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AN EFFICIENT ALLOCATION OF RESOURCES
The allocation of resources refers to how the resources of land, labour and capital are used
to produce goods and services in the economy. When resources are used to produce one
type of good or service then they cannot be used for the production of another good or
service (there is an opportunity cost). The most efficient allocation of resources will occur
where the maximum amount of satisfaction is obtained by society at the lowest opportunity
cost. Another way of looking at this is to say that the allocation of resources cannot make
anyone better off unless someone else is made worse off.
The aim of any economy is to extend its production possibility curve so that as many of
societies needs and wants as possible can be satisfied.
This can be achieved if we are able to allocate more resources to the production of goods
and services or if scarce resources (land, labour, capital) are used more efficiently.
The following may help to increase a country’s productive capacity:
•
The use of the latest technology.
•
The upgrading of workers’ skills.
•
The use of the most efficient production methods.
•
Business and government to be innovative and creative.
•
This generation to be mindful of future generations and their needs and wants.
An efficient allocation of resources exists when productive resources are used to maximise
the production of goods and services (and society’s welfare) at the minimum possible
opportunity cost.
IMPORTANT CONCEPTS
•
Allocative efficiency: Maximising consumer satisfaction, minimising opportunity cost.
Allocative efficiency will occur when resources are directed towards the area where
they generate the best outcome for society. This will tend to occur when all market
moves towards equilibrium.
•
Productive (technical) efficiency: Maximising output per unit of input, least cost
method.
•
Dynamic efficiency: Firms being creative and innovative, adapting to latest
technology, upgrading workers skills.
•
Inter-temporal efficiency: Balance between resource use for current use and that of
future generations. This may also take into account the balance between current levels
of consumption and investment which will enable society to consume in the future.
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The Essentials – Unit 3 Economics – Book 1
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MICROECONOMIC ANALYSIS — THE MARKET MECHANISM
A market is any place where buyers and sellers interact to exchange goods and/or services.
The market mechanism coordinates the activities of buyers and sellers. There is assumed to
be a high degree of competition in a market to establish the price for each good or service.
The market or price mechanism is where the forces of demand and supply set a
market equilibrium price where consumers and producers agree on the quantity and
price.
Before looking at demand and supply analysis we consider the case of a pure market.
The closer that a market is to the conditions outlined below, the more competitive it will
generally be:
•
Price taking (the result of a large number of buyers and sellers).
•
Homogenous products.
•
Low barriers to entry.
•
Perfect information about relevant prices, quantities, conditions and technologies by all
economic agents.
•
Rational behaviour.
If the market is able to operate freely then the equilibrium price should be achieved. At this
price the market clears so that there are no shortages or surpluses. In many markets in
Australia, however, the level of competition is somewhat compromised by market power. In
the case of oligopolistic industries, a small number of firms will dominate the market and this
will effectively reduce competition and lead to above average levels of profits. In some ways
it could be argued that the consumer is worse off because they may be forced to pay higher
prices and face less real choice.
One of the key assumptions underlying the market mechanism is that producers and
consumers generally act in their own self-interest when they approach a transaction.
Consumers will try to obtain goods and services at the lowest possible price and will not pay
for any product which is offered at a higher price than what they think it will provide in terms
of utility (wellbeing). Producers and suppliers on the other hand will try to obtain the highest
possible price and will not supply the product if the price received is below what it costs them
to make it. The price that is determined in the market is therefore a compromise between the
competing interests.
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The Essentials – Unit 3 Economics – Book 1
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DEMAND — SUPPLY ANALYSIS
DEMAND
Demand is the quantity of a good or service that consumers are willing to buy at a particular
price. For producers to fully account for consumers wants and needs in their pricing
decisions they must have effective demand. This means that the consumer not only desires
the good or service but they are also willing and able to pay for it.
The law of demand states that as the price rises for a good or service then there will be a
decrease in the quantity demanded for that good or service (other things being equal). This
is represented by a downward sloping demand curve when price is shown on the vertical
(y-axis) and quantity demanded is shown on the horizontal (x-axis).
The price paid will represent the value of that product to the consumer. At higher prices the
opportunity cost of consumption will increase and certain individuals will either value it less
than the higher price or be unable to purchase it due to insufficient income levels.
Demand Schedule For CDs
Quantity
5
2000
10
1500
15
1000
20
500
25
50
30
25
20
Price
Price ($)
Demand
15
10
5
0
50
500
1000
1500
2000
Quantity
Movements in price will not shift the demand curve but will be represented by a movement
along the curve. A decrease in price will result in an expansion in demand and an increase
in price will result in a contraction in demand.
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The Essentials – Unit 3 Economics – Book 1
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DEMAND FACTORS
The demand curve is drawn in two dimensions. That means for every price there is an
associated quantity demanded. All other factors (conditions of demand), which affect
demand, have been held constant (cetirus paribus) so that a change in any of these factors
will move the demand curve left or right. If the demand curve moves right this means that for
each given price, there is a greater quantity demanded
A change in a condition of demand will cause a shift in the demand curve. If demand
increases, the D-curve will shift to the right. If demand decreases the D-curve will shift to the
left. Conditions of demand include:
A.
Total disposable income
Disposable income is defined as the total income that households have received in
exchange for their participation in the production process plus government transfers
less direct (income taxes). This represents the total amount that consumers (or
businesses) have to spend on goods and services.
An increase in disposable income will generally lead to an increase in demand for
normal goods. This will shift the demand curve to the right as consumers will be willing
and able to purchase more at any given price.
Example:
B.
Changes in interest rates (please note that this is a different factor than the last
one)
Increases in interest rates will generally have the greatest impact on those who are
indebted. An increase in interest rates will mean that indebted households will have
less available income after paying interest. This will result in a decrease in demand and
a shift of the demand curve to the left (less purchased at each price).
Example:
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The Essentials – Unit 3 Economics – Book 1
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Exam Tip: Do not say that an increase in interest rates leads
to a decrease in disposable income.
C.
Tastes and Fashion (which may be influenced by advertising)
If an item becomes fashionable then it is generally assumed that consumers will be
willing (and possibly able) to purchase more of the good or service at a given price.
Example:
D.
The price and availability of substitutes
A substitute product is one that acts as a viable alternative to the product in question.
If the price of a substitute increases then consumers will alter their buying behaviour.
They may switch from buying the more expensive product to the cheaper substitute.
Example:
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The Essentials – Unit 3 Economics – Book 1
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E.
The price and availability of complements
Complementary products are generally consumed together.
An increase in the price of a complementary product will essentially mean that the total
cost of consuming both (or all) of the products has increased. As a result demand for
both products will generally decrease.
Example:
F.
Consumer Sentiment (confidence)
Consumer sentiment is a measure of the general expectations about the future state of
the economy. If sentiment has increased then consumers may be willing to increase
their marginal propensity to consume and take on additional debt. This will lead to an
increase in demand.
Example:
G.
Population size
A larger population will mean that there are more people demanding products. This will
result in a shift of the demand curve to the right as more will be demanded at any given
price.
H.
Other Government Policies
The Government can influence the demand for certain products especially if they
mandate certain products. For example, the fact that seat belts are compulsory
increases their demand. The government can also subsidise the consumer of a product
which will increase their ability to pay. For example, purchasers of gas conversions for
automobiles receive a rebate from the Federal Government.
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The Essentials – Unit 3 Economics – Book 1
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An increase in demand – e.g. Lower PAYG tax rates.
The demand curve shifts to the right. Lower PAYG taxes mean that each income earner has
greater disposable income and can therefore afford to pay a higher price (or demand more
at a given price).
Demand
30
25
Price
20
15
10
5
0
50
500
1000
1500
2000
Quantity
A decrease in demand – e.g. A fall in consumer confidence.
Demand curve shifts to the left.
Demand
30
25
Price
20
15
10
5
0
50
500
1000
1500
2000
Quantity
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The Essentials – Unit 3 Economics – Book 1
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SUPPLY
Supply is the quantity of a good or service that producers are willing and able to supply at a
particular price. When analysing supply one needs to consider the motivations of business
owners. A business generally aims to make a profit and will therefore supplies
goods/services if there is profit to be made from the activity.
The law of supply states that as the price rises for a good or service then there will be
greater supply for that good or service (other things being equal). This is represented by a
upward sloping supply curve when price is shown on the vertical (y-axis) and quantity
supplied is shown on the horizontal (x-axis).
The willingness to supply is dependent upon costs of production and profitability. At higher
prices it is assumed that firms will be able to generate higher profits (assuming all else is
held constant) and that higher prices received in a market for a product will entice new
suppliers into the market.
Supply Schedule For CDs
Price ($)
Quantity
5
50
10
500
15
1000
20
1500
25
2000
Supply
30
25
Price
20
15
10
5
0
50
500
1000
1500
2000
Quantity
Movements in price will not shift the supply curve but be represented by a movement along
the curve. An increase in price will result in an expansion in supply and a decrease in price
will result in a contraction in supply.
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The Essentials – Unit 3 Economics – Book 1
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SUPPLY FACTORS
These factors are held constant for any given supply curve. A change in any of these factors
(or cetirus paribus conditions) will result in a shift of the supply curve. If the supply curve
shifts left then this means that for a given price there is a lower quantity supplied. A helpful
way of analysing supply is to consider how much the supplier needs to receive in order to
cover costs. A shift of the supply curve to the left may also therefore be interpreted as:
The supplier now needs a higher price to supply the same quantity.
Conditions of supply include:
A.
Changes in the costs of the factors of production
If the cost of production increases then the suppliers will be less willing and able to
supply at each given price. Alternatively it may be useful to consider the profitability of
the firm. When costs increase the supplier will need a higher price to cover these costs
for a given quantity. As a result the supply curve will shift left (think of it as an upward
movement if you like) as the cost of production increases.
Example:
B.
Technological change
New technology will generally increase the productivity of existing resources. This will
have the impact of lowering the cost per unit and shift the supply curve to the right.
With higher levels of productivity, the firm is able to supply more at a given price.
Example:
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C.
Climatic conditions
Favourable climatic conditions will tend to increase the ability and willingness of firms to
supply at any given price.
Example:
D.
Government policies
Governments at each level will influence the ability and willingness to supply. This can
be direct or indirect.
A tax (such as excise or a carbon tax) will essentially increase the cost of production for
firms and result in a shift in the supply curve to the left. The curve will shift vertically
(upward) by the amount of tax placed on each unit of the good or service.
Governments may subsidise the production which will reduce the cost of production.
This acts in the opposite way to a tax.
Governments may legislate to ensure that businesses follow certain protocols. For
example, firms may be required to reduce their Carbon Dioxide emissions. To comply
with these regulations may increase their cost of production.
Governments may ban the production and consumption of certain products which
reduces (but does not necessarily eliminate) the supply of the product.
E.
Business (and consumer) sentiment
If businesses expect future economic conditions to be favourable then they may invest
in new capital and technology which will improve their capacity to supply in the future.
F.
Substitutes and complements in production
A substitute in production exists when a firm can use its factors of production to
produce more than one alternative. An increase in the price of a substitute in
production lowers the supply of its alternative in production.
Complements in production arise when two (or more) goods and services are produced
together. For example, the extraction of chemicals from coal produces coke, coal tar
and nylon. An increase in the price of any of these products will result in an increase in
supply of all three.
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The Essentials – Unit 3 Economics – Book 1
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An increase in supply – e.g. a fall in labour costs.
Lower production costs mean that the firm is able to supply more at a given price.
Alternatively the firm is now able to supply any given quantity at a lower price.
Supply
30
25
Price
20
15
10
5
0
50
500
1000
1500
2000
Quantity
A decrease in supply – e.g. a drought affecting agricultural products.
Supply
30
25
Price
20
15
10
5
0
50
500
1000
1500
2000
Quantity
Exam Tip – whenever the demand or supply curve shift – a shift to the right
always means an increase (in demand or supply) and a shift to the left means
a decrease (in demand or supply).
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The Essentials – Unit 3 Economics – Book 1
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EQUILIBRIUM
The intersection of the demand and supply curves represents the equilibrium (where quantity
demanded is equal to quantity supplied). This is the only price where consumers and
producers are in agreement. There will be no shortages and no surpluses and the market is
cleared. No one is able to make a better choice given the available factors of production and
the behaviour of other buyers and sellers. As a result, the equilibrium is seen as the most
efficient allocation of resources.
Demand and Supply Schedule For CDs
Price ($)
Quantity
Demanded
Quantity
Supplied
5
2000
50
10
1500
500
15
1000
1000
20
500
1500
25
50
2000
Equilibrium
30
25
Price
20
15
10
5
0
50
500
1000
1500
2000
Quantity
 The School For Excellence 2016
The Essentials – Unit 3 Economics – Book 1
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MOVEMENT TO EQUILIBRIUM
If the price is initially set above equilibrium, then quantity supplied will be greater than
quantity demanded creating a surplus in the market. For example, if the price was set at
$20 quantity demanded would be 500 but the quantity supplied would be 1500 creating a
surplus of 1000.
Suppliers will notice that they are not selling all of their stock at existing prices. They may
offer the CDs at a discounted price which encourages new buyers to enter the market
(demand will expand). At the same time the suppliers will no longer find the production and
supply of CDs to be as profitable so they may supply less CDs and/or leave the CD market
(a contraction in supply). Therefore this will continue until the market converges and meets
at the equilibrium price.
If the price is initially set below the equilibrium, the quantity demanded will be greater than
quantity supplied creating a shortage in the market. For example, if the price was set at $10
the quantity demanded would be 1500 with a quantity supplied of 500. This creates a
shortage of 1000 CDs.
Some consumers in a competitive market will be willing to pay more for the CDs than the
going price and will therefore try to outbid competing consumers to obtain the product. As
the price increases suppliers will find it more profitable to supply CDs and therefore supply
will expand (new firms may enter the market). The higher prices will reduce the number of
consumers who are willing and able to purchase the product (a contraction in demand).
Prices will continue to increase until demand and supply converge and meet at the
equilibrium price.
QUESTION 4 (VCAA 2015)
The effect on the market for product A of a rise in the price of a substitute product B will be
to:
A
shift the demand curve left and decrease the equilibrium price of product A.
B
shift the demand curve right and increase the equilibrium price of product A.
C
shift the supply curve left and increase the equilibrium price of product A.
D
shift the supply curve right and decrease the equilibrium price of product A.
QUESTION 5 (VCAA 2015)
An expansion in the quantity supplied would be shown graphically as a
A
movement up the supply curve.
B
shift to the left of the supply curve.
C
shift to the right of the supply curve.
D
movement down the supply curve.
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The Essentials – Unit 3 Economics – Book 1
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QUESTION 6 (VCAA 2014)
A major determinant of demand in one particular market could be the:
A
Cost of raw materials.
B
Method of production.
C
Number of sellers in the market.
D
Disposable incomes of buyers in the market.
QUESTION 7 (VCAA 2014)
The effect on the market for product A from a rise in the price of a complementary product B
will:
A
Shift the demand curve right and increase the equilibrium price.
B
Shift the demand curve left and decrease the equilibrium price.
C
Shift the supply curve left and increase the equilibrium price.
D
Shift the supply curve right and decrease the equilibrium price.
QUESTION 8 (VCAA 2013)
The effect of an introduction of a carbon tax of $23 per tonne of CO2 emissions on the
market for electricity that is generated from burning coal would be to
A
Shift the supply curve to the left and cause a contraction in supply.
B
Shift the supply curve to the left and cause a contraction in demand.
C
Shift the demand curve to the left and cause a contraction in supply.
D
Shift the demand curve to the left and cause a contraction in demand.
QUESTION 9 (VCAA 2012)
Which one of the following will cause the supply curve for a good or service to increase (shift
to the right)?
A
An increase in government taxes
B
An increase in the level of income
C
An increase in worker productivity
D
A decrease in the price of a substitute good or service
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The Essentials – Unit 3 Economics – Book 1
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QUESTION 10
On the curves shown below, indicate:
A
The shift of the curve.
B
The effect on the equilibrium price and quantity.
Train tickets
Tomato Sauce
iPods
P
P
P
S
S
S
D
D
Q
Petrol prices increase
D
Q
Q
Pies increase in price
The tax free threshold is
increased to $8,000
PQ
PQ
PQ
Apples
Haircuts
Motorscooters
Effect on:
P
P
P
S
S
D
S
D
Q
A shortage of bananas
D
Q
Increase wages for hairdressers
Q
An increase in petrol
prices
Effect on:
PQ
PQ
PQ
Leather
Private health cover
Electricity
P
P
S
P
S
D
Q
The increased popularity of
steak
S
D
An increase in average weekly
earnings
 The School For Excellence 2016
D
Q
Water shortages
The Essentials – Unit 3 Economics – Book 1
Page 25
Q