Table of Contents

Chapter 1: Foundations of Economics.................................................................................1

1.1: Demand and Supply....................................................................................................3
1.2: Elasticities...................................................................................................................8
1.4: Market Failure..........................................................................................................11
1.5: Theory Of The Firm....................................................................................................15
2.1 Macroeconomics........................................................................................................22

Economics Exam Notes

Chapter 1: Foundations of Economics

Scarcity: All products that have a price are relatively scarce.

Opportunity Cost: When you give up an opportunity for a seperate one. E.g. giving up a DVD costing
$15 for a weeks shopping.

Basic Economic Problem: Scarce resources but infinite consumer wants.

Factors of Production:
Land
Labour
Capital
Enterprise (management, risk factor of production).

PPC (Production Possibility Curve)

 Shows maximum production in a given time frame.
 Shows scarcity and opportunity cost.

 Z show PPC (maximum production output).

  V is current production curve, if V moves to W, then actual growth has occurred.

Utility
 Measure of usefulness and pleasure received by consumers
 As consumers consume more of product, it becomes less pleasurable over time, until they
completely stop consuming.

Free Market Economies vs Planned Economies

Disadvantages

Free  Demerit good (e.g. drugs) will be overprovided, used as profit since is legal.
Market  Merit goods are underprovided as only rich people can afford.
 Resources used up too quickly.
 Members of society will get sick, no healthcare provided.
 Large firms dominate society.

Planned  Production too difficult to plan, misallocation of resources, shortages +

surpluses.
 Resources won’t be used efficiently as no price schematic to find real value
of prices.
 Government controlled - loss of freedom.
 Governments may be corrupt, keep goods/money to them self.

Economic growth
 ‘Real’ value measured after taken away effects of inflation.
 Measured in GDP (Growth domestic product).
 National income is value of all products produced in an economy in given time period.
 Real national income increased = economic growth.

Economic development
 Measure of health & wellbeing in an economy, e.g. health, education levels.
 Usually measured in HDI.

HDI
 Factors include real income per person, literacy rate, life expectancy.
 Each country given value between 0 and 1, 0.5 or above means developed, below means
developing country.

Sustainable Development: Development that meets the present needs of an economy without
compromising the needs of a future generation and their needs.
1.1: Demand and Supply
Demand: The quantity of a good or services that consumers are able or willing to purchase in a given
time period.

Law of Demand: “as the price of a product falls, the quantity demanded of the product will usually
increase, ceteris paribus”

Price Determinants of Demand:

Income Effect:
When the price of a product falls, consumers ‘real’ income effectively increases, making it more
likely to purchase the product.

Substitution Effect:
When the price of a product falls, it becomes more attractive that substitutes of the same product,
hence it becomes more likely that consumers will purchase that product.

Non-Price Determinants of Demand:

Income:
 For normal goods, the demand for a product will increase as income rises.
 For inferior goods, the demand for a product will decrease as income rises, as people will
lean towards buying higher-quality standards for that product.

Price of other products:

 Substitutes, if price increases for a product, consumers will turn to substitutes with lower
prices as alternatives.
 Complements, goods that complement each other (e.g. printers and ink cartridges) will be
responsive to a price change in the complement good.

Change in taste/consumer preferences:

 As consumers tastes change for certain products, the demand will shift accordingly. E.g. if
the winter olympics recently aired, more people may demand a snowboard, therefore there
has been a change in consumer tastes.
Linear Demand Functions/Demand Schedules:

Qd = a-bP

Supply: The quantity of a good or services that producers are able or willing to purchase in a given
time period.

Law of Supply: “as the price of a product rises, the quantity supplied of the product will usually
increase, ceteris paribus”

Non-Price Determinants of Supply:

Cost of factors of production:

 A change in cost factors in a firm will lead to an increase/decrease in the quantity supplied,
e.g. if employees wages increase, the firm has to allocate less money into quantity supplied
of product.

Price of substitute products:

 If other substitute products are demanded more than current products, producers will
decide to produce the products with more demand to gain more profit. E.g. if skateboards
are currently more expensive than roller skates due to increase in demand, then producers
will decide to produce more skateboards than roller skates, making the supply of roller
skates decease.
Technology:
 Increase in technology in a production facility will generally increase supply potential, or
natural disasters/accidents in facilities will set them back.

Government Intervention:
 Indirect taxes on products will increase their price, hence shifting the supply curve.
 Government  subsidation on products lowers costs, hence decreasing supply.

Equilibrium: “A state of rest in the absence of outside disturbance.”

 In equilibrium when demand and supply curves intersect.
 Also known as market-clearing price.

When market is not in equilibrium, there is either excess demand or supply.

 In this example, there is excess demand as producers can only produce at Q3, whilst the
demand for the product is at Q4, so there is excess demand.

Shift in Demand or Supply Upon the Equilibrium

When there is a shift in supply in demand, the market, if left alone, will adjust to a new equilibrium.

In this example, demand has increased from D to D1, which has caused an excess in demand. The
market then adjusts to a new equilibrium (Qe1), and a new market equilibrium is achieved.
Price Mechanism: The mechanism which moves markets into a new equilibrium and helps to
allocate scarce resources.
It gives signals to producers on how much to produce more/less of based on what consumers are
willing to pay.

E.g. If there is a decrease in the price of a product due to a decrease in demand, this signals
producers to produce less of the product, as consumers are not willing to pay as much for the
product.

Market Efficiency:
Consumer Surplus:

 Consumer surplus is ‘gain’ some consumers have that were willing to purchase a good at a
higher price, but didn’t have to.
 E.g. Some consumers were willing to purchase ‘thingies’ for $15, but only had to pay $10.

Producer Surplus:
  Producers were willing to
produce 3 thingies at $3,
but didn’t have to.

Calculating and Illustrating Market Equilibrium

Demand/Supply Schedules

To find P (price equilibrium), let Q = Q

e D S

2,000 - 200P = -400 + 400P

2,400 = 600P

P = ($)4  - show in table.

Allocative Efficiency:

 When market is in equilibrium.

 Efficiency does not mean maximum output, but when market is at greatest community
surplus.
 Community surplus = Consumer surplus + Producer surplus.
 Optimal efficiency from society’s view.

1.2: Elasticities
Elasticities of Demand:
 Measure of responsiveness.
 Measure of how much the demand for a product changes when there is a change in one the
the factors that determine demand.
  Most unresponsive market for demand are addictive substances.

Price Elasticity of Demand (PED)

Price Elasticity of Demand is a measure of the change of the quantity demanded for a product in
correlation to a price change of that product.

Determinants:
 Number/closeness of substitutes
 Necessity of product and how widely the product is defined (e.g. food is low elasticity, meat
is higher elasticity).

(Workbook examples)

Range of Values for PED:

Perfectly inelastic demand curve:
When the demand for a product is perfectly inelastic, it doesn’t matter what the price of the product
is set at, the demand will never change.

Perfectly elastic demand curve:

At one price, the quantity demanded for a product is infinite, however any change of that changes
the demand to 0.

Unit Elastic Demand:

If the demand for a product is unit elastic, then it’s demand changes exactly in accordance with its
price.

Income Elasticity of Demand (YED)

 Income elasticity of demand is a measure of how much a product’s demand changes if there
is an increase or decrease in consumer’s income.

Cross Elasticity of Demand (XED)

Percentage change in quantity demanded for product Y

Percentage change in price for product X

POSITIVE elasticity means products are substitutes.

NEGATIVE elasticity means products are complements.

Price elasticity of supply (PES)

Measure of change in supply if change in price.

Determinants

How much costs rise as output is increased

If it costs a lot for higher supply, producers will won’t produce as much, therefore making the
product relatively inelastic.

Ability to store stock - if producers can store a lot of stock for the product, they can produce more-
higher elasticity.

1.4: Market Failure

Definition: Market failure is the economic situation defined as an inefficient distribution of goods
and services in the free market.

Types of Market Failure:

 Lack of public goods:

o Lack of goods such as national defence which wouldn’t be provided in a free market.

 Under-supply of merit goods:

o Goods which the government believe bring positive benefits that will be under-
provided as private firms won’t have any incentive to provide merit goods unless a
profit can be made. Examples of merit goods are education and health care.
o Governments subsidize merit goods.

 Oversupply of demerit goods:

o Demerit goods are goods which would be over provided by the market, therefore
over-consumed. Governments may attempt to reduce the supply and demand of
goods depending on how harmful they believe the good is.

Definition for externality: An externality is the secondary effect a good or service has on a third
party.

Negative Externalities of Production:

  Occurs when the production of a
good causes harmful effects to a third
party, which is generally to the
environment. E.g. air pollution from a
factory in China.
 The government has multiple options
to remedy the situation.
o Could tax the firm to shift its
MPC to meet MSC
 However this becomes
difficult when trying to
figure out how much
and which firms are
polluting.

o Could restrict firm’s output by passing on new environmental legislation,

forcing firms to increase costs.
 This however could lead to job loss and unemployment.
o Could use a cap and trade system (explained later).

Positive Externalities of Production

 Occurs when the production of a

good or service is enjoyed by a third
party.

 For example, schools provide an

education to society which in the
long term improve an economy,
hence providing a positive
externality.

 To promote positive externalities,

governments may subsidize these
firms, shifting the MPC curve down
and meeting MSC.
o A problem with this is it’s difficult to judge how much the government should
subsidize a firm by, also subsidies cause an opportunity cost for the
government in another sector they could be spending on.

Negative Externalities of Consumption

 Occurs when consumers use a good or service which

has harmful effects on society.
  Examples include second-hand smoking, car pollution, noise pollution.
 Consumers produce at MPB, which is high than the social cost (equilibrium point).
 To decrease this, governments can impose an indirect tax on the good/service
causing the negative externality, which shifts the MSC curve up to where it meet
equilibrium point at Q*, therefore no market failure.
o Problem with this is if the market is very inelastic, this may not have such a
large impact on consumption.
 Governments could ban cigarettes, however this would cause may problems.
o Many shareholders of tobacco industry would be heavily impacted.
o Significant loss of employment.
o Loss of government revenue/potential from indirect taxes.
o Black market formed.

 Goods which when consumed bring

positive externalities for example
receiving healthcare for contagious
illness (no spread to anyone else), or
doing and promoting healthy eating.
 If governments want to promote this
behaviour in firms, they can once
again subsidize particular firms, also
can promote through advertising.
o Downside to both solutions is
cost and opportunity cost.

Externality Curve Rules

1. Consumption = 2 demand curves

Production = 2 supply curves.

2. Positive externality = always undersupply

Negative externality = always oversupply

3. Actual production is always at private curve (MPC).

Common Access Resource: A common access resource is a naturally-occurring resource that
nobody has ownership over, for example forests, fishing grounds, and gas fields. The fear
surrounding common access resources are that the inability to charge for common access
resources will lead to them being over-exploited and depleted.
 Pose a threat to sustainability
o Over-exploitation of land
o Soil erosion.
o Deforestation.

Fossil Fuels also pose a threat to sustainability. In the current economy fuel is strongly
demanded, which poses an immense threat to future generations due to their large external
cost.
 Extraction of coal and oil.
 Air pollution.
 Increased greenhouse gases.

Sustainability: The ability to meet the consumption needs of the present generation
without hindering the future generation(s).

Government Responses:

Cap and Trade System:

A government regulatory program, similar to a carbon tax, which limits the amount of
emissions a firm is legally allowed to produce. An example of this was the carbon tax
imposed by the Gillard Labour Government in 2011.

Clean Technologies:
Renewable sources of energy such as solar power, wind power, hydro power and biofuels.
Governments may subsidize the development of these technologies by offering tax credit to
firms that invest in the use of clean technologies. The extent as to which governments will
subsidize firms is dependant on how much they believe carbon emissions must be reduced
in the economy.

1.5: Theory Of The Firm

Short Run: A period of time in which at least one factor of production is fixed. Production
takes place in short run.
E.g. A firm can’t suddenly increase quantity of items sold.
Long Run: The period of time in which all factors of production are variable, but technology
is fixed. Planning takes place.

Total, Average and Marginal Product

Total Product: Total output a firms produces in a given time period.

Average product: Total output divided by amount of unit sold, therefore price.

Marginal Product: Extra output produced by the use of an extra variable unit.

Law of Diminishing Returns: The point at which the profit level gained is less than the
money or energy invested in it.

Economic Cost: The economic cost of producing a good is the opportunity cost of the firm’s
production.

Explicit Costs:
- Factors not already owned by the firm that could have been spent elsewhere.
- For example if a firm hires workers for $1000 the opportunity cost is what else could have
been bought.

Implicit Costs:
- Earnings a firm could have had if it employed its resources elsewhere.
- E.g. loss of interest on an investment.

Short Run Costs

Total Costs
o Sum of TFC + TVC
 TFC
 TFC are total fixed costs a firm has in period of time, e.g.
machinery and rent.
  TVC
 Costs that vary with output, e.g. wages, materials.

Average Costs
o Same as Total, fixed and variable costs, but per unit of production. (TC/q,
TFC/q, TVC/q).

Marginal Costs

Same as total fixed and variable cost, but measure change in units of production (MC=
ΔTC/ΔQ).

Long Run Costs

 In theory, the long run costs envelope all the short-run average cost curves.
 The diagram shows where production is attainable and unattainable.
 Firms will always want to produce at the lowest cost per output variable, e.g.
C3, C2, C1.

Perfect Competition

Assumptions:
- Industry is made up of a large number of very small firms that produce identical products.
- Firm cannot alter its output to have any noticeable difference in industry supply or
demand.
- Firms have no barriers to entry or exit.
- Closest example of this is the growing of wheat in the European Union, where there are
multiple small firms which will have little to no impact if they change their output or price
level.

 Firms are price-takers, they can’t change their price, as the consumers will simply go
to another firm producing at the lower price point to buy the product.

 Firms always maximize their profit level, which is where MC=MR, which is where
their output level; q is.
 Abnormal Profit – C point is set where MC intersects AC, and the shaded blue area is
the abnormal profit region.
 Only occurs in the short run, and occurs as average costs are lower than average
revenue returned.
 Where AC intersects q.

 Opposite for losses, AC curve is above average revenue.

  When there is an opportunity for firms to make abnormal profits in the short-run,
then the industry supply will shift to the right, decreasing price until profits become
normal again.
 This is the same for losses, it will cause a shift to left in industry supply, increasing
price that firms sell at.
 This occurs in long run.

Monopoly

Assumptions:
 Only 1 firm exists in industry, therefore it is the industry supply and demand.
 Barriers to entry exist, so no firms can enter the industry.
o These include:
 Economies of scale – can sell at much lower price to consumers.
 Legal barriers – Patents are laws which prohibit other firms from
producing a particular product for a particular time period.
 Brand loyalty – Consumers think the product is the brand.

Diagram of monopoly

 Demand is downwards-sloping, so monopolist can control price level.

 Profit-maximization point where MC=MR again, which is where q is.
 Profit situations in monopoly

 Since there are barriers to entry and other firms cannot share in abnormal profits, if
firms are making abnormal profits in the short run as shown here, they can also
make them in the long run.

 If a firm is making losses in the short run, they have the option to close down
temporarily or continue production.
 However, it would plan ahead in the long run to see if changes could be made to
receive at least normal profits. If no changes could be made and the firm would
make losses in the long run, it will shut down and the industry will cease to exist.

Advantages and Disadvantages of Monopoly

 Achieving large economies of scale, can produce at a lower price to consumers.

 Helps fund research
o However…
 Since they have market power, they can charge higher prices for lower output.
 Allocatively and productively inefficient.
 Large economies of scale cause anti-competitive behaviour amongst monopolies.

Monopolistic Competition
Assumptions
 Fairly large amount of firms in industry which are small, but able to act
independently from one another
 Slightly differentiated products, so consumers can tell between products.
 Firms are completely free to enter/exit market.

Short Run to Long Run

 In the short run, if firms make abnormal profits, new firms can enter the market as
there are no barriers to entry. This will take business away from existing firms,
eventually shifting their demand curve to the left, until abnormal profits become
normal profits.

Oligopoly
2.1 Macroeconomics
Aggregate Demand

 Average price level indicates the price of all goods and services within an economy.
 Real output measures the quantity of all goods and services produced within a given
time period in an economy.
 Hence, aggregate demand shows the relationship between average price level and
real output.

Aggregate Demand: The sum of all goods and services produced in an economy in a given
time period.

Factors:

Consumption:
 Total spending by consumers
o Durable goods
 Used for a longer period of time – cars, bikes, computers.
o Non-durable goods
 Used immediately – toilet paper, food.

Investment
 Purchase of capital stock by firms in an economy.
o Replacement investment – firms spend capital to maintain productivity.
o Induced investment – Higher spending to respond to higher demand.
Government Spending:
 Government investment into education, law, transport etc..

Net Exports (X-M)

*Any changes in these factors of aggregate demand will cause a price increase/decrease
(movement along curve).

Shifts in Aggregate Demand

Consumption:
 Change in income
o If income rises, people will spend more.
 Changes in interest rates
o If interest rates rise, people will spend less as the price of borrowed money
will increase, so less people will in fact borrow money.
 Change in wealth
o If the value of individual’s assets go up, for example stock prices, they will
spend more.
 Changes in consumer confidence
o Consumers’ confidence will vary based on what they personally believe about
the economy’s state.

Investment:
 Change in interest rates
o If interest rates rise, firms will save more and spend less. They will also save
their retained profits.
 Change in the level of national income
o Increase in national income means an increase in demand, and firms will
respond to that by spending more to sell more.
 Technological change
o To keep up with technology firms may spend more, shifting demand.

Exports:
 If a country’s consumption increased they will be more willing to buy exports from
another country, causing the second country’s exports to increase.
 If a country’s exchange rate increases, then their exports will decrease and other
countries won’t want to pay a higher price.
 Trade policies, such as tariffs also will affect how much a country exports.
 Inflation also affects exports, as if inflation increases, so does price of exports hence
exports decrease.

Imports:
 When national income increases, imports will too.
 Exchange rate also affects this – if a country has a lower exchange rate imported
goods are more expensive hence spending decreases.
Government Policies

Fiscal
 Government policy relating to its spending and taxation rates through direct and
indirect taxes.
o Expansionary fiscal policy
 Can lower taxes to increase consumption.
 Can spend more which also impacts AD.

Monetary
 Government policy relating to how interest rates are altered to affect expenditure in
an economy.
o Country’s central bank (essentially the government’s bank) dictates the base
interest rate, at which banks can compete with one another at their own
interest rates. To increase AD central bank may lower interest rates.

Aggregate Supply

Aggregate Supply: The amount of goods an economy will produce in a given time period.

Short Run Aggregate Supply Shift Factors

 Change in wage rates
o Increased wage rates mean an increased cost to firms, hindering their
production and lowering the AS curve in an economy.
 Change in cost of raw materials
o Products with wide use would likely have an effect on AS, such as price of oil.
 Change in the price of imports
o If import price increases, cost of production increases and supply decreases
 Change in indirect taxes and subsidies
o If the government increases indirect taxes, then cost of production is greater
to firms and supply decreases.

Long Run Aggregate Supply

 New classical approach

o Should be very little government intervention.
o Natural market forces will dictate appropriate aggregate supply.
o Price level does not change.
o Output is always at its greatest, regardless of price.
  Keynesian
o Believes that output can be increased to a certain point, before any increase
in output becomes inflation.

Shifts in LRAS
 Dependant on a countries factors of production.
 If there is an increase in a country’s qualitative or quantitative factors of production,
there will be a shift in LRAS.
 Factors include:
o Labour
 Increased birth rate – larger workforce.
 Education – increased quality of workforce
 Training
o Capital
 Investment – more spending on capital = more advanced economy.
 Technological advancements
o Land
 Discovery of new resources.
 Fertilisers – increased quality of production.