The operation of an economy

Production of goods and services from resources

The market economy

- Advanced industrialised, capitalist economies - What to produce and how much to produce

o Determined by price mechanism in which consumer preferences, supply and demand determine the pattern of product and the quantities of outputs.

- How to produce o Determined by profit motives as producers will tend towards cheaper and more

efficient forms of production with technology being a driving force. Demand for resources is dependent on consumer demand as well as prices in the factor markets.

- To whom to distribute o Determined by the distribution of incomes as higher income earner possess higher

purchasing power. Income is determined by an individual’s marginal productivity as well as the demand for various labour skills.

- Key characteristics o Price mechanism determines; prices, quantity and allocation of resources. Producers

motivated by profit. No intervention in the market by the government

The planned economy

- Use of government planning to allocate resources according to the priorities for production set by a state planning authority agency

- What to produce and how much to produceo Determined by the government. Short, medium and long term plans set out

production priorities and targets. Resource allocation in government controlled with individual farms and factories given quota they must fulfil.

- How to produce o Determined by government to allocate resources in sufficient quantities to meet

output targets. Differential wage rates are sued to control the supply of workers. - To whom to distribute

o Determined by government to share out production on the basis of needs and areas of priority. Higher wages and salaries are paid to workers in high priority industry with prices for basic needs generally subsided and health/education is generally free

Distribution of goods and services

The distribution of outputs depends on individual incomes. The higher the personal income, the greater the ability to purchase goods and services and raise individual living standards.

Most economies display an uneven distribution of income because individuals are free to accumulate income and wealth. The government’s tax/transfer system helps to redistribute income and make the distribution of income less unequal than it was determined solely by market forces.

Prices are monetary indicators of the relative value of goods and services in an economy. Prices guide the decision making process in four main ways –

1. Prices match the output by producer with the demand of consumers. 2. Prices ration the limited supply of resources and commodities.

3. Prices help prevent the wastage of resources by avoiding shortages and surpluses of production in relation to demand, so producers aim to achieve allocative efficiencies.

4. Prices signal to producers and consumer to adjust economic behaviour as a result of changes in market conditions.

Resources and provision of income

Factors of Production

- Land o Refers to all naturally occurring elements or environmental resources which may be

utilised for production. The price of land resources are determined largely through demand.

o Factor income return – rent - Labour

o Refers to the overall productivity of the workforce in performing production tasks. Labour productivity can be raised by using inputs efficiently or increasing amount and through capital equipment

o Factor income return – wages - Capital

o Refers to the produced means of production use to further produce goods/service in the future.

o Saving investment capital accumulation o Factor income return – interest

Real interest rate = nominal interest rate – inflationary expectations - Entrepreneurship

o Refers to the entrepreneurs that establish manage and operating business enterprises. They combine the other three factors of income to produce the final good/service.

o Factor income return – profit Normal profit is the rate of profit sufficient to keep the entrepreneur in

business. Supernormal profit is profit over and above what is necessary.

Factor income returns are influenced by the productivity of each factor of production

Households provide resources to firms and the government through factor markets. Firms and governments pay households factor incomes in return. Firms supply goods/service to households and government in return for money expenditure. Governments produce goods and services and transfer payments, collecting tax in return.

Provision of employment and quality of life

Due to high levels of specialisation in an economy, there is increased interdependence between households, firms and governments.

- Households depend on firms and governments for the provision of employment and payment of income. Firms in turn depend on the expenditure of households for the goods/services for their income. Both firms and households pay taxes to the government which in turn, provide collects goods/services and transfer payments.

- Employment is the primary industry (raw material extraction) and secondary industry (manufacturing) has seen decreased over the past year as a result of mechanisation and automation. As an economy grows, it becomes more specialised leading the changes in the structure of production and employment.

Quality of life

- Dependent on the quantity and quality of goods and services in the economy. - Quality of life indicators

o Material considerations Level of income individuals can earn, types and nature of employment

available, and the range of goods/services. o Non-material considerations

Access to collective goods and services e.g. health care, education, housing, public transport, emergency services etc.

o Other – access to safe drinking water, clean environment, safe community, personal freedom (i.e. participation of individuals in the political process)

The business/economic cycle

- The business cycle is a macroeconomic model that illustrates GDP/output/level of production over time.

Note:

- Growth in GDP overtime- Does not grow at a constant

rate- Increasing GDP economic

growth

Key aspects looked at include; supply and demand, expenditure, output and employment

Peak/Boom

- Expenditure, output, employment is at capacity. Economic activity is at its peak- This point represents a supply constraint where demand>supply which leads to an increase

in prices because of inflation - less consumption decreased outputs increase unemployment

Upswing

- Consumer and business confidence is high increased demand - Increased demand increased consumption increase outputs increased employment

Trough

- Expenditure, output, unemployment are at its lowest levels - Increased supply of available labour decreased price of labour (wages) decreased

demand decreased prices i.e. deflation

Downswing

- A result of supply capacity of the boom where demand>supply, hence deflation - Economy is cooling

The circular flow of income model

- Closed economy is one with no overseas sector and therefore no international trade - An open economy has an overseas sector and therefore international trade and money flow

Sectors

- The household sector o All individuals in the economy who earn income by selling productive resources to

the firms sector. Income is used to purchase goods/services from firms to satisfy needs and wants and improve standard of living.

- The firms sector o Firms buy productive resources from household sectors and make factor income

payments in return. - The finance sector

o All financial institutions who engage in the borrowing and lending of money and the sale and purchase of financial assets and services to firms and households

- The government sector o Economic activities of local, state and federal governments

- The overseas sector

o Exporters and importers of goods and serviceso Trade flows

Export and imports of goods and services. o International money or financial flows

Borrowing and lending of money between Australia and foreign financial institutions and companies. All international transactions are recorded in the balance of payments; current account, capital account and financial account.

Five Sector Circular Flow of Income Model

- Equilibrium; S+T+M = I+G+X- Disequilibrium

o Leakages > Injections causing fall in level of income, output, expenditure and employment leading to a contraction in economic activity (recession-like)

o Leakages < Injections causing a rise in level of income, output, expenditure and employment leading to an expansion in economic activity (boom-like).

o Regaining Equilibrium When leakages > injections, households will cut back on savings, pay less tax

and purchase fewer imports as a result of reduced income. This will balance out the injections and a lower level of equilibrium will be established.

When leakages < injections, house wills increase saving, pay more tax and spend more on imports. This will increase the leakages and therefore establish a higher level of equilibrium.