The Market Economy

Contents
Introduction to Economics....................................................................................................................2
Economic Problem / Role of Choices.................................................................................................2
Understanding wants.....................................................................................................................2
Key Economic Problem..................................................................................................................2
The production possibility frontier....................................................................................................3
New technology and the frontier...................................................................................................3
New resources...............................................................................................................................3
Unemployment..............................................................................................................................3
The shape of the production possibility frontier............................................................................3
The future implications of choices.....................................................................................................3
Economic factors underlying choice..............................................................................................4
How economies operate.......................................................................................................................4
Production of goods & services.........................................................................................................4
Distribution and exchange of Goods & Services................................................................................5
Role of consumers in a market economy:
 Consumer sovereignty
 Role of consumers in the economy
 Saving and dissaving
 Factors influencing whether to spend or save
 Factors influencing consumer choice
 Factors of consumer choice
THE ROLE OF BUSINESSES IN THE MARKET ECONOMY

 Firm and an industry

 Production decisions
 Goals of the firm
 Productivity
 Specializing and productivity
 Internal economies of scale
 Internal diseconomies of scale
 External economies of scale
 External economies of scale
 Investment, technological change and ethical decision making
TOPIC 1: Introduction to Economics
Economic Problem / Role of Choices
The satisfaction of unlimited wants with limited resources:

 Unlimited wants
 Scarce resources
 Choose between wants
 Rank our preferences – some wants go unsatisfied

Economics is about solving the economic problem of allocating resources to satisfy unlimited and
competing wants

Understanding wants
Wants are the material desires of individuals or the community, includes

 Basic needs – food, shelter, health education

 Non essential items - range of other goods and services that make life easier or give
pleasure

Individuals derive utility from the consumption of goods and services

Individual wants
Dependent upon personal preferences and level of income

Collective wants
Dependent upon preferences of the community as a whole – these wants are usually provided by
the government (local, state and federal)

Generally more pressing wants will be satisfied first

Recurrent wants – food, newspapers, clothes, petrol

Complementary wants - where one wants flows from the satisfaction of another – e.g. purchase a
new dress want new shoes, purchase a car want petrol

Wants change over time

 As we age
 As income levels change
 As technology introduces new produces
 As family circumstances change

Key Economic Problem

1. What to produce
2. How much to produce
3. How to produce
4. How to distribute the product – whether to have an equitable (even) or inequitable (uneven)
distribution

Opportunity cost – is not the money spent but it represents the cost of satisfying one want over an
alternative want – also known as the “real cost” or the economic cost.
  The individual consumer, with limited resources represented by limited income, might have
to choose between a new car and an overseas holiday – the opportunity cost of a new car is
the holiday foregone
 The business firm must make a choice in allocation of scarce resources, produce shoes or
furniture
 The government has limited resources to satisfy community needs, new highway or
new hospital

The production possibility frontier

Also known as the production possibility curve, it graphically shows the various combinations of two
alternative products that can be produced with constant state of technology and a fixed quantity of
resources used at full capacity.

Simple assumptions:

 Only 2 goods produced

 Technology is constant
 Quantity of resources remains constant
 All resources fully employed

It shows the upper limit of what an economy can produce at a given point in
time. All points on the curve are where the economy is operating at full
productive capacity

New technology and the frontier

With the application of new technology, more efficient methods of production are possible which
can shift the frontier outward to the right allowing more goods to be produced using the same
resources.

New resources
Discoveries of new resources, expansion of population can increase resources, pushing the frontier
outward

Unemployment
If any of our resources are not fully employed then the frontier is not changed but the economy
operates at a point somewhere within or underneath the production possibility frontier. The
economy is not operating efficiently as resources are unemployed.

The shape of the production possibility frontier

With a straight line frontier, it must be possible to shift resources between the
production of either good at a constant rate; in the real world this is generally not
the case, the shape of the frontier is generally concave – as more and more
resources are shifted to the alternate good, then they become less productive.

The future implications of choices

Economics choices also influence the choice between producing consumer goods (goods for
immediate consumption) and capital goods (goods used to produce other goods, e.g. machinery).
In the long run an economy which focuses more upon production of capital goods will increase its
productive capacity and experience a higher level of economic growth – implications for individuals,
businesses and government.

 An individual can save for a mortgage, less disposable income in the short term but in
the longer term home ownership provides financial security
 Businesses are likely to be more effective if they can identify where the next wave of
business growth is likely to come from and invest (product capital goods) for that
growth
 Choice between immediate welfare benefits (politically more popular) and education,
infrastructure and R&D, in the longer term less spending in the latter reduces workforce
skills, less innovation and weaker infrastructure.
 The ‘marginal rate of substitution’ measures the opportunity cost - Units given up/units gained

Economic factors underlying choice

1. Individual choice influenced by
a. Spend or save
b. Age, income
c. Expectations about future level of income
d. Plans regarding education, family, retirement, travel etc
e. Individuals can also vote to influence government
2. Business choice influenced by
a. Cost, and changes in cost, of raw materials
b. Ethical issues relating to sourcing raw materials
c. Where they position themselves in the market for labour
3. Government influenced by
a. Changes in taxation
b. Prohibitions on certain activities
c. Incentives, e.g. health insurance
d. Encourage spending e.g. stimulus packages

How economies operate:

 The factors of production

 Distribution and exchange of goods and services
 The business cycle
 The circular flow of income
o Injections
o Leakages
 Equilibrium
 Disequilibrium

How economies operate

Production of goods & services
Factor of production – any resource that can be used in production of goods & services. Each is
limited in supply reflecting the problem of scarcity.

In modern economies, decisions about how scarce resources are used, are largely determined by
consumer spending patterns.
Factor of Production Reward
Natural resources Rent
Land, soil, water, forest, mineral deposits, All income derived from productive use of natural
fishing areas resources
Labour Wages
Human effort both physical & mental, Includes all regular payments plus variable pay as
dependent upon population size (birth, well as earnings of self-employed and
deaths, immigration); school age, women in professionals
workforce, educational standards
Capital Interest
Capital is the “produced means of Interest is the price of capital whether as the
production”, goods not used for immediate amount paid on borrowed funds or as the
consumption, e.g. machinery, tools, interest foregone on retained earnings
Includes Infrastructure which is public capital
Capital improves productivity of other
resources
Enterprise Profit
The organisation of the other factors of Profit is returned to the entrepreneur as a reward
production – the vital ingredient which for setting up and running a successful business,
brings the production process together - for risk taking
management

Distribution and exchange of Goods & Services

GDP – Gross Domestic product – total market value of all final goods and services produced in an
economy over a period of time (normally one year)

Market economies don’t attempt to distribute output equally, instead they provide people with
income, which in turn is influenced by workers ‘skill, expertise and bargaining power. Differentiation
provides incentive for individuals to improve their education and work harder.

However outcomes can be unfair, therefore governments intervene to correct inequitable market
outcomes, via taxation and redistribution to lower income earners through social security payments.

Money – medium for exchanging goods and services

Barter – non c ash exchange of goods and services – recent resurgence of bartering Bartercard
business

Business Cycle
Business Cycle – fluctuations in level of economic growth due to either domestic or international
factors

Gross domestic product: the total market value of all final goods and services produced in an economy over
time.
Markets are subject to a continuing cyclical pattern of strong growth, followed by economic
slowdown. These patterns cause problems for economies.

Recession – decreasing economic activity, defined as two consecutive quarters of negative economic
growth in GDP – lower quality of life

Boom – increasing economic growth, falling unemployment, improvement in quality of life

Governments smooth out the business cycle, e.g. stimulating the economy in periods of downturn
and building surplus in times of growth.

Circular Flow of Income

5 sector circular flow of income model
 The 5 sector circular flow of income model illustrates the different sectors of the economy
and how they co-exist with each other.
 Individuals
Deals with their activities in earning an income and spending it on goods and services.
 Businesses
Consists of business firms engaged in the production and sale of goods and services.
The individual and business work interdependent
 Financial institutions (banks)
Engaged in the borrowing and lending of money. Both consumers and businesses for
saving and investment need financial institutions.
 Governments
Local, state and federal. Involved in the satisfaction of collective wants for the
community. Taxation imposed by the government cause a reduction in the level of
economic activity. Government expenditure represents an injection.
 International trade and financial flows
Deals with all transactions of imports and exports . an inward flow of money into
economy: injection, outward flow of money: leakage.

 Leakage: refers to items that remove money from the circular flow and in affect lowers
the level of economic activity.
Savings, taxation, imports
Recession Boom
 Economic downturn  Economic upturn
 Neg. growth for at least 6 months  Increased investment and production
 Postpone investment  Rising employment levels
 Reduce production  Increase disposable income
 Falling employment  Rising income levels
 Reduce demand for labor  Ultimately leads to rising quality of life.
 Ultimately leads to lower quality of life.
 Injections: refers to items that bring money into the circular flow of income and in affect,
increases economic activity.
Investment, government spending, exports.
 EQUILIBRIUM
Leakage = injection
Savings + taxation + imports = government spending + investment + exports
15 10 3 9 18 ?

 DISEQUILIBRIUM
 Total leakage > total injections = economic downturn
 Total injection >total leakage = economic upturn
Sectors Receipts From Outgoing To
Individuals Income rewards Business Expenditure on G&S Business
Social Security Government Savings Financial Instit’ns
Interest Financial Instit’ns Taxation Government
Dividends Business Interest Payments Financial Instit’ns
Imports Intern Flow
Businesses Sales Individuals
Investment funds Financial Instit’ns
Expenditure Government
Exports Intern Flow
Financial
Institutions
Governments
International Flows
Leakage – anything which removes money from the circular flow of income - 3 leakages are:

 Savings
 Taxation
 Imports

Injections – anything which increases income and economic activity – 3 injections are:

 Investment
 Government spending
 exports

Equilibrium – when the sum of all leakages equals all injections

Disequilibrium – inequality between leakages and injections

 total leakages > than total injections – economic downturn

 total leakages < than total injections – economic upturn

Circular Flow of income is in equilibrium when

Savings + Taxation + Imports = Investment + Government expenditure +

Exports S + T + M = I+G+X

Leakages = Injections

 Consumer sovereignty determines what goods and services will be produced

 The government has control over the production of goods and services; may
implement tariffs, taxes, ads or laws
 Oversupply means a waste of scarce resources. This will ultimately generate sales to get rid
of excess supply
 ‘The market economy’ is a system where product prices are determined by the interaction
between consumers and businesses
CONSUMERS AND BUSINESSES
Role of consumers in a market economy:
 Consumer sovereignty
 Role of consumers in the economy
 Saving and dissaving
 Factors influencing whether to spend or save
 Factors influencing consumer choice
 Factors of consumer choice

Consumer sovereignty is where consumers have power to determine what is produced in an

economy.
Businesses can influence consumer choice:
 Marketing
 Misleading conduct
 Planned obsolescence- design faulty products to encourage consumers to spend in future.
 Anti-competitive behavior.

 Consumer’s role is to signal to businesses what is in demand so businesses produce goods

and services to gain profit.

Main factors influencing consumers choice to spend or save:

 Age
 Income
 Y= C + S
o Income = consumption + savings

 Average propensity to save:

o The proportion of income that is saved
o Average propensity to consume:
o The proportion of income that is consumed
o APS+APC= 1

 Substitute: product in place of another product

 Compliment: product used together with another.
 Dissaving: when consumption exceeds disposable income.

Factors influencing consumer choice

 Level of income
 Price of good or service
 Price of substitute and compliment goods
 Consumer tastes and preferences
 Advertising.

Source of consumer income:

 Wage from labor
 Rent from land
 Interest from capital
 Profit from entrepreneurial skills
 Social welfare payments.
 THE ROLE OF BUSINESSES IN THE MARKET ECONOMY
 Firm and an industry  Internal economies of scale
 Production decisions  Internal diseconomies of scale
 Goals of the firm  External economies of scale
 Productivity  External economies of scale
 Specializing and productivity
 Investment, technological change and ethical decision making

 Firm: an organization that uses the factors of production to produce goods and services.
 Industry: a group of firms that are involved in a providing similar goods and they compete
with each other.

Businesses must make production decisions on:

 What to produce- based skills and experience, business opportunity, consumer demand and
available capital.
 How much- do market research, may produce too little or too much
 How to produce- depends on the relative efficiency of the four production factors

Goals of the firm Main points
Maximizing profit Use resources efficiently
Smallest possible loss
Meet shareholders expectations Serve the interest of shareholders
Shareholders want to maximize short
term investments
Increase market share Increase sales rather than profit
Maximize growth of assets Maximize growth of assets to
achieve higher profits in long run.
E.g. ABC learning centers (1988-
2010)
Satisficing behaviour Pursue satisfaction in all areas

 Business performance effects the economy’s prosperity

 Growing businesses increase employment, attract tourism, improve economy’s productive
capacity; resulting in improved living standards.

 Productivity: how much we produce with a given amount of resources i.e. labor, capital.
 Increasing productivity increase our overall living standards.
 Less wastage of our scarce resources
 Lower production costs and higher business profits
 Lower inflation rate- no need to raise prices
 Higher incomes for workers
 Improved international competitiveness
 ‘Specialization’ can be used to improve productivity where the factors of production
are used more intensely.
Type Main points Example
Internal economies of When there is cost saving Increased specialization of
scale advantages to producing a large labor and capital.
amount.
FIRM  Increase production,
decrease average
cost/unit
Internal diseconomies of The disadvantages of firms As firm grows, more inputs
scale getting too large and cost/unit need to be purchased,
FIRM will start to rise. increasing variable costs.

External economies of The cost saving advantages for a Better transport system,
scale firm due to outside influence. which reduces costs within
INDUSTRY an industry.

External diseconomies of The cost disadvantages due to The cost of recourses such
scale external influences. as land, labor, capital and
INDUSTRY enterprise increases.