Contemporary microeconomic issues pages 7

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Chapter

Focus questions and inquiries

• Whatismicroeconomics?• Howcancost–benefitanalysisassistinmakingeconomicdecisions?• Howmightindividualsandbusinessesusecost–benefitanalysiswhenmaking

economicdecisions?• Whataresomecontemporarymicroeconomicsissues?• Whydogovernmentsdevelopmicroeconomicpoliciesandseekmicroeconomic

reform?

To provide a basis for answering such questions and carrying out such inquiries, this chapter will examine the following:

• thenatureofmicroeconomics• somecontemporarymicroeconomicissues• thecost–benefitanalysismodel• individualandbusinesseconomicdecisionmaking• governmentandmicroeconomicissues.

Contemporary microeconomic issues

7Competing uses: decisions need to be made

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226 Economics for the Real World 1 Chapter 7 Contemporary microeconomic issues 227

Economic data update

LogontoPearsonPlacesandfollowthepromptstotheAustralianProductivityCommission.FindupdateddataforthefollowingstatisticsforAustralia.• Productivityimprovementovertime• Currentmicroeconomicreforminitiatives

7.1 What is microeconomics?

ConceptsMacroeconomics:thestudyoftheeconomyasawhole,dealinginaggregatessuch

asemploymentlevelsandoverallpricechanges

Microeconomics:thestudyofdecisionsthatpeople,businessesandgovernmentsmakeregardingtheallocationofresourcesandpricesofgoodsandservices

In previous chapters in this book, we examined the price mechanism (Chapter 2), and personal economics (Chapter 3). Both of these chapters dealt with some aspects of microeconomics, in that they demonstrated how the economic decisions that individuals make help to determine prices of goods and services.

The branch of economics that investigates and explains the market behaviour of individual consumers and businesses is called microeconomics. It attempts to understand and explain the decision-making processes of households and businesses within an economy. Microeconomics is concerned with the interaction between individual buyers and sellers and the factors that influence the decisions made by them. In particular, it focuses on patterns of supply and demand and the determination of price and output in individual markets.

Microeconomics deals with the economic decisions made at a small, or micro, level. Hence, it covers an analysis of the decisions made by individuals and businesses, the factors that affect those decisions and how those decisions affect others.

The economist investigating microeconomic decisions is likely to be looking at questions such as those below.• How can a specific company maximise its production and capacity so that it can

lower its prices and better compete in its industry?• How would a change in the price of a good influence a household’s purchasing

decisions?• If my salary increases, should I work more hours or fewer hours?• What determines how much a consumer will save?• Why do people buy both insurance and Lotto tickets?Microeconomics also deals with the effects of national economic policies (such as changing taxation levels) on the decisions and behaviours of individuals and businesses.

Microeconomic decisions by both individuals and businesses are motivated by cost and benefit considerations. Costs can be either in terms of financial costs, such as averaged fixed costs and total variable costs (see Chapter 8) or they can be in terms of opportunity cost, which assigns a value to alternatives foregone.

The general concern of microeconomics, then, is the efficient allocation of scarce resources between alternative uses. More specifically, it involves the determination of price through the optimising behaviour of economic decision makers, with individuals maximising satisfaction and firms maximising profit.

Questions

7.1 Explain the difference between microeconomics and macroeconomics.

7.2 List five microeconomic questions that a microeconomist might investigate.

Economics enrichmentStevenD.LevittreceivedhisBAfromHarvardUniversityin1989andhisPhDfromMassachusettsInstituteofTechnologyin1994.HehasbeenaProfessorofEconomicsattheUniversityofChicagosince1997andtherecipientofthe2003JohnBatesClarkMedal,whichisawardedtothemostinfluentialeconomistinAmericaundertheageof40.In2004,LevitthelpedtoestablishtheBeckerCenteronChicagoPriceTheoryattheuniversityandwasappointedthedirectorofthecentre.Morerecently,hewasnamedoneofTimemagazine’s‘100PeopleWhoShapeOurWorld’.

Levitthasworkedinvariousfieldsofeconomicenquiry,suchascrime,politicsandsports,andhasbeentheauthorofmorethan60academicpublications.Duringhiscareer,hehasacquiredareputationforaskingquestionsabouttheworldthatarenotonlytoughbutalsounexpected.BeforeheandfelloweconomistStephenJ.Dubnerwrotethebest-selling Freakonomics: A rogue economist explores the hidden side of everythingin2006,anditssequelSuperfreakonomics: Global cooling, patriotic prostitutes and why suicide bombers should buy life insurancein2009,Levittwasalreadywell-knownforpaperssuchasThe Impact of Legalized Abortion on Crime(2001).Inthispaper,

co-authoredwithJohnDonohue,heshowedthatthelegalisationofabortionintheUSwasfollowedapproximately18yearslaterbyareductionincrime.Levittcontendedthatunwantedchildrencommitmorecrimesthanwantedchildren;thatlegalisingabortionresultedinfewerunwantedchildren;thereforefewercrimeswerebeingcommittedasthesechildrenreachedtheageatwhichcriminalactivityoftenbegins.Inanotherexample(An Economic Analysis of a Drug-Selling Gang’s Finances,2000)Levittanalysedtheaccountsofacriminalganganddrewsomeconclusionsaboutthedistributionofincomeamonggangmembers.

Hisco-authorofFreakonomics,SteveDubner,writes:‘AsLevittseesit,economicsisasciencewithexcellenttoolsforgaininganswersbutaseriousshortageofinterestingquestions.Hisparticulargiftistoasksuchquestions…’

Manypeople—includingsomeofhispeers—mightnotconsiderLevitt’sstudiesaseconomics.Buthehaschallengedtheso-calleddismalsciencebyreturningtoitsmostbasicaim:explaininghowpeoplegetwhattheywant.Levittandco-authorStephenJ.Dubnershowthateconomicsis,atroot,thestudyofincentives—howpeoplegetwhattheywant,orneed,especiallywhenotherpeoplewantorneedthesamething.

7.1.1 MacroeconomicsMacroeconomics, on the other hand, is a field of economics that examines the behaviour of the economy as a whole. This looks at economy-wide data, such as Gross

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National Product (GNP), and how it is affected by changes in unemployment, national income, rate of growth and price levels. For example, macroeconomics would examine how a decrease or increase in employment would affect the country’s GNP, or how a change in interest rates would affect investment in the economy.

While these two areas of economic study appear to be different, they are interdependent and complement one another since there are many overlapping issues between the two areas. For example, increased inflation (a macro effect) would cause the price of raw materials to increase for companies and in turn affect the price charged to the public for the end product (a micro effect).

In essence, microeconomics takes a bottom-up approach to analysing the economy while macroeconomics takes a top-down approach. Regardless, both micro- and macroeconomics provide fundamental tools for anyone and should be studied together in order to fully understand how companies operate and earn profit, and thus how an entire economy is managed and sustained.

Individual decision making is affected by a large number of factors—some measurable to a certain degree, some not—and predicting the behaviour of individuals is, at best, an inexact science. However, microeconomics provides enough data to build a case for probable consumable behaviour. How businesses use this data and its implications is dealt with in Chapter 8.

7.1.2 Applications of microeconomicsThere is a range of specialised areas of study in which microeconomic tools are applied. Industrial management and regulation deals with areas such as the entry and exit of firms, innovation and the role of trademarks. Law and economics applies microeconomic principles to the selection and enforcement of competing legal regimes and their relative efficiencies. Labour economics is the study of employment conditions, wages, and labour market changes. The design of government taxation and spending policies and the economic effects of these is dealt with in public finance. Health economics examines the organisation of health care systems, including the role of the health care workforce and health insurance programs. Urban economics, which examines the issues faced by cities and towns, such as sprawl, air and water pollution, traffic congestion and lack of green space, also draws on the fields of urban geography and sociology. There are many other applications in other fields too: economic history, financial planning, financial analysis and accounting all use elements of microeconomics.

Questions

7.3 List an additional four areas in which you might find microeconomics being used.

7.4 In what ways are microeconomics and macroeconomics interdependent? Give specific examples where possible.

7.2 Microeconomic issuesTo examine microeconomic issues, we need to understand what an ‘issue’ is. An issue is an area or policy that is in debate or need of change. An example of an issue would

be aircraft noise over suburbs close to the airport, or a dispute over the use of public land for private purposes. In everyday life, we are constantly faced with issues.

What makes an issue a microeconomic issue? Obviously, a microeconomic issue is one that affects our economic decision making and which has implications for the efficient allocation and use of resources to satisfy our wants.

7.2.1 Issues facing the individualAs an individual within an economy, there are many microeconomic issues that we face on a day-to-day basis. These can be as simple as deciding what is the best use we can make of our time, or whether we should buy a new car or a used car.

It would be obvious that all individuals want to maximise the satisfaction they can obtain from their available resources. For many of us, this may mean some of the following issues need to be considered.• Should I work longer hours or should I have more relaxation time?• Is a laptop computer or a desk computer the best for my needs?• Should I invest in superannuation or should I go on holiday?• Will I continue to make as many calls on my mobile phone if the price of calls

increases?These are but a few examples of issues that we all face frequently. Sometimes, we make rushed decisions when answering these questions, without really considering the costs and benefits of such decisions. At other times, we take longer to make a decision, such as when deciding to rent a house or purchase a house.

More generally, decision making is a thought process of selecting a course of action from among multiple alternatives. Common examples include shopping and deciding what to eat. Decision making is said to be a psychological construct. This means that although we can never ‘see’ a decision, we can infer from observable behaviour that a decision has been made. Therefore we conclude that a psychological event that we call ‘decision making’ has occurred. It is a construction that implies commitment to action. That is, based on observable actions, we assume that people have made a commitment to effect the action.

In general there are three ways of analysing consumer buying decisions.1 Economic models. These models are largely quantitative and are based on the

assumptions of rationality and near-perfect knowledge. The consumer is seen to maximise their utility. However, as we probably know, consumers seldom have perfect knowledge of a market.

2 Psychological models. These models concentrate on psychological and cognitive processes such as motivation and need recognition. They are qualitative rather than quantitative and build on sociological factors such as cultural and family influences.

3 Consumer behaviour models. These are practical models used by marketers. They typically blend both economic and psychological models.

Clearly, as consumers, we would be better off if we made conscious decisions based on market knowledge. Carrying out a cost–benefit analysis would enable us to be better informed.

Questions

7.5 Why are individual decisions important to the economy?

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Key Idea

Questions

7.6 What is decision making?

7.7 What models can be used to analyse decision making?

• business regulation• labour relations• education and training• health regulations in the food industry• tariff reform.The above would all be issues in productivity improvement, thus making firms more efficient and contributing to better use of scarce resources.

Questions

7.8 Why should businesses analyse most decisions that they need to make very carefully?

7.9 a Using a newspaper, find three examples of decisions that a business has made.

b From these articles, is there any evidence to suggest that the business had alternative possibilities to their final choice? If so, what were the choices?

7.10 How are businesses affected by decisions made by governments? Is it desirable that governments make decisions that affect business performance?

Economics inactionComplete a media scan to identify issues facing the individual within the economy. Compile a list of these and share your findings with other students in a group. Which issues were included on more than one list? Why would this be? Which issues might lend themselves to greater economic analysis?

7.2.2 Issues facing businessesWe have already found that the aim of the entrepreneur is usually to maximise profits. This is a fundamental principle of economics. Hence, issues faced by businesses are those that would be a barrier to maximising profits. The entrepreneur is keen to improve the operation of his/her business so that greater profit can be made.

There will be many issues facing each and every business at any point in time. Some of these are listed below.• Should the business use available technology to a greater degree?• Would workplace reform enhance the business?• Will expanding production increase my profit?• What will happen if another competitor reduces the price of a good?• How can I afford to pay a higher level of superannuation for my employees?Some issues are not limited to just one business—they may be issues faced by all firms in an industry. For example, a new government regulation requiring more stringent standards of pollution control or the reduction of the tariff on imported motor vehicles will affect more than one firm.

Economics inactionComplete a media scan to identify issues facing businesses within the economy. Compile a list of these and share your findings with other students in a group. Which issues were included on more than one list? Why would this be? Which issues might lend themselves to greater economic analysis?

7.2.3 Issues facing governmentsEvery business operates within a wider economy and there will be numerous microeconomic issues within the economy as a whole. Some of these will be addressed by governments at all levels, and could include:• taxation reform• emissions trading

7.3 Opportunity cost

Resourcesarelimited,wantsarenot;thereforedecisionmakersmustmakechoicesregardinghowbesttousetheirresources.

ConceptsOpportunity cost:thebestalternativeopportunityforegonewhenachoiceismade.

Oftenreferredtoas‘realcost’or‘economiccost’;forexample,beingunabletostudychemistrybecauseyouchosetostudyeconomics

Opportunity cost value:thevalueofthenetbenefitassociatedwiththenextbestalternative

Scarcity:insufficiencyrelativetowants—auniversalproblem,becausetheresourcesavailableforthesatisfactionofhumanwantsarelimitedwhilewantsappeartobeunlimited

Economics inactionComplete a media scan to identify issues facing governments within the economy. Compile a list of these and share your findings with other students in a group. Which issues were included on more than one list? Why would this be? Which issues might lend themselves to greater economic analysis?

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Key Idea

The concepts of scarcity and opportunity cost were discussed in Chapter 1. While it is relatively easy to state that the opportunity cost of a decision to buy a DVD is the trip to a theme park that you had to forego, it does not really tell us much.

Opportunity cost is one way to measure the cost of something. It is easy to add up all the costs associated with a project and show that the total cost is $5 million, for example. Opportunity cost identifies the next best alternative way to spend $5 million. The foregone profit of this next best alternative is the opportunity cost of the original decision. A simple example might be a person who owns two houses. He chooses to live in one and can then either rent the other one to tenants or allow his son/daughter to live in it free of charge. Clearly the opportunity cost of the decision to allow his child to use it is the lost rental income. In another example, the opportunity cost of choosing a vacation in Europe might be the deposit money for a house.

You should be aware that opportunity cost is not the total of the available alternatives but rather the benefit of the single, best alternative. Possible opportunity costs of choosing to build a sports stadium on vacant land might be that the land is no longer available to develop as parkland, as a site for a new hospital or for sale, or the loss of other possible uses—but not the total of all of these. The true opportunity cost would be the forgone profit of the most lucrative of those listed.

It is often difficult to place a dollar value on everything, so that an accurate comparison of benefit and opportunity cost can be assessed. For example, how does one place a dollar value on the loss of scenic beauty on the Great Barrier Reef when an oil tanker spills its load after running aground on the reef? Often, we are asked to make subjective choices with ethical and moral implications.

It is imperative to understand that nothing is free. No matter what one chooses to do, you are always giving something up in return. Opportunity cost is more than alternatives forgone. It can also be defined as the value of the net benefit associated with the next best alternative. This means there is a need to make a cost–benefit analysis of each alternative before making a choice. Only when the net benefit of all alternatives can be ascertained can the true opportunity cost be determined.

Questions

7.11 How can it be that there is an opportunity cost to every decision made in economics?

7.12 Why is it difficult to place a dollar amount on every example of opportunity cost?

7.13 Why is it important to value both the choice you make and the alternative course of action? How do you decide which choice is the best to make?

7.4 Cost–benefit analysis

Thecost–benefitmodelstatesthatdecisionmakersshouldonlytakeaparticularcourseofactioniftheyexpectbenefitstobeequaltoorgreaterthantheexpectedcosts.Applicationofthismodelallowslimitedresourcestobeusedinawaythatachievesthehighestpossiblelevelofsatisfaction.

ConceptsBenefits:thepositivefactorsofaprojectorpolicy

Cost–benefit analysis:theprocesswherebyaprojectorpolicyisassessedforitssocialandwelfarebenefitsaswellasthefinancialreturnonaprojectorpolicydecision

Costs:thenegativefactorsofaprojectorpolicy

Externalities:indirectcostsandbenefitsassociatedwiththeproductionandconsumptionofcertaingoodsandservicesthatthemarketfailstotakeintoaccount

Internalisation of costs (benefits):inclusionofallthecosts(benefits)intomarketprices

Social costs (benefits):costs(benefits)thataresuffered(enjoyed)byagroup,orsocietyasawhole

In Chapter 1, you were introduced into the basic principles of cost–benefit analysis (CBA) as a tool for an economist to use when making economic decisions. You should review this section again (Chapter 1 Section 1.2) so that you revise the basic principles of CBA.

Cost–benefit analysis tests the economic viability of an existing or proposed activity, and/or compares two or more ways of doing something. Because of prevailing social and economic structures, the standard of measure generally used is money. This may result in difficulties establishing the worth of ‘un-priced values’ such as scenery, clean air and personal happiness.

Cost–benefit analysis involves subtracting the monetary costs of a development from the monetary value of all the benefits generated by the same development to obtain a net monetary benefit or cost for the proposed activity. Benefits or costs for various options for a particular project can be compared. Usually the method with the highest monetary benefit is selected by the decision maker.

The principles of CBA are simple:1 Appraisal of a decision. Cost–benefit analysis is an economic technique for

appraising a particular decision that has to be made and is widely used by individuals, businesses and governments (for example, should a business invest in a new information technology system).

2 Incorporation of externalities into the decision. It can, if needed, include the wider social/environmental impacts as well as ‘private’ economic costs and benefits so that externalities are included into the decision process. This is known as internalisation of costs and benefits. In this way, CBA can be used to estimate the social welfare effects of an investment.

3 Time matters. Cost–benefit analysis can take account of the economics of time (known as discounting). This is important when looking at environmental impacts of a project in the years ahead.

Questions

7.14 What is the purpose of a cost–benefit analysis?

7.15 What are the three principles that need to be considered when carrying out a CBA?

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Figure 7.1 The circular-flow modelKey Idea

7.4.1 Who uses cost–benefit analysis?Cost–benefit analysis can be used by people at all levels when making decisions regarding economic value. The basic principles of CBA are such that households, businesses and governments are all able to use CBA when making an economic decision. This is shown in Figure 7.1.

In the government sector, CBA has traditionally been used for comparing alternative courses of action by reference to the net social benefits that they produce for the community as a whole. It is used when examining public sector projects such as new motorways, dams, tunnels, bridges, flood mitigation schemes, new power stations and other infrastructure projects.

The basic principles of CBA can be applied to many other government programs; for example, a public health program (such as a child immunisation scheme), an investment in a new rail safety system or the construction of a new hospital. Another example might be to use CBA in assessing the costs and benefits of raising taxes on petrol or cigarettes, or the costs and benefits of a refugee settlement scheme. Increasingly, the principles of CBA are used to evaluate the returns from investment in environmental projects, such as wind farms or the installation of solar panels on roofs.

Because financial resources are scarce, CBA allows different projects to be ranked according to those that provide the highest expected net gains in social welfare. This is particularly important, given the limitations on government spending.

Questions

7.16 We have discussed the fact that individuals, businesses and governments use CBA. Is it possible that the financial sector and the external sector would also use CBA? Why do you think this would be the case?

7.17 What are social benefits? Why are governments interested in these?

7.18 Is it possible that a government might choose a project with a lower net social benefit than another project? Why might this be so?

7.4.2 Cost–benefit analysis as a process

Choosingbetweentwoalternatives,decisionmakersshouldmakethechoicethatmaximisestheireconomicsurplus.

ConceptsDiscounting:valuingfuturecostsandbenefitsusingalowerlevelofvaluethanthe

oneusedtovaluepresentcostsandbenefits

Intangibles:costsorbenefitsthatresistquantification

Net benefits:benefitslesscosts

Net present value (NPV):thepresentvalueofthecurrentbenefitsplusdiscountedfuturebenefitslessthepresentvalueofthecurrentcostsanddiscountedfuturecostsofaproject

Sunk costs:retrospective(past)coststhathavealreadybeenincurredandcannotberecovered

Imports (M)

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Income (Y)

Consumer expenditure on goods and services (C)

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SECTOR

Income taxes (T) Government expenditure (G)

HOUSEHOLDSECTOR

Consumers

PRODUCTIONSECTOR

Businesses

Leakages

Inje

ctio

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GOVERNMENTSECTOR

A household might use CBA when deciding issues that affect their economic decisions. While many households are unlikely to carry out a fully-costed CBA for every decision they make, they do consider the opportunity cost of decisions. Questions as simple as: should I work overtime tonight or should I spend time with my family; should I buy take-away food or cook my own; should I purchase a new car or a second-hand car—all are examples of decisions that households make. Obviously the larger the monetary cost of the decision, the more time is taken to make that decision, and the more likely it will be that the household will appraise the costs and benefits of that decision.

Business makes great use of CBA when making business decisions. Virtually all major projects undertaken by businesses are subjected to a CBA in the planning stage of a project, and before any decisions are made to proceed with the project. This might be as simple as choosing whether to buy a PC or an Apple computer, or it could be as complex as deciding whether to develop a new coal mine costing in excess of a billion dollars. Whatever the decision, businesses need to be sure that it is the correct decision for their business. An incorrect decision might be very costly indeed.

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Figure 7.2 Using CBA to compare alternatives

Key Idea

While there is a variety of ways in which CBA can be undertaken, any CBA would involve a number of steps and principles. These are shown in Figure 7.2.

Similarly, for each alternative, a list of costs should be drawn up. These might include:• capital expenditure• ongoing costs such as operational and maintenance costs for the life of the project• labour costs• costs of other inputs (materials, transport etc)• research, design and development costs• opportunity costs associated with using land and other resources• harmful effects such as pollution.

Quantify/value costs and benefits

Notallcostsandbenefitsareintheformofmoney.However,economistshavetechniquestoassigndollarvaluestoallcostsandbenefitsinordertofacilitateacomparison.

Cost–benefit analysis compares costs and benefits using a common measure, preferably dollars. For this to be possible, values must be assigned to as many of the costs and benefits as possible.

Market prices, where they exist, provide a great deal of information concerning the value of costs and benefits. In most markets, consumers at the margins are willing to pay no more or no less than the actual price in the market. Accordingly, that price can usually be taken as a measure of the value placed by society on the good or service. The price of inputs usually reflects the value that alternative users of these inputs place upon them. However, actual prices sometimes have to be altered to convert private costs and benefits into social ones; that is, costs and benefits that reflect gains and losses to the economy as a whole rather than to individual persons or groups.

Costs and benefits must be estimated for the whole period of the project or decision. Hence forecasting is a key part of valuing costs and benefits. Forecasters often overestimate the rate of growth of benefits and underestimate the rate of growth of costs.

Costs and benefits that cannot be quantified are called ‘intangibles’ and should be considered by the decision maker so that they can be weighed up alongside the quantifiable variables in the decision-making process. It may be that some costs and benefits can be measured in physical units but not in money terms; for example, complex pollution effects. Factors with unpriced values include wilderness areas, pleasant views, pure water, spiritual values, cultural traditions, diverse gene pools and functioning ecosystems. Economists agree that these unpriced values have worth. However, their monetary value is difficult or impossible to establish, and these values are very open to personal interpretation.

Discount future values

Costs and benefits accrue over time, especially with regard to natural resource development. In a simplified example, if an analyst chose to examine only the last three years of a timber management development, the analysis would be distorted because all of the revenue-producing activities would be included (logging, milling) but many of the costs (regeneration, surveys, protection, environmental damage) may have been omitted.

Conventional CBA discounts all future costs and revenues to present value at a set interest rate. This reflects the business principle that money received today is worth more than money received in the future. The basis of this principle is the belief

AlternativesThere should be a sufficient number of alternatives to provide the decision maker with real scope for exercising choice. Alternatives should also be able to be clearly distinguished from each other. A ‘do nothing’ alternative should always be identified. This is useful because costs and benefits are always incremental to what would have happened if the project had not advanced.

Costs and benefitsA list of benefits likely to occur as a result of the decision should be compiled. The list of benefits might include:• the value of revenues generated by the decision• avoided costs; that is, costs that would have occurred in the ‘do nothing’ situation• productivity savings• health, environmental and other social benefits.

Identify the alternatives

Identify the costs and benefits

Quantify/value costs and benefits

Tangible costs and benefits Intangible costs and benefits

Discount the future value of benefits (calculate the net present value)

Compare costs and benefits and net rate of return

Compare net rate of return from different options

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that a person, given the use of a sum of money for a year, can use the money to earn profits. Thus, maximising today’s dollars maximises return on investment. If money cannot be quickly acquired, profits will be lost. Discounting justifies this perception by calculating a reduced current value for all future income. The discount rate should generally reflect the opportunity cost of capital—that is, the return on capital foregone in alternative use of the resources.

Compare costs and benefits

To facilitate comparison between alternatives, it may be desirable to compile a graphic profile of net benefits–total costs less total benefits. Figure 7.3 shows two net cost–benefit profiles.

Comparing different options

Obviously the decision maker, when faced with an economic problem to solve, should choose the project that will maximise the net rate of return; that is, where the difference between costs and benefits is the greatest, all other things being equal. However, sometimes decision makers have other priorities that can affect their decision such as political issues, ethical issues etc.

7.4.3 Ethics of analysisA CBA is based on a framework of assumptions and decisions. An analysis is a model of the interaction of economic, social and ecological factors in a study area. As with all models, a CBA is only as good as the skill of the modellers, and reflects their personal biases and viewpoints. The combination of personal and/or institutional viewpoints that shape a CBA can be termed the ‘ethic’ of the analysis.

Persons with a conserver ethic, for example, will tend to produce an analysis that places high value on the protection and the ecologically responsible use of natural and social resources. Diversity within biological and social/economic communities will be stressed. The community will often be ‘locally’ defined, such as local towns or a region.

A person with a short-term profit/technology ethic will be influenced by an economic principle that states ‘dollars gained today are more valuable than dollars obtained tomorrow’. Such an approach relies upon the belief that technology will overcome any social or biological/ecological problems that arise from human actions.

Given identical information, these two hypothetical people/analysts would likely come to different conclusions.

The choice of the community, or group of people, to which the cost–benefit analysis will be limited is also important. Are benefits that accrue to distant communities, or to corporations external to the local community, sustainable compensation for costs incurred to the local community and the local ecology? Conventional cost–benefit analysis indicates that costs to a local community may be outweighed by benefits to a distant, larger community. Is it acceptable that distant benefits should not offset local costs to communities?

Questions

7.19 Why do economists try to place dollar values on all costs and benefits?

7.20 How does valuing the environment present a challenge?

7.21 What are some ethical issues involved in using CBA?

7.22 Is it possible that two people carrying out a CBA could arrive at different results?

7.4.4 Limitations of cost–benefit analysisLike many models and processes used by economists, CBA has a number of limitations and criticisms. • There may be problems in attaching valuations to costs and benefits.• Not everyone affected may be covered.• There are distributional consequences.• Social welfare is not the same as individual welfare.• Valuing the environment is difficult.• Valuing human life is impossible.Some costs are easy to value, such as running costs (e.g. labour) and capital costs (e.g. new equipment). Other costs are more difficult to value, especially when the project has a significant impact on the environment. The value attached to the destruction of a habitat is to some ‘priceless’ and to others ‘worthless’. Costs are also subject to change over time.

Another criticism is that CBA may not cover everyone affected; that is, third parties. Inevitably, with major construction projects such as a new freeway or a new tunnel, there are a huge number of potential ‘stakeholders’ who stand to be affected (positively or negatively) by the decision. Inevitably, CBA does not include all stakeholders and there is a risk that some groups might be left out of the decision. What of future generations, who are not included in the analysis? What of non-human stakeholders such as the flora and fauna affected?

Costs and benefits may mean different things to different socioeconomic groups. Benefits to the poor are usually worth more. Those receiving benefits and those burdened with the costs of a project may not be the same. Are the losers to be compensated? To many economists, the equity issue is as important as the efficiency argument.

Social welfare may not be the same as individual welfare. What we want individually may not be what we want collectively. Do we attach a different value to those who feel ‘passionately’ about something (e.g. the building on former open space) contrasted with those who are ambivalent about the project?

In terms of valuing the environment, how are we to place a value on public goods such as open space, clean air and water, and scenic beauty when there is no market established for the valuation of these? How does one value ‘nuisance’ and ‘aesthetic values’?

Some measurements of benefit require the valuation of human life. Many people are intrinsically opposed to any attempt to do this. This objection can be partly overcome if we focus instead on the probability of a project ‘reducing the risk of death’, and there are insurance markets in existence that tell us something about how much people value their health and life when they take out insurance policies.

Figure 7.3 Two net cost–benefit profiles

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Key Idea

A CBA will only be as good as its design brief and the assumptions it makes. It compares a project scenario with an alternative scenario based on estimates of what would have happened in the absence of the project. Any margin for error in the specification of the alternative scenario is carried over into the project analysis. The analysis itself may be rather obscure. However, the analysis will only be as good as its assumptions and these should always be set out as clearly as possible.

Sunk costs

Therearecertainpitfallsthatdecisionmakersroutinelyencounter.

In economics and business decision making, sunk costs are retrospective (past) costs that have already been incurred and cannot be recovered. Sunk costs are sometimes contrasted with prospective costs, which are future costs that may be incurred or changed if an action is taken. Both fixed costs (that is, costs that are not dependent on the volume of economic activity, however measured) and variable costs (dependent on volume) may be either retrospective (sunk) or prospective costs.

In traditional microeconomic theory, only prospective (future) costs are relevant to an investment decision. Traditional economics proposes that when a decision is made it should not be influenced by sunk costs, because doing so would not be rationally assessing a decision exclusively on its own merits.

Evidence suggests this theory fails to predict real-world behaviour. Sunk costs in fact greatly affect participants’ decisions, because humans are inherently loss-averse. Thus it is normal to act irrationally when making economic decisions.

Decision makers may also make rational decisions according to their own incentives, which may dictate different decisions than would be dictated by efficiency or profitability. This is considered to be an incentive problem, which is distinct from a sunk cost problem.

Sunk costs should not affect the rational decision maker’s best choice. However, until a decision maker irreversibly commits resources, the prospective cost is an avoidable future cost and is properly included in any decision-making processes. For example, if you are considering pre-ordering movie tickets, but have not actually purchased them yet, the cost remains avoidable. If the price of the tickets rises to an amount that requires you to pay more than the value you place on them, the change in prospective cost should be figured into the decision making, and the decision should be re-evaluated.

7.4.5 Evaluating cost–benefit analysisBecause cost–benefit analysis seeks to place costs and benefits on a directly comparable basis, it is well-suited to resource allocation decisions: to situations where choices must be made between alternative uses of funds and resources. However, the method can also play a role in effectiveness evaluations, which examine whether a program is achieving its objectives and whether the objectives themselves are still relevant and desirable. In essence, the project outcome that is measured in cost–benefit analysis is the estimated value that consumers place on the goods or services that they purchase or receive even when the goods or services are not sold in a conventional market. While this way of measuring effectiveness will not be appropriate in all contexts, the approach is a powerful one in those situations in which it can be sensibly applied.

Questions

7.23 There are a number of limitations to the use of CBA. Two are environmental issues and social equity issues. To what extent do these limit the value of CBA?

7.24 Why should sunk costs be included in a CBA?

7.25 What is the opportunity cost of sunk costs? Are they capable of being put to alternative uses?

7.26 Why is CBA useful in resource allocation decisions?

7.5 Cost–benefit analysis and the individual

Individuals are unlikely to complete a detailed cost–benefit analysis for every economic decision that is made. Most likely, they will make use of the CBA process for major decisions, such as whether to rent or buy a house, or whether to purchase a new or used motor vehicle, but for everyday situations, such as choosing whether to buy a sandwich or a meat pie for lunch, the decision is more likely to be a subconscious one that does not go through the rigours of CBA analysis.

People face trade-offs by having to give up something to get what they want or need. This is no surprise for most people, who learn early in life that few things are free. As an example of a trade-off, many school students give up spending time with their friends and families in order to do homework and reach their goal of university entrance.

Rational people think at the margin. A rational decision maker takes an action if and only if the marginal benefit of that action is greater than the marginal cost. An example of this type of decision occurs when you wish to visit your ailing mother, who lives interstate. You need to decide whether to purchase a last-minute airline ticket at the most expensive price or wait seven days to get a cheaper ticket. Your other choice is to drive. The marginal benefits of shorter travel time, fewer days off work, comfort while travelling and seeing your mother without delay all outweigh the marginal cost of the more expensive airline ticket.

The principles of economics affect decision making, interaction and the workings of the economy as a whole because all people make decisions based on what they want and what is best for them personally.

Let’s look at a simple example of a person making a decision. Each week, Chris hires a football video that costs about $5. He likes to analyse games, watch world-class players in action and gain some ideas for when he plays. The videos have really helped him understand what it is like to play in the best competition. One day he hopes to play in the national competition as well.

He has just found out that a coaching clinic will be held in his town in ten weeks but it will cost $50 to attend. He has no savings. If he is to afford the clinic, something will have to give. Chris decides to do a cost/benefit analysis.

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Key Idea

Fixed costs:thosecoststhatafirmmustmeetwhetherornotanyproductionoccurs;forexample,capitalequipmentandrates

Marginal cost:theadditiontototalcoststhatoccurswhenonemoreunitofoutputisproduced

Marginal revenue:theextra(ormarginal)revenueobtainedbyproducingandsellinganotherunitofoutput

Normal profit:theminimumreturnthatabusinessispreparedtoaccepttoremaininbusiness

Total costs:allthecostsinvolvedinproducingagivenvolumeofoutput

Total revenue:thetotalmonetaryreturntothefirmwhenanyvolumeofoutputissold

Variable costs:thecostsincurredbyafirmwheneverproductionoccurs;forexample,powerandwages

A business or firm’s main aim is to maximise profit. This is a basic assumption in many economic models. When a business is maximising profit, the business is in equilibrium because there will be no incentive for it to either increase or decrease output.

Profit is the difference between the total cost of producing any output and the total revenue obtained from selling the output. Thus, the equilibrium position of the firm will be the point or level of production where the difference between total cost and total revenue is the greatest.

There are a number of cost and revenue concepts that should be understood. Total costs includes all of the costs involved in producing a given volume of output. Because costs of production include all expenses involved in bringing a product to market, total costs will also include a normal profit return to the business. Normal profit is the minimum return that a business is prepared to accept to remain in business and is therefore a necessary cost to be met by the business.

Average cost is the cost per unit of output: total cost divided by the number of units of output. Marginal cost is the addition to total costs that occurs when one more unit of output is produced. Thus, it is the extra (or marginal) cost involved in producing another unit of output.

Total revenue is total monetary return to the firm when any volume of output is sold. Average revenue is the return per unit of output and is obtained by dividing total revenue by the number of units of output sold. Marginal revenue is the addition to total revenue that occurs when one more unit of the output is sold.

Hence, the equilibrium position of the firm can now be redefined. The firm always maximises profit when it produces at the point where marginal revenue equals marginal cost. This is shown in Figure 7.5.

If the firm whose marginal cost curve (MC) and marginal revenue curve (MR) are shown in Figure 7.5 is producing output 0Q1, it can increase its profits by increasing its output to 0Q2 because between 0Q1 and 0Q2 the marginal revenue obtained from selling the extra output is greater than the marginal cost incurred in producing it. Similarly, the firm’s profits will fall if it

Figure 7.4 Chris’s dilemma: weighing up decisions using CBA

Football videos Coaching clinic

Cost $5 per week $50

Benefit Give him lots of information about football and also help him im-prove his game

Will have the chance to be coached in a face-to-face situation and hear from top-line coaches

Availability As they are videos, he can always hire them another time

It is a one-off chance

Chris decides to save $5 per week and attend the coaching clinic. He can hire the videos later. What would you do if you were in Chris’s place? Maybe you don’t like football, but what if you had to decide about something you do care about—such as whether to go to the movies once a week and have a hamburger afterwards, or go twice a month, skip the burger and put the money you have saved towards something else instead. It all depends on you—what your wants are.

Weighing up these decisions is like doing a cost–benefit analysis. Taking the time to do one can help you make better decisions.

EconomicsandICTDevelop an Excel spreadsheet that you could use when conducting a cost–benefit analysis. Save it to file and then try using it to carry out a CBA relating to the following issue: ‘Should I get a part-time job or should I spend my time doing additional home study?’

Question

7.27 Think of an economic decision that you made today, or recently. Did you complete a CBA for this decision? Carry out a CBA for that decision now. Did you arrive at the same decision?

7.6 Cost–benefit analysis and business

Thebusinessdecisionsmadebypeopleoftenreflectarationalevaluationofbenefitsandcosts,eveniftheyarenotconsciouslyawareofthis.

ConceptsAverage cost:thecostperunitofoutput

Average revenue:thereturnperunitofoutputFigure 7.5 Equilibrium position of the firm

MC

MR

0 Q1 Q2 Q3

Units of output

Cos

t +

rev

enueSam

ple pa

ges


Figure 7.8 A firm’s cost curves

produces an output greater than 0Q2, say 0Q3, because after output 0Q2 marginal costs exceeds marginal revenue for all additional units.

It is important to determine the likely shape of the business’s cost curves for various levels of output. Costs are either fixed (they do not vary with changes in output in the short run) or variable. When the business opens its plant and installs its machinery, it finds that costs fall naturally into these two types. Fixed costs are all those payments that continue as a constant total amount whether production levels are high or low. Variable costs are those that increase or decrease in total amount as production levels rise and fall.

Fixed costs or overhead costs must be met whatever the level of output is. At higher levels of output, average fixed costs, or fixed costs per unit of output, must fall.

Average variable costs are likely to fall for a time as resources are used more efficiently, but then they are likely to rise after production passes a certain point. They

will begin to rise because efficiency will begin to fall and, especially, because higher rewards or prices will have to be paid to attract the extra raw materials and labour etc. that are required.

Average total costs (ATC) at any level of output will equal average fixed costs (AFC) plus average variable costs (AVC) at that level of output. This is shown in Figure 7.6.

Having determined the likely shape of the average cost curve (AC), we can also consider the shape of the marginal cost curve (MC). The set of figures in Figure 7.7 is based on the ‘U-shaped’ curve that is the likely shape of the average cost curve of any firm operating in any type of market situation.

Questions

7.28 Is it true that a competitive business will always maximise its profit by producing at the lowest possible cost per unit?

7.29 If advertising increases costs, how can it increase profits?

7.6.1 Business profitThere are four categories in which the profit of a business may be considered.1 A firm is said to be making an economic

profit when its average total cost is less than the price of each additional product at the profit-maximising output. The economic profit is equal to the quantity output multiplied by the difference between the average total cost and the price.

2 A firm is said to be making a normal profit when its economic profit equals zero. This occurs when average total cost equals price at the profit-maximising output.

3 If the price is between average total cost and average variable cost at the profit-maximising output, then the business is said to be in a loss-minimising condition. The business should still continue to produce, however, since its loss would be larger if it were to stop producing. By continuing production, the business can offset its variable cost and at least part of its fixed cost, but by stopping completely it would lose the entirety of its fixed cost.

4 If the price is below average variable cost at the profit-maximising output, the business should go into shutdown. Losses are minimised by not producing at all, since there is no level of production that would generate returns significant enough to offset any fixed cost and part of the variable cost. By not producing, the business loses only its fixed cost. By losing this fixed cost the company faces a challenge. It must either exit the market or remain in the market and risk a complete loss.

7.6.2 Business decision makingIt is important for a business to understand its cost structures so that the decisions it makes are made with the knowledge of how each decision will impact on costs, and hence profit.

Businesses draw upon microeconomic data to make a variety of important decisions, any one of which could mean the difference between profit or loss for the business. The reliability and current state of the information a business uses is therefore vitally important.

What a business does with that data is decided by its management team (be it a sole trader or the world’s largest company).

Microeconomic data may be reduced to mathematical constructs from which reasoned decisions may be made. We will examine the U-Beaut Clothing Company,

Figure 7.6 Variable, fixed and total costs

ATC (AVC+ AFC)

AVC

AFC

Output per unit of time

Cos

t pe

r un

it of

out

put

Figure 7.7 Schedule of costs for a business

Units of output Average cost($)

Total costs($)

Marginal cost($)

1 15.00 15.00

2 10.00 20.00 5.00

3 7.50 22.50 2.50

4 6.00 24.00 1.50

5 5.00 25.00 1.00

6 6.00 36.00 11.00

7 7.50 52.50 16.50

8 10.00 80.00 27.50

9 15.00 135.00 55.00

10 22.50 225.00 90.00

In all cases, the marginal cost curve (MC) will cut the average cost curve (AC) at its lowest point. Thus, while marginal cost is less than average cost, the new average cost will be lower; but as soon as marginal cost exceeds average cost, then average cost will start to rise.

Cost ($)

20

15

10

5

0

ACMC

Units of output1 2 3 4 5 6 7 8 9 10

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which makes and sells men’s clothing. Microeconomic data from this imaginary company has shown that its customers have a preference for navy blue jeans at a certain price.

The previous year the company sold 50 000 jeans at $40 each. We will assume that economic conditions have remained the same. Logic would suggest that at least another 50 000 navy blue jeans should be manufactured and offered for sale again.

Although that seems logical, is that the best choice to make?

What the competition is doingThis season the Smart Clothing Company, which competes against U-Beaut, is selling jeans similar in style and quality to those sold by U-Beaut. Smart Clothing’s jeans are offered in the market at $36 a pair, 10 per cent cheaper than U-Beaut’s jeans.

How does U-Beaut compete now? Traditional theory suggests a price reduction should increase demand. If the price of U-Beaut’s jeans is reduced to less than the price of Smart’s jeans, then theoretically U-Beaut’s jeans would outsell the competition.

But what impact would a reduced price have on the profit margin of U-Beaut? Would there be sufficient money for marketing its product? Would the reduced profit impact on its ability to meet repayments on its start-up loan from the bank? Would its share price be reduced because of the reduced profitability of the company?

It is logical to assume that such questions would be addressed by the manage-ment of U-Beaut Clothing Company when it meets to decide what decision to make. Is there an alternative?

The finance director asks a question: What if U-Beaut increases its marketing and advertising budget by 5 per cent rather than reduce its profit margin by 10 per cent? Would more jeans be sold because of the increased marketing, and could U-Beaut therefore beat its competitor? Microeconomic data has shown that in some cases a vigorous marketing campaign is often a successful way to beat a competitor.

Another management member states that the economy is good at the moment, but economic forecasts suggest a downturn in the December quarter of the year—the quarter that includes the Christmas season, when U-Beaut makes a large percentage of its sales.

When the economy starts to slide during the December quarter, would U-Beaut be better off selling jeans at a lower price than its competitor, maintaining a profit that would be lower than the previous year? Although the economy in general is the study of macroeconomics, its impact on the micro-economy must be considered in the decision-making process.

There are other variables and unknown factors that need to be considered by U-Beaut. Consumer tastes may have changed and they may want something new. Perhaps a different colour is in fashion, or perhaps last year’s jeans were so well made they are still able to be worn, and consumers won’t need new jeans this year.

All of these factors—the microeconomic data, the questions and issues it raises, the possible outcomes of alternative choices made in the decision-making process—are what management must consider to ensure U-Beaut maximises its profitability. A cost–benefit analysis is an excellent tool for them to use.

Let us look closer at U-Beaut Clothing Company.It is just one of many firms competing in the jeans market. All aim to maximise

profits. Each business is aware that beyond a certain number of jeans manufactured and sold, the cost of making an additional pair and selling it returns no more income to the business than the cost of manufacturing the jeans. In other words, no matter how many jeans are sold over a certain level of units, the business is breaking even because costs equal revenues.

Because U-Beaut competes with many other firms, it is involved in what economists call ‘perfect competition’. This means that there are many competitors making the same or similar product, and each of them has a small percentage of the total market.

In such a market, manufacturers have little or no control over pricing. The price of the jeans is fixed at the intersection of the market supply and demand curves. Such businesses are price takers because they have little control over price.

They cannot reduce prices because profit will be reduced. They cannot charge higher prices because sales will decline, which affects profits. This business reality leaves competing firms one question: how many pairs of jeans to manufacture, a decision that will affect their profit.

But how do they decide on the right number? Because the cost of making each pair of jeans increases as more are made, a theoretical point is reached where making more eats into profit and eventually causes a loss. Assuming the market price is high enough, a firm will make a profit when its marginal revenue is equal to or greater than its marginal cost.

In the case of U-Beaut, if manufacturing and selling a single extra pair of jeans costs less than the revenue it earns, then the smart decision is to produce and sell the product. If the cost of producing and selling a product is more than the revenue, a firm should stop producing it.

An economist uses various measures of costs, such as fixed costs, variable costs or opportunity costs. In business, an opportunity cost might be accepting a temporarily smaller profit or a slight loss in return for remaining in business, keeping a plant functioning, retaining personnel or similar trade-offs. These are the decisions that must be made by a firm’s top management using microeconomic data and formulas. The decision-making processes are determined by analysing the information and then choosing the best case situation, based on a cost–benefit analysis.

7.7 Cost–benefit analysis and government

Governments too use cost–benefit analysis in decision making. When determining whether or not to implement a particular project, governments use CBA to assess the merit of the project. Of course, governments have objectives that are not economic, but which are political and social in nature, and so the decision may not always be based solely on CBA.

Microeconomic issues affect governments at all levels. Let’s look at some instances where government decisions might have an impact.

7.7.1 Why modern buildings are boring to look at

ConceptsDemerit good:onethathasnegativeexternalities

Merit good:aprivategoodwithpositiveexternalities

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One of the joys of travelling through Europe is the opportunity to view and appreciate the beauty of the buildings in cities like Paris. The architectural beauty of Paris provides a positive externality that benefits many firms operating in Paris, because the attractions of the city bring in many tourists each year. The tourists spend money on accommodation, food and transportation, among other things. Without the beauty of the city, these firms would not gain as much revenue as they currently do.

A merit good is a private good with positive externalities; that is, it provides social benefits to other people. The architecture of Paris is a merit good.

A modern property developer undertakes the construction of a new building because he or she sees the potential for a private benefit: profit to the developer. Accordingly, the developer incurs private costs to build the building. We may enjoy looking at beautiful buildings but a property developer cannot make us pay for doing so. The developer may agree with you that a little extra money could have been spent to make the building look much more aesthetically pleasing, but who is going to pay for it?

Markets provide goods at the optimal private level; that is, where the marginal private benefit equals the marginal private cost. Figure 7.9 shows this position at P0Q0. With a merit good that accrues positive externalities, the marginal social benefit will exceed the marginal private benefit (P1Q1), and thus the merit good is likely to be under-provided at a socially optimal level; that is, it will be provided at Q0 instead of the desirable

Q1. This is an example of market failure: the market does not meet the social goals of society.

Governments can influence the supply of merit goods in a number of ways. In Brisbane, for example, the Brisbane City Council is encouraging owners of ‘heritage-listed’ buildings to keep these buildings maintained and in use, and not to demolish them. It does this by subsidising the cost of repairs and maintenance of these buildings. If the owner of a heritage building were to decide it needed to be repainted, the local council might provide free paint. In this way the stock of old buildings will be retained.

A subsidy effectively decreases the cost of preserving these buildings and allows the developer to capture and thus internalise some of the positive externality. Figure 7.10 shows that at the lower private cost, the private marginal cost curve (PMC) moves out towards the social marginal cost curve (SMC). This means that the stock of heritage buildings will be preserved at the socially optimal level (QS). Instead of having QM heritage houses left in a suburb, QS are maintained.

The private cost of buying and maintaining a heritage-listed house has fallen because the council is assisting the owner to maintain the house in appropriate condition. The effect of this is to move the private cost curve outwards, thus increasing the number of heritage houses that are preserved. The council is assisting the community to gain the benefits of a positive externality.

7.7.2 Government CBA affects marketsGovernments use CBA in so many ways. Several years ago, the Australian Government made a decision based on CBA to phase out leaded petrol. The use of leaded petrol in cars creates pollution. Lead can accumulate in the human body, and high levels of lead can lead to mental illness in children, and illness such as liver failure in later life. Leaded petrol is cheaper to make than unleaded petrol. After looking at alternatives, governments could have placed a higher tax on leaded petrol. Such a higher tax would decrease the negative externality created by the use of leaded petrol. The tax would shift the supply curve to the left, raising the price of leaded petrol from Pe to PS (Figure 7.11). Consequently the quantity of leaded petrol demanded would fall from Qe to QS, thus reducing the negative externality of toxic lead in the environment.

Ultimately the government used its legislative powers and legislated that production of motor vehicles using leaded petrol would cease and that leaded petrol would be phased out of the market place.

Cigarette smoking is well known to contribute to cancer. Governments attempt to reduce cigarette smoking by using taxation and by educating people on the dangers of smoking. In theory, the tax collected on cigarettes should cover the cost of the additional health care required by smokers as well as the cost of the education programs.

The effect of the tax will shift the supply curve to the left; and shift the demand curve to the left as well. Instead of Qe cigarettes being consumed, now only Qs2 will be consumed. This is shown in Figure 7.12.

Figure 7.9 A positive externality: the supply of merit goods

Figure 7.10 Capturing a positive externality: the supply of heritage buildings, with and without a subsidy

Figure 7.11 The supply of leaded petrol, with and without an additional tax

Price

Quantity

Supply private + social

Supply private

Negative externality

Demand private

Pe

QeQs

Ps

Marketequilibrium

Subsidy

Socialequilibrium

SMB

SMC

PMB

PMC

PM

QM Qs

Ps

PC

PMB

SMB

0 Q1

P1

P0

Q0

Social equilibrium

Marketequilibrium

Figure 7.12 Effects of an increased tax on cigarettes

Price

Quantity

Supply private + social

Supply private

Negative externality

Demand private

Pe

Ps1

QeQsQs2

D2

Ps

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Questions

7.30 Do governments always make decisions based on economic principles? Why, or why not?

7.31 Suggest some other areas in which governments could make decisions regarding microeconomic issues that might affect you personally.

BenefitsThe following benefits might be identified:• Economic growth. Demand for air travel is forecast to double in the next

20 years, making expansion vital. Many thousands of jobs and businesses depend on the airport expanding to provide sufficient supply capacity to meet this growing demand. An increase in the capacity of the airport will make best use of the airport’s existing infrastructure and land.

• The economy and trade. The economy will lose airlines and investment to other airports and economies if it does not meet demand. The benefits of a world-beating industry would be diminished. Some sections of our aviation industry have a comparative advantage and add huge sums of money to the region’s economy.

• Jobs. the terminal’s project will create or safeguard an estimated 16 500 jobs, as well as creating 6000 construction jobs during the building phase. This will have multiplier effects on the local, regional and national economy.

• Transport. The terminal will be the centre of a world-class transport interchange, with rail links. Car traffic would rise only slightly, the social costs of increased traffic congestion being overstated by opponents.

• Environment. The site earmarked for the terminal is currently unused land, and any displaced wildlife and plant life will be carefully relocated. The noise climate around the airport has been improving for many years, even though the number of aircraft movements has increased, due to the phasing out of older, noisier aircraft. There would be no increase in night flights or overall noise levels.

CostsThe following costs have been identified:• Growth. Forecasts are misleading and will result in uncontrolled expansion, rather

than targetting better solutions such as using existing space at other airports.• The economy. The airport does not really contribute to long-term macroeconomic

benefits. The terminal is wanted for commercial prestige.• Jobs. Only 6000 jobs will be created—a tiny fraction of the new jobs that are

needed in the region. Local studies indicate that jobs will increase anyway, even without the new terminal.

• Transport. There will be a significant increase in road-widening and car parks to cater for the tens of thousands of extra car journeys to the airport every year.

• Environment. Air pollution will increase significantly and hundreds of acres of wildlife and Green Belt land will be lost forever. There will also be environmental costs associated with the increased traffic congestion.

• Noise and night flights. More flights will mean more noise under the flight paths, and the pressure for controversial night flights and an additional runway will increase.Faced with a mountain of information, costs, benefits and other material, a

government would then make a decision, after weighing up all the costs and benefits, and considering net social welfare.

Question

7.32 Examine the cost–benefit analysis above of the new terminal at the airport. What recommendation would you make to the government? Should it accept the proposal or not?

7.7.3 Cost–benefit analysis prioritises government decisions

ConceptAllocative efficiency:theeconomy’sabilitytoshiftresourcestowheretheyaremost

valuedandcanbeusedmostefficiently

Cost–benefit analysis is used by governments to help determine the projects and policies that it wishes to implement.

These analyses are undertaken to identify options that are consistent with efficiency in resource allocation. Allocative efficiency means that, in an environment of scarce resources, the level of output of any good or service cannot be increased without reducing the output of some more highly valued good or service.

Resources are allocated efficiently when the benefit an individual derives from the last unit of consumption is just equal to the cost of production of that unit. Thus, a producer in competitive markets who prices his or her output at the marginal cost of production will be operating consistently with the concept of allocative efficiency.

Pricing at marginal costs implies that costs and benefits are valued at their opportunity costs. This is made operational in CBA through the ‘willingness to pay’ criterion. Outputs are valued according to the willingness of consumers to pay for them—an amount that includes the consumer surplus, or the difference between the price actually paid and the amount the consumer would have been willing to pay for them.

For governments, the fundamental principle of cost–benefit analysis, based on the concept of allocative efficiency, is to accept projects when the net social benefits are positive (subject to budget and other constraints). The rule produces outcomes that are consistent with allocative efficiency. Financial profitability and social equity may also be important goals in public sector decision-making.

An exampleLet’s imagine a government is considering whether to add an additional terminal at a major international airport. The debate over doing this will be fierce and ongoing, as there will be many interest groups: the airlines, the passengers, local residents affected by flight pathways etc. The government almost certainly will complete a cost–benefit analysis of the proposal. There will be many submissions from various parties, some of which will highlight the many examples of environmental impact (externalities), such as noise, air quality, water pollution.

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Economics challengeExaminethetwoarticlesthatfollow.TheybothrelatetotheResourceSuperProfitsTaxthatwasproposedinJune2010.Readthetwoarticles,andthencompleteacost–benefitanalysisoftheproposal.YoumayneedtoresearchontheInternettoobtainfurtherinformation.

Whatwouldyourrecommendationbe—toproceedornotproceedwiththetax?Doesyourconclusionagreewithwhatthegovernmentimplemented?

Wayne Swan I’m a Queenslander, born and bred, and I know how important the mining industry is to our state economy and to the broader Australian economy.

I also know Australia’s mineral resources belong to all Australians and all Australians deserve a fair share. It’s not good enough that the one dollar in three we get from mining profits in the form of royalties and resource charges a decade ago has become just one dollar in seven today.

That’s why we need to invest the proceeds of the resource super profits tax in retirement savings, big tax breaks for small business and standard tax deductions for 6.4 million Australians.

Queenslanders will be among the biggest winners because we’ll also be using the proceeds to invest in more world-class infrastructure, focused on the bottlenecks in mining communities like our own.

We always expected a massive scare campaign from the Liberals and the resource companies—they don’t want to see Australians getting a fairer share of their super profits, so that’s hardly surprising.

Exactly the same scare campaign was rolled out when a profits-based tax was introduced on petroleum. Of course, that industry went on to grow and flourish and support thousands of jobs. So we won’t be deterred by threats and scaremongering.

We’re determined to boost Australians’ retirement savings so that whenever the mining boom ends, Australians have got something real to show for it. We’ll help over-50s with low

superannuation balances and Australians on low incomes to boost their super savings.

We’ll lift the super guarantee from 9 to 12 per cent. That will mean a 30-year old worker today will retire with up to $108 000 more super.

Secondly, we’ll invest in world-class infrastructure such as roads so our kids and grandkids also enjoy the benefits of the boom well into the future. I know for my fellow Queenslanders this is a really big issue, which is why Queensland will get a permanent infrastructure boost from the resource super profits tax.

Thirdly, we will invest more of our mining wealth in creating jobs right across the country by cutting business taxes.

And we’ll give small business a head-start in these tax cuts because they have been vital to our economic success during the global recession and deserve to be big winners from our tax plans.

We will deliver a major cash-flow boost for small business by allowing an upfront tax deduction for the full value of assets purchased for up to $5000.

We’ll also provide standard tax deductions which will benefit about 6.4 million Australians and on average give them an extra $192 in their tax return. And we’re providing tax incentives for savings accounts and other savings products which will help put more competition into the banking sector over time.

Mother lode at stakeShould Canberra rake in a greater cut of our mineral resources bonanza? Two key players have their say.

We will do all this in a way which continues the responsible economic management we showed to keep Australia out of recession.

We will also deliver our plans in a way which is fair to the mining industry.

It’s a simple formula—if mining company profits go up, then the Australian people get a bigger slice. If profits go down, then the mining companies pay less.

We should all be proud of Australia’s success in fighting off the global recession and preventing massive job losses. Now it’s time to convert that success into jobs, wages and wealth for families and businesses in Queensland and right around the country.

Michael Roche Australian citizens are entitled to their fair share of Australia’s resources wealth.

There is no contest from resource companies over this principle but mounting community concern that it is being misrepresented by the federal government as justification for a new tax grab.

From day one, the government’s primary response to the Henry tax review has been marketed as a resource ‘super profits’ tax.

To date, the debate over the consequences for the Australian economy and its global reputation has been sidetracked by ham-fisted attempts to demonise individuals and mining companies as ‘foreign devils’.

What is becoming clearer to an overwhelming number of Australians with significant superannuation investments in resource companies is that the federal government could have achieved a much better response to a real tax reform agenda through a process of genuine consultation with the resources sector.

The only result to date of the government’s crash or crash-through strategy has been damage to Australia’s reputation as a safe and reliable destination for the international investment that we rely upon to grow and prosper as a trading nation of just 22 million people.

Without serious regard for the real-world consequences of an ‘elegant’ taxation model assembled by theorists in Canberra, the federal government has rolled the dice on the future of more than $100 billion worth of new resource projects in Queensland.

These are the projects that the state government is banking on to create about 19 000 new jobs, particularly in regional centres.

However, they are at a virtual standstill while such a high level of uncertainty surrounds the fate of the federal Government’s new tax.

In the interim, a lot of hot air, confusion and reputational damage could be avoided by a few simple acknowledgements and a coming together.

First is that the resources sector currently does pay a lot of tax. In 2008–09 the mining industry’s tax contribution was $22 billion, 13 per cent higher than the all-industry average.

Mining companies paid around 18 per cent of company income tax, even though the sector made up around 8 per cent of the national economy.

There is no more reliable source for such information than the Australian taxation Office, which only goes to show how much time and energy has been wasted in the debate to this point.

What the federal government should have done from the start, and what it can still do now, is sit down with the resources sector and hear their arguments on basic principles such as a profits tax applying to new investments, not existing projects directly and indirectly employing one in every eight Queenslanders.

The federal government should also seriously consider the potential damage to our economy that will be caused by introducing the world’s highest resource taxes as the ranks of competitor nations swell. Other material concerns include recognising that not all minerals and energy resources are the same and that rates of return vary, along with their developer’s ability to shoulder additional tax burdens.

It doesn’t sound that hard, but it has certainly become a point of increasing frustration within the resources sector that the federal government is not interested in a conversation over the long-term future of Australia.

Michael is CEO of Queensland Resources Council.

Courier Mail, 28 May 2010

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7.8 Microeconomic policyConceptsAllocative efficiency:theeconomy’sabilitytoshiftresourcestowheretheyaremost

valuedandcanbeusedmosteffectively

Dynamic efficiency:theeconomy’sabilitytoshiftresourcesbetweenindustriesinresponsetochangingpatternsofconsumerdemand

Microeconomic policy:actiontakenbygovernmentstoimproveresourceallocationbetweenfirmsandindustries,inordertomaximiseproductionfromscarceresources.

Technical efficiency:theeconomy’sabilitytoachievethemaximumlevelofoutputforagivenquantityofinputs

Governments take action to improve resource allocation in the economy. This is called microeconomic policy and is aimed at firms and industries. In this way, governments hope to create even more sustainable growth in Australia.

Microeconomic policy focuses on the supply side of economics; it does not seek to influence demand, but rather seeks to create favourable conditions to increase productivity and hence output. This should shift the aggregate supply curve to the right, as in Figure 7.13.

If the productivity of industry is improved, then business will become more competitive and efficient and this should encourage the efficient operation of markets. This will encourage Australian business to be more responsive to changing market conditions, and encourage them to seek export markets, to improve their output levels and their level of profit.

7.8.1 The three efficienciesMicroeconomic policy seeks to have improvements in the efficiency of businesses and industries. As such, it seeks to improve:• allocative efficiency• technical efficiency• dynamic efficiency.Allocative efficiency seeks to have market forces result in a more efficient allocation of resources. Resources should be shifted to those producers who have the greatest capacity to pay, and that capacity to pay will reflect relative efficiency and value to the economy. In essence, this means that resources are put to optimal use and not wasted. Inefficient businesses and industries would need to restructure and reorganise their production to become more efficient.

Technical efficiency seeks to have businesses improve their productivity; that is, an increase in output for a given quantity of inputs. Businesses will need to adopt the latest production technology and use the least-cost combination of resources to

Figure 7.13 Increased supply

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generate their production. Essentially, they seek to get more output for the same or fewer inputs.

Dynamic efficiency identifies the need to develop innovation and to be able to respond to changes in demand, both domestically and internationally, quickly. Microeconomic policy aims to increase the level of competition that forces producers to be more responsive to changes in demand and supply.

Figure 7.14 shows some of the microeconomic policies implemented by Australian governments.

Figure 7.14 Microeconomic policies implemented by Australian governments

Policy Example Impact Outcome

Tariff reductions CarsClothing

More competition for Australian producers

Increased technical and dynamic efficiency

Privatisation QantasTelstra

Shift of ownership and control to businesses and households


Deregulation AirlinesTelecommunicationsElectricity and water

Additional companies have entered the market


Industry plans TextilesDairySugar

Rationalisation of plant and productReorganisation of the industry

Increased technical efficiency

Competition policy Hilmer report Trade Practices Act 1974 (Cth)

Adding competition to water & electricity providers


Education and training

Finn and Meyer reports

TAFE reorganisationVocational qualificationsRecognition of key technical skills


Infrastructure Upgraded road networkRail systemPorts

Better transport speeds up product delivery


Industrial relations Workplace reform Fair Work Act 2009 (Cth)Enterprise bargaining


Management reform Karpin report Quality management Improved technical efficiency

There are, of course, many other areas of microeconomic reform in the economy.

EconomicsandICTLog on to Pearson Places and follow the prompts to the Australian Productivity Commission. From the home page, select View Current Projects. Then select one project that the Productivity Commission is currently working on and review the information presented.

How will this project improve productivity? Develop no more than six PowerPoint slides to report your research to your fellow students.

Microeconomic policy aims to contribute to the overall health of the Australian economy. As can be seen in Figure 7.14 above, there has been a deliberate attempt on

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Figure 7.15 Microeconomic policy effects

the part of Government to increase the level of competition. Competition enhances productivity, and growth in productivity results in economic growth and improved standards of living. This is shown below.

Microeconomic policy

Improved levels of competition

Increased levels of productivity

Higher economic growth

Improved standards of living for Australians

Questions

7.33 Select any three policy initiatives listed in Figure 7.14 and explain how they might be expected to lead to improved efficiency.

7.34 Would these policies also have negative effects? Identify some negative effects of microeconomic policies.

7.35 Draw a production possibility curve model to show the effect that microeconomic reform policies would have on the production possibility curve.

7.8.2 Continued microeconomic reformAustralian governments have implemented a significant amount of microeconomic reform in the 1990s and 2000s. However, as we move into the 2010s, there is a significant number of microeconomic policies yet to be finished, and more yet to be implemented. During the 2010s, it is expected that Australian governments will address most, if not all, of the microeconomic issues listed below.• Taxation reform• Healthcare changes, including hospital reform• Infrastructure development, such as new coal ports in Central Queensland• Continued education and training reform, including the Australian Curriculum for

schools, and TAFE restructuring

• Environmental changes to address climate change, including a carbon trading scheme

• Further competition reform and changes, especially in energy, transport and water• Improved labour relations building on the Fair Work Act 2009 (Cth)• Further changes to tariffs• A national broadband scheme• Privatisation of government business enterprises

Questions

7.36 Use a newspaper to identify examples of microeconomic reforms occurring at present.

7.37 What reforms have you identified, and why are these reforms important to the Australian economy?

7.38 Do you think each reform will improve productivity and/or competition in the Australian market? Why?

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Review of chapter 7R 7.1 Structured overview

Complete the following structured overview from sectional headings provided in the chapter

R 7.2 True/False

For each statement, indicate whether you consider it to be True (T) or False (F).

1 Council rates are part of a business’s fixed costs.

2 Marginal cost can be measured by the change in total cost or the change in total variable cost per unit of output.

3 The role of microeconomic reform is to improve how markets operate.

4 Sunk costs should always be considered in a cost–benefit analysis.

5 Microeconomics is concerned with the supply side of economics.

6 The economics of education would be an example of a macroeconomics issue.

7 Cost–benefit analysis can only be used by a trained economist.

8 There are problems in accurately valuing all costs and benefits in many projects.

9 The improvement in productivity is a major aim of microeconomic reform.

10 The level of interest rates in an economy is a major issue for a microeconomist.

R 7.3 Matching terms

Select the correct term from the list below that describes each statement.

A Merit goods B Microeconomic policy C Marginal revenue

D Marginal cost E Net present value F Allocative efficiency

G Opportunity cost H Technical efficiency I Sunk costs

J Macroeconomics K Opportunity cost value L Dynamic efficiency

1 Occurs when all firms are producing at the lowest possible cost

2 The value of the net benefit associated with the next best alternative

3 A private good with positive externalities

4 The extra (or marginal) revenue obtained by producing and selling another unit of output

5 The study of the economy as a whole, dealing in aggregates such as employment levels and overall price changes

6 The present value of the current benefits plus discounted future benefits less the present value of the current costs and discounted future costs of a project

7 Retrospective (past) costs that have already been incurred and cannot be recovered

8 Action taken by governments to improve resource allocation between firms and industries, in order to maximise production from scarce resources

9 The economy’s ability to shift resources to where they are most valued and can be used most efficiently

10 Occurs when innovation is rapid and businesses react quickly to changing consumer demand

R 7.4 Multiple-choice questions

Select the correct response to each of the following:1 If average variable cost is at a

minimum, then:

A marginal cost equals average total costB marginal cost equals average variable

costC average variable cost equals average

fixed costD average variable cost equals average

total cost.

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2 As output rises in the short-run, all of the following eventually increase except:A marginal costB average total costC average fixed costD average variable cost.

3 The objective of microeconomic reform is to:

A reduce aggregate demand to limit inflationary pressures

B enable businesses to be more profitable

C improve efficiency and flexibility within the economy by removing distortions

D reduce government involvement in economic decision making.

4 Which of the following is the best example of microeconomic reform?

A Income tax changes

B Interest rate changes

C Tariff reductions

D Pay rises awarded to low-paid workers

5 Microeconomic reforms involve:A increasing effective competition in

a number of marketsB tightening control on price increases

in a number of key marketsC ensuring the demand for labour

matches the supply of labour in certain markets

D restricting imports of products that can be made efficiently in Australia.

6 Microeconomic reform increases the potential for economic growth by increasing:A allocative efficiencyB dynamic efficiencyC technical efficiencyD all of the above.

7 If Ben doesn’t take his girlfriend out on Saturday night, he will save $50 and be able to spend the evening watching the football on TV with his mates. The opportunity cost of Ben’s date is:A $50B $50 plus the cost of forgoing a

night watching the football

C dependent on how pleasant a time Ben would have off he took his girlfriend out

D the cost of forgoing an evening watching the football.

8 Opportunity cost is:A the real cost of the want sacrificedB only faced by market economiesC the price of a close substitute to a

certain articleD the cost of an investment project.

9 Marginal cost is defined as:A the addition to average total

cost incurred as a result of a unit increase in output

B the addition to average variable cost incurred as a result of a unit increase in output

C the total cost divided by total output

D the addition to total cost incurred as a result of a unit increase in output.

10 When average cost is falling, marginal cost:A must be risingB must be greater than average costC must be less than average costD must be equal to average cost.

11 Which of the following is not a limitation of cost–benefit analysis?A There are distributional

consequences.B Social welfare is not the same as

individual welfare.C Valuing the environment is difficult.D It can be used by individuals.

12 Which of the following identifies four steps of cost–benefit analysis in their correct order?A Identifying alternatives, valuing costs

and benefits, discounting future values, comparing different options

B Discounting future values, valuing costs and benefits, comparing different options, identifying alternatives

C Identifying alternatives, discounting future values, comparing different options, valuing costs and benefits

D Comparing different options, identifying alternatives, valuing costs and benefits, discounting future values

13 A firm will maximise its profits if it employs enough of each variable factor to:A equalise its marginal revenue with

its marginal costB equalise its marginal product and

its average productC maximise its marginal revenue D minimise its average cost.

14 A firm’s average cost is:A the price of the firm’s product on

the marketB the cost of each unit of a variable

factorC total costs divided by the number

of units of outputD total costs divided by the number

of workers employed.

15 Which of the following is an example of a microeconomic policy?A A decrease in interest ratesB A decrease in income taxC A decrease in regulation in the

telecommunications sectorD An increase in government

expenditure

R 7.5 Activities

Opportunity cost

The Queensland Government owns and controls a tract of scenic tropical rainforest in North Queensland. If a developer gained approval to construct a golf course on part of the land, what would be the opportunity cost of this decision?

Statistics

Examine the statistics below and answer the questions that follow.

Figure 7.16 Australia’s productivity 1965–2009

Productivity/ Components

Long-term

average

1966–69 1974–82 1982–85 1994–99 1999–2004

2004–09

Labour productivity 2.2 2.5 2.1 2.3 3.3 2.2 1.1

Capital deepening 1.1 1.3 1.1 1.2 1.0 1.1 1.4

Multifactor productivity 1.1 1.2 1.0 1.1 2.3 1.1 –0.3

1 What other factors would be included in the multi-factor productivity category?

2 What is the long-term trend for labour productivity?

3 What is the long-term trend for multi-factor productivity?

4 There was a sharp upwards movement in productivity between 1994 and 1999. Suggest reasons for this. Conduct some research if necessary.

5 Suggest reasons why labour productivity has fallen away since 1999.

Source: ABS

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Complete the table below

Output Fixed costTotal variable

costTotal cost

Average total cost

Average variable

cost

Marginal cost

0 10 10

1 15

2 18

3 20

4 11

5 13

6 26

7 30

8 35

9 41

10 48

Diagram interpretation

Explain the diagram below. Using the information in the diagram, write a letter to the Editor (of no more than 300 words) outlining the importance of productivity growth in Australia.

Once the table is completed, construct graphs to show the following: average total cost, average variable cost and marginal cost.

Using the graphs, identify the most profitable point for the firm to produce at.

Cost–benefit analysis

At the conclusion of Year 12, you are debating in your mind what you should do the following year. You think you will gain a university entrance mark that will enable you to enter your preferred choice of study. Your parents own a furniture manufacturing business and you could work in the office of the business, learning the business and perhaps take over its management in ten years or so.

An alternative is to enter university immediately, and to study for an international business degree, hoping for good results and a career in international business, probably in hotel management.

A final option that you are keen on is to travel for a year, picking up odd jobs wher-ever you go, with the intention of having a ‘gap year’ before deciding on your future.

You remember that in Economics you studied decision-making processes and you think about costs and benefits of each of the three possibilities, including actual costs and opportunity costs. Make a list of the things you should consider when trying to make your decision. To what extent is your decision influenced by personal values?

Australia’s wellbeing has many dimensions, with material living standards being central

Other factors such as social capital, for example:

• social attachments• community involvement• safety

Other factors such as environmental capital, for example:• amenity• biodiversity• air quality

Per capita income growth and distribution contribute through:

• consumption and saving• funding of social activities• funding of institutions such as

law and order etc.

Growth in labour participation:• hours worked

Improvement in the terms of tradeNote: This can lead to a decline in productivity if resources are reallocated to more profitable but less productive activities

Labour productivity growth reflects both capital deepening and

multifactor productivity

Multifactor productivity growth

Capital growth: • physical capital stock

Source: Enhancing Australia’s Productivity; Productivity Commission, 2007–08 Annual Report

Figure 7.17 How productivity growth contributes to wellbeing

R 7.6 Inquiries

Using the economic method of problem solving, complete one of the following inquiries:

1 Do governments face the scarcity problem? Use a media scan to identify some of the key issues about which the Commonwealth government is currently being forced to make choices; for example, whether government spending should be used to offset falls in private expenditure or whether to raise aged pensions. Prepare a report that identifies the relevant costs and benefits associated with taking a particular course of action.

2 Assume the role of an economic analyst and, using the cost–benefit analysis model, prepare a report that explains why a company made a particular choice; for instance, the decision by Telstra to base call centres in India.

3 Do decision makers always correctly apply the cost–benefit analysis principle in their decision-making? Prepare a report that uses the cost–benefit principle to critique a particular decision made by an individual, business or government.

Review of chapter 7 answers at

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Documents

Contemporary microeconomic issues pages 7