STAGE 2 ECONOMICS
THE ECONOMIC PROBLEM
KEY AREA
1
The economic problem Identifying the economic problem This section of the course is covered primarily in the multiple choice and short answer components of the exam. However, you must aim to link parts of the course together in your essays. For example, you might be able to incorporate a production possibility curve (ppc) into an essay discussing the possible outcomes of globalisation.
Scarcity, choice and resources •
Scarcity arises because resources are finite but wants are unlimited. Wants may be recurring (e.g. food), complementary (cars and petrol) or substitutable (apples and oranges). Resources may be classified as land, labour, capital, or enterprise. These are the factors of production. ‘Land’ refers to anything natural. ‘Capital’ in an economic sense relates to produced means of production. ‘Labour’, of course, is human effort while the initiators or risk-takers in a new project provide ‘enterprise’. Economic problem:
• •
– WHAT to produce (more/less/switching output) – HOW to produce it (the method: land, labour or capital intensive) – TO WHOM it is to be distributed (depends on income of consumers)
Production possibility curves Show opportunity cost – alternatives foregone when a particular decision is made. A new curve results from a change in technology or resources. If resources or technological development change, potential will change, thus creating a new curve. It is possible for the potential to change for one or both of the items being plotted. And potential may either increase or decrease. Microeconomic reform is aimed at increasing potential as it aims to increase efficiency/productivity. You can see the effect of a change in potential below.
wool
•
New disease-resistant wheat variety developed
wheat
wheat
Parasitic disease sweeps through sheep industry
Significant drought hits rural areas
wheat
• •
wool
wool
No new curve results if there is a change in demand (potential does not change). There is just a movement within or along the existing curve.
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KEY AREA 1 If producing at a point marked inside the ppc, output along both axes can increase without an opportunity cost because of original resource unemployment. See below.
wheat
•
A B
wool
Output can only move outside the production possibility frontier if the whole curve moves (increase in potential). A position on the curve indicates resource use is being maximised. In the graph below, position A is not necessarily ‘better’ than position B, or vice versa.
wheat
• •
A B
wool
Economic systems All systems must tackle the economic problem. All countries are affected by the nature of ownership and must make decisions regarding the allocation and co-ordination of their productive resources. Traditional (subsistence) economies: What
Usually decided by tradition, maybe by chief/elders. Depends on basic needs and available resources.
How
Usually land/labour intensive. Little capital used.
To whom
Group may share depending on custom. Bartering is common.
Resource allocation Directed towards satisfying basic needs, e.g. food, clothing, shelter. Market (price, capitalist, laissez-faire, free enterprise) system: What
Consumers casting ‘dollar votes’.
How
Producers choosing most cost-efficient method.
To whom
Those with highest incomes (greatest share of productive resources).
Resource allocation Largely determined through the market mechanism (forces of demand and supply determine price). Planned (command) system: What
Decided by central planners/committee, representing the state.
How
May vary according to political agenda – not necessarily cheapest method (e.g. if there is a large labour surplus, the state may want to use labour-intensive methods and achieve full employment).
To whom
In theory to those most in need – based on the social good of the community. In practice may go to those with greatest power.
Resource allocation Depends largely on government priorities, e.g. capital goods at expense of consumer goods. Market mechanism plays minor role.
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THE ECONOMIC PROBLEM
Source: Dianne Averis
STAGE 2 ECONOMICS
Scenes from Cuba, one of the world’s very few remaining planned economic systems. Wages average about $8 a week but the price of basics is kept very low. Citizens such as these singers and the banana seller try to earn a little more by selling goods or services on the streets. With the American blockage on exports to Cuba in place since 1960, vintage cars from that era can still be seen on the streets. It is worth investigating the current situation in Cuba as liberalisation is occurring, with the scaling back of sanctions announced in late 2015.
Economies in transition Causes of major change in the command economies The latter part of the 20th century saw a number of countries which had been operating under the command economic system, undergo profound changes. Economies such as those in the Soviet Union had experienced low economic growth, with rigid long-range plans culminating in either vast shortages or surpluses. Resource wastage was excessive. Development fell way behind that of advanced western nations (who were operating under the market economic system). There were no incentives for individual workers to increase output as the factors of production were owned by the state. Even if employees had earned more money, highly desirable consumer goods and services were few and far between. The collapse of Communism in the Soviet Union, Poland and Albania, amongst others, saw these countries change direction and embrace the market economy. Even some countries continuing to operate under the Communist political system, for instance China and Vietnam, decided to free up their economies and allow the profit-motive to dominate.
Features of change Reforms included the encouragement of foreign investment (as in Vietnam), the privatisation of state assets, for example in Hungary and Poland, the lowering of trade barriers (China) and a willingness to embrace globalisation and join trade blocs. China became a member of the World Trade Organization in 2001. In 2007, Bulgaria and Romania joined the European Union, the world’s largest single trading block, comprising approximately 500 million people. Amongst the relative newcomers are the Czech Republic, Latvia, Poland, Hungary and Slovakia – all of whom used planned economic systems during the 20th century. Croatia was admitted in 2013; Albania, Macedonia, Montenegro, Serbia and Turkey have their applications for membership under review. A willingness to be more transparent in business practices and to free up their financial markets have been other features of these countries in transition. Legal, labour market and also institutional reforms (e.g. regarding taxation principles and practices) were encouraged.
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KEY AREA 1
Effects Output in some countries actually declined in the first years of the market economic system. Some of those countries which had belonged to the old Soviet Union, for example, were particularly hit hard. Countries which were previously very poor found it hard to adapt to a system where prices were no longer controlled by the state. Prices of essentials rose when left to the market mechanism, and many consumers suffered. Some countries were not sufficiently organised to cope with the massive change, and, in others, political pressures were applied to slow/reverse the reform process. The Russian economy collapsed in 1998! Crime and corruption escalated. Externalities of economic production have been experienced. (Externalities are experienced by those other than the decision maker, e.g. annual burning of forests in Indonesia creates significant pollution in Malaysia because of the smoke blown over that country by the prevailing winds.) In some Asian countries pollution is so extensive inhabitants frequently wear masks. In other places deforestation has occurred. The rapid pace of economic growth has not often been accompanied by laws to minimise external costs. Recovery has occurred in many instances, however. Key factors which have contributed to growth under the market system include: • • • • •
the ability to reduce corruption and become more transparent in dealings and processes. Tax reform and administration and public sector reform have helped in these areas. the existence of an entrepreneurial culture, where individuals have embraced the profit-motive and shown flair in adapting to the new system. emphasis on education/literacy which produces a flexible, well-educated workforce and encourages foreign investment (as in Vietnam). countries well-endowed with natural resources (such as Russia with oil) have generally found it easier to find markets and earn foreign currency than those without such resources. But then plunging global oil prices contributed significantly to Russia’s recession in 2016. countries where political interference in the change mechanism has been minimal have tended to gain in the long term. Those who resisted, or reversed, reforms because of short-term unemployment, for instance, have been slower to improve.
Those countries which have been able to adapt have achieved a number of benefits, including: •
Source: Dianne Averis
• • • • •
higher economic growth (China has averaged over 8% annual growth throughout the past two decades) and the possibility of higher living standards, though China’s 2016 slow-down significantly reduced demand for Australian commodities greater choice and better quality goods and services for consumers as a result of increased trade exposure to new markets and increased earnings of foreign currencies development of strategic links with developed nations acceptance into multilateral trading blocs and organisations such as the World Trade Organization exposure to new technologies and encouragement of innovation/initiative.
The modern centre of Shanghai
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STAGE 2 ECONOMICS
THE ECONOMIC PROBLEM
Transition in the market economies The market economies themselves have not been immune from change. Prior to the global financial crisis of 2008, the governments of many market economies revealed a willingness to reduce their regulation and involvement in the running of their economies, preferring to leave the market forces of demand and supply to determine output. There was a concentrated movement towards globalisation, with the expansion of economic and social ties between countries to allow better access to trade, communication, finance and technology. (Some global issues will be discussed in Key Area 4, later on in this book). The global financial crisis was largely caused by easy credit, deregulation, and the movement of complex financial instruments which hid mountains of debt. Recession was experienced in most major economies, and with attempts at recovery after the crisis came the call for wider re-regulation, in an attempt to avoid a repeat of the worst financial crisis since the Great Depression of the 1930s. The USA imposed new restrictions on its financial sector, and the G20 countries agreed in 2010 that strengthening of the international financial regulatory system was imperative. To strengthen the financial stability of the world’s banking system, a voluntary, global code of conduct, known as Basel III, has been adopted by many countries, with implementation to be completed before 2019. One of the key requirements to limit bank collapses (and ensuing financial panic), is that banks must hold sufficient liquid assets to cover their total cash outflows over a month. Thus banks should be able to meet their obligations in the short term if consumers or firms suddenly want to make cash withdrawals. From 2008 to 2012, 465 banks failed in the USA alone.
Questions A. Multiple choice questions 1. The government’s raising of a sales tax on luxury cars would be primarily intended to affect the: J K L M
‘WHAT’ to produce question ‘HOW’ to produce question ‘HOW MUCH’ to produce question ‘FOR WHOM’ to produce question. Answer:
2. Economics is the study of relative scarcity. Relative scarcity means: J K L M
insufficient money to buy essential goods and services insufficient food to keep the population at a reasonable level of health insufficient resources to satisfy all wants and needs in an economy insufficient capital goods to produce all essential services. Answer:
3. A feature of the Chinese economy since the late 20th century has been: J K L M
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greater use of labour intensive production methods technological advance, which has led to drops in pollution levels greater government control over the economy significant foreign investment into China as the country has embraced the market mechanism. Answer:
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