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COMPAK | ECONOMICS UNIT 3

ECONOMICS UNIT 3

Key concepts in Area of Study 1

CHRISTOPHER CHRISTIES | PENLEIGH AND ESSENDON GRAMMAR

The following article examines a number of concepts covered in Area of Study 1 in VCE Economics Unit 3 (Australia’s Economic Prosperity) including the types of efficiency, perfect competition, efficiency in resource allocation, common access resources and the law of unintended consequences. Area of Study 1 in the reaccredited study design focuses on the market system, resource allocation and government intervention. Also included are review questions, activities and an exam-style question.

TYPES OF ECONOMIC EFFICIENCY

The term ‘economic efficiency’ refers to a state in which every resource available is allocated optimally and reallocating the resource will not result in any one person being better off without making another person worse off. Given the basic economic problem of relative scarcity, it is paramount that economies achieve an efficient allocation of resources in order to maximise society’s living standards or wellbeing. This requires the attainment of four types of efficiency that are interconnected. They are:

productive (or technical) efficiency

allocative efficiency

dynamic efficiency

inter-temporal efficiency.

Productive (or technical) efficiency occurs when a business or an economy extracts as much output as possible from a given quantity of resources. Therefore, it follows that goods and services are being produced at the lowest possible cost. Allocative efficiency, on the other hand, occurs when those goods and services that society values most are produced, so that living standards are maximised.

vcta.asn.au | published March 2017 | © VCTA and Christopher Christies


Economists generally believe that free and competitive markets coupled with consumer sovereignty, that is, where consumers have the power to determine how resources are allocated by ‘casting dollar votes’, is the best way to achieve an efficient allocation of resources. However, in practice, some markets are dominated by one seller or a few large sellers that compromise consumer sovereignty. So it is conceivable that an economy can be achieving productive efficiency without achieving allocative efficiency, if it is producing the maximum amount of output from its resources but is not producing those goods and services most valued by society.

However, it is not possible to achieve allocative efficiency without first achieving productive efficiency. This is because failing to achieve productive efficiency necessarily implies that living standards are not being maximised as further gains to efficiency and thus output levels (of the goods and services that society values most) can still be made.

Dynamic efficiency occurs when resources are reallocated as quickly as possible in order to achieve allocative efficiency. The absences of market impediments combined with businesses that are highly responsive to the needs of consumers are important preconditions for achieving dynamic efficiency. Some businesses, such as the Australian subsidiary of the Ford Motor Company, were criticised in some quarters for lacking dynamic efficiency. Over the past decade, Australian consumers increasingly opted for small, fuel-efficient cars, such as diesel-powered and hybrid vehicles rather than the large six-cylinder family sedans manufactured by companies, such as Ford and GM Holden at their plants in Victoria and South Australia. This lack of responsiveness to the changing tastes and preferences of Australian consumers, perhaps because of management inertia, is one of many factors that led to the demise of the car manufacturing industry in Australia.

The best way to encourage efficiency of all kinds is to ensure that markets, whether product or labour, are generally free (only lightly regulated) and competitive.

For a discussion of inter-temporal efficiency refer to the section on public goods and common access resources.

PERFECTLY COMPETITIVE MARKETS AND RESOURCE ALLOCATION

Perfect competition is considered to be the gold standard of market structures as it is compatible with the achievement of an efficient allocation of resources. However, very few real-world markets conform to the ideal of perfect competition. Nonetheless, it is a useful benchmark that can be used to critique other market structures, such as monopolistic competition, oligopoly and monopoly (these other market structures are not covered in this article and do not have to be have to be studied in Economics Units 3 and 4).

The characteristics or features of perfectly competitive markets include:

many buyers and many sellers

homogeneous or identical products

low barriers to entry/exit

perfect information.

The combination of these characteristics results in a complete absence of ‘market power’ among sellers. Consequently, all sellers are ‘price takers’, that is, they must accept the prevailing market price as set by the forces of supply and demand.


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Perfect competition is the market structure that is most likely to result in an efficient allocation of resources. In a perfectly competitive market consumer sovereignty applies, that is, businesses driven by the profit motive allocate resources to the production of those goods and services most valued or wanted by consumers.

Furthermore, because there are low barriers to entry, such as low start-up costs, new businesses can easily enter the market to increase production in response to growing consumer demand. The entry of new businesses ensures that existing ones face competitive pressure helping, to put downward pressure on prices and profits. As a result, businesses will only earn ‘normal profits’. Normal profit is a profit level that is just sufficient to warrant continued participation by businesses in a given market. In addition, every business is a price taker, meaning it has to accept the prevailing market price for what it produces because it is selling a homogeneous or identical product and its share of output only accounts for a tiny fraction of the industry’s total output.

These conditions should result in the production of those goods most wanted by consumers at the lowest possible prices, helping to maximise society’s living standards.

Perfect competition also leads to productive efficiency because businesses are always under pressure to produce goods at the lowest possible cost. These competitive market conditions exist when there are many sellers coupled with ease of market entry. This ensures that output is produced at the lowest possible cost, which, of course is reflected in the prevailing market price. Because products are homogeneous, businesses that attempt to charge more than the prevailing market price would lose product sales to their rivals and be driven out of the market. Also, buyers are well informed, that is, they know what the prevailing market price is and won’t pay any more than that amount.

Perfect competition is best placed to promote productive, dynamic and ultimately allocative efficiency.

The Sydney fish market is an example of a perfectly competitive market where there are many buyers and many sellers, low barriers to entry and homogenous products.



SOURCES OF MARKET FAILURE: PUBLIC GOODS AND COMMON ACCESS RESOURCES

Public goods have two characteristics: they are non-excludable and non-rival in consumption. This means people cannot be prevented from using a public good (non-excludable) and one person’s enjoyment of a public good does not reduce another person’s enjoyment of it (non-rival in consumption). Because of these characteristics people cannot be made to pay for such goods resulting, in what economists call the ‘free-rider problem’. Consequently, businesses are not willing to supply such goods because their inability to charge users prevents them from making a profit, resulting in market failure. This means the market fails to allocate resources efficiently as there is no incentive for profit-motivated businesses to provide such highly valued goods to society. For example, once a lighthouse is erected it is impossible to prevent any single ship from enjoying the benefits that this infrastructure provides. Therefore, it is non-excludable in consumption. Furthermore, when one ship enjoys the benefit that a lighthouse brings, that is, safe passage to harbour, it does not diminish the benefits for all other ships. Hence, it is non-rival in consumption. Other examples of public goods include flood control systems, national defence, streetlights and the judiciary.

On the other hand, common access resources are non-excludable but rival in consumption. For example, fish in the ocean are rival in consumption because when one person catches fish there are fewer fish for other people to catch. However, these fish are considered to be a non-excludable good because of the vast size of the ocean it can be difficult to stop people taking fish out of it. Hence, fish stocks can become easily exhausted or depleted, which is to the detriment of all relying on this resource for their livelihood and also the final users of the resource. Other examples of common access resources relate to the natural environment, such as air quality.

PRIZED BELUGA CAVIARAn interesting illustration of the concept of common access resources is the beluga sturgeon, the source of the prized beluga caviar, found in the Caspian Sea. (Frank 2008, page 121) Prior to the dissolution of the Soviet Union in 1991, beluga caviar although expensive was readily available. This was because the Soviet Union and the Islamic Republic (IR) of Iran, the two nations abutting the Caspian Sea, strictly regulated commercial fishing in the Caspian Sea, forbidding the harvest of smaller beluga sturgeon. However, following the dissolution of the Soviet Union, the Caspian Sea was surrounded by five rather than two nations—the IR of Iran and four independent nations that were formerly part of the Soviet Union (Russia, Kazakhstan, Turkmenistan and Azerbaijan), making the coordination and control of commercial fishing far more difficult. As a result, people fishing beluga sturgeon realised that self-restraint, meaning, refraining from harvesting smaller beluga sturgeon, was not in their immediate economic interest, as they would simply be harvested by rival fishing fleets from the other nations that share this common access resource. The consequences of such action were predictable; stocks of beluga sturgeon plummeted and the price of beluga caviar rose sharply to around A$425 for around 100 grams.

More recently, Russia and the IR of Iran have begun cooperating in an effort to curb overfishing in the Caspian Sea to ultimately protect this common access resource.

Common access resources are similar to public goods as they are non-excludable; in other words, they are available free of charge to anyone who wants to use them. However, common access resources are different in the sense that one person’s use of the common access resource reduces other people’s enjoyment of it. This is not the case for public goods as public goods are non-rival in consumption.



Both public goods and common access resources are instances of market failure, that is, where the interaction of the market forces of demand and supply are unable to allocate resources efficiently. This means allocating them in a way that maximises the living standards or welfare of society. Therefore, there is a strong case for government intervention to address these sources of market failures.

Governments must address the under-allocation of resources to public goods in order to correct the market failure connected to public goods. To do this, a government can provide the public good themselves using taxpayers’ funds. Alternatively, it can subsidise production by the private sector.

The government must aim to ensure that the common access resource in question, such as fish stocks, is used in a sustainable manner, so that future generations are not deprived of them. The inability of future generations to enjoy the benefits that this resource yields will undoubtedly lower their living standards. Managing the resource in order to provide for future generations promotes inter-temporal efficiency. This type of efficiency occurs when resources are appropriately allocated between current consumption and future consumption. The concept of inter-temporal efficiency is closely connected to the idea of sustainable development.

According to the World Commission on Environment and Development report, commonly referred to as the Brundtland Report (1987, page 41) ‘Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs.’

Returning to the example of the common access resource of fish, overfishing occurs when the rate at which fish are caught exceeds the ability of fish stocks to be replenished. This clearly undermines the achievement of inter-temporal efficiency and by extension, jeopardises sustainable development. This is because there is an over-allocation of resources, such as fish, to current consumption and an under-allocation of resources to future consumption. The government can address this problem by issuing fishing licences to control the number of fishing vessels permitted to fish the oceans. Such licences impose quotas on the quantity of fish that can be harvested from the oceans. Furthermore, licences and quotas can be enforced through monitoring by coast guards, police and the Department of Economic Development, Jobs, Transport and Resources. These actions should help strike the right balance between current and future consumption and thus address the market failure associated with common access resources.

THE LAW OF UNINTENDED CONSEQUENCES

This law lies at the heart of many of the possible causes of government failure in markets. The law of unintended consequences says that a government policy will always lead to at least one reaction from either consumers or producers (businesses) that are unanticipated or unintended. Economic agents do not always act in the way that the economics textbooks would predict—this is of course the essence of a social, behavioural science—we do not live our lives in sanitised laboratories where all of the conditions can be controlled. The law of unintended consequences is often used to criticise the effects of government legislation, taxation and regulation. People find ways to circumvent laws, such as developing shadow markets to undermine an official policy and acting in unexpected ways either because of ignorance and/or error.



Unintended consequences can add hugely to the financial costs of some government programs so they become extremely expensive when set against their original goals and objectives. (Government failure 2016)

Levitt and Dubner (2009, pages 138–139) assert that ‘the law of unintended consequences is among the most potent laws in existence. Governments, for instance, often enact legislation meant to protect their most vulnerable charges but that instead ends up hurting them’. They provide a number of examples to illustrate the potency of the law of unintended consequences.

One example is the Americans with Disabilities Act 1990 (ADA), passed by the United States Congress that had the noble intention of protecting disabled workers from discrimination. However, the data revealed that the net result of the ADA was fewer jobs for Americans with disabilities because many employers were so worried they would not be able to reprimand or sack bad workers who had a disability that they avoided hiring such workers in the first place. This outcome was bad for efficiency because a large number of people with disabilities capable of working remained idle. The existence of idle resources necessarily means that output from inputs (or resources) is not being maximised, compromising productive efficiency and therefore allocative efficiency.

Another example relates to the practice adopted by some local governments worldwide of charging households volume-based garbage collection fees. So rather than charging a flat or standard garbage collection fee for all households, those households that placed more bags of garbage for kerbside collection would pay higher fees, while those households that placed fewer bags for collection would be subject to lower fees. This price-based scheme was meant to encourage good behaviour by households, meaning by charging households per bag of garbage, they had a pretty strong financial incentive to reduce their output of garbage.

Some local governments worldwide charge households volume-based garbage collection fees to encourage them to reduce their output of garbage.



What happened in those jurisdictions where this was implemented was in hindsight not all that surprising! For example, in Seattle, Washington, householders stuffed their garbage bags even fuller, a practice known as the ‘Seattle Stomp’. While in Charlottesville, Virginia, some householders dumped their rubbish in nearby forests. In Germany, householders seeking to minimise their garbage collection fees resorted to flushing uneaten food down the toilet. The problem got so bad that the sewer system became infested with rats. In Ireland, the authorities introduced a volume-based garbage tax that unintentionally prompted many householders to burn their garbage in their backyards. The motive behind such behaviour was obvious; households were trying to minimise their garbage collection taxes. This practice was not only bad for the environment but threatened life and limb too. For example, St James’s Hospital in Dublin reported a threefold increase in the number of people presenting at its Emergency Department with burn injuries incurred while setting their garbage on fire.

These schemes intended to minimise waste, slow the rate of resource depletion, reduce the need for landfill and mitigate carbon (CO2) pollution. They are all worthy outcomes for the environment and for the achievement of inter-temporal efficiency; however, policymakers perhaps understandably, failed to predict the unintended consequences of their actions.

Closer to home in Indonesia’s capital city, Jakarta, the authorities introduced 3-in-1 high-occupancy lanes on the major arterial roads leading into Jakarta to deal with the city’s notorious traffic jams (Onishi 2009). In order to use these high-occupancy lanes a vehicle must carry three people: the driver and two passengers. The intention of this well-meaning policy is to encourage carpooling, hence reducing the number of vehicles on the roads and easing congestion. However, this policy inadvertently gave birth to a new ‘profession’, the so-called ‘jockey’. A jockey is a person who is willing to ride in a motorist’s vehicle to make up the ‘numbers’ for a small fee. This enables the motorist to use a presumably ‘fast moving’ 3-in-1 high-occupancy lane provided they have two passengers or jockeys onboard. Jockeys are typically Jakarta’s poor. They are often unemployed and many of them are children. Offering their services is a way of earning a little extra income. People commuting to and working in Jakarta are often prepared to pay jockeys for their services for altruistic motives, namely, a desire to help their socially disadvantaged fellow citizens.

However, this policy did little to relieve the gridlock on Jakarta’s roads as the carpooling that it sought to encourage degenerated into a farce. This is because picking up a couple of jockeys on the way into the city is both cheap and convenient, unlike genuine carpooling that requires far more planning and coordination. So rather than promoting greater productive efficiency, for example by permitting trucks to make more deliveries per hour or reducing the fatigue of workers commuting to Jakarta’s CBD to improve workplace productivity, the 3-in-1 high-occupancy lanes fell well short of their good intentions.

In the United States of America, laws have been enacted in many states that mandate the wearing of seatbelts. Yet again, this is a well-meaning policy aimed at protecting drivers and passengers from serious injury or death. However, such laws have led to an increase in pedestrian and cyclist fatalities. Some economists have suggested that wearing seatbelts makes drivers feel more secure, leading them to drive more aggressively. So it could be argued that these laws did little to reduce the loss in productive efficiency connected with road fatalities and/or injuries requiring hospitalisation and long periods of convalescence before such victims can return as productive members of the workforce.

References

Frank, R. H. 2008, The economic naturalist: why economics explains almost everything, Virgin Books Ltd, London.

Government failure, Tutor2u: http://tutor2u.net/economics/revision-notes/a2-micro-government-failure.html

Levitt, S. D. & Dubner, S. J. 2009, Superfreakonomics, Allen Lane, London.


http://tutor2u.net/economics/revision-notes/a2-micro-government-failure.html

http://tutor2u.net/economics/revision-notes/a2-micro-government-failure.html


ACTIVITIES REVIEW QUESTIONS

1 Explain the relationship between the following pairs of concepts:

a. productive efficiency and allocative efficiency

b. dynamic efficiency and allocative efficiency.

2 Analyse the impact of the market structure of perfect competition on allocative, productive and dynamic efficiency. In your answer, make reference to the characteristics of perfect competition.

3 ‘Over the past decade the Australian car manufacturing industry lacked dynamic efficiency.’ Explain this statement.

4 Explain what is meant by a public good. In your answer, make reference to its characteristics and provide appropriate supporting examples.

5 Explain what is meant by a common access resource. In your answer, make reference to its characteristics and provide appropriate supporting examples.

6 Explain why public goods and common access resources are considered sources of market failure.

7 Describe how the government can correct the market failures connected with public goods and common access resources.

8 Explain the connection between inter-temporal efficiency and sustainable development.

9 Explain what is meant by the law of unintended consequences.

10 Using two examples, explain how the law of unintended consequences can result in inefficient economic outcomes.

SEE/THINK/WONDER

In 1968, Garrett Hardin, an American ecologist, coined the term ‘the tragedy of the commons’. This term describes an economic problem in which individuals tried to gain the greatest benefit from a common access resource so that demand exceeds supply, which harms others who can no longer benefit from the resource.

Click on the link below to view a graphic that illustrates the tragedy of the commons concept. Respond to it by applying the See/Think/Wonder thinking routine.

This routine comprises three key questions:

1 What do you see? For example, what are the key facts? What are the key elements? Describe what you see.

2 What do you think about the topic/event/object?

3 What does it make you wonder? For example, what puzzles you? What questions do you have?

Use these questions to organise your response to the concept of market failure.

Tragedy of the commons graphic link: https://tinyurl.com/hooxxwm



https://tinyurl.com/hooxxwm


CARTOON ANALYSIS Click on the link below to view a cartoon illustrating the tragedy of the commons concept. Use your understanding of common access resources to analyse the cartoon. Analysis essentially involves answering ‘what’ questions, namely:

what are the individual components or parts of the cartoon?

what is the structure or meaning of the cartoon? What key messages are depicted in the cartoon?

what does it make you wonder? For example, what would happen if you changed one of the components?

Tragedy of the commons cartoon link: http://tinyurl.com/hw9cdfl

EXAM-STYLE QUESTION

The following is a sample exam question focusing on market failure.

Question (7 marks)

Compare public goods with common access resources as sources of market failure.

In your response, make reference to two characteristics of each source of market failure and provide appropriate supporting examples.


http://tinyurl.com/hw9cdfl


Teacher notesThis article is designed to help students develop an understanding of some of the key knowledge and apply some of the key skills identified in Area of Study 1 (‘An introduction to microeconomics: the market system, resource allocation and government intervention’).

The reaccredited study design (2017-2021) for Area of Study 1 in VCE Economics Unit 3 contains some new content, namely it has not been in a previous study design or was only implied. However, some content from the 2010-2016 study design has been reallocated to Area of Study 1.

New content includes:

common access resources

types of efficiency (allocative, productive, dynamic and inter-temporal).

This article focuses on selected key knowledge and key skills from Area of Study 1. These are studied in the context of students being able to demonstrate Outcome 1:

‘On completion of this unit the student should be able to explain how markets operate to allocate resources, and discuss the effect of government intervention on market outcomes.’

Source: VCE Economics Study Design (2017-2021), VCAA, page 18

It should be noted that a condition of demonstrating this outcome is the use of a contemporary (past two years) real-world case study that illustrates market failure due to inefficient resource allocation, taking into consideration the effectiveness of government intervention.

RELEVANT KEY KNOWLEDGE AND KEY SKILLSKey knowledgeThis resource addresses the following key knowledge outlined in Area of Study 1 in Unit 3:

the nature of, and conditions for, a perfectly competitive market

the effects of changes in supply and demand on equilibrium prices and quantity traded

the meaning and significance of economic efficiency: allocative efficiency, productive efficiency, dynamic efficiency and inter-temporal efficiency

the effect of competitive markets on the efficiency of resource allocation

reasons for market failure: public goods … common access resources

the role and effect of … subsidies, government regulations … as forms of government intervention in the market to address market failure

one contemporary example of government intervention in markets that unintentionally leads to a decrease in the efficiency of resource allocation.

Note: The effect of competitive markets relates only to perfectly competitive ones.




Key skillsThis resource addresses the following key skills outlined in Area of Study 1 in Unit 3:

define key economic concepts and terms and use them appropriately

evaluate the role of the market in allocating resources

explain the effect of government intervention in markets.

Source: VCE Economics Study Design (2017-2021), VCAA, pages 18-19

CARTOON ANALYSIS

Students may need some further guidance when analysing the cartoon, in addition to the prompts provided by the three key questions of the See/Think/Wonder thinking routine.

what are the individual components or parts of a problem/object/event? These could be the actions, actors (participants) and information. So the first question (or requirement of analysis) is to identify the key elements or parts of the cartoon.

what is the structure or meaning of the problem/object/event? This would involve explaining the relationship between each of the components and identifying what is being achieved through these interactions. What key messages are depicted in the cartoon?

what does it make you wonder? This involves thinking about the possible effects of changing some of the components and/or relationships, for example the effect on output if a variable is changed, such as imposing a fishing quota (action).

Source: Harvard Graduate School of Education, Project Zero, See/Think/Wonder, Harvard University, http://www.pz.harvard.edu/resources/see-think-wonder-0

EXAM-STYLE QUESTION

This suggested marking guide can be used when assessing student responses to the sample exam question in the ‘Activity section’ on page 10.

2 marks for identifying and explaining the two characteristics of each of public goods and common access resources, and 1 mark for highlighting how they are different yet similar.

2 marks for providing correct examples of a public good and a common access resource.

2 marks for explaining the meaning of market failure by making reference to the fact that public goods result in an under-allocation of resources, while common access resources result in an over-allocation of resources to current consumption and an under-allocation of resources to future consumption.


http://www.pz.harvard.edu/resources/see-think-wonder-0


WHOLE-CLASS ACTIVITY

All of the above-listed student activities can be undertaken independently; however, the following whole-class activity requires teacher direction. It focuses on common access resources.

Click on the ‘classroom activities’ link, scroll down to the Paper Clip Activity (page 2), and follow instructions.

Classroom activities link: http://billofrightsinstitute.org/wp-content/uploads/2013/07/FEE-Activities-for-Founders-Fellowship.pdf

Source: Classroom activities: a high school teacher’s guide, Founders Fellowship, Queensland Government.

FURTHER READING

The following resources are referred to in the article.

Onishi, N. 2009, ‘Finding a detour to earn a living in Indonesian traffic jams’, The New York Times, 12 May 2009, http://www.nytimes.com/2009/05/13/world/asia/13indo.html?_r=0

World Commission on Environment and Development 1987, Our common future, United Nations, http://www.un-documents.net/our-common-future.pdf

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Disclaimer: These student activities have been written by the author (Christopher Christies) for use with students of VCE Economics. This does not imply that it has been endorsed by the Victorian Curriculum and Assessment Authority (VCAA). The current VCE Economics Study Design (2017–2021) can be accessed directly via the VCTA website. VCE is a registered trademark of VCAA. While every care is taken, we accept no responsibility for the accuracy of information or advice contained in Compak. Teachers are advised to preview and evaluate all Compak classroom resources before using them or distributing them to students.


http://www.vcaa.vic.edu.au/Pages/vce/studies/economics/economicsindex.aspx

http://www.un-documents.net/our-common-future.pdf

http://www.nytimes.com/2009/05/13/world/asia/13indo.html?_r=0

http://billofrightsinstitute.org/wp-content/uploads/2013/07/FEE-Activities-for-Founders-Fellowship.pdf

http://billofrightsinstitute.org/wp-content/uploads/2013/07/FEE-Activities-for-Founders-Fellowship.pdf

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