expression: if we ‘party’ too hard today, we may have less opportunity to ‘party’

tomorrow.

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Chapter 1: An introduction to economics

economicdecisions.Businesses,forexample,willtypicallyconsidertheshortruntobethatperiodoftimewheretheyareunabletoexpandcapacity.[InEconomics,werefertothisasthatperiodoftimewherethefactorsofproductionarefixed.]Forexample,abusinessmightexperiencewhatappearstobeapermanentsurgeinthedemandforitsproducts.Itsabilityto increaseoutput(i.e.makemoreproducts)willbe limitedbythesizeof itsoperation(i.e. itsproductivecapacity).Intheshortrun,itisunabletoincreasethesizeofitsoperation(e.g.buildabiggerfactory)becauseitscapitalfactorsofproduction(e.g.thefactoryandthemachinery)arefixedforacertainperiodoftime.Incontrast,thelongrunisthatperiodoftimewhereallfactorsofproductionarenotfixed.Inotherwords,allfactorsofproductionarevariableandthebusinessis better able to respond to changingmarket conditions. In thiscontext,thedecisionbyabusinessnottoexpanditscapacitytoday(e.g.byinvestinginnewplantandequipment)willmeanthatitiseffectivelyfocussingonshortrunbenefits(e.g.protectingitsbankbalance or keeping debt levels low) and trading off the potentiallongrunbenefitsthatcomefromhavingabiggeroperationthatcanbetterrespondtogrowingdemandforitsproductsinthefuture.

Somefurtherexamplesofshortandlongruntrade-offsinclude:

• The government controlling our natural resources via thegrantingoflicences(e.g.intheloggingandfishingindustries)tobalancetheshorttermneedsofthepopulationwiththeneedtoensurethatwehaveguaranteedsupply inthelongterm.

• Pursuitofeconomicgrowthtosatisfyourshorttermneedswhichcomesattheexpenseoftheenvironmentinthelongterm(e.g.carbonpollutionandclimatechange).

• Government efforts to stimulate the economy in order tocreate jobs in the short term can come at the expense ofhigherratesofinflation(i.e.higherprices)inthelongterm.

ThesewillbeexploredmorefullywhenwecoverUnit2laterinthetext.

Cost-benefit analysis

Theneedfortrade-offsbetweenthecurrentandfuture,orbetweentheshort runandlong run,willofteninvolvetheneedforacost-benefit analysis tohelpdeterminethebesttrade-offstomake-onethatminimisestheopportunitycostassociatedwithanygivendecision.

Acost-benefitanalysisisacomparisonoftheexpectedcostsandtheexpectedbenefitsofaparticularcourseofactionorproject.Mostofuswillconductasimplecost-benefitanalysiswheneverwemakeadecisionabouthowtospendourtimeormoney.Thisisusuallycompletedinourminds,withouttheuseoftechnologyorothertools,andincludeseveryday decisions such aswhether to attend school,whether to smoke cigarettes or drink alcohol, orwhether toindulge in excessive consumption of fatty foods. Clearly, thesetypes of decisions necessarily involve weighing up whether thebenefitsofaparticularcourseofactionoutweighthecosts.Inthecase of cigarettes for example, consumption today will providebenefits in the short term (e.g. relieving stress or looking ‘cool’)butwillultimatelybeoutweighedbylongtermcostsintheformofpoorhealth.Manypeoplewillbeabletomakethisdeterminationwithoutanycomplexcalculationsordetailedanalysis,choosingtorefrainfromcigaretteconsumptionasthewidelyknownevidencepointsto itbeingextremelydamagingtothe longtermhealthofsmokers.

Morecomplexcost-benefitanalysesareundertakenbygovernments(andbusinesses)beforeadecisionismadeonwhethertoproceedwithamajorproject(suchastheconstructionofanewroadorrailway)orinvestthefundsinsomeotheractivity.Thecost-benefitanalysiswillgenerallybecomeakeycomponentof‘thebusinesscase’putforwardbythegovernmentandwilloftentakeaconsiderableperiodoftimetoprepare,involvingtheexpertinputofnumerousprofessionals,includingaccountants,economists,actuaries,andotherfinanceprofessionals.Allofthebenefitsandcostswilltypicallybelistedinacommonunitofmeasurement(i.e.money),withfuturecosts/benefitsvaluedincurrentdollartermstoremovetheeffectsofinflation(orhigherprices).Oncetheexpertshaveitemisedallcostsandbenefitsincurrentdollarterms,theprojectwillonlybecomeviableifthebenefitsoutweighthecosts(i.e.thenet benefitsarepositiveandnotnegative).

Study tip

The distinction between the short and long run is also often used in the context of macroeconomics [see the distinction between macro and microeconomics in the previous Study Tip]. For example, many economists would consider that the short run is characterised by that period of time in which prices and wages are relatively ‘sticky’ (or inflexible) and the long run as that period where economic variables (like wages and prices) have time to adjust to new economic conditions. Other economists would argue that the short and long run distinction depends on the time it takes before government policy actions have minimal effect on real values in the economy. These economists would therefore argue that short run attempts to stimulate economic activity will only result in inflation in the long run, with no change in real output or activity. However, these types of considerations are beyond the scope of the Unit 1 and 2 course.

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Economics from the ground up (3rd ed)

Itisalsocommontorefertothismeasureasa‘benefit-cost ratio’(benefitsdividedbycosts).Inabenefit-costratio,aratiogreaterthan1.0indicatesthataproject’sbenefitsoutweighsthecosts,whereasaratiooflessthan1.0indicatesthatthecostsoutweighthebenefits.SeeFigure1.7belowforfurtherclarification.

Therehavebeennumerousexamplesofcost-benefitanalysesbeingconductedbygovernmentsandothergroupsoverrecentyears.ArguablythetwohighestprofileprojectshavebeentheMelbourneMetrolRailProjectandtheabandonedEastWestLinkProject.Thebenefit-costratio(BCR)fortheMelbourneMetrolRailProjectwasinexcessof1.0,suggestingthattheexpectedbenefitsoutweighedthecosts,andtheprojectwasapproved.However,theEastWestLinkProject’sBCRwaslessthanoneandtheprojectdidnotproceed.

Bene�t-cost ratio (BCR)[bene�ts/costs]1.0 2.00

Figure 1.7Cost-bene�t analysis

bene�t-cost ratio (BCR)

costs > bene�ts[negative net bene�ts]

E.g. East West Link ProjectNOT APPROVED

bene�ts > costs[positive net bene�ts]

E.g. Melbourne Metrol Rail ProjectAPPROVED

Giventhatmanycostsandbenefitsarenon-monetaryinnature,itcanbeasubjectiveexerciseconvertingtheseintomonetaryvaluesforthepurposesofacost-benefitanalysis. Forexample,thefailedproposaltobuildtheEast-WestRoadLink(connectingtheEasternFreewaytotheWesternRingRd)neededtotakeintoaccountthelossofsomepublicparkland(i.e.partsofRoyalPark).Clearly,thelossofparklandwillbeabiggerlosstosomecomparedtoothersandthemeasurementofthis‘cost’inthecost-benefitanalysisishighlysubjective.Despitethis,organisationsandgovernmentscontinue to see thevalue inconductingcost-benefitanalyses tominimise theopportunity costsofmajoreconomicdecisionsandensurethatthemostefficientallocationofresourcesisachieved(e.g.allocativeefficiency).

Review questions 1.71. Outlinetherelationshipbetweentrade-offsandopportunitycost.2. Explainwhytrade-offsarenecessary.Inyouranswerrefertoscarcity.3. Distinguishmicroeconomicsfrommacroeconomics.4. Identifyoneexampleofamicroeconomictrade-off5. Identifyoneexampleofamacroeconomictrade-off6. Explainwhatismeantby‘tradingoffcurrentconsumptionforfutureconsumption’.7. Explainwhatismeantby‘tradingofffutureconsumptionforcurrentconsumption’.8. Outlinewhyitiseasierforanolderpersontotrade-offcurrentconsumptionforfutureconsumptioncomparedto

ayoungerperson.9. Describehowminingcompaniesmightmakeatrade-offbetweencurrentandfuturespending.10. Explainhowanageingpopulationhasforcedthegovernmenttomakeatrade-offbetweencurrentandfuture

spending.11. Explainwhatismeantbythetrade-offbetweentheshortrunandthelongrun.Useanexampletoillustrate.12. Define‘cost-benefitanalysis’anddiscusshowacost-benefitanalysisisrelatedtotrade-offsandopportunitycosts.13. Brieflyoutlinehowacost-benefitanalysisisundertaken.14. Define‘benefit-costratio’(BCR)andexplaintheimplicationsofaBCRonaprojectbeinglessthan1.15. DescribewhythestategovernmentofVictoriadecidedtoproceedwiththeMelbourneMetrolRailProjectand

abandontheEastWestLinkProject.Inyouranswer,refertotherespectiveBCRsoftheprojects.16. Explainwhysomeofthecostsandbenefitscontainedinacost-benefitanalysisaresubjectiveinnature.

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Chapter 1: An introduction to economics

1.8 Multiple choice review questions

1. Which of the following is not regarded as being a ‘factor of production’?a) moneyb) machineryc) landd) workers

2. The opportunity cost of producing a given product is:a) thepriceoftheproductb) thebestalternativeproductthatcouldhavebeenpurchasedc) thepricepaidfortheresourcesusedintheproductionoftheproductd) thevalueofthebestforegonealternativewhichtheresourcesusedinitsproductioncouldhaveproduced

3. Economics can be best defined as the study ofa) resourceallocationinamarketcapitalisteconomyb) howscarceresourcesareallocatedinaneconomybythepublicandprivatesectorsc) howgovernment,householdsandfirmsinfluencebusinessdecisionmakingd) howlimitedwantsaffectanabundanceofresources

4. Which of the following is not regarded as a key factor describing economic activity in Australia?a) Governmentsb) Productionc) Incomed) Expenditure

5. A business has narrowed down the most viable investment options to (1) the construction of a new mine costing $100 million and (2) the purchase of a $100 million shareholding in a foreign mining firm. The opportunity cost associated with the construction of a new mine is which of the following?a) the$100millionspentontheconstructionofthemineb) thebenefitsthatwouldhavebeenprovidedbythe$100mshareholdingc) thedividends(shareofprofits)thatwouldhavebeengeneratedfromthe$100mshareholdingd) unknownsinceinsufficientinformationisgiven

6. With respect to the production possibility curve, which of the following statements is false?a) amovementalongthecurve,fromonepointtoanother,isrelatedtoopportunitycostb) unemploymentislikelytooccurwhentheeconomyisproducinginsidethecurvec) itisnotpossibletoproduceatapointoutsidethecurve(i.e.beyondthefrontier)d) atanypointintime,aneconomycannotpossiblyproduceattwodifferentpointsalongthecurve

Application Exercise 1m: Cost-benefit analysisAssumethatyouareontheStudentRepresentativeCouncilatyourschoolandthePrincipalhasinvitedyoutojoinaCommitteeinvestigatingthefeasibilityofconstructinganewgymnasiumattheschool. It isexpectedthat$5millionisneededtobuildthegymnasium,withthefundscomingfromacombinationofhigherschoolfees(or increasedpaymentsfromparents)andborrowingfromafinancial institution. Youhavebeenassignedthetaskofconductingacost-benefitanalysistodetermineiftheprojectshouldgoahead.

Questions/tasks1. Explain how the construction of the gym highlights the following trade-offs:

• Current versus future• Short run versus long run

2. Compile a list of benefits of building the gym and attempt to place a monetary value on each benefit.3. Compile a list of costs of building the gym and attempt to place a monetary value on each cost.4. Calculate a benefit-cost ratio (BCR) and outline what this number represents.5. Prepare a brief report detailing whether the construction of the gymnasium should (or should not) proceed.

Make reference to the BCR in your report.

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Economics from the ground up (3rd ed)

7. Which of the following is not one of the basic economic questions faced by Australia?a) Whattoproduceb) Whentoproducec) Forwhomtoproduced) Howtoproduce

8. If a technically productive nation further improves efficiency via the introduction of new technology, then the change may be illustrated graphically bya) amovementalongtheproductionpossibilitycurveb) ashiftoutwardsoftheproductionpossibilitycurvec) ashiftinwardsoftheproductionpossibilitycurved) ashifttowardstheproductionpossibilitycurve

9. With respect to the distinction between normative and positive economics, which of the following is most likely to be a normative statement?a) Spendingoneducationismoreimportantthanspendingonscienceandtechnologyb) Anincreaseinpersonaltaxrateswilltendtoreduceexpenditurebyhouseholdsc) Anageingpopulationwillincreasehealthcostsinthefutured) Paymentofschoolfeesisanexampleofexpenditureinaneconomy

10. Assume that we have the production possibilities shown in the table below:

Combination Militarygoods(000) Consumergoods(000)A 120 0B 115 20C 100 40D 75 60E 35 80F 0 90

The opportunity cost of producing 40,000 consumer goods is:a) 120,000militarygoodsb) 20,000militarygoodsc) 115,000militarygoodsd) 100,000militarygoods

11. In relation to the two sector flow model of the economy, which statement is incorrect?a) WagesflowfromtheBusinesssectortotheHouseholdsectorb) ResourcesflowfromtheBusinesssectortotheHouseholdsectorc) ExpenditureflowsfromtheHouseholdsectortotheBusinessSectord) ProductionofgoodsandservicesflowsfromtheBusinessSectortotheHouseholdsector

12. In Australia, resources are allocated by a) consumersandtheirdemandforfactorsofproductionb) producersandtheirdemandsforscarceresourcesc) ‘themarket’primarily,withsomegovernmentintervention(orplanning)d) governmentdecisionmaking,withalimitedrolefor‘themarket’

13. Which of the following is most likely to increase material living standards?a) Increasedlevelsofproductionb) Increasedfreedomofexpressionc) Reducedlevelsofstressd) Increasedleisuretime

14. The need for trade-offs in economics is closely related to which of the following?a) Theconceptofopportunitycostb) Howtoproducegoodsandservicesc) Non-materiallivingstandardsd) Thecircularflowofincome

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Chapter 1: An introduction to economics

15. Relative scarcity in economics means thata) Thedemandsplaceduponresourcesareveryhighb) Thedemandsplaceduponresourcesareexcessivewhencomparedtotheavailabilityofthoseresourcesc) Resourcesavailableforuseinproductionarelimitedd) Economiesexperienceshortagesofallfactorsofproduction

16. In relation to the Production Possibility Curve (or frontier) to the right, which of the following statements is correct?a) Points1to5representsproductioncombinationswhereproductive efficiencyisbeingachievedb) A movement from point 1 to 4 means that the economy will be

producing a combination of goods and services that better satisfiessociety

c) Point6representsaproductioncombinationwhereallocative efficiencyisbeingachievedd) Amovementfrompoint5to3meansthatfewerresourceswillbe- allocatedtotheproductionofGoodA

17. Which of the following is least likely to push the PPC outwards in Australia?a) Anincreaseinproductivityb) Adiscoveryofironoredepositsc) Investmentinasuperfastbroadbandnetworkd) AlargedecreaseinthenumberofskilledmigrantstoAustralia

18. Which of the following is incorrect in relation to the benefit-cost ratio (BCR)?a) ABCRgreaterthanonesuggeststhatthenetbenefitsofaprojectarepositiveb) ABCRlessthanonesuggeststhatthecostsofaprojectoutweighthebenefitsc) ABCRforaprojectthatistoohighsuggeststhataprojectislikelytoberejectedd) ABCRiscalculatedbydividingthebenefitsofaprojectbythecosts

19. Which of the following factors about a cost-benefit analysis is incorrect?a) Acost-benefitanalysisisusuallysubjectivewhichreducesthevalueofacost-benefitanalysisb) Acost-benefitanalysishelpsbusinessesandgovernmentachieveamoreefficientallocationofresourcesc) Acost-benefitanalysiswillusuallybedoneusingacommonunitofmeasurement(e.g.money)d) Acost-benefitanalysisistypicallycompletedformajorgovernmentprojectsthatareplannedforthefuture

20. Which of the following is not a return to the Household sector for their contribution to production?a) wagesb) expenditurec) profitsd) interest

1.9 Chapter crossword puzzle

Across2. Theprocesswherebygoodsandservicesaremadeandalsoreferstothetotalamountofgoodsandservices

thathavebeenmadeoveraperiod5. Anyplaceorregionaroundtheworldwhereproductionofgoodsandservicestakesplace6. ThisprimarilydetermineshowresourcesareallocatedinAustralia11. Whenthisratioisaboveoneitsuggeststhataproject’sbenefitsoutweighitscosts(2words)12. Factorsofproduction,suchaslabourandcapital13. Resourcesthathavebeenmadebycombining labourandnatural resourcestocreateamoresophisticated

inputintheproductionprocess16. Thetypeofefficiencywheretheresourcesareallocatedincombinationsthatcreatethemaximumpossible

benefitsforthenation17. Thisismadeupofbothmaterialandnon-materialfactorsthatimpactonourqualityoflife(2words)18. Thisisacostthatismeasuredintermsofthebenefitforegone(orsacrificed)20. Moneyreceivedbythoseinvolvedintheproductionofgoodsandservices,suchaswages

Goo

d A

Good B

1

2

3

6

7

5

4

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Economics from the ground up (3rd ed)

Down1. Theexchangeofmoneyorsomethingelseofvalueforsomethinginreturn3. Thetypeofefficiencywhereanation’sresourcesareproducingthemaximumamountpossible(andatthe

lowestcost)4. Spendingofincomeongoodsandservices7. Thisisrelatedtoopportunitycostandreferstosomethingbeingsacrificedwhenachoiceismade(2words)8. Unlimitedwantscomparedtolimitedresources(ormoney)thatareusedtosatisfythesewants(2words)9. Apartoftheprivatesectorthatisnotpartofthebusinesssector10. Thoseeconomicstatementsthatcanbeverifiedortestedtobeeithertrueorfalse14. Therewardforthisfactorofproductionismostcommonlywages15. Economicstatementsorclaimsthatarebasedonopinionorvaluejudgements19. Theacronymusedtorepresenttheproductionalternativesavailabletoaneconomy

1

2

3 4

5

6

7 8

9 10

11

12

13 14

15

16

17

18 19

20

1.10 Chapter summary

1. Aneconomyexistsinanyplaceorregionaroundtheworldwhereproductionofgoodsandservicestakesplace,expenditureonthosegoodsandservicesoccursandincomeismadefromthesellingofthosegoodsandservices.

2. Economicsprimarilyconcernswhyandhowindividualsorgroupsmakedecisionsaboutthetransactionstheywillundertakeonadailybasis.

3. Factbasedeconomicstatementscomeunderthebannerofpositiveeconomicsandtheycanbeverifiedortestedtobeeithertrueorfalse.Incontrast,statementsorclaimsthatarebasedonopinionorvaluejudgementscomeunderthebannerofnormativeeconomics.

4. Relative scarcity is the coreproblemdeterminingdecisionmaking ineveryeconomyaround theworld. It isdefinedasthewantsandneedsofsocietiesbeinglargerthantheresourcesavailabletosatisfythosewantsandneeds.Thiscreatestheneedtomakeeconomicdecisionsandchoices.

5. Theneeds of individuals or households in societies can be defined as the basic goods and services that arenecessaryforsurvival.

6. Resourcesarethosethingsthatareusedtoproducegoodsandservicesandarealsoreferredtoas‘factorsofproduction’.Landornaturalresourcesareallthoseresourcesthatoccurinnature.Labourreferstothementalandphysicaleffortbyhumansintheproductionprocess.Capitalreferstothoseresourcesthathavebeenmade

25

Chapter 1: An introduction to economics

by combining labour and natural resources to create amore sophisticated input in the production process.Entrepreneurship(orenterprise)referstotheskillsofthoseindividualswhocombineourresourcestoproducegoodsandservices.

7. Theproducersinvolvedindecisionmakingfacetheproblemofrelativescarcitybydeterminingthebestwaytocombineresourcesinordertobestsatisfyconsumersandthereforemakethemostprofit.Incomeearnersfacetheproblemofrelativescarcitywhentheydeterminehowbesttousetheir incomeearningcapacity,ortheirskillsandlabour,inordertoderivethebestpossibleoutcome.Consumersfacetheproblemofrelativescarcitywhentheymakedecisionsabouthowtoturntheirincomeorwealthintothesatisfactionprovidedbyspendingorconsumption.

8. Opportunitycostisthebenefitforegone(orsacrificed)whenchoosingonealternativeoverothersandismeasuredbythevalueofusingtheresourcesintheirnextbestalternativeuse.

9. Allrationaleconomicagentswillseektominimisetheiropportunitycostswhenmakingdecisionsorundertakingeconomictransactions.

10. TheProductionPossibilityCurve(PPC)isanabstracttoolusedbyeconomiststohighlightanumberofdifferentconcepts,includingtheconceptofopportunitycost.Itinvolvesadiagrammaticrepresentationoftheproductionalternativesavailabletoaneconomyproducingonlytwogoodsorservices.

11. AmovementfromonepointtoanotheralongthePPCmeansacountryisallocatingmoretotheproductionofonegoodandlesstoanother.Allpointsalongthecurverepresentthemaximumproductionpossibilitiesachievableatthatparticularpointintime.PointsinsidethePPCreflectthattheeconomyisnotusingitsresourcesefficientlyandthereisanunderutilisationofresources.

12. Technical (productive) efficiency is defined as that situation where a nation’s resources are producing themaximumamountpossible(andatthelowestcost).

13. Allocativeefficiencyoccurswhen resources are allocated in combinations thatderive themaximumpossiblebenefitsforconsumersandthenation.

14. Themostefficientallocationofresourcesoccurswhenallofthenation’sresourcesarebeingusedtoproducethebestpossiblecombinationofgoodsandservicessuchthatnationalwelfareorlivingstandardsismaximised.

15. If ‘themarket’ determines how thenation’s resources are allocated, then consumers andproducers, guidedprimarilybyself-interest,determinewhatgoodsandserviceswillbeproduced,howthesegoodsareproducedandwhogainsaccesstoorenjoymentofthesegoodsandservices.

16. Nocountryallows ‘themarket’ to solelydetermine theallocationof resourcesbecausemarkets fail inmanyinstances.Thismeansthatmarkets,leftunregulatedorwithoutanyformofgovernmentintervention,willleadtoanundesirable(orinefficient)allocationofresources.

17. Australiahasamarketcapitalisteconomy,withapproximately80%ofAustralia’sresourcesprivatelyownedandwiththeallocationofAustralianresourcesbeingdeterminedprimarilybythemarket.

18. In Australia, a combination of government decision making and ‘markets’ will answer the basic economicquestionsofwhattoproduce,howtoproduceandforwhomtoproduce.

19. Economic activity in Australia, characterised by the production, income and expenditure taking place in theAustralianeconomy,isundertakenorinfluencedbyindividualsorgroupsoperatingwithineitherthepublicorprivatesector.

20. Economicactivitytakesplacebecauseithelpstoimproveourindividualandcollectivestandardsofliving,bothinmaterialandnon-materialterms.

21. Australiangovernmentsarekeentostimulategrowthinproductionasmeasuredbygrowthinrealgrossdomesticproduct,orrealGDP,overtime.

22. Thereismoretoourlivingstandardsthantheabilitytopurchasegoodsandservices.Inotherwords,thereexistsawiderangeof factors that influenceourwell-beingbeyondourability topurchasegoodsandservices (e.g.accesstocleanairandleisuretime).

23. Aseconomicagents,anydecisionwemakewilltypicallybemadewithaviewtomaximisingoursatisfactionandthesedecisionswillalwaysinvolvetrade-offs.

24. Oureconomicdecisionswillneedtobalanceourcurrentneedsagainstourfutureneeds.25. Tradingofftheshortrunforthelongrunisverysimilartotradingoffthecurrentforthefuture.Similarly,trading

offthelongrunfortheshortrunisverysimilartotradingoffthefutureforthecurrent.26. Asageneralrule,decisionsmadewithshorttermbenefitsinmindwillofteninvolveatrade-offintheformoflong

termbenefitsthatarenecessarilysacrificed.27. Acost-benefitanalysis isacomparisonoftheexpectedcostsandtheexpectedbenefitsofaparticularcourse

ofactionorproject.Allofthebenefitsandcostswilltypicallybelistedinacommonunitofmeasurement(i.e.money),withfuturecosts/benefitsvaluedincurrentdollartermstoremoveseffectsofinflation(orhigherprices).

28. Inabenefit-costratio,aratiogreaterthan1.0indicatesthataproject’sbenefitsoutweighsthecosts,whereasaratiooflessthan1.0indicatesthatthecostsoutweighthebenefits.