Economics for Business Decision Making (BUSS1040)

Foundations and Models: Economics: the study of the choices that businesses and governments make to

attain their goals, given their scarce resources o Society has unlimited wants, but limited resources (which leads to

scarcity) o Scarcity: the situation where unlimited wants exceed the limited

resources available to fulfill those wants o Resources: inputs used to produce goods and services (e.g. land, labor,

capital and entrepreneurial skill) o E.g. Australia needs to manage the scarcity of water efficiently to

maximize the possible benefits across various uses o Trade-off: the idea that, because of scarcity, producing more of one

good or service means producing less of another good or service (e.g. BMW management faced many trade offs like that of whether to produce sedan or convertible cars and whether to concentrate production in Germany, or to build factories in overseas markets).

Three important ideas in economics: o People are rational: economists assume that consumers and firms use

as much of the available information as they can to achieve their goals and they will choose an action only if the benefits outweigh the costs

o People respond to economic incentives o Optimal decisions are made at a margin:

o Most business decisions arent all or nothing, but rather the decision of whether to do more or less of something

o Economists reason that the optimal decision is to continue any activity up to the point where the marginal benefit equals the marginal cost (MB=MC)

o Marginal refers to the extra benefit (marginal benefit) or cost (marginal cost) of a decision

o Optimal decisions are made at a margin as, in doing more of something, the benefit would not be worth the cost, while any less of something would mean that there is potential to benefit more without excessive costs (marginal analysis)

Scarce resources and unlimited wants results in society making trade-offs in order to answer the questions of what products to produce, how the products will be produced and who will receive the products

o What goods and services to produce: answered through choices of customers, firms and governments as they measure the opportunity cost of an activity (highest value alternative that must be given up) when deciding what to buy/sell

o How the goods and services are produced: trade-off is faced between labor and capital and will attempt to achieve the most efficient combination to maximize profits

o Who will receive the goods: consumers with the highest benefit should receive the goods. However, it is dependent on income as those individuals that have the highest income will be able to buy the most

goods and services. Most countries attempt some form of income redistribution (progressive tax).

To answer these questions, society generally has to choose whether the government or the decisions of households and firms should allocate economic resources (centrally planned economy vs. market economy)

o The defining factor of market economies is consumer sovereignty (consumers ultimately decide what goods and services will be produced) and those who are willing to buy the goods/services will receive them

Most economies are mixed market economies as, while most economic decisions are due to the interaction between buyers and sellers in market, the government still plays a significant role in the allocation of resources

Market and planned economies also differ in terms of efficiency, as market economies tend to be more efficient in all three kinds of efficiency:

o Productive efficiency: when a good or service is produced using the least amount of resources

o Allocative efficiency: when production reflects consumer preferences, in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it

o Dynamic efficiency: occurs when new technology and innovation are adopted over time (as this will help firms secure their share of the market)

Efficient markets promote competition and facilitate voluntary exchange where both parties are better off by the transaction

o When inefficiency arises (e.g. a firm ignores environmental damage), the government can set in, however this usually makes the situation worse

Just because an economic outcome is efficient, it does not mean that it is desirable, as society believes in equity

o Equity is where there is a fair distribution of economic benefits between individuals and between societies

o There is usually a trade off between efficiency and equity, as most policies to increase fairness distort market forces (e.g. progressive tax reduces the incentive to work hard and earn more)

In order to solve economic questions, economists develop economic models An economic model is a simplified version of reality used to analyse real-

world economic situations An economic model requires the economist to:

o Decide on assumptions being used o Formulate a testable hypothesis o Use economic data to test the hypothesis o Revise the model if it fails to explain the data o Retain the revised model to help answer future economic questions

Common assumptions include that firms will try to maximise profits as well as ceteris paribus

The hypothesis will be testing an economic variable o Correlation does not mean causation: if 2 variables are correlated, they

are associated with each other, but a change in one will not cause

change in the other. Causation or causality is when one thing causes the other

Economics is based around positive analysis, which concerns value-free facts

that can be checked Microeconomics: focuses on the individual and firms and the way they make

choices Macroeconomics: study of the economy as a whole (dealing with countries)

o E.g. inflation, unemployment and economic growth Choices and Trade-offs in the Market:

The problem of resource scarcity means that a trade-off must be made over what goods and services should be produced.

This trade-off is shown by a production possibility frontier which is a curve that shows the maximum attainable combinations of two products that may be produced with the available resources

A production possibility frontier tells us that once a firm is producing efficiently, it must give up some quantity of one product to produce more of another. This is the opportunity cost.

Opportunity Cost = Explicit Costs + Implicit Costs Explicit costs: the costs an accountant would write down (monetary costs) Implicit Costs: the costs that an accountant would not consider E.g. the explicit cost of travelling to Melbourne would be the cost of a flight,

but the implicit cost would be the time used up which could have been otherwise spent on something else. Implicit costs also include foregone salary and foregone interest on saving. Accounting only considers explicit costs while economics considers both explicit and implicit.

Production possibility frontier also highlights the concept of increasing marginal cost, because as an economy moves along the curve, it must give up more and more of one good to produce another. Increasing marginal cost occurs because some resources are better suited for producing one good rather than the other, the increase will be small but the cost will be large.

I.e. the more resources already devoted to an activity, the smaller the pay-off from devoting additional resources to the activity

I.e. opportunity costs are higher for making one product than the other (as highlighted by the arc shape).

o E.g. increase from 0 to 200 roadsters requires only 25 convertibles to be given up but an increase from 600 to 800 requires 400 convertibles to be given up

The only way to increase the production of both goods is if the economy

experiences economic growth o This could occur through the discovery of new resources or

technological advanced that make additional resources more efficient o Technological advances may only affect one industry so total

production for that industry may increase even if the rest of the economy stays the same

o Disasters and wars cause the PPF to shift inwards When the opportunity costs of producing product A = the opportunity costs of

producing product B, the PPF is a straight line

Absolute advantage: the ability of an individual, firm or country to produce more of a good or service than competitors using the same amount of resources.

Comparative advantage is the ability of an individual, firm or country to produce a good or service at a lower opportunity cost than other producers

This basis of trade is comparative advantage o Parties should specialise in the production of the good in which they

incur the lowest opportunity cost to produce (and therefore a higher comparative advantage)

o This is because we want to minimise production costs and maximise the outputs

This is essential for trade, as companies should specialise in the areas where they have a comparative advantage and then trade for other goods and services in order for all parties to benefit.

o E.g. you can either pick 20kg of cherries or 20kg of apples while your neighbour could either pick 30kg of apples or 60kg of cherries. Since your neighbour can pick more apples and cherries than you with the same amount of resources, they are said to have an absolute advantage. However apple picking is more expensive for them as they have to give up more cherries than you do. Consequently both parties will benefit from trade if they specialised in whichever they have the lowest opportunity cost.

The other reason why trade was beneficial was because the trading price was

between the two partys opportunity costs. For example, your opportunity cost per apple was 1 cherry while their opportunity cost per apple was 2 cherries. Hence, a fair trading price would be you give 1 apple for every 1.5 cherries

o The ratio of opportunity costs determines price range o The basis for free trade is comparative advantage NOT absolute

advantage (otherwise the U.S. would have no reason to trade with Australia)

Trade allows people to raise their standards of living, however, it is only possible due to the existence of markets

The two main types of markets are factor markets and product markets: o Factor markets: markets for the factors of production, including

labor, capital, natural resources and entrepreneurial ability. Households are suppliers and firms demand

o Product markets: markets for final goods and services. Firms and suppliers and households demand

Free markets tend to be the most efficient at providing goods and services and raising living standards, as the prices coordinate the activities of buyers and sellers

o This is due to the price mechanism, which is the system in a free market where price changes lead to producers changing production in accordance with the level of consumer demand. This assumes individuals act in a ration, self-interested way (fundamental assumption of economics).

Free market: an economic system in which prices are determined by unrestricted competition between privately owned businesses

o A market with few government restrictions on how a good or service can be produced or sold, or on how a factor of production can be employed

Markets are dependent on entrepreneurs who bring together the other factors of production in order to produce a good/service

The market system is also dependent on private property laws and the enforcement of contracts

o Protection of private property rights (right to have exclusive use and ability to buy and sell property) is essential to markets as people must be able to securely invest their funds without the possibility of it being seized by the government or criminal gangs

o Enforcement of contracts in an independent court system is also very important in order for businesses to function efficiently as they rely on these contracts when operating. A lack of enforceable contracts will mean production is inside the PPF

Supply and Demand: Demand:

Quantity demanded of a product is the amount of a product consumers are both willing and able to buy at a particular price

Market: where buyers and sellers meet o Any arrangement that enables buyers and sellers to get information and

do business together Perfectly Competitive Market:

o All the goods offered are the same (homogeneous) o There are many buyers and sellers o In a perfectly competitive marker, no individual or seller has any

impact on the market prices they accept market prices as given (they are price takers)

The market demand is found by adding the individual demand curves of all consumers of a given product:

Law of Demand: when the price of a

product falls, the quantity

demanded will increase (hence curve is downwards sloping)

o Also, inversely, as the price of a good goes up, the quantity demanded increases

Quantity Demanded: the amount of a good or service that a consumer is willing and able to buy during a given time period at a given price (willingness to buy at the market price)

Demand schedule: a table showing the relationship between the price of a product and the quantity demanded

A demand schedule can be converted into a demand curve, which shows the relationship between the price of a product and the quantity of the product demanded at that price

Certis paribus: everything is held constant (except one variable) The law of demand is due to the substitution effect and the income effect:

o Substitution effect: when a change in price of a good makes it more or less expensive relative to other substitute goods. This leads to

consumers buying more of the good when the price falls and less when the price increases

E.g. you want to snack and you could buy chips (or something healthy), but as the price of biscuits goes down, you substitute products into this product so hence the quantity demanded goes up

o Income effect: when a change in the price of a good changes the purchasing power of the consumers income. This means they will buy more when the price falls due to increased purchasing power and less when the price increases

E.g. as the price of biscuits falls, you can buy more (your purchasing power goes up)

As the price goes up, the purchasing power of your money falls, so then you buy relatively less of the product

Changes in price (only) will cause a change in the quantity demanded, as there is a movement along the demand curve

Variables other than price will cause an increase in demand and shift the demand curve either right or left respectively. These variables include:

o Income: income affects an individuals and a markets ability to buy more expensive products.

Normal good: a product for which the demand increases as income rises, and decreases as income falls

Inferior good: a product for which the demand increases as income falls and decreases as income rises

E.g. a UNSW degree is an inferior good o Price of other goods:

Substitute product: goods or services that can be used for the same purpose. Demand for your good/product increases when the price of a substitute increases

Complements: demand for your product decreases when the price of a complementary product increases

E.g. as petrol prices increase, demand for cars decreases o Tastes: affects demand as consumers can be affected by advertising

campaigns, trends, etc. which will either increase or decreases their demand for a product

o Population and demographics: also affects demand as an increase in population will increase demand for all good while a change in a countrys demographics (e.g. ageing population) will change demand for particular goods or services

o Expected future prices: affect demand as if consumers expect prices to rise in the future, they will bring forwards spending and increase demand. Opposite is true for expected future price falls

Supply: The quantity supplied of a good or service is the amount that a firm is willing

and able to supply at any given price Supply schedule: a table showing the price of a product and the

corresponding quantity supplied Supply curve: a graph of the supply schedule

o Shows the relationship between the prices of a product and the quantity supplied

Law of Supply: holding everything else constant (Certis Paribus), as the price of a product increases, the quantity supplied will increase and as the price decreases, the quantity supplied decreases

o Occurs because firms attempt to maximise their profit, and as the price of a product increases, it will become more profitable and firms will increase their supply to sell more

o The price increase is important as marginal costs increase as more of a product is produced so the price must justify these high costs

The supply curve slopes upwards Changes in price (only) of a product will cause a change in the quantity

supplied and a movement along the supply curve A change in any other variable that affects supply will cause an increase in

decrease in supple and a shift of the supply curve either to the right or the left. Such variables include:

o Price of inputs (most likely cause): affects the cost of producing the good and hence either increasing or decrease supply directly

o Technological Change: the change in the ability of a firm to produce a given level of output with a given quantity of inputs

Positive technological change occurs when the productivity of resources increases which lowers costs and hence increases supply

Negative technological change occurs when the productivity of resources decreases which increases costs and decreases supply

o Prices of substitutes: these are the alternate products that firms could produce instead of a given good/service. If the price of these alternates increases, there will be a decrease in supply of the initial good as firms direct resources to producing the alternate

o Number of firms in the market: when new firms enter the market, the supply increases and the curve shifts to the right. When existing firms exit, the supply decreases and then the supply curve shifts to the left

o Expected future prices: if firms expect the price to increase, they will decrease supply initially so that they can increase it later and maximise profits. However, this is dependent on how easily the product can be stored to supply could be increased