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microeconomic issues
Competing uses:
decisions need
to be made
Focus questions and inquiries
• What is microeconomics?
• How can cost–benefit analysis assist in making economic decisions?
• How might individuals and businesses use cost–benefit analysis when making
economic decisions?
• What are some contemporary microeconomics issues?
• Why do governments develop microeconomic policies and seek microeconomic
To provide a basis for answering such questions and carrying out such inquiries,
this chapter will examine the following:
the nature of microeconomics
some contemporary microeconomic issues
the cost–benefit analysis model
individual and business economic decision making
government and microeconomic issues.
7.1 What is microeconomics?
Economic data update
Log on to Pearson Places and follow the prompts to the Australian Productivity
Commission. Find updated data for the following statistics for Australia.
• Productivity improvement over time
• Current microeconomic reform initiatives
Macroeconomics: the study of the economy as a whole, dealing in aggregates such
as employment levels and overall price changes
Microeconomics: the study of decisions that people, businesses and governments
make regarding the allocation of resources and prices of goods and services
Economics enrichment
Steven D. Levitt received his BA from
Harvard University in 1989 and his
PhD from Massachusetts Institute of
Technology in 1994. He has been a
Professor of Economics at the University
of Chicago since 1997 and the recipient
of the 2003 John Bates Clark Medal,
which is awarded to the most influential
economist in America under the age of
40. In 2004, Levitt helped to establish the
Becker Center on Chicago Price Theory
at the university and was appointed the
director of the centre. More recently, he
was named one of Time magazine’s �100
People Who Shape Our World’.
Levitt has worked in various fields of
economic enquiry, such as crime, politics
and sports, and has been the author of
more than 60 academic publications.
During his career, he has acquired a
reputation for asking questions about
the world that are not only tough but
also unexpected. Before he and fellow
economist Stephen J. Dubner wrote
the best-selling Freakonomics: A rogue
economist explores the hidden side
of everything in 2006, and its sequel
Superfreakonomics: Global cooling,
patriotic prostitutes and why suicide
bombers should buy life insurance in
2009, Levitt was already well-known for
papers such as The Impact of Legalized
Abortion on Crime (2001). In this paper,
In previous chapters in this book, we examined the price mechanism (Chapter 2),
and personal economics (Chapter 3). Both of these chapters dealt with some aspects
of microeconomics, in that they demonstrated how the economic decisions that
individuals make help to determine prices of goods and services.
The branch of economics that investigates and explains the market behaviour
of individual consumers and businesses is called microeconomics. It attempts to
understand and explain the decision-making processes of households and businesses
within an economy. Microeconomics is concerned with the interaction between
individual buyers and sellers and the factors that influence the decisions made by them.
In particular, it focuses on patterns of supply and demand and the determination of
price and output in individual markets.
Microeconomics deals with the economic decisions made at a small, or micro,
level. Hence, it covers an analysis of the decisions made by individuals and businesses,
the factors that affect those decisions and how those decisions affect others.
The economist investigating microeconomic decisions is likely to be looking at
questions such as those below.
• How can a specific company maximise its production and capacity so that it can
lower its prices and better compete in its industry?
• How would a change in the price of a good influence a household’s purchasing
• If my salary increases, should I work more hours or fewer hours?
• What determines how much a consumer will save?
• Why do people buy both insurance and Lotto tickets?
Microeconomics also deals with the effects of national economic policies (such as
changing taxation levels) on the decisions and behaviours of individuals and businesses.
Microeconomic decisions by both individuals and businesses are motivated by
cost and benefit considerations. Costs can be either in terms of financial costs, such as
averaged fixed costs and total variable costs (see Chapter 8) or they can be in terms of
opportunity cost, which assigns a value to alternatives foregone.
The general concern of microeconomics, then, is the efficient allocation of scarce
resources between alternative uses. More specifically, it involves the determination of
price through the optimising behaviour of economic decision makers, with individuals
maximising satisfaction and firms maximising profit.
co-authored with John Donohue, he
showed that the legalisation of abortion
in the US was followed approximately 18
years later by a reduction in crime. Levitt
contended that unwanted children commit
more crimes than wanted children; that
legalising abortion resulted in fewer
unwanted children; therefore fewer
crimes were being committed as these
children reached the age at which criminal
activity often begins. In another example
(An Economic Analysis of a Drug-Selling
Gang’s Finances, 2000) Levitt analysed
the accounts of a criminal gang and drew
some conclusions about the distribution of
income among gang members.
His co-author of Freakonomics,
Steve Dubner, writes: �As Levitt sees it,
economics is a science with excellent tools
for gaining answers but a serious shortage
of interesting questions. His particular gift
is to ask such questions …’
Many people—including some of his
peers—might not consider Levitt’s studies
as economics. But he has challenged the
so-called dismal science by returning to
its most basic aim: explaining how people
get what they want. Levitt and co-author
Stephen J. Dubner show that economics
is, at root, the study of incentives—how
people get what they want, or need,
especially when other people want or
need the same thing.
7.1 Explain the difference between microeconomics and macroeconomics.
7.2 List five microeconomic questions that a microeconomist might investigate.
226 Economics for the Real World 1
7.1.1 Macroeconomics
Macroeconomics, on the other hand, is a field of economics that examines the
behaviour of the economy as a whole. This looks at economy-wide data, such as Gross
Chapter 7 Contemporary microeconomic issues
7.1.2 Applications of microeconomics
7.2.1 Issues facing the individual
There is a range of specialised areas of study in which microeconomic tools are
applied. Industrial management and regulation deals with areas such as the entry
and exit of firms, innovation and the role of trademarks. Law and economics applies
microeconomic principles to the selection and enforcement of competing legal regimes
and their relative efficiencies. Labour economics is the study of employment conditions,
wages, and labour market changes. The design of government taxation and spending
policies and the economic effects of these is dealt with in public finance. Health
economics examines the organisation of health care systems, including the role of
the health care workforce and health insurance programs. Urban economics, which
examines the issues faced by cities and towns, such as sprawl, air and water pollution,
traffic congestion and lack of green space, also draws on the fields of urban geography
and sociology. There are many other applications in other fields too: economic history,
financial planning, financial analysis and accounting all use elements of microeconomics.
be aircraft noise over suburbs close to the airport, or a dispute over the use of public
land for private purposes. In everyday life, we are constantly faced with issues.
What makes an issue a microeconomic issue? Obviously, a microeconomic issue
is one that affects our economic decision making and which has implications for the
efficient allocation and use of resources to satisfy our wants.
7.3 List an additional four areas in which you might find microeconomics being used.
7.4 In what ways are microeconomics and macroeconomics interdependent? Give
specific examples where possible.
As an individual within an economy, there are many microeconomic issues that we
face on a day-to-day basis. These can be as simple as deciding what is the best use we
can make of our time, or whether we should buy a new car or a used car.
It would be obvious that all individuals want to maximise the satisfaction they
can obtain from their available resources. For many of us, this may mean some of the
following issues need to be considered.
• Should I work longer hours or should I have more relaxation time?
• Is a laptop computer or a desk computer the best for my needs?
• Should I invest in superannuation or should I go on holiday?
• Will I continue to make as many calls on my mobile phone if the price of calls
These are but a few examples of issues that we all face frequently. Sometimes, we
make rushed decisions when answering these questions, without really considering the
costs and benefits of such decisions. At other times, we take longer to make a decision,
such as when deciding to rent a house or purchase a house.
More generally, decision making is a thought process of selecting a course of action
from among multiple alternatives. Common examples include shopping and deciding
what to eat. Decision making is said to be a psychological construct. This means that
although we can never �see’ a decision, we can infer from observable behaviour that a
decision has been made. Therefore we conclude that a psychological event that we call
�decision making’ has occurred. It is a construction that implies commitment to action.
That is, based on observable actions, we assume that people have made a commitment
to effect the action.
In general there are three ways of analysing consumer buying decisions.
1 Economic models. These models are largely quantitative and are based on the
assumptions of rationality and near-perfect knowledge. The consumer is seen to
maximise their utility. However, as we probably know, consumers seldom have
perfect knowledge of a market.
2 Psychological models. These models concentrate on psychological and cognitive
processes such as motivation and need recognition. They are qualitative rather than
quantitative and build on sociological factors such as cultural and family influences.
3 Consumer behaviour models. These are practical models used by marketers. They
typically blend both economic and psychological models.
Clearly, as consumers, we would be better off if we made conscious decisions based
on market knowledge. Carrying out a cost–benefit analysis would enable us to be
better informed.
National Product (GNP), and how it is affected by changes in unemployment, national
income, rate of growth and price levels. For example, macroeconomics would examine
how a decrease or increase in employment would affect the country’s GNP, or how a
change in interest rates would affect investment in the economy.
While these two areas of economic study appear to be different, they are
interdependent and complement one another since there are many overlapping issues
between the two areas. For example, increased inflation (a macro effect) would cause
the price of raw materials to increase for companies and in turn affect the price
charged to the public for the end product (a micro effect).
In essence, microeconomics takes a bottom-up approach to analysing the economy
while macroeconomics takes a top-down approach. Regardless, both micro- and
macroeconomics provide fundamental tools for anyone and should be studied together
in order to fully understand how companies operate and earn profit, and thus how an
entire economy is managed and sustained.
Individual decision making is affected by a large number of factors—some
measurable to a certain degree, some not—and predicting the behaviour of individuals
is, at best, an inexact science. However, microeconomics provides enough data to
build a case for probable consumable behaviour. How businesses use this data and its
implications is dealt with in Chapter 8.
7.2 Microeconomic issues
To examine microeconomic issues, we need to understand what an �issue’ is. An issue
is an area or policy that is in debate or need of change. An example of an issue would
7.5 Why are individual decisions important to the economy?
228 Economics for the Real World 1
Chapter 7 Contemporary microeconomic issues
• business regulation
• labour relations
• education and training
• health regulations in the food industry
• tariff reform.
The above would all be issues in productivity improvement, thus making firms more
efficient and contributing to better use of scarce resources.
7.6 What is decision making?
7.7 What models can be used to analyse decision making?
Economics in action
Complete a media scan to identify issues facing the individual within the economy.
Compile a list of these and share your findings with other students in a group. Which
issues were included on more than one list? Why would this be? Which issues might
lend themselves to greater economic analysis?
7.8 Why should businesses analyse most decisions that they need to make very
7.9 a Using a newspaper, find three examples of decisions that a business has
b From these articles, is there any evidence to suggest that the business had
alternative possibilities to their final choice? If so, what were the choices?
7.2.2 Issues facing businesses
Economics in action
We have already found that the aim of the entrepreneur is usually to maximise profits.
This is a fundamental principle of economics. Hence, issues faced by businesses are
those that would be a barrier to maximising profits. The entrepreneur is keen to
improve the operation of his/her business so that greater profit can be made.
There will be many issues facing each and every business at any point in time.
Some of these are listed below.
• Should the business use available technology to a greater degree?
• Would workplace reform enhance the business?
• Will expanding production increase my profit?
• What will happen if another competitor reduces the price of a good?
• How can I afford to pay a higher level of superannuation for my employees?
Some issues are not limited to just one business—they may be issues faced by all firms
in an industry. For example, a new government regulation requiring more stringent
standards of pollution control or the reduction of the tariff on imported motor
vehicles will affect more than one firm.
Complete a media scan to identify issues facing businesses within the economy.
Compile a list of these and share your findings with other students in a group. Which
issues were included on more than one list? Why would this be? Which issues might
lend themselves to greater economic analysis?
7.10 How are businesses affected by decisions made by governments? Is it desirable
that governments make decisions that affect business performance?
Economics in action
Complete a media scan to identify issues facing governments within the economy.
Compile a list of these and share your findings with other students in a group. Which
issues were included on more than one list? Why would this be? Which issues might
lend themselves to greater economic analysis?
7.3 Opportunity cost
Resources are limited, wants are not; therefore decision makers must make
choices regarding how best to use their resources.
Opportunity cost: the best alternative opportunity foregone when a choice is made.
Often referred to as �real cost’ or �economic cost’; for example, being unable to
study chemistry because you chose to study economics
7.2.3 Issues facing governments
Opportunity cost value: the value of the net benefit associated with the next best
Every business operates within a wider economy and there will be numerous
microeconomic issues within the economy as a whole. Some of these will be addressed
by governments at all levels, and could include:
• taxation reform
• emissions trading
Scarcity: insufficiency relative to wants—a universal problem, because the resources
available for the satisfaction of human wants are limited while wants appear to be unlimited
230 Economics for the Real World 1
Chapter 7 Contemporary microeconomic issues
7.11 How can it be that there is an opportunity cost to every decision made in
7.12 Why is it difficult to place a dollar amount on every example of opportunity cost?
7.13 Why is it important to value both the choice you make and the alternative
course of action? How do you decide which choice is the best to make?
7.4 Cost–benefit analysis
Benefits: the positive factors of a project or policy
Cost–benefit analysis: the process whereby a project or policy is assessed for its
social and welfare benefits as well as the financial return on a project or policy
Costs: the negative factors of a project or policy
Externalities: indirect costs and benefits associated with the production and
consumption of certain goods and services that the market fails to take into
Internalisation of costs (benefits): inclusion of all the costs (benefits) into market
The cost–benefit model states that decision makers should only take a
particular course of action if they expect benefits to be equal to or greater
than the expected costs. Application of this model allows limited resources
to be used in a way that achieves the highest possible level of satisfaction.
Social costs (benefits): costs (benefits) that are suffered (enjoyed) by a group, or
society as a whole
The concepts of scarcity and opportunity cost were discussed in Chapter 1. While it is
relatively easy to state that the opportunity cost of a decision to buy a DVD is the trip
to a theme park that you had to forego, it does not really tell us much.
Opportunity cost is one way to measure the cost of something. It is easy to add up
all the costs associated with a project and show that the total cost is $5 million, for
example. Opportunity cost identifies the next best alternative way to spend $5 million.
The foregone profit of this next best alternative is the opportunity cost of the original
decision. A simple example might be a person who owns two houses. He chooses to
live in one and can then either rent the other one to tenants or allow his son/daughter
to live in it free of charge. Clearly the opportunity cost of the decision to allow his
child to use it is the lost rental income. In another example, the opportunity cost of
choosing a vacation in Europe might be the deposit money for a house.
You should be aware that opportunity cost is not the total of the available
alternatives but rather the benefit of the single, best alternative. Possible opportunity
costs of choosing to build a sports stadium on vacant land might be that the land is no
longer available to develop as parkland, as a site for a new hospital or for sale, or the
loss of other possible uses—but not the total of all of these. The true opportunity cost
would be the forgone profit of the most lucrative of those listed.
It is often difficult to place a dollar value on everything, so that an accurate
comparison of benefit and opportunity cost can be assessed. For example, how does
one place a dollar value on the loss of scenic beauty on the Great Barrier Reef when
an oil tanker spills its load after running aground on the reef? Often, we are asked to
make subjective choices with ethical and moral implications.
It is imperative to understand that nothing is free. No matter what one chooses
to do, you are always giving something up in return. Opportunity cost is more than
alternatives forgone. It can also be defined as the value of the net benefit associated
with the next best alternative. This means there is a need to make a cost–benefit
analysis of each alternative before making a choice. Only when the net benefit of all
alternatives can be ascertained can the true opportunity cost be determined.
In Chapter 1, you were introduced into the basic principles of cost–benefit analysis
(CBA) as a tool for an economist to use when making economic decisions. You should
review this section again (Chapter 1 Section 1.2) so that you revise the basic principles
of CBA.
Cost–benefit analysis tests the economic viability of an existing or proposed
activity, and/or compares two or more ways of doing something. Because of prevailing
social and economic structures, the standard of measure generally used is money. This
may result in difficulties establishing the worth of �un-priced values’ such as scenery,
clean air and personal happiness.
Cost–benefit analysis involves subtracting the monetary costs of a development
from the monetary value of all the benefits generated by the same development to
obtain a net monetary benefit or cost for the proposed activity. Benefits or costs for
various options for a particular project can be compared. Usually the method with the
highest monetary benefit is selected by the decision maker.
The principles of CBA are simple:
1 Appraisal of a decision. Cost–benefit analysis is an economic technique for
appraising a particular decision that has to be made and is widely used by
individuals, businesses and governments (for example, should a business invest in a
new information technology system).
2 Incorporation of externalities into the decision. It can, if needed, include the wider
social/environmental impacts as well as �private’ economic costs and benefits
so that externalities are included into the decision process. This is known as
internalisation of costs and benefits. In this way, CBA can be used to estimate the
social welfare effects of an investment.
3 Time matters. Cost–benefit analysis can take account of the economics of time
(known as discounting). This is important when looking at environmental impacts
of a project in the years ahead.
7.14 What is the purpose of a cost–benefit analysis?
7.15 What are the three principles that need to be considered when carrying out a CBA?
232 Economics for the Real World 1
Chapter 7 Contemporary microeconomic issues
7.4.1 Who uses cost–benefit analysis?
In the government sector, CBA has traditionally been used for comparing
alternative courses of action by reference to the net social benefits that they produce
for the community as a whole. It is used when examining public sector projects such as
new motorways, dams, tunnels, bridges, flood mitigation schemes, new power stations
and other infrastructure projects.
The basic principles of CBA can be applied to many other government programs;
for example, a public health program (such as a child immunisation scheme), an
investment in a new rail safety system or the construction of a new hospital. Another
example might be to use CBA in assessing the costs and benefits of raising taxes
on petrol or cigarettes, or the costs and benefits of a refugee settlement scheme.
Increasingly, the principles of CBA are used to evaluate the returns from investment in
environmental projects, such as wind farms or the installation of solar panels on roofs.
Because financial resources are scarce, CBA allows different projects to be ranked
according to those that provide the highest expected net gains in social welfare. This is
particularly important, given the limitations on government spending.
Cost–benefit analysis can be used by people at all levels when making decisions
regarding economic value. The basic principles of CBA are such that households,
businesses and governments are all able to use CBA when making an economic
decision. This is shown in Figure 7.1.
Income (Y)
Consumer expenditure on goods and services (C)
Savings (S)
7.16 We have discussed the fact that individuals, businesses and governments use
CBA. Is it possible that the financial sector and the external sector would also
use CBA? Why do you think this would be the case?
Investment expenditure (I)
Imports (M)
Figure 7.1 The circular-flow model
Exports (X)
7.18 Is it possible that a government might choose a project with a lower net social
benefit than another project? Why might this be so?
Government expenditure (G)
Income taxes (T)
7.17 What are social benefits? Why are governments interested in these?
A household might use CBA when deciding issues that affect their economic
decisions. While many households are unlikely to carry out a fully-costed CBA
for every decision they make, they do consider the opportunity cost of decisions.
Questions as simple as: should I work overtime tonight or should I spend time with
my family; should I buy take-away food or cook my own; should I purchase a new car
or a second-hand car—all are examples of decisions that households make. Obviously
the larger the monetary cost of the decision, the more time is taken to make that
decision, and the more likely it will be that the household will appraise the costs and
benefits of that decision.
Business makes great use of CBA when making business decisions. Virtually all
major projects undertaken by businesses are subjected to a CBA in the planning stage
of a project, and before any decisions are made to proceed with the project. This might
be as simple as choosing whether to buy a PC or an Apple computer, or it could be as
complex as deciding whether to develop a new coal mine costing in excess of a billion
dollars. Whatever the decision, businesses need to be sure that it is the correct decision
for their business. An incorrect decision might be very costly indeed.
234 Economics for the Real World 1
7.4.2 Cost–benefit analysis as a process
Choosing between two alternatives, decision makers should make the
choice that maximises their economic surplus.
Discounting: valuing future costs and benefits using a lower level of value than the
one used to value present costs and benefits
Intangibles: costs or benefits that resist quantification
Net benefits: benefits less costs
Net present value (NPV): the present value of the current benefits plus discounted
future benefits less the present value of the current costs and discounted future
costs of a project
Sunk costs: retrospective (past) costs that have already been incurred and cannot be
Chapter 7 Contemporary microeconomic issues
While there is a variety of ways in which CBA can be undertaken, any CBA would
involve a number of steps and principles. These are shown in Figure 7.2.
Similarly, for each alternative, a list of costs should be drawn up. These might include:
• capital expenditure
• ongoing costs such as operational and maintenance costs for the life of the project
• labour costs
• costs of other inputs (materials, transport etc)
• research, design and development costs
• opportunity costs associated with using land and other resources
• harmful effects such as pollution.
Identify the alternatives
Identify the costs and benefits
Quantify/value costs and benefits
Not all costs and benefits are in the form of money. However, economists
have techniques to assign dollar values to all costs and benefits in order to
facilitate a comparison.
Tangible costs and benefits
Quantify/value costs and benefits
Intangible costs and benefits
Discount the future value of benefits
(calculate the net present value)
Figure 7.2 Using CBA to compare alternatives
Compare costs and benefits and net rate of return
Compare net rate of return from different options
There should be a sufficient number of alternatives to provide the decision maker
with real scope for exercising choice. Alternatives should also be able to be clearly
distinguished from each other. A �do nothing’ alternative should always be identified.
This is useful because costs and benefits are always incremental to what would have
happened if the project had not advanced.
Costs and benefits
A list of benefits likely to occur as a result of the decision should be compiled. The list
of benefits might include:
• the value of revenues generated by the decision
• avoided costs; that is, costs that would have occurred in the �do nothing’ situation
• productivity savings
• health, environmental and other social benefits.
236 Economics for the Real World 1
Cost–benefit analysis compares costs and benefits using a common measure, preferably
dollars. For this to be possible, values must be assigned to as many of the costs and
benefits as possible.
Market prices, where they exist, provide a great deal of information concerning the
value of costs and benefits. In most markets, consumers at the margins are willing to
pay no more or no less than the actual price in the market. Accordingly, that price can
usually be taken as a measure of the value placed by society on the good or service.
The price of inputs usually reflects the value that alternative users of these inputs place
upon them. However, actual prices sometimes have to be altered to convert private
costs and benefits into social ones; that is, costs and benefits that reflect gains and
losses to the economy as a whole rather than to individual persons or groups.
Costs and benefits must be estimated for the whole period of the project or
decision. Hence forecasting is a key part of valuing costs and benefits. Forecasters
often overestimate the rate of growth of benefits and underestimate the rate of growth
of costs.
Costs and benefits that cannot be quantified are called �intangibles’ and should
be considered by the decision maker so that they can be weighed up alongside the
quantifiable variables in the decision-making process. It may be that some costs and
benefits can be measured in physical units but not in money terms; for example,
complex pollution effects. Factors with unpriced values include wilderness areas,
pleasant views, pure water, spiritual values, cultural traditions, diverse gene pools
and functioning ecosystems. Economists agree that these unpriced values have worth.
However, their monetary value is difficult or impossible to establish, and these values
are very open to personal interpretation.
Discount future values
Costs and benefits accrue over time, especially with regard to natural resource
development. In a simplified example, if an analyst chose to examine only the last
three years of a timber management development, the analysis would be distorted
because all of the revenue-producing activities would be included (logging, milling) but
many of the costs (regeneration, surveys, protection, environmental damage) may have
been omitted.
Conventional CBA discounts all future costs and revenues to present value at
a set interest rate. This reflects the business principle that money received today is
worth more than money received in the future. The basis of this principle is the belief
Chapter 7 Contemporary microeconomic issues
that a person, given the use of a sum of money for a year, can use the money to earn
profits. Thus, maximising today’s dollars maximises return on investment. If money
cannot be quickly acquired, profits will be lost. Discounting justifies this perception
by calculating a reduced current value for all future income. The discount rate should
generally reflect the opportunity cost of capital—that is, the return on capital foregone
in alternative use of the resources.
7.20 How does valuing the environment present a challenge?
7.21 What are some ethical issues involved in using CBA?
8 10
Comparing different options
Obviously the decision maker, when faced with
an economic problem to solve, should choose the
project that will maximise the net rate of return; that
is, where the difference between costs and benefits is
the greatest, all other things being equal. However,
sometimes decision makers have other priorities
that can affect their decision such as political issues,
ethical issues etc.
Figure 7.3 Two net cost–benefit profiles
7.4.4 Limitations of cost–benefit analysis
7.4.3 Ethics of analysis
7.22 Is it possible that two people carrying out a CBA could arrive at different results?
A CBA is based on a framework of assumptions and decisions. An analysis is a model
of the interaction of economic, social and ecological factors in a study area. As with all
models, a CBA is only as good as the skill of the modellers, and reflects their personal
biases and viewpoints. The combination of personal and/or institutional viewpoints
that shape a CBA can be termed the �ethic’ of the analysis.
Persons with a conserver ethic, for example, will tend to produce an analysis that
places high value on the protection and the ecologically responsible use of natural and
social resources. Diversity within biological and social/economic communities will
be stressed. The community will often be �locally’ defined, such as local towns or a
A person with a short-term profit/technology ethic will be influenced by an
economic principle that states �dollars gained today are more valuable than dollars
obtained tomorrow’. Such an approach relies upon the belief that technology will
overcome any social or biological/ecological problems that arise from human actions.
Given identical information, these two hypothetical people/analysts would likely
come to different conclusions.
The choice of the community, or group of people, to which the cost–benefit
analysis will be limited is also important. Are benefits that accrue to distant
communities, or to corporations external to the local community, sustainable
compensation for costs incurred to the local community and the local ecology?
Conventional cost–benefit analysis indicates that costs to a local community may be
outweighed by benefits to a distant, larger community. Is it acceptable that distant
benefits should not offset local costs to communities?
238 Economics for the Real World 1
Like many models and processes used by economists, CBA has a number of limitations
and criticisms.
• There may be problems in attaching valuations to costs and benefits.
• Not everyone affected may be covered.
• There are distributional consequences.
• Social welfare is not the same as individual welfare.
• Valuing the environment is difficult.
• Valuing human life is impossible.
Some costs are easy to value, such as running costs (e.g. labour) and capital costs
(e.g. new equipment). Other costs are more difficult to value, especially when the
project has a significant impact on the environment. The value attached to the
destruction of a habitat is to some �priceless’ and to others �worthless’. Costs are also
subject to change over time.
Another criticism is that CBA may not cover everyone affected; that is, third
parties. Inevitably, with major construction projects such as a new freeway or a
new tunnel, there are a huge number of potential �stakeholders’ who stand to be
affected (positively or negatively) by the decision. Inevitably, CBA does not include
all stakeholders and there is a risk that some groups might be left out of the decision.
What of future generations, who are not included in the analysis? What of non-human
stakeholders such as the flora and fauna affected?
Costs and benefits may mean different things to different socioeconomic groups.
Benefits to the poor are usually worth more. Those receiving benefits and those burdened
with the costs of a project may not be the same. Are the losers to be compensated? To
many economists, the equity issue is as important as the efficiency argument.
Social welfare may not be the same as individual welfare. What we want
individually may not be what we want collectively. Do we attach a different value to
those who feel �passionately’ about something (e.g. the building on former open space)
contrasted with those who are ambivalent about the project?
In terms of valuing the environment, how are we to place a value on public
goods such as open space, clean air and water, and scenic beauty when there is no
market established for the valuation of these? How does one value �nuisance’ and
�aesthetic values’?
Some measurements of benefit require the valuation of human life. Many people
are intrinsically opposed to any attempt to do this. This objection can be partly
overcome if we focus instead on the probability of a project �reducing the risk of
death’, and there are insurance markets in existence that tell us something about how
much people value their health and life when they take out insurance policies.
Net benefits ($m)
7.19 Why do economists try to place dollar values on all costs and benefits?
Compare costs and benefits
To facilitate comparison between alternatives, it
may be desirable to compile a graphic profile of net
benefits–total costs less total benefits. Figure 7.3
shows two net cost–benefit profiles.
Chapter 7 Contemporary microeconomic issues
A CBA will only be as good as its design brief and the assumptions it makes. It
compares a project scenario with an alternative scenario based on estimates of what
would have happened in the absence of the project. Any margin for error in the
specification of the alternative scenario is carried over into the project analysis. The
analysis itself may be rather obscure. However, the analysis will only be as good as its
assumptions and these should always be set out as clearly as possible.
Sunk costs
7.25 What is the opportunity cost of sunk costs? Are they capable of being put to
alternative uses?
7.24 Why should sunk costs be included in a CBA?
7.26 Why is CBA useful in resource allocation decisions?
There are certain pitfalls that decision makers routinely encounter.
In economics and business decision making, sunk costs are retrospective (past) costs
that have already been incurred and cannot be recovered. Sunk costs are sometimes
contrasted with prospective costs, which are future costs that may be incurred or
changed if an action is taken. Both fixed costs (that is, costs that are not dependent on
the volume of economic activity, however measured) and variable costs (dependent on
volume) may be either retrospective (sunk) or prospective costs.
In traditional microeconomic theory, only prospective (future) costs are relevant to
an investment decision. Traditional economics proposes that when a decision is made
it should not be influenced by sunk costs, because doing so would not be rationally
assessing a decision exclusively on its own merits.
Evidence suggests this theory fails to predict real-world behaviour. Sunk costs in
fact greatly affect participants’ decisions, because humans are inherently loss-averse.
Thus it is normal to act irrationally when making economic decisions.
Decision makers may also make rational decisions according to their own incentives,
which may dictate different decisions than would be dictated by efficiency or profitability.
This is considered to be an incentive problem, which is distinct from a sunk cost problem.
Sunk costs should not affect the rational decision maker’s best choice. However, until
a decision maker irreversibly commits resources, the prospective cost is an avoidable
future cost and is properly included in any decision-making processes. For example, if
you are considering pre-ordering movie tickets, but have not actually purchased them
yet, the cost remains avoidable. If the price of the tickets rises to an amount that requires
you to pay more than the value you place on them, the change in prospective cost should
be figured into the decision making, and the decision should be re-evaluated.
7.4.5 Evaluating cost–benefit analysis
Because cost–benefit analysis seeks to place costs and benefits on a directly comparable
basis, it is well-suited to resource allocation decisions: to situations where choices
must be made between alternative uses of funds and resources. However, the method
can also play a role in effectiveness evaluations, which examine whether a program
is achieving its objectives and whether the objectives themselves are still relevant and
desirable. In essence, the project outcome that is measured in cost–benefit analysis is
the estimated value that consumers place on the goods or services that they purchase
or receive even when the goods or services are not sold in a conventional market.
While this way of measuring effectiveness will not be appropriate in all contexts, the
approach is a powerful one in those situations in which it can be sensibly applied.
240 Economics for the Real World 1
7.5 C
ost–benefit analysis and the
7.23 There are a number of limitations to the use of CBA. Two are environmental
issues and social equity issues. To what extent do these limit the value of CBA?
Individuals are unlikely to complete a detailed cost–benefit analysis for every economic
decision that is made. Most likely, they will make use of the CBA process for major
decisions, such as whether to rent or buy a house, or whether to purchase a new or
used motor vehicle, but for everyday situations, such as choosing whether to buy a
sandwich or a meat pie for lunch, the decision is more likely to be a subconscious one
that does not go through the rigours of CBA analysis.
People face trade-offs by having to give up something to get what they want or
need. This is no surprise for most people, who learn early in life that few things are
free. As an example of a trade-off, many school students give up spending time with
their friends and families in order to do homework and reach their goal of university
Rational people think at the margin. A rational decision maker takes an action if
and only if the marginal benefit of that action is greater than the marginal cost. An
example of this type of decision occurs when you wish to visit your ailing mother, who
lives interstate. You need to decide whether to purchase a last-minute airline ticket at
the most expensive price or wait seven days to get a cheaper ticket. Your other choice
is to drive. The marginal benefits of shorter travel time, fewer days off work, comfort
while travelling and seeing your mother without delay all outweigh the marginal cost
of the more expensive airline ticket.
The principles of economics affect decision making, interaction and the workings
of the economy as a whole because all people make decisions based on what they want
and what is best for them personally.
Let’s look at a simple example of a person making a decision. Each week, Chris
hires a football video that costs about $5. He likes to analyse games, watch worldclass players in action and gain some ideas for when he plays. The videos have really
helped him understand what it is like to play in the best competition. One day he
hopes to play in the national competition as well.
He has just found out that a coaching clinic will be held in his town in ten weeks
but it will cost $50 to attend. He has no savings. If he is to afford the clinic, something
will have to give. Chris decides to do a cost/benefit analysis.
Chapter 7 Contemporary microeconomic issues
Figure 7.4 Chris’s dilemma: weighing up decisions using CBA
Fixed costs: those costs that a firm must meet whether or not any production occurs;
for example, capital equipment and rates
Coaching clinic
$5 per week
Give him lots of information about
football and also help him improve his game
Will have the chance to be
coached in a face-to-face situation
and hear from top-line coaches
As they are videos, he can always
hire them another time
It is a one-off chance
Normal profit: the minimum return that a business is prepared to accept to remain in
Chris decides to save $5 per week and attend the coaching clinic. He can hire the
videos later. What would you do if you were in Chris’s place? Maybe you don’t like
football, but what if you had to decide about something you do care about—such as
whether to go to the movies once a week and have a hamburger afterwards, or go
twice a month, skip the burger and put the money you have saved towards something
else instead. It all depends on you—what your wants are.
Weighing up these decisions is like doing a cost–benefit analysis. Taking the time to
do one can help you make better decisions.
Economics and ICT
Develop an Excel spreadsheet that you could use when conducting a cost–benefit
analysis. Save it to file and then try using it to carry out a CBA relating to the
following issue: �Should I get a part-time job or should I spend my time doing
additional home study?’
7.27 Think of an economic decision that you made today, or recently. Did you
complete a CBA for this decision? Carry out a CBA for that decision now. Did
you arrive at the same decision?
7.6 C
ost–benefit analysis and
The business decisions made by people often reflect a rational evaluation
of benefits and costs, even if they are not consciously aware of this.
Average cost: the cost per unit of output
Average revenue: the return per unit of output
242 Economics for the Real World 1
Total costs: all the costs involved in producing a given volume of output
Total revenue: the total monetary return to the firm when any volume of output
is sold
Marginal revenue: the extra (or marginal) revenue obtained by producing and selling
another unit of output
Variable costs: the costs incurred by a firm whenever production occurs; for example,
power and wages
A business or firm’s main aim is to maximise profit. This is a basic assumption in many
economic models. When a business is maximising profit, the business is in equilibrium
because there will be no incentive for it to either increase or decrease output.
Profit is the difference between the total cost of producing any output and the total
revenue obtained from selling the output. Thus, the equilibrium position of the firm
will be the point or level of production where the difference between total cost and
total revenue is the greatest.
There are a number of cost and revenue concepts that should be understood. Total
costs includes all of the costs involved in producing a given volume of output. Because
costs of production include all expenses involved in bringing a product to market,
total costs will also include a normal profit return to the business. Normal profit is
the minimum return that a business is prepared to accept to remain in business and is
therefore a necessary cost to be met by the business.
Average cost is the cost per unit of output: total cost divided by the number of
units of output. Marginal cost is the addition to total costs that occurs when one
more unit of output is produced. Thus, it is the extra (or marginal) cost involved in
producing another unit of output.
Total revenue is total monetary return to the firm
when any volume of output is sold. Average revenue is
the return per unit of output and is obtained by dividing
total revenue by the number of units of output sold.
Marginal revenue is the addition to total revenue that
occurs when one more unit of the output is sold.
Hence, the equilibrium position of the firm can now
be redefined. The firm always maximises profit when it
produces at the point where marginal revenue equals
marginal cost. This is shown in Figure 7.5.
If the firm whose marginal cost curve (MC) and
marginal revenue curve (MR) are shown in Figure 7.5
is producing output 0Q1, it can increase its profits by
Q1 Q2 Q3
increasing its output to 0Q2 because between 0Q1 and
Units of output
0Q2 the marginal revenue obtained from selling the
extra output is greater than the marginal cost incurred
Figure 7.5 Equilibrium position of the firm
in producing it. Similarly, the firm’s profits will fall if it
Cost + revenue
Marginal cost: the addition to total costs that occurs when one more unit of output is
Football videos
Chapter 7 Contemporary microeconomic issues
Figure 7.7 Schedule of costs for a business
Average cost
Total costs
Marginal cost
Units of output
In all cases, the marginal cost curve (MC) will cut the average cost curve (AC) at
its lowest point. Thus, while marginal cost is less than average cost, the new average
cost will be lower; but as soon as marginal cost exceeds average cost, then average cost
will start to rise.
244 Economics for the Real World 1
7.28 Is it true that a competitive business
will always maximise its profit by
producing at the lowest possible cost
per unit?
7.29 If advertising increases costs, how can
it increase profits?
Cost ($)
7.6.1 Business profit
Units of output
There are four categories in which the profit
of a business may be considered.
Figure 7.8 A firm’s cost curves
1 A firm is said to be making an economic
profit when its average total cost is
less than the price of each additional product at the profit-maximising output.
The economic profit is equal to the quantity output multiplied by the difference
between the average total cost and the price.
2 A firm is said to be making a normal profit when its economic profit equals zero.
This occurs when average total cost equals price at the profit-maximising output.
3 If the price is between average total cost and average variable cost at the profitmaximising output, then the business is said to be in a loss-minimising condition.
The business should still continue to produce, however, since its loss would be
larger if it were to stop producing. By continuing production, the business can
offset its variable cost and at least part of its fixed cost, but by stopping completely
it would lose the entirety of its fixed cost.
4 If the price is below average variable cost at the profit-maximising output, the
business should go into shutdown. Losses are minimised by not producing at all,
since there is no level of production that would generate returns significant enough
to offset any fixed cost and part of the variable cost. By not producing, the business
loses only its fixed cost. By losing this fixed cost the company faces a challenge. It
must either exit the market or remain in the market and risk a complete loss.
Cost per unit of output
produces an output greater than 0Q2, say 0Q3, because after output 0Q2 marginal
costs exceeds marginal revenue for all additional units.
It is important to determine the likely shape of the business’s cost curves for
various levels of output. Costs are either fixed (they do not vary with changes in
output in the short run) or variable. When the business opens its plant and installs
its machinery, it finds that costs fall naturally into these two types. Fixed costs are all
those payments that continue as a constant total amount whether production levels
are high or low. Variable costs are those that increase or decrease in total amount as
production levels rise and fall.
Fixed costs or overhead costs must be met whatever the level of output is. At
higher levels of output, average fixed costs, or fixed costs per unit of output, must fall.
Average variable costs are likely to fall for a time as resources are used more
efficiently, but then they are likely to rise after production passes a certain point. They
will begin to rise because efficiency will begin to
fall and, especially, because higher rewards or
prices will have to be paid to attract the extra raw
materials and labour etc. that are required.
Average total costs (ATC) at any level of
+ AFC)
output will equal average fixed costs (AFC) plus
average variable costs (AVC) at that level of
output. This is shown in Figure 7.6.
Having determined the likely shape of the
average cost curve (AC), we can also consider the
shape of the marginal cost curve (MC). The set
of figures in Figure 7.7 is based on the �U-shaped’
Output per unit of time
curve that is the likely shape of the average cost
curve of any firm operating in any type of market
Figure 7.6 Variable, fixed and total costs
7.6.2 Business decision making
It is important for a business to understand its cost structures so that the decisions it
makes are made with the knowledge of how each decision will impact on costs, and
hence profit.
Businesses draw upon microeconomic data to make a variety of important
decisions, any one of which could mean the difference between profit or loss for
the business. The reliability and current state of the information a business uses is
therefore vitally important.
What a business does with that data is decided by its management team (be it a
sole trader or the world’s largest company).
Microeconomic data may be reduced to mathematical constructs from which
reasoned decisions may be made. We will examine the U-Beaut Clothing Company,
Chapter 7 Contemporary microeconomic issues
which makes and sells men’s clothing. Microeconomic data from this imaginary
company has shown that its customers have a preference for navy blue jeans at a
certain price.
The previous year the company sold 50 000 jeans at $40 each. We will assume
that economic conditions have remained the same. Logic would suggest that at least
another 50 000 navy blue jeans should be manufactured and offered for sale again.
Although that seems logical, is that the best choice to make?
This season the Smart Clothing Company, which competes against U-Beaut, is selling
jeans similar in style and quality to those sold by U-Beaut. Smart Clothing’s jeans are
offered in the market at $36 a pair, 10 per cent cheaper than U-Beaut’s jeans.
How does U-Beaut compete now? Traditional theory suggests a price reduction
should increase demand. If the price of U-Beaut’s jeans is reduced to less than the price
of Smart’s jeans, then theoretically U-Beaut’s jeans would outsell the competition.
But what impact would a reduced price have on the profit margin of U-Beaut?
Would there be sufficient money for marketing its product? Would the reduced profit
impact on its ability to meet repayments on its start-up loan from the bank? Would its
share price be reduced because of the reduced profitability of the company?
It is logical to assume that such questions would be addressed by the management of U-Beaut Clothing Company when it meets to decide what decision to make.
Is there an alternative?
The finance director asks a question: What if U-Beaut increases its marketing and
advertising budget by 5 per cent rather than reduce its profit margin by 10 per cent?
Would more jeans be sold because of the increased marketing, and could U-Beaut
therefore beat its competitor? Microeconomic data has shown that in some cases a
vigorous marketing campaign is often a successful way to beat a competitor.
Another management member states that the economy is good at the moment, but
economic forecasts suggest a downturn in the December quarter of the year—the quarter
that includes the Christmas season, when U-Beaut makes a large percentage of its sales.
When the economy starts to slide during the December quarter, would U-Beaut
be better off selling jeans at a lower price than its competitor, maintaining a profit
that would be lower than the previous year? Although the economy in general is the
study of macroeconomics, its impact on the micro-economy must be considered in the
decision-making process.
There are other variables and unknown factors that need to be considered by
U-Beaut. Consumer tastes may have changed and they may want something new.
Perhaps a different colour is in fashion, or perhaps last year’s jeans were so well made
they are still able to be worn, and consumers won’t need new jeans this year.
All of these factors—the microeconomic data, the questions and issues it raises,
the possible outcomes of alternative choices made in the decision-making process—are
what management must consider to ensure U-Beaut maximises its profitability. A cost–
benefit analysis is an excellent tool for them to use.
Let us look closer at U-Beaut Clothing Company.
It is just one of many firms competing in the jeans market. All aim to maximise
profits. Each business is aware that beyond a certain number of jeans manufactured
and sold, the cost of making an additional pair and selling it returns no more income
to the business than the cost of manufacturing the jeans. In other words, no matter
how many jeans are sold over a certain level of units, the business is breaking even
because costs equal revenues.
What the competition is doing
246 Economics for the Real World 1
Because U-Beaut competes with many other firms, it is involved in what
economists call �perfect competition’. This means that there are many competitors
making the same or similar product, and each of them has a small percentage of the
total market.
In such a market, manufacturers have little or no control over pricing. The price
of the jeans is fixed at the intersection of the market supply and demand curves. Such
businesses are price takers because they have little control over price.
They cannot reduce prices because profit will be reduced. They cannot charge
higher prices because sales will decline, which affects profits. This business reality
leaves competing firms one question: how many pairs of jeans to manufacture, a
decision that will affect their profit.
But how do they decide on the right number? Because the cost of making each
pair of jeans increases as more are made, a theoretical point is reached where making
more eats into profit and eventually causes a loss. Assuming the market price is high
enough, a firm will make a profit when its marginal revenue is equal to or greater than
its marginal cost.
In the case of U-Beaut, if manufacturing and selling a single extra pair of jeans
costs less than the revenue it earns, then the smart decision is to produce and sell the
product. If the cost of producing and selling a product is more than the revenue, a firm
should stop producing it.
An economist uses various measures of costs, such as fixed costs, variable costs or
opportunity costs. In business, an opportunity cost might be accepting a temporarily
smaller profit or a slight loss in return for remaining in business, keeping a plant
functioning, retaining personnel or similar trade-offs. These are the decisions that
must be made by a firm’s top management using microeconomic data and formulas.
The decision-making processes are determined by analysing the information and then
choosing the best case situation, based on a cost–benefit analysis.
7.7 Cost–benefit analysis and
Governments too use cost–benefit analysis in decision making. When determining
whether or not to implement a particular project, governments use CBA to assess the
merit of the project. Of course, governments have objectives that are not economic,
but which are political and social in nature, and so the decision may not always be
based solely on CBA.
Microeconomic issues affect governments at all levels. Let’s look at some instances
where government decisions might have an impact.
7.7.1 Why modern buildings are boring to
look at
Demerit good: one that has negative externalities
Merit good: a private good with positive externalities
Chapter 7 Contemporary microeconomic issues
The private cost of buying and maintaining a heritage-listed house has fallen
because the council is assisting the owner to maintain the house in appropriate
condition. The effect of this is to move the private cost curve outwards, thus increasing
the number of heritage houses that are preserved. The council is assisting the
community to gain the benefits of a positive externality.
7.7.2 Government CBA affects markets
of heritage buildings, with and without a subsidy
Governments use CBA in so many ways.
Several years ago, the Australian Government
Supply private + social
made a decision based on CBA to phase out
leaded petrol. The use of leaded petrol in cars
Supply private
creates pollution. Lead can accumulate in the
human body, and high levels of lead can lead
to mental illness in children, and illness such
as liver failure in later life. Leaded petrol is
Negative externality
cheaper to make than unleaded petrol. After
looking at alternatives, governments could
have placed a higher tax on leaded petrol.
Such a higher tax would decrease the negative
Demand private
externality created by the use of leaded petrol.
The tax would shift the supply curve to the
Qs Qe
left, raising the price of leaded petrol from Pe
to PS (Figure 7.11). Consequently the quantity
of leaded petrol demanded would fall from Qe
Figure 7.11 The supply of leaded petrol, with and without
to QS, thus reducing the negative externality of
an additional tax
toxic lead in the environment.
Ultimately the government used its legislative powers and legislated that
production of motor vehicles using leaded petrol would cease and that leaded petrol
would be phased out of the market place.
Cigarette smoking is well known to contribute to cancer. Governments attempt to
reduce cigarette smoking by using taxation and by educating people on the dangers
of smoking. In theory, the tax collected on cigarettes should cover the cost of the
additional health care required by smokers as
well as the cost of the education programs.
Supply private + social
The effect of the tax will shift the supply
curve to the left; and shift the demand curve
Supply private
to the left as well. Instead of Qe cigarettes
being consumed, now only Qs2 will be
consumed. This is shown in Figure 7.12.
One of the joys of travelling through Europe is the opportunity to view and appreciate
the beauty of the buildings in cities like Paris. The architectural beauty of Paris
provides a positive externality that benefits many firms operating in Paris, because the
attractions of the city bring in many tourists each year. The tourists spend money on
accommodation, food and transportation, among other things. Without the beauty of
the city, these firms would not gain as much revenue as they currently do.
A merit good is a private good with positive externalities; that is, it provides social
benefits to other people. The architecture of Paris is a merit good.
A modern property developer undertakes the construction of a new building
because he or she sees the potential for a private benefit: profit to the developer.
Accordingly, the developer incurs private costs to build the building. We may enjoy
looking at beautiful buildings but a property developer cannot make us pay for doing
so. The developer may agree with you that a little extra money could have been spent
to make the building look much more aesthetically pleasing, but who is going to pay
for it?
Markets provide goods at the optimal private
level; that is, where the marginal private benefit
equals the marginal private cost. Figure 7.9 shows
this position at P0Q0. With a merit good that
accrues positive externalities, the marginal social
benefit will exceed the marginal private benefit
Social equilibrium
(P1Q1), and thus the merit good is likely to be
under-provided at a socially optimal level; that is,
it will be provided at Q0 instead of the desirable
. This is an example of market failure: the
market does not meet the social goals of society.
Governments can influence the supply of
merit goods in a number of ways. In Brisbane, for
example, the Brisbane City Council is encouraging
owners of �heritage-listed’ buildings to keep
Figure 7.9 A positive externality: the supply of
these buildings maintained and in use, and not to
merit goods
demolish them. It does this by subsidising the cost
of repairs and maintenance of these buildings. If
the owner of a heritage building were to decide
it needed to be repainted, the local council might
provide free paint. In this way the stock of old
buildings will be retained.
A subsidy effectively decreases the cost
of preserving these buildings and allows the
developer to capture and thus internalise some of
the positive externality. Figure 7.10 shows that
at the lower private cost, the private marginal
cost curve (PMC) moves out towards the social
marginal cost curve (SMC). This means that the
stock of heritage buildings will be preserved at
the socially optimal level (QS). Instead of having
QM heritage houses left in a suburb, QS are
Figure 7.10 Capturing a positive externality: the supply
Negative externality
Demand private
Qs Qe
Figure 7.12 Effects of an increased tax on cigarettes
248 Economics for the Real World 1
Chapter 7 Contemporary microeconomic issues
7.30 Do governments always make decisions based on economic principles? Why,
or why not?
7.31 Suggest some other areas in which governments could make decisions
regarding microeconomic issues that might affect you personally.
Allocative efficiency: the economy’s ability to shift resources to where they are most
valued and can be used most efficiently
Cost–benefit analysis is used by governments to help determine the projects and
policies that it wishes to implement.
These analyses are undertaken to identify options that are consistent with
efficiency in resource allocation. Allocative efficiency means that, in an environment
of scarce resources, the level of output of any good or service cannot be increased
without reducing the output of some more highly valued good or service.
Resources are allocated efficiently when the benefit an individual derives from the
last unit of consumption is just equal to the cost of production of that unit. Thus, a
producer in competitive markets who prices his or her output at the marginal cost of
production will be operating consistently with the concept of allocative efficiency.
Pricing at marginal costs implies that costs and benefits are valued at their
opportunity costs. This is made operational in CBA through the �willingness to
pay’ criterion. Outputs are valued according to the willingness of consumers to
pay for them—an amount that includes the consumer surplus, or the difference
between the price actually paid and the amount the consumer would have been
willing to pay for them.
For governments, the fundamental principle of cost–benefit analysis, based on the
concept of allocative efficiency, is to accept projects when the net social benefits are
positive (subject to budget and other constraints). The rule produces outcomes that are
consistent with allocative efficiency. Financial profitability and social equity may also
be important goals in public sector decision-making.
7.7.3 Cost–benefit analysis prioritises
government decisions
An example
Let’s imagine a government is considering whether to add an additional terminal at a
major international airport. The debate over doing this will be fierce and ongoing, as
there will be many interest groups: the airlines, the passengers, local residents affected
by flight pathways etc. The government almost certainly will complete a cost–benefit
analysis of the proposal. There will be many submissions from various parties, some of
which will highlight the many examples of environmental impact (externalities), such
as noise, air quality, water pollution.
250 Economics for the Real World 1
The following benefits might be identified:
• Economic growth. Demand for air travel is forecast to double in the next
20 years, making expansion vital. Many thousands of jobs and businesses depend
on the airport expanding to provide sufficient supply capacity to meet this growing
demand. An increase in the capacity of the airport will make best use of the
airport’s existing infrastructure and land.
• The economy and trade. The economy will lose airlines and investment to other
airports and economies if it does not meet demand. The benefits of a world-beating
industry would be diminished. Some sections of our aviation industry have a
comparative advantage and add huge sums of money to the region’s economy.
• Jobs. the terminal’s project will create or safeguard an estimated 16 500 jobs, as
well as creating 6000 construction jobs during the building phase. This will have
multiplier effects on the local, regional and national economy.
• Transport. The terminal will be the centre of a world-class transport interchange,
with rail links. Car traffic would rise only slightly, the social costs of increased
traffic congestion being overstated by opponents.
• Environment. The site earmarked for the terminal is currently unused land, and
any displaced wildlife and plant life will be carefully relocated. The noise climate
around the airport has been improving for many years, even though the number of
aircraft movements has increased, due to the phasing out of older, noisier aircraft.
There would be no increase in night flights or overall noise levels.
The following costs have been identified:
• Growth. Forecasts are misleading and will result in uncontrolled expansion, rather
than targetting better solutions such as using existing space at other airports.
• The economy. The airport does not really contribute to long-term macroeconomic
benefits. The terminal is wanted for commercial prestige.
• Jobs. Only 6000 jobs will be created—a tiny fraction of the new jobs that are
needed in the region. Local studies indicate that jobs will increase anyway, even
without the new terminal.
• Transport. There will be a significant increase in road-widening and car parks to
cater for the tens of thousands of extra car journeys to the airport every year.
• Environment. Air pollution will increase significantly and hundreds of acres of
wildlife and Green Belt land will be lost forever. There will also be environmental
costs associated with the increased traffic congestion.
• Noise and night flights. More flights will mean more noise under the flight paths, and
the pressure for controversial night flights and an additional runway will increase.
Faced with a mountain of information, costs, benefits and other material, a
government would then make a decision, after weighing up all the costs and benefits,
and considering net social welfare.
7.32 Examine the cost–benefit analysis above of the new terminal at the airport.
What recommendation would you make to the government? Should it accept
the proposal or not?
Chapter 7 Contemporary microeconomic issues
Economics challenge
Mother lode at stake
Should Canberra rake in a greater cut of our mineral resources bonanza?
Two key players have their say.
252 Economics for the Real World 1
superannuation balances and Australians on low
incomes to boost their super savings.
We’ll lift the super guarantee from 9 to 12 per
cent. That will mean a 30-year old worker today
will retire with up to $108 000 more super.
Secondly, we’ll invest in world-class
infrastructure such as roads so our kids and
grandkids also enjoy the benefits of the boom
well into the future. I know for my fellow
Queenslanders this is a really big issue, which
is why Queensland will get a permanent
infrastructure boost from the resource super
profits tax.
Thirdly, we will invest more of our mining
wealth in creating jobs right across the country by
cutting business taxes.
And we’ll give small business a head-start
in these tax cuts because they have been vital
to our economic success during the global
recession and deserve to be big winners from
our tax plans.
We will deliver a major cash-flow boost
for small business by allowing an upfront tax
deduction for the full value of assets purchased
for up to $5000.
We’ll also provide standard tax deductions
which will benefit about 6.4 million Australians
and on average give them an extra $192 in their
tax return. And we’re providing tax incentives
for savings accounts and other savings products
which will help put more competition into the
banking sector over time.
Wayne Swan
I’m a Queenslander, born and bred, and I know
how important the mining industry is to our state
economy and to the broader Australian economy.
I also know Australia’s mineral resources belong
to all Australians and all Australians deserve a fair
share. It’s not good enough that the one dollar in
three we get from mining profits in the form of
royalties and resource charges a decade ago has
become just one dollar in seven today.
That’s why we need to invest the proceeds of
the resource super profits tax in retirement savings,
big tax breaks for small business and standard tax
deductions for 6.4 million Australians.
Queenslanders will be among the biggest
winners because we’ll also be using the proceeds
to invest in more world-class infrastructure,
focused on the bottlenecks in mining communities
like our own.
We always expected a massive scare campaign
from the Liberals and the resource companies—they
don’t want to see Australians getting a fairer share
of their super profits, so that’s hardly surprising.
Exactly the same scare campaign was rolled
out when a profits-based tax was introduced
on petroleum. Of course, that industry went on
to grow and flourish and support thousands of
jobs. So we won’t be deterred by threats and
We’re determined to boost Australians’
retirement savings so that whenever the mining
boom ends, Australians have got something
real to show for it. We’ll help over-50s with low
We should all be proud of Australia’s success
in fighting off the global recession and preventing
massive job losses. Now it’s time to convert that
success into jobs, wages and wealth for families
and businesses in Queensland and right around
the country.
Michael Roche
Australian citizens are entitled to their fair share
of Australia’s resources wealth.
There is no contest from resource companies over
this principle but mounting community concern that
it is being misrepresented by the federal government
as justification for a new tax grab.
From day one, the government’s primary
response to the Henry tax review has been
marketed as a resource �super profits’ tax.
To date, the debate over the consequences for
the Australian economy and its global reputation
has been sidetracked by ham-fisted attempts to
demonise individuals and mining companies as
�foreign devils’.
What is becoming clearer to an overwhelming
number of Australians with significant
superannuation investments in resource
companies is that the federal government could
have achieved a much better response to a real
tax reform agenda through a process of genuine
consultation with the resources sector.
The only result to date of the government’s
crash or crash-through strategy has been damage
to Australia’s reputation as a safe and reliable
destination for the international investment that
we rely upon to grow and prosper as a trading
nation of just 22 million people.
Without serious regard for the real-world
consequences of an �elegant’ taxation model
assembled by theorists in Canberra, the federal
government has rolled the dice on the future of
more than $100 billion worth of new resource
projects in Queensland.
These are the projects that the state government
is banking on to create about 19 000 new jobs,
particularly in regional centres.
However, they are at a virtual standstill while
such a high level of uncertainty surrounds the fate
of the federal Government’s new tax.
In the interim, a lot of hot air, confusion and
reputational damage could be avoided by a few
simple acknowledgements and a coming together.
First is that the resources sector currently does
pay a lot of tax. In 2008–09 the mining industry’s
tax contribution was $22 billion, 13 per cent
higher than the all-industry average.
Mining companies paid around 18 per cent of
company income tax, even though the sector made
up around 8 per cent of the national economy.
There is no more reliable source for such
information than the Australian taxation Office,
which only goes to show how much time and
energy has been wasted in the debate to this point.
What the federal government should have done
from the start, and what it can still do now, is
sit down with the resources sector and hear their
arguments on basic principles such as a profits tax
applying to new investments, not existing projects
directly and indirectly employing one in every
eight Queenslanders.
The federal government should also seriously
consider the potential damage to our economy
that will be caused by introducing the world’s
highest resource taxes as the ranks of competitor
nations swell. Other material concerns include
recognising that not all minerals and energy
resources are the same and that rates of return
vary, along with their developer’s ability to
shoulder additional tax burdens.
It doesn’t sound that hard, but it has certainly
become a point of increasing frustration within
the resources sector that the federal government
is not interested in a conversation over the longterm future of Australia.
Examine the two articles that follow. They both relate to the Resource Super Profits
Tax that was proposed in June 2010. Read the two articles, and then complete a
cost–benefit analysis of the proposal. You may need to research on the Internet to
obtain further information.
What would your recommendation be—to proceed or not proceed with the
tax? Does your conclusion agree with what the government implemented?
We will do all this in a way which continues the
responsible economic management we showed to
keep Australia out of recession.
We will also deliver our plans in a way which is
fair to the mining industry.
It’s a simple formula—if mining company
profits go up, then the Australian people get a
bigger slice. If profits go down, then the mining
companies pay less.
Michael is CEO of Queensland Resources
Courier Mail, 28 May 2010
Chapter 7 Contemporary microeconomic issues
7.8 Microeconomic policy
generate their production. Essentially, they seek to get more output for the same or
fewer inputs.
Dynamic efficiency identifies the need to develop innovation and to be able
to respond to changes in demand, both domestically and internationally, quickly.
Microeconomic policy aims to increase the level of competition that forces producers
to be more responsive to changes in demand and supply.
Figure 7.14 shows some of the microeconomic policies implemented by Australian
Allocative efficiency: the economy’s ability to shift resources to where they are most
valued and can be used most effectively
Dynamic efficiency: the economy’s ability to shift resources between industries in
response to changing patterns of consumer demand
Microeconomic policy: action taken by governments to improve resource allocation
between firms and industries, in order to maximise production from scarce
Tariff reductions
Technical efficiency: the economy’s ability to achieve the maximum level of output
for a given quantity of inputs
More competition for
Australian producers
Increased technical and
dynamic efficiency
Shift of ownership and control
to businesses and households
Increased technical and
dynamic efficiency
Electricity and water
Additional companies have
entered the market
Increased technical and
dynamic efficiency
Industry plans
Rationalisation of plant and
Reorganisation of the industry
Increased technical
Competition policy
Hilmer report
Trade Practices Act
1974 (Cth)
Adding competition to water &
electricity providers
Increased technical and
dynamic efficiency
Education and
Finn and Meyer
TAFE reorganisation
Vocational qualifications
Recognition of key technical
Increased technical
Upgraded road
Rail system
Better transport speeds up
product delivery
Increased technical
Industrial relations
Workplace reform
Fair Work Act 2009 (Cth)
Enterprise bargaining
Increased technical and
dynamic efficiency
Management reform
Karpin report
Quality management
Improved technical
O O1
Total output
Figure 7.13 Increased supply
7.8.1 The three efficiencies
Microeconomic policy seeks to have improvements in the efficiency of businesses and
industries. As such, it seeks to improve:
• allocative efficiency
• technical efficiency
• dynamic efficiency.
Allocative efficiency seeks to have market forces result in a more efficient allocation
of resources. Resources should be shifted to those producers who have the greatest
capacity to pay, and that capacity to pay will reflect relative efficiency and value to the
economy. In essence, this means that resources are put to optimal use and not wasted.
Inefficient businesses and industries would need to restructure and reorganise their
production to become more efficient.
Technical efficiency seeks to have businesses improve their productivity; that is,
an increase in output for a given quantity of inputs. Businesses will need to adopt
the latest production technology and use the least-cost combination of resources to
254 Economics for the Real World 1
General price level
Governments take action to improve resource
allocation in the economy. This is called microeconomic
policy and is aimed at firms and industries. In this way,
governments hope to create even more sustainable
growth in Australia.
Microeconomic policy focuses on the supply side
of economics; it does not seek to influence demand, but
rather seeks to create favourable conditions to increase
productivity and hence output. This should shift the
aggregate supply curve to the right, as in Figure 7.13.
If the productivity of industry is improved, then
business will become more competitive and efficient
and this should encourage the efficient operation of
markets. This will encourage Australian business to be
more responsive to changing market conditions, and
encourage them to seek export markets, to improve
their output levels and their level of profit.
Figure 7.14 Microeconomic policies implemented by Australian governments
There are, of course, many other areas of microeconomic reform in the economy.
Economics and ICT
Log on to Pearson Places and follow the prompts to the Australian Productivity
Commission. From the home page, select View Current Projects. Then select one
project that the Productivity Commission is currently working on and review the
information presented.
How will this project improve productivity? Develop no more than six PowerPoint slides
to report your research to your fellow students.
Microeconomic policy aims to contribute to the overall health of the Australian
economy. As can be seen in Figure 7.14 above, there has been a deliberate attempt on
Chapter 7 Contemporary microeconomic issues
the part of Government to increase the level of competition. Competition enhances
productivity, and growth in productivity results in economic growth and improved
standards of living. This is shown below.
• Environmental changes to address climate change, including a carbon trading
• Further competition reform and changes, especially in energy, transport and water
• Improved labour relations building on the Fair Work Act 2009 (Cth)
• Further changes to tariffs
• A national broadband scheme
• Privatisation of government business enterprises
Microeconomic policy
Improved levels of competition
7.36 Use a newspaper to identify examples of microeconomic reforms occurring at
7.37 What reforms have you identified, and why are these reforms important to the
Australian economy?
Increased levels of productivity
7.38 Do you think each reform will improve productivity and/or competition in the
Australian market? Why?
Higher economic growth
Improved standards of living for Australians
Figure 7.15 Microeconomic policy effects
7.33 Select any three policy initiatives listed in Figure 7.14 and explain how they
might be expected to lead to improved efficiency.
7.34 Would these policies also have negative effects? Identify some negative effects
of microeconomic policies.
7.35 Draw a production possibility curve model to show the effect that
microeconomic reform policies would have on the production possibility curve.
7.8.2 Continued microeconomic reform
Australian governments have implemented a significant amount of microeconomic
reform in the 1990s and 2000s. However, as we move into the 2010s, there is a
significant number of microeconomic policies yet to be finished, and more yet to
be implemented. During the 2010s, it is expected that Australian governments will
address most, if not all, of the microeconomic issues listed below.
• Taxation reform
• Healthcare changes, including hospital reform
• Infrastructure development, such as new coal ports in Central Queensland
• Continued education and training reform, including the Australian Curriculum for
schools, and TAFE restructuring
256 Economics for the Real World 1
Chapter 7 Contemporary microeconomic issues
Review of chapter 7
R 7.2 True/False
R 7.1 Structured overview
1 Council rates are part of a business’s fixed costs.
For each statement, indicate whether you consider it to be True (T) or False (F).
2 Marginal cost can be measured by the change in total cost or the change in total
variable cost per unit of output.
3 The role of microeconomic reform is to improve how markets operate.
4 Sunk costs should always be considered in a cost–benefit analysis.
5 Microeconomics is concerned with the supply side of economics.
6 The economics of education would be an example of a macroeconomics issue.
7 Cost–benefit analysis can only be used by a trained economist.
9 The improvement in productivity is a major aim of microeconomic reform.
8 There are problems in accurately valuing all costs and benefits in many projects.
2010 and beyond
Three efficiencies
Complete the following structured overview from sectional headings provided in
the chapter
R 7.3 Matching terms
Select the correct term from the list below that describes each statement.
C Marginal revenue
D Marginal cost
E Net present value
F Allocative efficiency
G Opportunity cost
H Technical efficiency
J Macroeconomics
K Opportunity cost value
L Dynamic efficiency
Sunk costs
2 The value of the net benefit associated with the next best alternative
3 A private good with positive externalities
4 The extra (or marginal) revenue obtained by producing and selling another unit
of output
5 The study of the economy as a whole, dealing in aggregates such as employment
levels and overall price changes
6 The present value of the current benefits plus discounted future benefits less the
present value of the current costs and discounted future costs of a project
7 Retrospective (past) costs that have already been incurred and cannot be recovered
8 Action taken by governments to improve resource allocation between firms and
industries, in order to maximise production from scarce resources
9 The economy’s ability to shift resources to where they are most valued and can be
used most efficiently
10 Occurs when innovation is rapid and businesses react quickly to changing consumer
B Microeconomic policy
R 7.4 Multiple-choice questions
Select the correct response to each of the
1 If average variable cost is at a
minimum, then:
Some possible
258 Economics for the Real World 1
A Merit goods
1 Occurs when all firms are producing at the lowest possible cost
Opportunity cost
10 The level of interest rates in an economy is a major issue for a microeconomist.
A marginal cost equals average total cost
B marginal cost equals average variable
C average variable cost equals average
fixed cost
D average variable cost equals average
total cost.
Chapter 7 Contemporary microeconomic issues
C improve efficiency and flexibility
within the economy by removing
D reduce government involvement in
economic decision making.
4 Which of the following is the best
example of microeconomic reform?
A Income tax changes
B Interest rate changes
C Tariff reductions
D Pay rises awarded to low-paid
5 Microeconomic reforms involve:
A increasing effective competition in
a number of markets
B tightening control on price increases
in a number of key markets
C ensuring the demand for labour
matches the supply of labour in
certain markets
D restricting imports of products that
can be made efficiently in Australia.
6 Microeconomic reform increases the
potential for economic growth by
A allocative efficiency
B dynamic efficiency
C technical efficiency
D all of the above.
7 If Ben doesn’t take his girlfriend out on
Saturday night, he will save $50 and be
able to spend the evening watching
the football on TV with his mates. The
opportunity cost of Ben’s date is:
A $50
B $50 plus the cost of forgoing a
night watching the football
260 Economics for the Real World 1
9 Marginal cost is defined as:
A the addition to average total
cost incurred as a result of a unit
increase in output
B the addition to average variable
cost incurred as a result of a unit
increase in output
C the total cost divided by total
D the addition to total cost incurred
as a result of a unit increase in
10 When average cost is falling, marginal
A must be rising
B must be greater than average cost
C must be less than average cost
D must be equal to average cost.
B enable businesses to be more
A reduce aggregate demand to limit
inflationary pressures
13 A firm will maximise its profits if it employs
enough of each variable factor to:
A equalise its marginal revenue with
its marginal cost
B equalise its marginal product and
its average product
C maximise its marginal revenue
D minimise its average cost.
8 Opportunity cost is:
A the real cost of the want sacrificed
B only faced by market economies
C the price of a close substitute to a
certain article
D the cost of an investment project.
11 Which of the following is not a
limitation of cost–benefit analysis?
A There are distributional
B Social welfare is not the same as
individual welfare.
C Valuing the environment is difficult.
D It can be used by individuals.
3 The objective of microeconomic
reform is to:
D Comparing different options,
identifying alternatives, valuing
costs and benefits, discounting
future values
C dependent on how pleasant a time
Ben would have off he took his
girlfriend out
D the cost of forgoing an evening
watching the football.
2 As output rises in the short-run, all
of the following eventually increase
A marginal cost
B average total cost
C average fixed cost
D average variable cost.
12 Which of the following identifies four
steps of cost–benefit analysis in their
correct order?
A Identifying alternatives, valuing costs
and benefits, discounting future
values, comparing different options
B Discounting future values, valuing
costs and benefits, comparing
different options, identifying
C Identifying alternatives,
discounting future values,
comparing different options,
valuing costs and benefits
14 A firm’s average cost is:
A the price of the firm’s product on
the market
B the cost of each unit of a variable
C total costs divided by the number
of units of output
D total costs divided by the number
of workers employed.
15 Which of the following is an example
of a microeconomic policy?
A A decrease in interest rates
B A decrease in income tax
C A decrease in regulation in the
telecommunications sector
D An increase in government
R 7.5 Activities
Opportunity cost
The Queensland Government owns and controls a tract of scenic tropical rainforest in
North Queensland. If a developer gained approval to construct a golf course on part of
the land, what would be the opportunity cost of this decision?
Examine the statistics below and answer the questions that follow.
Figure 7.16 Australia’s productivity 1965–2009
Labour productivity
Capital deepening
Multifactor productivity
Source: ABS
1 What other factors would be included in the multi-factor productivity category?
2 What is the long-term trend for labour productivity?
3 What is the long-term trend for multi-factor productivity?
4 There was a sharp upwards movement in productivity between 1994 and 1999.
Suggest reasons for this. Conduct some research if necessary.
5 Suggest reasons why labour productivity has fallen away since 1999.
Chapter 7 Contemporary microeconomic issues
Diagram interpretation
Complete the table below
Fixed cost
Total cost
total cost
Explain the diagram below. Using the information in the diagram, write a letter to the
Editor (of no more than 300 words) outlining the importance of productivity growth in
Australia’s wellbeing has many dimensions, with material
living standards being central
Once the table is completed, construct graphs to show the following: average total cost,
average variable cost and marginal cost.
Using the graphs, identify the most profitable point for the firm to produce at.
Cost–benefit analysis
Per capita income growth and
distribution contribute through:
• social attachments
• community involvement
• safety
• consumption and saving
• funding of social activities
• funding of institutions such as
law and order etc.
Improvement in the terms of
Note: This can lead to a decline
in productivity if resources are
reallocated to more profitable
but less productive activities
At the conclusion of Year 12, you are debating in your mind what you should do the
following year. You think you will gain a university entrance mark that will enable you
to enter your preferred choice of study. Your parents own a furniture manufacturing
business and you could work in the office of the business, learning the business and
perhaps take over its management in ten years or so.
An alternative is to enter university immediately, and to study for an international
business degree, hoping for good results and a career in international business, probably
in hotel management.
A final option that you are keen on is to travel for a year, picking up odd jobs wherever you go, with the intention of having a �gap year’ before deciding on your future.
You remember that in Economics you studied decision-making processes and you
think about costs and benefits of each of the three possibilities, including actual costs
and opportunity costs. Make a list of the things you should consider when trying to make
your decision. To what extent is your decision influenced by personal values?
Other factors such as social
capital, for example:
Total variable
Other factors such as
environmental capital, for
• amenity
• biodiversity
• air quality
Growth in labour participation:
• hours worked
Labour productivity growth reflects
both capital deepening and
multifactor productivity
Multifactor productivity
Capital growth:
• physical capital stock
Figure 7.17 How productivity growth contributes to wellbeing
Source: Enhancing Australia’s Productivity;
Productivity Commission, 2007–08 Annual Report
R 7.6 Inquiries
Using the economic method of problem solving, complete one of the following inquiries:
1 Do governments face the scarcity problem? Use a media scan to identify some of the
key issues about which the Commonwealth government is currently being forced to
make choices; for example, whether government spending should be used to offset
falls in private expenditure or whether to raise aged pensions. Prepare a report that
identifies the relevant costs and benefits associated with taking a particular course of
2 Assume the role of an economic analyst and, using the cost–benefit analysis model,
prepare a report that explains why a company made a particular choice; for instance,
the decision by Telstra to base call centres in India.
3 Do decision makers always correctly apply the cost–benefit analysis principle in their
decision-making? Prepare a report that uses the cost–benefit principle to critique a
particular decision made by an individual, business or government.
262 Economics for the Real World 1
Chapter 7 Contemporary microeconomic issues
Review of
chapter 7
answers at
Economy and Finance
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