Economics Review Flashcards: Micro & Macro Concepts from Lecture Notes

1. Microeconomics and Macroeconomics

• Microeconomics: the study of the economic behaviour of individual consumers and businesses, and the role of markets, price mechanisms, and the factors influencing buying/selling decisions.
• Macroeconomics: explains economy-wide phenomena, government goals, unemployment rate, etc.
• Distinction helps explain how decisions are made at the levels of individuals/firms vs the whole economy.
• Ceteris paribus (all else equal):
  • Relationships between products are analyzed assuming no other changing factors at a point in time.
  • Useful for isolating key relationships but not fully reflective of the real world.
• Rational economic decision making:
  • Economists assume humans are rational and consider all potential costs and benefits before deciding.
• Consumers and firms maximize utility and profit, respectively:
  • Consumers maximise utility; firms maximise profit.
• Diminishing marginal utility:
  • Each additional unit of a good provides less additional satisfaction; pizza example illustrates decreasing marginal satisfaction.

2. Relative Scarcity and Resources

• Relative scarcity: needs/wants are infinite, resources are finite; decision-making allocates resources to best meet needs/wants.
• Resources (factors of production):
  • Natural resources (land, water, forests, etc.).
  • Labour resources (mental/physical effort by humans).
  • Capital resources (made to enable more production; e.g., factories, machinery, AI, infrastructure).
• Key economic questions (what, how much, for whom):
  • 2.1 What and how much to produce: in market-based economies (e.g., Australia), determined by demand and supply interactions of self-interested consumers/producers; COVID example: government produced facemasks.
  • 2.2 How goods/services will be produced: labour-intensive vs technology; businesses aim to maximise profits.
  • 2.3 For whom: in Australia, largely those who can afford to buy; government can allocate to specific households.
• Opportunity cost (1.4):
  • The value of the next best alternative that is foregone when a choice is made.
• The Production Possibility Frontier (PPF) (1.5):
  • A diagram representing opportunity cost and the allocation of scarce resources between two goods.
  • Assumptions when constructing a PPF:
  • Fixed quantity of land, labour, and capital.
  • Resources are used efficiently to maximise production.
  • Changes to the PPF:
  • Points outside the PPF are currently unattainable unless borrowing, which may imply lower future consumption.
  • Over time, productive capacity can expand (ppf shifts out to the right) via:
    • Discoveries or new resources (land, labour, capital).
    • More efficient production techniques increasing output from existing resources.
  • Points inside the PPF indicate underutilised resources or unemployment; no economy operates on the PPF due to unemployment or inefficiency.
  • In reality, economies rarely operate on the outer boundary due to unemployment/idle resources.
• Economic efficiency types and their link to the PPF:
  • Allocative efficiency: resources are allocated to maximise societal satisfaction; only one point on the PPF is allocatively efficient (the mix that best satisfies consumer preferences).
  • Productive (technical) efficiency: producing at maximum output given resources; all points on the PPF are technically efficient.
  • Dynamic efficiency: how quickly an economy can reallocate resources to improve efficiency.
  • Intertemporal efficiency: optimal balance between current and future consumption (e.g., Superannuation Guarantee Scheme).

3. The Market System and the Basic Economic Questions

• The conditions for a free and perfectly competitive market:
  • Large numbers of buyers and sellers; no single actor can influence price.
  • Homogeneous products; easy entry/exit; full information; resources mobile.
  • Self-interested behavior drives decisions; consumers seek utility, firms seek profits.
• The law of demand and related effects:
  • Law of demand: inverse relationship between price and quantity demanded (ceteris paribus).
  • Income effect: higher prices reduce purchasing power, decreasing quantity demanded.
  • Substitution effect: when a good becomes expensive, consumers substitute toward cheaper alternatives.
  • Demand curve: shows price vs quantity demanded; typically downward sloping.
  • Movements along the demand curve (expansion/contraction) are caused by price changes; shifts occur due to non-price determinants.
• Non-price determinants of demand (causing shifts):
  • Disposable income: total income available to spend; DI = Earnings + Government Benefits − Tax.
  • Normal goods vs inferior goods:
  • Normal goods: demand increases as income increases.
  • Inferior goods: demand decreases as income increases.
  • Discretionary income vs disposable income: discretionary is income after essential expenditures.
  • Substitutes and complements: changes in the price of substitutes or complements affect demand for the good.
  • Population demographics, consumer confidence, interest rates, preferences.
• The law of supply and the supply curve:
  • Law of supply: quantity supplied varies directly with price; higher prices incentivise higher production due to higher profits.
  • The supply curve is upward sloping; movements along vs shifts due to non-price determinants.
• The interaction of demand and supply and equilibrium:
  • Equilibrium price (P) and quantity (Q) where QD = QS.
  • Shortage: price below equilibrium; quantity demanded exceeds supply.
  • Surplus: price above equilibrium; quantity supplied exceeds demand.
  • How to analyse equilibrium changes: identify whether a factor affects demand or supply, determine the direction of the shift, and deduce the new equilibrium and whether a surplus or shortage arises.

4. Elasticity of Demand and Supply

• Price elasticity of demand (PED):
  • PED =
    PED = \left| \frac{\%\Delta Q_D}{\%\Delta P} \right|
  • Interpretation: >1 elastic, <1 inelastic, =1 unit elastic (magnitude is used; sign ignored).
  • Firms prefer inelastic demand (less sensitive to price changes).
• Price elasticity of supply (PES):
  • PES =
    PES = \left| \frac{\%\Delta Q_S}{\%\Delta P} \right|
• Factors affecting price elasticity of demand:
  • Degree of necessity (necessities are less elastic).
  • Availability of substitutes (more substitutes → more elastic).
  • Proportion of income (items with larger share of income are more elastic).
  • Time horizon (longer time → more elastic).
• Factors affecting price elasticity of supply:
  • Spare capacity: more capacity → higher PES.
  • Production period: longer production cycles → lower PES in the short run.
  • Durability of goods: durable goods often have higher PES because they can be stored and redeployed.
• Extra notes:
  • The flatter the supply/demand curve, the more responsive the quantity is to price changes.
  • In practice, firms like inelastic demand and elastic supply to maximise profits under price changes.

5. Relative Prices and Market Allocation

• Relative prices, not absolute prices, guide resource allocation in a market economy.
• Demand and supply determine relative prices, which influence resource allocation toward goods/services that maximize social welfare.
• Allocative efficiency is achieved when the relative prices reflect the true scarcity and preferences of society.

6. Market Failure and Government Intervention

• Market failure occurs when free market forces fail to allocate resources efficiently, resulting in underallocation or overallocation of resources.
• Types of market failure:
  • Public goods: non-rivalrous and non-excludable; underprovided in a free market (e.g., street lighting, national defence).
  • Common access resources: non-excludable but rivalrous; overconsumption leads to overuse (e.g., environmental resources like fisheries).
  • Externalities: spillover costs/benefits not borne by decision-makers (negative or positive); can lead to under/overproduction relative to social optimum (e.g., smoking, vaccines, education).
  • Asymmetric information: buyers/sellers have unequal information; can lead to adverse selection and market inefficiency (e.g., used car market).
• Government intervention tools to address market failure:
  • Indirect taxes and subsidies
  • Regulations and enforcement
  • Advertising and information provision
  • Direct provision of goods/services
• Government failure: interventions can fail to improve allocation or may reduce efficiency compared to free markets due to unintended consequences.
• The law of unintended consequences: policies often trigger reactions that counteract intended effects.
• Examples of intervention effects: minimum wage and labour market outcomes (possible surplus of labour if set above the equilibrium; debate on short-term vs long-term effects).

7. Living Standards, Circular Flow, and the Business Cycle

• Living standards: two main components:
  • Material living standards (MLS): measured by income and consumption per person (GDP per capita).
  • Non-material living standards (NMLS): quality of daily life (health, education, environment, equality, etc.).
• Relationship between MLS and NMLS:
  • They can be conflicting (trade-offs) or compatible (progress in MLS may support NMLS).
  • MLS is easier to measure with quantitative data (GDP), while NMLS is qualitative.
• The circular flow model (five-sector):
  • Households, firms, government, financial institutions, and the external sector.
  • Shows injections and leakages to the circular flow of money, goods, and services.
• The business cycle: fluctuation of economic activity over time with four stages:
  • Expansion: rising activity, falling unemployment, rising wages, rising AD.
  • Peak/boom: strong growth, full capacity use, unemployment very low, inflation may rise rapidly.
  • Contraction: falling output, rising unemployment, falling wages, reduced spending.
  • Trough: low activity, unemployment persists, economy begins to recover.

8. Aggregate Demand (AD) and Aggregate Supply (AS)

• Aggregate demand (AD): total expenditure on Australian-made goods/services; AD = C + I + G + (X − M).
• Determinants of AD (factors affecting the level of demand):
  • Disposable or discretionary income.
  • Interest rates (cost of borrowing; reward for saving).
  • Consumer confidence and business confidence.
  • Exchange rate and overseas economic growth (net exports).
• Aggregate supply (AS): total output supplied by the economy at different price levels.
• Determinants of AS (quantity/quality of factors, costs, technology, productivity, exchange rates, climate, regulations):
  • Quantity of factors of production (land, labour) and participation rates.
  • Quality of factors (education, capital quality, technology).
  • Costs of production (COP).
  • Technological change and productivity growth.
  • Exchange rates and climatic conditions.
• Exchange rates and TOT (terms of trade) influence on AD/AS and living standards:
  • The exchange rate is the value of the AUD relative to other currencies; it is normally floating.
  • Demand for AUD factors into its appreciation; supply (imports) can cause depreciation.
  • TOT measures export prices relative to import prices; (
    TOT = \frac{P{export}}{P{import}} \times 100).

9. Macroeconomic Goals and Measurements

• The three primary macro goals (interrelated):
  • Strong and sustainable economic growth: growth in real GDP; typical target ~3% per year; projections influence unemployment and inflation dynamics.
  • Low and stable inflation (price stability): measured by CPI; includes disinflation and deflation concepts.
  • Full employment: lowest unemployment rate compatible with stable inflation; NAIRU (Non-Accelerating Inflation Rate of Unemployment) is the target level (approx 4–4.5% in the provided notes).
• Inflation, disinflation, and deflation:
  • Inflation: general rise in price level.
  • Disinflation: inflation rate slows but remains positive.
  • Deflation: general fall in price level.
• Measurement and data considerations:
  • Real GDP and chain-volume GDP (to account for price changes when measuring growth).
  • The CPI has limitations: small sample size, quality changes, and weightings.
• Consequences of failing to achieve macro goals: environmental degradation, external pressures, inflationary pressures if growth is too high, unemployment if growth is too low.

10. International Trade and Payments

• Gains from international trade: lower prices, greater choice, resource access, economies of scale, increased competition and efficiency, and specialization.
• Absolute advantage: a country can produce a G/S at lower cost than another country.
• Comparative advantage: a country can produce a G/S at a lower opportunity cost than another country.
• Specialisation and trade beyond the PPF can yield welfare improvements for both parties.
• Economies of scale: cost per unit falls as output increases; trade expands markets and allows firms to lower prices while maintaining profits.
• The balance of payments (BOP): a record of a country’s financial transactions with the rest of the world over a period (year or quarter).
  • Composed of Current Account (CA) and Capital & Financial Account (C&FA).
  • Current Account includes: Trade in goods (BOMT: Balance of Merchandise and Trade), net services, net primary income, and net secondary income.
  • Capital & Financial Account records capital transactions (buying/selling assets, lending/borrowing) and typically nets to zero when aggregated (vBOP = 0).
• Net foreign debt and net foreign equity: measures of a country’s external obligations and ownership of assets abroad.
• Net foreign debt (NFD) and net foreign equity (NFE): flows and stocks; exposure to external obligations and earnings from foreign ownership.
• The balance of payments and external stability are influenced by savings-investment balance, competitiveness, exchange rates, TOT, and global growth.

11. The Exchange Rate, TOT, and International Competitiveness

• Exchange rate concepts:
  • The value of the Australian dollar (AUD) relative to other currencies.
  • Floating exchange rate determined by supply and demand; changes influence imports/exports and investment flows.
• Determinants of the exchange rate (factors affecting demand for AUD):
  • Relative interest rates: higher rates attract foreign capital, increasing demand for AUD.
  • Commodity prices and terms of trade: higher export prices (TOT improvements) increase demand for AUD.
  • Demand for exports and imports: more exports require more foreign currency that must be converted to AUD, and more imports increase supply of AUD.
  • Foreign investment and credit ratings: stronger investment inflows/support for AUD; better credit ratings generally strengthen AUD.
  • Speculation and global confidence: expectations about future value affect current demand/supply.
• The terms of trade (TOT): the ratio of export prices to import prices:
  • TOT = (Export price index) / (Import price index) × 100; often presented as export prices relative to import prices.
  • A rise in TOT generally improves a country’s real purchasing power for a given volume of exports and can support a stronger currency.
• The impact of exchange rate movements on macro goals and living standards:
  • Appreciation: exports become more expensive to foreign buyers, imports cheaper; may improve CA if imports rise less than exports fall.
  • Depreciation: exports become cheaper, imports more expensive; can boost AD via higher net exports but may raise import costs.
• International competitiveness factors:
  • Productivity and production costs directly influence competitiveness; lower COP or higher productivity improves price competitiveness.
  • Availability of natural resources, exchange rates, and inflation relative to trading partners affect IC.
  • Relative inflation: slower inflation in a country improves competitiveness if prices rise more slowly than abroad.

12. The Productivity and Policy Context

• Productivity growth: increases output per unit of input, reducing per-unit costs and enhancing competitiveness.
• Policy levers and unintended consequences:
  • Government intervention can stabilise activity and correct market failures but may also cause government failure if misapplied.
  • The balance between policy aims and market freedom is delicate; policies like minimum wage can have mixed short-term and long-term effects on employment and efficiency.

13. Key Formulas Summary (LaTeX)

• Aggregate demand: AD = C + I + G + (X - M)
• Disposable income: DI = E + GB - T
• Production Possibility Frontier (PPF): representation of trade-offs given finite resources; shifts out with improvements in capacity
• Opportunity cost: value of next best alternative foregone
• Price elasticity of demand: PED = \left| \frac{\%\Delta Q_D}{\%\Delta P} \right|
• Price elasticity of supply: PES = \left| \frac{\%\Delta Q_S}{\%\Delta P} \right|
• Terms of trade: TOT = \frac{P{export}}{P{import}} \times 100
• Demand/Supply shifts and equilibrium analysis follow the standard microeconomic framework described above.

14. Quick Reference Steps for Equilibrium Questions

• Identify whether the factor affects demand, supply, or both.
• Determine the direction of the shift (increase/decrease) for the curves involved.
• Assess the new equilibrium: is there a surplus or shortage, and how do price and quantity change?
• If asked, discuss the magnitudes and potential impacts on consumers and producers (welfare, price stability, etc.).

15. Real-World Relevance and Examples

• COVID-19 and policy responses illustrate how government actions can affect production capacity, demand, and pricing dynamics.
• Examples such as substituting alcohol production for hand sanitiser demonstrate dynamic efficiency and adaptability in the face of shocks.
• The interaction of markets, policy, and technology shows how different efficiency metrics (allocative, productive, dynamic, intertemporal) matter for overall welfare.

16. References to Foundational Concepts

• The relationship between MLS and NMLS, and how they interact under different policy regimes and market conditions.
• The circular flow model as a framework for understanding injections/leakages and macroeconomic stability.
• The balance of payments as a broad indicator of a country’s external position and health, including how debt and equity flows influence future obligations and living standards.