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The operation of an economy

Production of goods and services from resources

The market economy
- Advanced industrialised, capitalist economies
- What to produce and how much to produce
o Determined by price mechanism in which consumer preferences, supply and
demand determine the pattern of product and the quantities of outputs.
- How to produce
o Determined by profit motives as producers will tend towards cheaper and more
efficient forms of production with technology being a driving force. Demand for
resources is dependent on consumer demand as well as prices in the factor markets.
- To whom to distribute
o Determined by the distribution of incomes as higher income earner possess higher
purchasing power. Income is determined by an individuals marginal productivity as
well as the demand for various labour skills.
- Key characteristics
o Price mechanism determines; prices, quantity and allocation of resources. Producers
motivated by profit. No intervention in the market by the government
The planned economy
- Use of government planning to allocate resources according to the priorities for production
set by a state planning authority agency
- What to produce and how much to produce
o Determined by the government. Short, medium and long term plans set out
production priorities and targets. Resource allocation in government controlled with
individual farms and factories given quota they must fulfil.
- How to produce
o Determined by government to allocate resources in sufficient quantities to meet
output targets. Differential wage rates are sued to control the supply of workers.
- To whom to distribute
o Determined by government to share out production on the basis of needs and areas
of priority. Higher wages and salaries are paid to workers in high priority industry
with prices for basic needs generally subsided and health/education is generally free
Distribution of goods and services
The distribution of outputs depends on individual incomes. The higher the personal income, the
greater the ability to purchase goods and services and raise individual living standards.
Most economies display an uneven distribution of income because individuals are free to
accumulate income and wealth. The governments tax/transfer system helps to redistribute income
and make the distribution of income less unequal than it was determined solely by market forces.
Prices are monetary indicators of the relative value of goods and services in an economy. Prices
guide the decision making process in four main ways
1. Prices match the output by producer with the demand of consumers.
2. Prices ration the limited supply of resources and commodities.
3. Prices help prevent the wastage of resources by avoiding shortages and surpluses of
production in relation to demand, so producers aim to achieve allocative efficiencies.
4. Prices signal to producers and consumer to adjust economic behaviour as a result of changes
in market conditions.
Resources and provision of income
Factors of Production
- Land
o Refers to all naturally occurring elements or environmental resources which may be
utilised for production. The price of land resources are determined largely through
o Factor income return rent
- Labour
o Refers to the overall productivity of the workforce in performing production tasks.
Labour productivity can be raised by using inputs efficiently or increasing amount
and through capital equipment
o Factor income return wages
- Capital
o Refers to the produced means of production use to further produce goods/service in
the future.
o Saving investment capital accumulation
o Factor income return interest
Real interest rate = nominal interest rate inflationary expectations
- Entrepreneurship
o Refers to the entrepreneurs that establish manage and operating business
enterprises. They combine the other three factors of income to produce the final
o Factor income return profit
Normal profit is the rate of profit sufficient to keep the entrepreneur in
business. Supernormal profit is profit over and above what is necessary.
Factor income returns are influenced by the productivity of each factor of production
Households provide resources to firms and the government through factor markets. Firms and
governments pay households factor incomes in return. Firms supply goods/service to households
and government in return for money expenditure. Governments produce goods and services and
transfer payments, collecting tax in return.

Provision of employment and quality of life
Due to high levels of specialisation in an economy, there is increased interdependence between
households, firms and governments.
- Households depend on firms and governments for the provision of employment and
payment of income. Firms in turn depend on the expenditure of households for the
goods/services for their income. Both firms and households pay taxes to the government
which in turn, provide collects goods/services and transfer payments.
- Employment is the primary industry (raw material extraction) and secondary industry
(manufacturing) has seen decreased over the past year as a result of mechanisation and
automation. As an economy grows, it becomes more specialised leading the changes in the
structure of production and employment.
Quality of life
- Dependent on the quantity and quality of goods and services in the economy.
- Quality of life indicators
o Material considerations
Level of income individuals can earn, types and nature of employment
available, and the range of goods/services.
o Non-material considerations
Access to collective goods and services e.g. health care, education, housing,
public transport, emergency services etc.
o Other access to safe drinking water, clean environment, safe community, personal
freedom (i.e. participation of individuals in the political process)

The business/economic cycle
- The business cycle is a macroeconomic model that illustrates GDP/output/level of
production over time.

- Growth in GDP overtime
- Does not grow at a constant
- Increasing GDP economic

Key aspects looked at include; supply and demand, expenditure, output and employment
- Expenditure, output, employment is at capacity. Economic activity is at its peak
- This point represents a supply constraint where demand>supply which leads to an increase
in prices because of inflation
- less consumption decreased outputs increase unemployment
- Consumer and business confidence is high increased demand
- Increased demand increased consumption increase outputs increased employment
- Expenditure, output, unemployment are at its lowest levels
- Increased supply of available labour decreased price of labour (wages) decreased
demand decreased prices i.e. deflation
- A result of supply capacity of the boom where demand>supply, hence deflation
- Economy is cooling

The circular flow of income model
- Closed economy is one with no overseas sector and therefore no international trade
- An open economy has an overseas sector and therefore international trade and money flow
- The household sector
o All individuals in the economy who earn income by selling productive resources to
the firms sector. Income is used to purchase goods/services from firms to satisfy
needs and wants and improve standard of living.
- The firms sector
o Firms buy productive resources from household sectors and make factor income
payments in return.
- The finance sector
o All financial institutions 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
o Economic activities of local, state and federal governments
- The overseas sector
o Exporters and importers of goods and services
o Trade flows
Export and imports of goods and services.
o International money or financial flows
Borrowing and lending of money between Australia and foreign financial
institutions and companies. All international transactions are recorded in
the balance of payments; current account, capital account and financial

Five Sector Circular Flow of Income Model
- Equilibrium; S+T+M = I+G+X
- Disequilibrium
o Leakages > Injections causing fall in level of income, output, expenditure and
employment leading to a contraction in economic activity (recession-like)
o Leakages < Injections causing a rise in level of income, output, expenditure and
employment leading to an expansion in economic activity (boom-like).
o Regaining Equilibrium
When leakages > injections, households will cut back on savings, pay less tax
and purchase fewer imports as a result of reduced income. This will balance
out the injections and a lower level of equilibrium will be established.
When leakages < injections, house wills increase saving, pay more tax and
spend more on imports. This will increase the leakages and therefore
establish a higher level of equilibrium.