Preliminary Economics Topic Two: Consumers and Business

The role of consumers in the economy

1.1 Consumer sovereignty: patterns of consumer spending and saving/dissaving: variations with income and age: individual consumers either spend or save their income, in the economy as a whole, as income rises the level of saving increases:

Consumer sovereignty refers to how the pattern of consumer spending determines the pattern of production and resource allocation

Y = C + S; (sources of consumption (C): income, past savings, borrowing) The consumption function: C = Co + cY where C is total consumption, Co

is autonomous consumption (how much money someone must spend with no income), c is the marginal propensity to consume (MPC; change

in how much of their income someone spends in the dollar: ΔCΔY ) and Y

is disposable income

Average propensity to consume (APC) is CY

The saving function: S = -Co + sY where S is total saving, -Co is

autonomous saving, s is the marginal propensity to save (c+s=1; Δ SΔY )

and Y is disposable income

Average propensity to save (APS) is SY

APC + APS = 1, MPC + MPS = 1 Breakeven point: C=Y, S=0 Saving: C<Y, Dissaving: C>Y Individuals/households with higher incomes have a higher APS and

MPS and lower APC and MPC, vice versa is true The paradox of thrift: the more individuals save, the more the

community’s ability to save decreases As well as varying with income, consumer consumption patterns also

vary with age as consumers’ preferences and needs change, as well as their employment and income

Dissaving typically occurs in childhood and old age with saving occurring in adulthood

Factors that influence saving: cultural and personality factors, expectations of the future, tax policies, availability of credit, age, income

1.2 Factors influencing individual consumer choice: income, price, price of complements, price of substitutes, preferences/tastes and advertising:

Income – increase in income is accompanied by an increase in the total amount of spending and also an increase in the total amount of saving, but spending decreases as a percentage of income and saving increases as a percentage of income (APC and MPC decrease as income increases and APS and MPS increase as income increases)

Price – consumers will buy the least expensive brand of a good (with quality and quantity being constant), and as price increases, demand for a good decreases

Price of substitutes – as the price of a product increases, the demand for a substitute increases

Price of complements – as the price of a product increases, the demand for a complement decreases

Preferences/tastes – consumers have difference tastes, a change in tastes or preferences towards a good/services may lead to an increase in demand, influenced by weather, fashion, education, social pressure, advertising

Advertising – dissemination of images or information about a good/service to influence consumer preferences, informative advertising conveys information, persuasive advertising attempts to build up an image or brand loyalty

1.3 Sources of income: the return for resources: wages, rent, interest and profits; social welfare

Earned income – factor payment of salaries and wages from labour Unearned income – factor payment of rent, interest, profits from

land, capital and enterprise respectively, social welfare is also unearned income

The role of business in the economy

2.1 Definition of a firm and an industry and a firm’s production decisions:

A firm is any business organisation which uses resources to produce goods and services to satisfy consumers’ needs and wants usually in return for a profit

Unincorporated firms: sole trades and partnerships that have unlimited liability

Incorporated firms: private and public companies that have limited liability

An industry is a group of firms producing a similar range of goods or services

Quaternary industry refers to ICT services (subset of tertiary), quinary industry refers to firms and individuals who provide personal services (eg. cleaning; subset of tertiary)

A firm’s production decisions include: what to produce?: determining the market demands and preferences of entrepreneur, what quantities to produce?: the quantity the difference between revenue and costs is maximised, how to produce?: question of resources and technology, entrepreneurs attempt to produce output at minimum cost, how to organise/manage production?: the entrepreneur must create an efficient management structure

2.2 Business as a source of economic growth and increased productive capacity and goals of the firm: maximising profits, maximising growth, increasing market share, meeting shareholders expectations, satisficing:

The assumed main goal of a firm is profit maximisation The short run is a production period where some costs are fixed, some

are variable and the scale of operations is also fixed The long run is a production period where all costs become variable as

well as the scale of operations In the long run the firm’s management can expand the business by

increasing productive capacity and/or resources The main goals of the firm are: maximising profts: π=TR−TC,

TR=Price x Quantity sold, TC=FC+VC, maximising growth – seeking to maximise growth may ensure that a firm survives in the long run and meets expected increases in demand for its products/services in the future, increasing market share – seeking to increase market share (by maximising sales) ensures that the firm increases its profitability in the long run, meeting shareholders expectations – (incorporated) firms attempt to meet shareholders expectations by maximising profits, increasing profits over time, capital growth and a rising the price to earnings ratio (share price/annual earnings per share), satisficing – managers will attempt to achieve a range of goals but will above all ensure the security of their jobs, statuses, images and salaries

Fixed costs don’t vary with output, variable costs do, TC=FC+VC, average costs = TC/O, marginal costs = ΔTC/ΔO , TR=Price x Quantity sold, average revenue = TR/O, marginal revenue = ΔTR/ΔO , a firm’s profit maximising position occurs when the positive difference between TR and TC is the greatest or when MC=MR

2.3 Efficiency and the production process: productivity, internal and external economies and diseconomies of scale:

Productivity = Output/inputs,

multifactor productivity (MFP) = Output/All inputs, single factor productivity (SFP) = Output/Single input

The main sources of productivity improvements in the production process are: the division and specialisation of labour – refers to the splitting up of workers and educating workers in specialised areas to reduce the time taken to complete work tasks, the specialisation/localisation of land/industry – refers to firms locating near each other or specific locations to reduce production costs and the specialisation of capital or large scale production refers to the use of large scale production to produce a high volume of output at minimum cost

The law of diminishing returns suggests that as increasing quantities of a variable factor are added to a fixed factor of production in the short run, total output will eventually decline, leading to diminishing returns to the variable factor

Total physical product (TPP) is the output produced (using the sum of fixed and variable factors of production)

Average physical product is: TPP/units of variable factor Marginal physical product is ΔTPP/Δunits of variable factor The section in which diminishing returns sets in can be determined

by graphing the production schedule of TPP, APP and MPP with the following assumptions being made: there are only two factors of production, one is variable and one is fixed, various quantities of the variable factor are used in combination with the fixed factor and the level of technology and all other factors of production are held constant

Increasing returns occur when: TPP is increasing at an increasing rate and APP and MPP are both increasing, MPP>APP

Diminishing returns occur when: TPP is increasing at a decreasing rate and APP and MPP are decreasing, MPP<APP

Negative returns occur when TPP is decreasing and APP and MPP are falling, MPP<0

In the long run firms can avoid the onset of diminishing returns by varying any or all the factors of production; this includes increasing the scale of operations

Economies of scale refer to the reductions in costs per unit of output as output increases (‘savings of size’)

Diseconomies of scale refer to the increases in costs per unit of output as output increases

Sources of internal economies of scale include: increased specialisation and division of labour, increased specialisation of capital, lower input costs, access to cheaper finance, recycling, research and development (technological advances)

Sources of internal diseconomies of scale include: management become costly and complex, increased output may only occur with more variable factors, congestion

External economies of scale are reductions in average costs due to factors outside the firm’s direct control

External economies of scale can result from the localisation of an industry and the benefits of growth in an industry and include: lower resource costs, improved transport facilities, access to cheaper infrastructure (government), proximity to a labour force, research and development and access to a lower cost of finance

External diseconomies of scale can result from the localisation of an industry and the disadvantages of growth in an industry and include: higher resource costs (may be paid as firms compete for available resources), increased government regulation, higher labour costs (due to skill shortages) and increased congestion and pollution

Returns to scale (can be increasing, constant or decreasing) and refers to the relationship between inputs and outputs (eg. decreasing is when input doubles but output increases by less than double)

A LRAC curve can be graphed (AC=y, O=x) as a planning curve:

2.4 The impact of investment, technological change and ethical decision making on the firm through: production methods, prices, employment, output, profits, types of products, globalisation, environmental sustainability:

Gross investment =net investment + replacement investment (depreciation of the capital stock)

Inventory investment refers to investment by a firm in new materials, intermediate goods and new plant and equipment that increases the firm’s existing productive capacity

Capital widening is when the rate of growth of capital stock is equal to the rate of growth of labour force

Capital deepening is wen the rate of growth of capital stock exceeds the rate of growth of labour force

Production methods – investment and technological change may change production methods from being labour intensive to being more capital intensive (may lead to increase in speed of production)

Prices – investment and technological change may lower production costs which in turn may lower the price of a good

Employment – investment and technological change will lead to a requirement for specialist labour skills and structural unemployment (due to labour saving production methods)

Output – investment and technological change may increase output and also different types of output may be produced due to economies of scope (which can lead to lower average costs)

Profits – investment and technological change may lead to an increase of profits in the future (due to capturing a greater market share, cutting production costs and reaping economies of scale)

Types of Products – investment and technological change may lead to the development of new products and services (diversification which will lead growth and expansion of the firm), the different types of diversification/expansion include: horizontal integration – firm takes over/merges with other firm in same line of production, vertical integration – firm takes over/merges with other firm engaged in different line of production, backward integration – firm takes over/merges with raw material supplier, forward integration – firm takes over/merges with other firm engaged in wholesaling/retailing of the firm’s product, conglomerate integration – where a firm establishes/buys subsidiaries under the umbrella of one firm

Globalisation – globalisation has led to firms investing in new capital and technology to access the global market for goods and services

Environmental sustainability – firms need to ensure that their production methods do not contribute much to environmental problems

Government legislation requires firms’ decision making to be ethical, authorities include: ACCC – protects consumers and market competition, ASIC – regulates companies, APRA supervises banks