Summary Notes
Chapter 1
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The Nature of Economics
Definition of Economics - defined as the study of the production, distribution and exchange of
goods and services in an economic system. It involves the study of the problem of scarcity of
resources in relation to human needs and wants.
The word ‘Economics’ is derived from the Greek word ‘oikonomia’ meaning management of the
house.
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Outline resources and the factors of production.
Resources refer to the factors of production in economics. The factors of production are bought
and sold in factor markets and are used in the production process to produce goods and
services to satisfy the needs and wants of consumers.
Four factors of production:
Land: Land refers to all natural resources such as forests, minerals, agricultural land, soil,
animals, fish, water, climate and vegetation. The factor income return or payment for the use of
land resources is called rent.
Labour: Labour refers to the human effort (both intellectual and physical) used in the production
of goods and services. A country’s labour force is the percentage of the population actually
employed (full time and part time) plus those unemployed but available for work, and actively
seeking work. The factor income return or payment for the use of labour resources is called
wages.
Capital: Capital refers to the ‘produced means of production’ or the goods that are used to
produce more goods and services in the future such as machinery, plant, tools and equipment.
Capital goods may also be referred to as producer goods. The factor income return or payment
for capital is called interest because for capital to be created, savings must be accumulated first,
then lent to borrowers through the process of investment. Since the cost of borrowing funds in
financial markets is interest, the factor income return or payment to capital is known as interest.
Enterprise: Enterprise or entrepreneurship refers to the ability of entrepreneurs to take risks in
organising the other factors of production in a business to produce goods and services for other
people. The factor income return or payment to the entrepreneur for risk taking in business is
called profit.
Chapter 2
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Resources and the Provision of Income
Land resources refer to all naturally occurring elements or environmental resources which may
be utilised for production such as climate, atmosphere, soils, vegetation, animals, fish stocks,
landforms or topography, minerals, rivers, oceans, lakes and water.
Labour resources refer to the knowledge, skills, education, training, health, experience and
overall productivity of the workforce in performing production tasks.
Capital refers to the produced means of production, or the goods and services used to produce
more goods and services in the future, such as machinery, tools, plant and equipment. Capital
accumulation occurs when there is savings out of current income set aside for investment in
capital goods. Investment is the process by which capital is accumulated for future wants
satisfaction - Savings→Investment→Capital Accumulation
Definition of Interest: The cost of borrowing funds for investment purposes from lenders in
financial markets.
What is the rate of interest? The rate of interest is the annual percentage return paid to lenders
by the borrowers of funds. The rate of interest is determined by the demand and supply of funds
or money in the money market.
Real Interest Rate = Nominal Interest Rate - Inflationary Expectations
Definition of Entrepreneurship(enterprise): refers to the risk taking behaviour of entrepreneurs
in establishing, managing and operating small, medium and large scale business enterprises.
The entrepreneur combines the other three factors of production (i.e. land, labour and capital) to
produce final goods and services.
Profit is the return to enterprise, and is equal to the positive difference between the total revenue
earned by a business and its total costs of production.
Definition of Normal Profit - The rate of profit sufficient to keep the entrepreneur in business or
the industry in which a firm operates.
Definition of Supernormal Profit - Refers to profit over and above what is necessary to keep the
entrepreneur in business or the industry in which a firm operates and is usually earnt by
businesses with a large degree of market power such as monopolies (e.g. Australia Post) and
oligopolies (e.g. oil companies such as BP and Shell).
Gross income is subject to income taxation by the federal government.
Disposable income is equal to gross income minus taxation.
Final income is calculated by adding cash and non cash benefits to disposable income, then
subtracting indirect taxes(eg. GST).
Final Income = Gross Income - Taxation + Social Wage - Indirect Taxes
Factors of Production and Factor Income Returns
Factors of Production
Factor Income Return
Land
Rent
Labour
Wages
Capital
Interest
Enterprise
Profit
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Business Cycles
Definition of Business Cycles: In market economies, economic activity tends to occur in cycles.
These cycles form the business or trade cycle which is characterised by four main phases:
upswings, booms, downswings and recessions.
Definition of Upswing
In the upswing phase of the business cycle, expenditure, output, income and employment levels
rise. Higher levels of tax collections to governments may finance increased spending on
infrastructure, community services, welfare and environmental quality which can raise the
quality of life.
Definition of Boom
In the boom phase of the business cycle, expenditure, output, income and employment levels
reach a maximum point as economic activity peaks. Shortages of labour and other resources
may occur, leading to inflation of the price level. The government may use contractionary
policies to slow down economic activity to more sustainable levels, including lower inflation and
the preservation of environmental resources to achieve ecological sustainability and improve the
quality of life.
Definition of Downswing
In the downswing phase of the business cycle, expenditure, output, income and employment
opportunities begin to fall as economic activity decelerates. With less economic activity there
may be less demand for labour leading to some unemployment of resources in the economy
and a decline in the quality of life for some individuals and households because of falling
incomes.
Definition of Recession
In the recession phase of the business cycle, expenditure, output, income and employment
opportunities reach a minimum point as economic activity troughs. An excess supply of labour
leads to rising unemployment, and deflation may occur, as businesses attempt to clear unsold
inventories of goods and services by cutting prices. The government may use expansionary
macroeconomic policies to stimulate spending and activity during the recession stage of the
business
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Circular Flow of Income
Utilised to simplify the structure and workings of a market economy. Broken down into five
sectors: household, firms, finance, government and overseas sectors. A sector is defined as an
aggregation of economic units which perform a similar economic activity or function.
Definition of Closed Economy: Economy where where there is no overseas sector and therefore
no international trade.
Definition of Open Economy: Economy characterised by the inclusion of an overseas sector and
international trade and money flows.
Five Sectors:
The Household Sector:
Consists of all individuals in the economy who earn income (i.e. wages, rent, interest and profit)
by selling productive resources (i.e. land, labour, capital and enterprise) to the firms sector. With
the money income earnt, households purchase goods and services from the firms sector to
satisfy their needs and wants and to improve or maintain their standard of living and quality of
life.
The Firms Sector:
Consists of all private business enterprises in the economy which produce and distribute goods
and services to consumers. Firms buy productive resources (i.e. land, labour, capital and
enterprise) from the household sector and make factor income payments (i.e. wages, rent,
interest and profits) in return for the use of these productive resources.
The Finance Sector:
Consists of all financial institutions(i.e. banks and non bank financial intermediaries or NBFIs)
who engage in the borrowing and lending of money and the sale and purchase of financial
assets and services to firms and households.
The Government Sector:
Consists of the economic activities of local, state, territory and federal governments
in Australia. Governments raise revenue through taxes, rates, fees and charges, and the profits
of public trading enterprises. They use this revenue to provide collective goods and services to
the community such as law and order, defence, education, health, social security and
community services.
The Overseas Sector:
Consists of firms who are the exporters and importers of goods and services to and from the
rest of the world.
Trade Flows Definition: refer to exports of goods (e.g. wool, wheat, beef, iron ore, coal
and natural gas) and services (e.g. freight, insurance, education and tourism) sold by Australian
firms to foreigners, and imports of goods (e.g. food, beverages, cars and machinery) and
services (e.g. freight, insurance, education and tourism) purchased by Australian residents from
foreigners.
International money/Financial flows: The borrowing and lending of money between Australian
residents and foreign financial institutions and companies, and the payments and receipts (e.g.
dividends, interest, rent and profit) associated with such transactions.
EQUILIBRIUM
Two Sector Model:
Equilibrium is defined as a situation in which there is no tendency for the levels of income,
expenditure and output to change, creating the formula Y=E=O for equilibrium.
Three Sector Model:
The equilibrium condition for the three sector model is for savings to equal investment. If S>I,
Y,E,O and employment fall, leading to a recession and higher unemployment in the economy.
This represents a contraction in the circular flow, as the leakage of savings is greater than the
injection of investment. If S<I, then Y, E,O and employment will rise, leading to a boom and
higher employment in the economy. This represents an expansion in the circular flow of income
since the leakage of saving is less than the injection of investment funds.
Four Sector Model:
If S+T>I+G, Leakages exceed injections causing the levels of income, output, expenditure
and employment to fall, leading to a contraction in economic activity (i.e. a downswing in the
business cycle) and higher unemployment in the economy. If S+T<I+G, Injections exceed
leakages causing the levels of income, output, expenditure and employment to rise, leading to
an expansion in economic activity (i.e. an upswing in the business cycle) and lower
unemployment in the economy.
Five Sector Model:
If S+T+M>I+G+X, Leakages exceed injections causing the levels of income, output,
expenditure and employment to fall, and a recession or contraction in economic activity and
higher unemployment in the economy. If S+T+M<I+G+X, Injections exceed leakages causing
the levels of income, output, expenditure and employment to rise, and a boom or expansion in
economic activity and lower unemployment in the economy.
Summarised Formulas
Two Sector:
Y=C
Y=E=O for equilibrium
Three Sector:
Y=C+S
O=C+I
S=I for equilibrium
Four Sector:
S+T=I+G for equilibrium
Five Sector:
S+T+M=I+G+X for equilibrium