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EconomicsUpdate

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Issue 1February 2014

Timmee GrinhamSuzanne Cory High School

The purpose of the Economics Update is to provide teachers and their students with contemporary examples which can be applied to the relevant key knowledge points from Areas of Study 1 of the VCE Unit 3 Economics Study Design.

Unit 3, Area of Study 1Relative scarcity, opportunity cost and an efficient allocation of resourcesThe VCE Economics Units 3 and 4 course begins with a consideration of the nature of economic decision making, the need for economic choices and the impact of economic choices on the allocation of resource. The fact that our unlimited needs and wants will always outweigh the limited (scarce) resources available to satisfy them, leads to relative scarcity. All economies experience relative scarcity, even those economies that are very affluent, since no matter how abundant the various economic resources (land, labour and capital), there will never be enough of them to satisfy every single need or want in that economy.

As a consequence of relative scarcity, choices must be made between allocating resources to competing purposes. As budding economists, you need to be aware that when resources are used for a particular purpose, those same resources cannot be used for a different one, so we sacrifice the benefit we would have gained from using the resources for that alternate purpose. This sacrifice occurs at an individual and an economy-wide level. This is the‘opportunity cost’ of an economic decision, defined as the value of the next best alternative use of the resources that is foregone (given up) when an economic decision (choice) is made.

In Australia in recent months, there have been many examples of relative scarcity and opportunity cost in action. The new Federal Government was elected with an explicit platform of returning the Federal Budget to a surplus (where tax revenues collected exceed government expenditure) following several years of budget deficits (where government expenditure has exceeded tax revenue). However, at the same time, the government has been under considerable pressure to make decisions about spending priorities, including

possible assistance to various Australian industries.One of the more common themes of economic news reporting in recent months has been the rolling announcements of job losses as various manufacturing companies have announced decisions to close or downsize their Australian operations. There are a number of reasons why manufacturing is struggling, including high

local production costs relative to other countries and a small local market meaning there are few options for economies of scale, and these have been exacerbated by a persistently high Australian dollar exchange rate in recent years.While manufacturing closures and restructures in Australia are not new, the sheer size and breadth of the recent announcements have created a lot of discussion and debate about government involvement in the economy, and in particular whether government should be providing financial support and incentives (subsidies) for manufacturers to continue producing in Australia.

The newly elected government has made clear that it is committed to removing assistance to manufacturing industries and has rejected direct approaches for support from some manufacturers, including SPC Ardmona.

The impending end of the local vehicle manufacturing industry has been particularly newsworthy and caused a lot of discussion around the economic case for and against ongoing or increased subsidies for vehicle manufacturing in Australia. In May 2013, Ford announced it would close its Broadmeadows and Geelong plants in 2016, resulting in the direct loss of at least 1,200 jobs. In December 2013, Holden announced it would cease manufacturing in Australia by the end of 2017. More recently in February this year Ford announced it was bringing forward 300 redundancies in its plants to the middle of this year. And then, shortly after, Toyota announced it would also close its vehicle manufacturing in Australia, also in 2017. This final announcement sounded what many commentators referred to as the ‘death knell’ for Australia’s vehicle manufacturing industry – it will mean that cars will no longer be manufactured in Australia. The total direct job losses are predicted to include the loss of 1200 jobs at Ford, 2900 at Holden and 2500 at Toyota. Once the impact on the wider automotive component parts and inputs sector is taken into account, it has been predicted up to 30,000 jobs could be lost.

In order to encourage the car industry’s continued operation,

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CPAP Economics Update Term 1 2014

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successive Australian federal and state governments have provided significant subsidies over many years. Subsidies are usually payments provided to producers, as an incentive to continue, or increase, production of specific products. These subsidies effectively reduce the cost of production of those producers, and therefore act as a favourable supply-side factor in that industry.

There has been much discussion about the level of Australian government subsidisation of the local vehicle manufacturing industry relative to the level of subsidisation by other governments of their own car industry. There are direct subsidies in the form of cash injections paid to producers. There are also indirect subsidies such as tax deductions to encourage companies to invest in research and development, and tariff protection on certain industries, or taxes on luxury cars that favour locally-produced vehicles. In terms of direct subsidies and tariff support, various estimates exist, including that Holden has received $1.8b, Ford $1.1b and Toyota around $1.2b, to total more than $4 billion dollars in the last decade. In per capita terms, this is modest compared to subsidies per capita to vehicle manufacturing in the USA and Germany. However, because of Australia’s low volume of vehicles produced, it means the estimated government subsidy per vehicle is, comparatively, quite high. This can be seen in the table below.

Source: h t tps://theco nv ersation.com/ f actchec k -do-othe r -countries- subsidise-thei r - ca r -industr y -mo r e-than - we-do-16308 , The Conversation website, Factcheck, 26th July 2013

However, in late January, the Productivity Commission (the government body tasked with evaluating economic and social policy with the goal of achieving a more productive economy), released a position paper on its inquiry into Australia’s automotive manufacturing industry. The paper estimated that around $30 billion in assistance had been provided to the automotive industry in the 15 years between 1997 and 2012, which means around$1.875b per annum on average.

The question of subsidies raises the issue of opportunity cost. When a government chooses to provide a subsidy or tax benefit to one industry this means that money cannot be used for an alternate purpose. The opportunity cost of the decision to subsidise the car industry is therefore the value of the benefit foregone from whatever was determined to be the next best alternate purpose that money could have been used for. Based on the figures provided by the Productivity Commission, had the government not provided assistance to the car industry, over the last fifteen years, $30 billion would have been available to spend on other areas of the economy, and the opportunity cost of the government’s subsidisation of the car industry is the economic benefits foregone by not spending that money in those alternate areas. Some

economists claim that this opportunity cost has been too high, and that the ongoing subsidisation of the auto industry has not been worthwhile.

On the other hand, since all economic choices come with an opportunity cost, it is also worth considering the opportunity cost of not providing subsidies to the vehicle industry in Australia.The peak industry body for car and component manufacturers and importers, the FCAI, claims that the auto industry generated $160



billion turnover in 2011, which equates to more than 10% of GDP. It also calculates that there are 50,000 people directly employed within the industry. The FCAI, along with several economists and business experts, argue that car manufacturers are among the most innovative and technologically advanced producers in the world, being leaders in the introduction and use of capital-intensive production methods reliant on robotics. Car manufacturers are also leaders in managing industrial relations and promoting innovative work practices and quality management systems that flow on to the communities and economies within which they operate. Many refer to the example of Toyota, which developed the approach to production called ‘lean operations’ which is now a feature of most manufacturing throughout the world.

Supporters of continued subsidisation of the auto industry in Australia also note that vehicle manufacturers are amongst the economy’s largest investors in research and development (R&D). They claim that the R&D undertaken by the car industry can improve a company’s performance, including developing new or improved products and improved production methods. As economists, we are aware that such outcomes, if achieved, may help a company to improve its productivity, and its productive capacity, and could contribute to an outwards movement in the whole economy’s production possibility frontier. It could also contribute to positive externalities in production that would benefit those beyond the company, such as new technological discoveries or innovation in the form of improved efficiency that reduces waste and pollution, or creates more fuel-efficient vehicles.

As vehicle manufacturers cease operations in Australia, there is a possibility that the opportunity cost of failing to continue to subsidise these businesses is excessive. Put in another way, the opportunity cost of using that billions of dollars previously allocated to car industry to pay off debt or reallocate to the provision of other government goods or services may be greater than the benefits that will be enjoyed by allocating the government funds to the alternate purpose.

We will return to a consideration of the car industry later in this Update, as we look at demand and supply factors affecting specific markets.

The (price) market mechanism and resource allocationA look at the 2013 VCE Economics examination reveals that the assessors are very concerned that students have an excellent understanding of the factors that affect the prices and quantity of goods and services in individual markets, and how changes in those factors cause quantities and prices to change, and how markets then return to equilibrium. In fact, an excellent familiarity with the price mechanism is crucial for success in economics at any level.

In Australia, the ultimate decisions about what will be produced are made largely by the operation of markets. In Australia, markets account for about eighty percent of economic decision making, while governments account for approximately the remaining twenty percent of economic

decisions.

Relative prices of products in markets will ultimately determine where resources are allocated and what is produced. As demand and supply factors change, this will cause prices to also change, and markets respond by reallocating resources based on relative prices.



Some demand factors affecting marketsThere are a number of key microeconomic demand-side factors that influence the prices and quantity of goods and services, and the willingness of consumers to purchase goods and services. Several of those currently having a significant impact are discussed below.

Changing consumer preferences

As discussed earlier in this update, the remaining vehicle manufacturers currently operating in Australia - Ford, Holden and Toyota –have all announced in the last nine months that they will cease manufacturing operations in Australian within the next few years. Along with high relative production costs in Australia, many commentators have observed that changing consumer preferences have had a significant impact on the market for vehicles in Australia.

Demand for formerly ‘iconic’ Australian-made vehicles – larger sedans such as Holden Commodores, Ford Falcons and the Toyota Camry – has declined greatly in recent decades. Consumer preferences in vehicles has shifted towards SUVs (small four-wheel drives) and small, compact city cars, which are models that are typically not made in the Australian car factories. In short, this means that Australian manufacturers are, generally, not making cars that Australians want to buy. As some commentators observed during the announcement of the end of car manufacturing in Australia, Australian manufacturers have continued to make cars in Australia that Australians don’t really want to buy, while their retail departments import from overseas the kinds of cars Australians do want to buy – where they have been manufactured in factories owned by the parent companies of the Australian manufacturers. The facts on vehicles sales appear to support this. The top-selling vehicles in Australia in 2013 are shown in the table below. The Holden Commodores is the only Australian-made model in the top five by sales volume. The Ford Falcon does not feature in the list of top twenty models by sales in Australia.

Ranking Model1 Toyota Corolla2 Mazda 33 Toyota HiLux4 Hyundai i305 Holden Commodore

Source: ww w .ca r advice.com.au

As consumer preferences have changed away from Australian-made vehicles, this has seen a decrease in demand across the board in these markets. In this regard, the decision to close the Australian car manufacturing plants is an economically rational response on the part of these businesses, who have seen a decline in demand for their product, and excess of supply in the market, and have responded by reallocating resources to production of vehicles that Australians do want to buy – those made in factories overseas.

Declining consumer sentiment (confidence)

Consumer sentiment (often referred to as consumer ‘confidence’) is measured by Westpac’s Consumer Sentiment Index and released monthly. A measure of more than 100 on the index indicates that positive sentiment outweighs negative sentiment among those surveyed. If consumers feel more positive (optimistic) about future economic conditions, they will be less inclined to save and more inclined to spend more. If, however, they feel more negative (pessimistic) about future economic conditions in Australia, they



will likely save more and spend less. Many things can influence whether consumers feel optimistic or pessimistic, and one of the most important is whether they feel secure in their employment. If workers (who are also consumers of course!) believe they may lose their job, they are likely to become more pessimistic, spend less, and save more, to provide a buffer of savings in case they do lose their job in the future.

The chart below shows Consumer Sentiment since the early1990s. From 2011 until late 2013, the overall trend in consumer sentiment has been upwards. However, it is noticeable that there has been a rapid worsening of consumer sentiment since late2013. In September 2013, the Consumer Sentiment Index rose to110.6 following the Federal Election. This indicated that optimistic consumers significantly outweighed pessimists. However, by February 2014, the measure had fallen to 100.2, indicating that consumers were feeling considerably less confident about their future economic prospects.

Source: RBA Chart Pack, February 2014 (data sourced fromMelbourne Institute and Westpac)

Recent news about wide-spread job losses (and speculation about likely future job losses) in manufacturing and service industries are likely to have contributed to the rapid decline in consumer confidence. These announcements have included the impending end of vehicle manufacturing in Australia, Alcoa’s announcement of closure of its Point Henry aluminium smelter, concerns over SPC’s future in Shepparton, and Qantas’ recent announcement that it will axe 5,000 jobs following a half-year loss of $252m and the need to restructure its organisation. The rising unemployment rate (6% seasonally adjusted in January 2014) has also added to worsening consumer sentiment. In the Statement on Monetary Policy (which provides an overview of Australia’s current and expected future economic conditions), the RBA predicted that the unemployment rate will continue to edge higher over the next year. The fear of rising unemployment is likely to have an ongoing negative effect on consumer confidence.

Worsening (declining) consumer sentiment is likely to decrease demand for goods and services across numerous markets. It can have a particular effect on

decisions about purchasing new, larger consumer items, such as taking out loans to buy new cars or take holidays. According to statistics from the Federal Chamber of Automotive Industries (FCAI – the peak industry body representing manufacturers and importers of vehicles in Australia), vehicles sales were 3.7% lower in January 2014 than in the same month in2013. This fall in new vehicle purchases is likely to reflect declining consumer confidence during 2013 and into 2014.



High, albeit depreciating, Australian dollar

Between April 2013 and early 2014, the Australian depreciated rapidly against the currencies of our major trading partners. One of the most common ways used to measure the value of the Australian dollar (AUD) is against the US dollar (USD), as well as the Trade Weighted Index (TWI – the average value of the AUD compared to a weighted basket of the currencies of Australia’s major trading partners).

In mid-April 2013, the Australian dollar was worth approximately1.05USD. One year later, in mid-February 2014, the Australian dollar was buying approximately 0.90USD, having fallen as low as0.87USD between those two dates. This rapid depreciation, while representing a significant fall in the value of the dollar, has still left the AUD above its historical average since it was floated in the early 1980s. This can be seen in the chart below. At its current rate of approximately 0.90USD, the Australian dollar is still above a price considered ‘competitive’ for Australian exporters and import- competing industries.

Consequently, the persistently high Australian dollar has negatively impacted many sectors of the Australian economy. Those sectors most negatively impacted include many exporting and import- competing industries, particularly manufacturing. A persistently high currency is considered an unfavourable demand factor. A high AUD means that domestically-produced (Australian-made) goods and services are less competitive compared to foreign-produced (imported) goods and services. This is because, when overseas buyers wish to purchase Australian-made products, a relatively-high AUD means they need to exchange more of their currency to buy the same amount of Australian products. This makes our exports relatively more expensive. It is also the case that when people in Australia wish to purchase imports from overseas, they need to exchange fewer of their Australian dollars to buy the same amount of imports, making imports relatively cheaper, and therefore more attractive.

The law of demand would predict that high relative price of Australian exports causes demand for exports to fall, and the lower relative price of imports into Australia will cause the demand for imports to rise. It is important to

remember that these changes in relative prices occur independently of any change in the foreign price of the imports, or the Australian price of the exports.

The most negatively-impacted markets are those that export goods and services (particularly if those goods and services are readily available from countries with lower exchange rates), or which



produce goods and services that compete with imports, called import- competing industries. It is important to remember that imports and exports take the form not only of goods, but also services such as tourism, education, financial and telecommunications services. The persistently-high AUD over recent years was one of the factors named by Australia’s vehicle manufacturers when they announced their decisions to cease manufacturing in Australia in coming years.

Despite the dollar remaining high, the depreciation of the AUD since April 2013 has had benefits for some markets. It has been observed that the rising relative price of overseas tourism from Australia has encouraged an increase in domestic tourism in preference to travelling overseas. The RBA observed in the Statement on Monetary Policy that there is some evidence that the‘pass through’ of increased prices as a result of the depreciating exchange rate may have been occurring quite rapidly, and if this is the case, it is possible that some Australian producers who compete with imported goods and services will find their improved relative competitiveness is a favourable demand side factor.

Changes in interest rates

Decreases in the official RBA cash rate often flow on to a reduction in interest rates charged on credit by financial institutions, including mortgages, personal loans and credit cards. When interest rates are reduced, households that are heavily indebted will have more discretionary income after meeting their debt servicing obligations. This can potentially lead to an increase in demand and a shift to the right of the demand curve for some products. During 2013, the RBA reduced the cash rate twice. In May, it reduced the cash rate by 25 basis points from 3.00% to 2.75%, and reduced the rate by a further 25 basis points in August, to reach a record low of 2.50%.

In response, many banks also decreased retail interest rates charged on credit, and those rates are now well below the long-run average interest rates charged on borrowing in Australia. The reduction in interest rates should continue to encourage increased consumer spending and impact positively on many markets, particularly those providing goods or services that are highly credit sensitive, such as the markets for consumer durables such as whitegoods and motor vehicles. In fact, recently there has been some media speculation that the low rates may be fuelling a property market ‘boom’ in several capital cities, pushing up housing prices. In the report of its decision to leave the cash rate unchanged at its first meeting of 2014, the RBA signalled it was likely to cease cutting rates for the time being, as it was of the opinion that a period of stability in interest rates was the most appropriate action at present. It can be expected, therefore, that the cash rate, and therefore retail interest rates, are likely to remain low into the coming months, further stimulating demand.

Some supply factors affecting marketsAvailability and cost of inputs – labour

A key factor affecting the supply of goods and services is the availability and cost of the factors of production (inputs) used in their production. One very significant factor of production for all goods and services is labour. In February, the ABS released the latest Wages Price Index (WPI) figures. It revealed that in the 12 months to December 2013, in seasonally adjusted terms, wages rose by 2.6%. While it is important to remember that the wage price index is not representative of every wage change across every industry in Australia, the wage price index is constructed, like the Consumer Price Index, to give a picture of the rise in average



wages across the economy.The increase of 2.6% was in fact the lowest annual rise in wages since the ABS began calculating the WPI in 1997. The RBA has referred to this as a ‘pronounced’ slowing in wages growth.

The WPI indicates the rise in nominal wages. As students studying economics, you will be aware that, in order to determine the change in real wages (which represent the change in purchasing power), the rate of inflation needs to be subtracted from the rise in nominal wages. Over the same twelve month period to December 2013, the headline CPI rose by 2.7%. This means, in effect, that over the last twelve months, real wages actually fell slightly. As many commentators have noted, the last time this happened was during the Global Financial Crisis. There are many possible reasons for this moderating of wages growth, including slow employment growth and rising unemployment, which both indicate there is increasing‘spare capacity’ in the labour market.

In addition to wages and salaries, the cost to businesses of employing labour (labour costs) also include additional costs such as Workcover, sick leave and payroll taxes. The RBA has observed that the growth in the overall cost of labour (unit labour costs) remains low, and this is evident from the chart below. This low growth has been caused by slower growth in wages and rising productivity.

Unit labour costs are the cost of labour relative to labour productivity. If the increase in labour productivity (the real value of the output gained for each hour worked) is greater than the increase in labour costs, then unit labour costs will fall. In Australia in the second half of 2013, there

was only a moderate increase in unit labour costs, as labour productivity grew almost as rapidly as wages over that time. The low increase in wages as indicated by the WPI, along with the modest increase in unit labour costs, will be favourable supply-side factors for many industries in Australia, by helping to keep cost increases in check.



In addition to the cost of labour, the available supply of labour is also a significant supply factor affecting many Australian markets. The labour force participation rate (LFPR) is an important indicator of the supply of labour. It measures the proportion of the working- age population either working or looking for work. Australia has historically had a low LFPR when compared many other similar countries, and a particularly low rate of participation for certain age groups and segments of the population, including women between the ages of 25 and 39. In recent years, governments have focused on policies to increase the LFPR (to be discussed further in Update4), and as a consequence the LFPR had risen in the last decade, reaching its peak in late 2010. However, in the last year there has been a noticeable decline in the LFPR, as is shown in the chart below. This is partly in response to the weakening labour market, and the steady increase in the unemployment rate (from 5.4% in January 2013 to 6.0% in January this year) which has caused discouraged workers to cease actively seeking employment as their chances of finding a job become slimmer.

Demographic change

However, of much more concern is the longer, structural change in the labour force that is taking place as a result of demographic change, namely the ageing of the population. In the last two years, the first of the ‘baby boomer’ generation (those born as part of the increased birth rate following the end of WWII) began to retire. The impact of this reduction in the available supply of labour is expected to be significant across many industries and markets, and will likely persist into the future. The impact will be most severely felt in those industries which have a large number of workers close to retirement, including teaching and, to some extent, healthcare.

Weather and climatic conditions

In February 2014, there were significant bushfires in some rural areas of Victoria and on the outskirts of Melbourne. These weather- related events had a negative supply-side impact on those areas. The fires damaged the operation of vital infrastructure in Victoria, with one fire burning alongside the large Hazelwood Power Station in the Latrobe Valley and threatening the power station’s operations. The bushfires also destroyed millions of dollars-worth of fencing and stock in farming areas. The fires damaged tourism infrastructure and impacted on

summer tourism in the popular Grampians and Victorian Alps tourism destinations.

In addition to the problems in power generation, the extreme heatwaves associated with the bushfires also created further problems. During the heatwaves, the pressure on Victoria’s power supply was so significant, as consumers demanded increased energy to power air conditioners, that some of the state’s largest



power users (factories and other industry) were asked to voluntary shut down or reduce production in order to reduce demand for electricity. This interruption to supply clearly exerted a negative supply effect on the economy. And, finally, during the period of the bushfire emergency, many CFA volunteer fire fighters would have been absent from their employment for extended periods of time as they were involved in the fire-fighting efforts, reducing the supply of labour and interrupting the operation of many businesses.

While it is not expected to be as extreme as the impact of the 2009Black Saturday fires, these fires and extreme weather conditions have exerted a negative effect on supply across some sectors of the economy, including agriculture and tourism.

While many parts of Australia has experienced relatively good rainfall over the past couple of years, parts of Queensland and New South Wales are currently experiencing drought conditions following two years of poor rainfall. This is having a negative impact on agricultural producers and contributing to higher costs and prices in various agricultural markets. In recognition of the significant positive externalities (see market failure later) associated with having a viable farming sector, the government announced measures in late February 2014 that seek to prevent ‘viable farms’ from closing down. This included a $320m package of measures including low interest loans and funds to access emergency water.

Relative prices and resource allocationRelative prices play an important role in the allocation of scarce resources in a market-based economy like Australia. ‘Relative prices’ is one of the building blocks of economic theory, and an extremely important concept to understand as a student of Economics.

The relative price is the price of any one good or service measured in terms of the price of another good or service. In a market economy, resources will be allocated to the production of those goods and services that are in high demand. This is because, as demand for one product rises, it should cause an increase in the price of that product, relative to other products. Firms are driven by the profit motive and will therefore produce goods and services most preferred by consumers. When a change in relative prices occur (for example, due to stronger demand for a certain good), it sends a signal to firms that profit opportunities exist if they reallocate their resources into the production of that good, since, if the cost of inputs remain the same, increased profits can be attained. In response to this ‘price signal’, firms will re-direct their resources. Therefore a change in relative prices will result in a reallocation of resources.

The high value of the Australian dollar against other currencies has been the cause of significant changes in relative prices across the Australian economy in the last few years, and similarly, the rapid depreciation of the Australian dollar since April 2013 has also affected relative prices.

An example of the impact of relative prices on resource

allocation in recent months has been the improvement of inbound tourism figures (people entering Australia from overseas) since the depreciation of the Australian dollar during 2013. Tourism Australia reports that there were 6.5 million visitor arrivals from overseas into Australia for the year ending December 2013, which was an increase of 5.5% relative to the previous year (2012). Even more noticeable was that, during December 2013 itself, there was a9.5% increase in visitor arrivals from overseas, compared to the same month in the previous year. There has also been a slowing in



growth of domestic departures – Australians leaving from Australia to travel overseas – as the Australian dollar has weakened. Tourism Australia predicts that, over the coming year, instead of travelling overseas for their holidays, more Australians will choose to stay in Australia and have their vacations domestically.

These results confirm what economists have observed about relative prices and the effect on resource allocation. As the relative price of tourism within Australia has fallen, there has been an increase in demand for that tourism experience. For Australians, the increase in the price of travelling overseas relative to the price of holidaying in Australia has caused some consumers to switch their demand towards Australian tourism. As Australian tourism operators observe this pattern, it should result in further investment in the Australian tourism sectors and a re-allocation of resources away from less profitable enterprises and towards the provision of Australian tourism.

Price elasticity of demand and supply in actionThe law of demand tells us that, as the price of a good or service rises, the quantity that consumers demand of that product will fall, and that as the price falls, consumers are likely to want to increase their consumption of that product. This is described as an inverse relationship between the price and quantity demanded. On the other hand, as price rises, profit-maximising firms will increase the supply of a good or service in line with that price rise. This is described as a positive relationship between price and quantity supplied.

However, something which is harder to predict is by how much a change in the price of a product will change the quantity demanded or supplied. The answer can be predicted by the price elasticity of demand or supply, which describes the change in quantity demanded or supplied relative to a change in price. Price elasticity is about the responsiveness of quantity demanded or supplied to changes in prices. You will have learnt in class that the gradient of the demand or supply curve indicates the relative price elasticity of a product.

The availability of substitutes is one of the factors that affect the price elasticity of demand (PED)for a good or service. The changes to the motor vehicle industry referred to earlier is a recent example of changing elasticities. Not only will the exit of Ford, Holden and Toyota from Australia mean that the demand for foreign

produced cars increases, it also means that the PED for foreign cars becomes smaller (i.e. demand becomes more price inelastic and the demand curve steepens). This is because there will be fewer substitutes for foreign cars (in fact, there will be no substitutes for foreign cars) and the number of substitutes in a market is a key factor determining the PED.



In relation to the price elasticity of supply (PES), the absence of domestic motor vehicle manufacturers will have an impact on the PES for car dealerships in Australia. As cars will be manufactured overseas, the transit time will effectively reduce the PES (i.e. supply becomes more price inelastic and the supply curve steepens). This is because Australian producers (i.e. car dealerships) operating in the market for new cars will now be less able to respond quickly and increase supply to the market when prices rise. In this case, the production period has increased (by the shipping time), which is a key determinant of the PES.

Market Failure in actionAs students of VCE Economics, there are four sources of market failure that you are required to study and understand: market power, public goods, externalities and asymmetric information.Market failure is defined as a situation where the free operation of the market delivers outcomes that are inefficient and therefore do not maximise the satisfaction of society’s wants and needs – an efficient allocation of resources is not achieved. What follows is a discussion of two current issues in the Australian economy that could lead to market failure.

Qantas, government guarantees and the risk of moral hazardIn February this year, the Federal Government met with Qantas CEO Alan Joyce to discuss the company’s request that the government provide it with a government guarantee for loans.

Qantas is an interesting case in Australia’s economy. Until 1993, Qantas was owned by the Federal Government. Legislation governing Qantas’ privatisation (the sale of a government asset to the private sector) requires that 51% of Qantas shares must be held by Australian investors and the company must be headquartered in Australia. Foreign ownership of Qantas is restricted to 49% of the company. This particular restriction is said by Qantas to be restricting the company’s ability to raise borrowings on global capital markets. Some argue this provides sufficient reason for the Federal Government to provide Qantas with government backing for its loans, to enable the company to access cheaper credit on the international markets than its current credit rating would allow.

The federal Treasurer, Joe Hockey, has shown a willingness to consider Qantas’ request, citing the fact that the company’s operations are fundamental to the economy and that foreign governments provide assistance to the airlines that Qantas competes against.



The kind of debt guarantee being asked for by Qantas is similar to that provided to Australia’s banks during the GFC, when, in return for a nominal fee paid by the banks to the government, the Federal Government guaranteed all borrowings by Australia’s banks. This enabled the banks to continue accessing money on global markets at a reasonable rate during the GFC.

However, for economists, the idea of government’s underwriting the commercial activities by providing a debt guarantee raises the spectre of ‘moral hazard’, which is a form of market failure. If a market is perfectly competitive, then economic agents are assumed to be making fully informed, rational decisions based on full information about factors such as prices, quantities, conditions and technologies. However, in many market transactions, one party to the transactions knows more about the product than the other, resulting in ‘asymmetric information’ and leading to inefficient outcomes – market failure.

In the particular instance of Qantas, the potential problem of moral hazard – one type of market failure resulting from asymmetric information- arises. Moral hazard occurs when economic agents adjust their behaviour in a way that leads to an inefficient outcome from society’s point of view. The problem arises because the government is unable to control and monitor the increased risk taking behaviour that is encouraged by the provision of the debt guarantee. If, for example, Qantas is insured against the loss that it would incur if it took out loans it could not repay (because the government has guaranteed those loans) it may be encouraged to undertaken more risky investment decisions and therefore become less ‘risk averse’. This is because any losses incurred that result in an inability to repay the debt are effectively transferred to Australian taxpayers. In essence, the debt guarantee could result in Qantas borrowing money to finance operations that are not economically sound (such as running services on loss-making routes or failing to implement productivity improvements by cutting costs), because it would ultimately not be responsible for those losses.

The concern expressed by economists is, firstly, that this may give Qantas an (unfair) advantage against other domestic competitors such as Virgin or Rex. Secondly, because Qantas would not bear the full cost of its risky decisions (which would be borne by Australian taxpayers), it could potentially make decisions that lead to less than optimal outcomes for the company and the economy overall. This would undermine the achievement of allocative efficiency in the Australian economy – a situation where resources are allocated such that the economy only produces those goods and services that maximises well-being.

The Coles/Woolworths duopoly

The domination of Australia’s grocery market by two major producers, Coles (owned by Wesfarmers) and Woolworths, has continued to be an issue of importance in Australia throughout 2013 and into 2014. This market structure is described as a duopoly, and with good reason, given the extent of the concentration compared to other comparable countries, as shown in the charts below comparing the

shares of the food retail sector held by companies in Australia compared to the UK.



market. For some time, the ACCC has been concerned by the negative impact of market power on both customers and suppliers to Woolworths and Coles. This is because, not only do Australian consumers face a highly concentrated market when it comes to buying groceries, the big two supermarkets also represent a duopsony since they are the only two buyers of the majority of output of suppliers of food and groceries in Australia, both food manufacturers and farmers.

For the last twelve months, the ACCC has been actively investigating the behaviour of the supermarkets, and whether Coles and Woolworths have been engaging in ‘unconscionable conduct in their dealings with their suppliers’ and misusing their market power by favouring their house brands. In October 2013, the ACCC revealed that the investigation was proving to be ‘complex’ and its report would be delayed until sometime this year.

While a final ruling on the behaviour of the supermarkets has been deferred, there have been some developments in this issue. In November 2013, Coles and Woolworths announced that they have agreed to a voluntary code of conduct to protect suppliers. The code prohibits the supermarkets from using the suppliers’ intellectual property to develop their own products (i.e. using similar or the same packaging strategies) and from changing contracts retrospectively. The code will be enforceable by law, as it will become a regulation under the Competition and Consumer Act. According to the Australian Food and Grocery Council, which signed the code with Coles and Woolworths, it is aimed at ensuring a ‘fair go’ for suppliers ‘in a market where there is an imbalance of power.’

Source: h t tp://theco nv ersation.com/ f actchec k -is-ou r -g r ocer y -mar k e t - one-o f -the- mos t -concent r ated-in-the - world-16520

This duopoly is an ongoing example of concentrated market power, which economists predict leads to market failure. Market power occurs when the absence of competition in a market leads to one or a few firms being in a position to ‘control’ the market. On its own, this does not constitute a market failure. However, it does constitute a market failure if those firms ‘abuse’ that market power through strategies such as predatory pricing or cartel conduct. Competition imposes a discipline on businesses that helps to ensure that consumers’ wants and needs are met at the lower possible price. However, in a highly concentrated market (one with few producers) producers have an incentive to restrict supply as this can lead to greater profitability, especially if their product(s) has a low price elasticity of demand. Also, firms are able to make very high profits without being forced to innovate or increase their productivity, because few or no competitors exist.

The impact of market power in creating market failure was discussed in detail in Update 1 of 2013. As was noted, as a consequence of lack of competition, companies operating in highly concentrated markets are under very little pressure to reduce their prices, improve their service or develop their product range. The lack of competition also means these companies have significant control over their selling price, which would not be the case in a market

which was less concentrated and included more competition.

The Australian Competition and Consumer Commission (ACCC) is the Australian government agency tasked with enforcing compliance with the Competition and Consumer Act (2010), and actively discouraging or preventing any anti-competitive behaviour in Australian markets. This government intervention is designed to limit the market failure involved with having a highly concentrated



Also, recently more evidence has come to light about the day-today impacts on the food industry of these practices where abuses of market power on behalf of the supermarket giants has been claimed. One supplier interviewed by the ABC Background Briefing program said that supermarkets expect a certain quantity of sales from the products they stock, and if that is not met they request a lump sum of money to be paid to them to make up for the shortfall. A further example is being asked to pay to be on the shelf in the first place. If the amount is not paid, the product will be removed from the shelves. Some producers claim they are being forced to sell their product to Coles or Woolworths at below the producer’s cost of production. According to Background Briefing:

South Australian dairy farmers this year have received 37c a litre from the milk processors. That’s under their cost of production which is 42c. The milk processors… say they have been hit hard by the supermarket price war (the decision by the two major retailers to sell their home-brand milk at $1 litre.) (The retailers) said they would absorb the cost of (their) $1 a litre campaign. But Background Briefing has seen a document from one of the main milk processors that shows in the past year Coles has dropped the price it’s paying the processor for milk.

In an industry where producers could potentially sell their product to another customer if they weren’t happy with the trading conditions, such issues would not necessarily be of concern. Producers would be likely to find a different company to sell to. However, in a situation where there are only two buyers – a duopsony – then producers find themselves unable to do anything but pay the money requested or accept the price offered by the buyer, or risk losing a market – their only market. For many producers, Coles and Woolworths combined could represent considerably more than half their sales, with few alternate possible customers. Evidence of this activity was provided to Background Briefing by a dairy farmer from South Australia:

I do know of other suppliers of fruit and vegetables, that food line, where the bigger the supermarkets, they take more and more of your product



until you’re producing most of your product out of your factory to go to them, and once that happens you’ve lost the rest of your market, and then they can tell you that they will pay you whatever they like, and that leaves you with nowhere else to go.

As some observers have noted, the apparent competition between the two big players has driven down prices for some grocery items. However, the concerns are that these reductions have come at the expense of suppliers and the impact on longer term benefits for consumers. In particular, if suppliers continue to experience pressure to lower the prices they charge the supermarket chains, will this impact the viability of the suppliers in the long run, and stifle innovation and investment by those suppliers?

Concern has been expressed that in the longer run, this could reduce the incentive to operate in these industries (e.g. farming), leading to an under-allocation of resources to the production of goods valued by households, such as fresh, Australian-produced food. It also has implications for future food security (Australian self-sufficiency), particularly if the supermarkets rely increasingly on foreign food supplies.

Read more: http://www.smh.com.au/business/consumer-watchdog-accc-takes-woolworths-coles-to-court-over-fuel-dockets-20140225-33egl.html#ixzz2uVrZNzaW

More recently, in late February 2014, Coles and Woolworths were subject to Federal Court action instigated by the ACCC, who alleges that the supermarket giants broke promises over fuel shopper dockets schemes. The original agreement that came into force in January 2014 provided for Coles and Woolworths to limit the fuel discounts to four cents per litre for shoppers who purchase fuel at Coles or Woolworths fuel outlets. However, larger discounts had been offered since that time and the ACCC feared that it would have a long term negative impact on the structure of the retail petrol market. In particular, smaller independent fuel retailers could be squeezed out of the market, leaving only the two dominant suppliers to control the market in the future and potentially abuse their market power.

REVIEW QUESTIONS:1. Explain how relative scarcity results in the

need for economic decision making and creates opportunity cost.

2. Define the concept of opportunity cost and explain the potential opportunity cost of the following possible Australian government policy decisions:

a. To continue to provide subsidies to the vehicle manufacturing industry



b. To cease all subsidies to the vehicle manufacturing industry

3. Construct a fully-labelled demand and supply graph to illustrate the impact of changing consumer preferences on the markets for both Ford Falcons and Toyota Corollas. Explain the likely impact of this change in consumer preferences on relative prices and resource allocation between these two markets.

4. Explain the likely impact of the recent depreciation of the AUD on the market for Australian tourism – both domestic and overseas.

5. Describe how one market in Australia may be positively impacted by lower interest rates over 2014.

6. Explain why the recent Wage Price Index (WPI) figures would represent a favourable supply side factor for many Australian producers.

7. Define the term labour force participation rate and explain why the LFPR is an important supply side factor.

8. Explain the impact of a falling labour force participation rate by ‘baby boomers’ on the market for teachers and nurses.

9. Explain why the recent bushfires in Victoria and the drought in parts of Qld and NSW would be considered unfavourable supply side factors impacting negatively on agricultural markets.

10. Explain how the recent depreciation of the Australian dollar has changed the relative pricesawithin tourism markets.

11. Explain how the impending changes to the motor vehicle industry in Australia will impact on both the price elasticity of demand for foreign cars as well as the price elasticity of supply for new cars in Australia.

12. Explain what is meant by the term ‘market failure’ and explain how the Federal government providing a debt guarantee to Qantas could result in market failure.

13. Explain what is meant by market power, and explain the difference between a duopoly and a duopsony.

14. Outline the accusations that have been made against Australia’s two largest supermarkets by some food producers in Australia. Explain how these might represent an example of market failure.

15. Explain how the misuse of their market power by the two big players in Australia’s grocery market contributes to an inefficient allocation of resources. In your answer, refer to specific types of efficiency. (Hint: you could discuss allocative and productive efficiency in your answer.)

Memorable quotesThe real problem (with subsidies to the car industry) is this creates a huge distortion in the labour markets because people are attracted to jobs in an industry that is going to fail - that are dead end jobs - and they spend a great deal of their time and human capital specialis- ing in skills that are not easily transferable.

Sinclair Davidson, Professor of Institutional Economics at RMIT Univer-

sity, h t tps://theco nv ersation.com/ f o r d-to-pull-ou t -o f -ca r -p r oduction-in - aust r alia- exper t - r eaction-14584

The sales for domestic-made cars have dropped quite considerably over the past 10 years and we have to ask ourselves why. It’s not just about foreign imports, but also the sorts of cars we’re making. We haven’t been as agile when it comes to looking at consumer preferences and the different requirements that consumers have. … It’s quite obvious foreign imports have been able to satisfy (those) changes in consumer preferences where domestic manufactured cars have not.

Paul Gollan, Associate Dean, Research and Professor of Management,Faculty of Business and Economics at Macquarie University, h t tps:// theco nv ersation.com/ f ord-to-pu l l-ou t -o f -ca r -production-in - aust r alia-exper t -rea c- tion-14584



With one of the most concentrated food retail sectors in the world dominated by the supermarket duopoly, the barriers to making it easy to buy local food in Australia are significant. It is time for Australia to learn from the example of other countries and provide assistance to rebuild local food systems.

The Australian Greens, Official website: h t tp://ww w .g r eens.o r g.au/helping- f arm- ers-sell-di r ect

‘While intensified competition between the two major chains has reduced grocery retail prices, there are concerns that those reductions come at the expense of suppliers and impact on the longer term durable benefit to consumers. We have to ask ourselves: will these price and market pressures impact on the viability of the food and grocery industry over the long term, and will they stifle innovation and investment by suppliers. And will this result on higher grocery prices in the longer term.’

Minister for Small Business, Bruce Billson MP, address to the Australian Food and Grocery Council,October 30th 2013 h t tp://brucebillson.com.au/Media/Speeches/tabid/68/articl e T ype/ ArticleView/article I d/823/Address-to-the - Aust r alian- F ood - And-Grocer y - Council . aspx

I do know of other suppliers of fruit and vegetables, that food line, where the bigger the supermarkets, they take more and more of your product until you’re producing most of your product out of your factory to go to them, and once that happens you’ve lost the rest of your market, and then they can tell you that they will pay you whatever they like, and that leaves you with nowhere else to go.

Barry Clarke, Dairy Farmer, quoted on ABC Background Briefing, 24th

March 2013

“Abdul the kebab maker in Parramatta mall, to quote [former Liberal MP] Ross Cameron, is not asking for a new oven …These businesses are there to compete in the open market place. We want to encourage enterprise, not entitlement.”

Federal Treasurer, Joe Hockey, 14th February, 2014.

‘I want to begin by saying that Australia is good at manufacturing. We have been a manufacturing country for decades and decades and decades, and I believe that manufacturing is a vital part of a strong economic future for our country.’

Prime Minister Tony Abbott, Joint Press Conference, Parliament House, Canberra, Wednesday,18 December 2013.

Application exerciseAustralia’s manufacturing future and the reallocation of resources

One of the major news stories for this year (and

throughout 2013) has been the announcement by many Australian manufacturing (and some service) companies of the decision to close or downsize their Australian-based production facilities. In addition to the major vehicle manufacturers discussed earlier in this update, in recent weeks there was the announcement by Alcoa of the closure of its Port Henry smelter, and SPC Ardmona’s announcement that it might have needed to close its Shepparton plant if government was not willing to provide assistance for a plant upgrade. (Ultimately, the Victorian state government



agreed to provide support to SPC Ardmona) Consequently, there has been considerable discussion about the future of manufacturing in Australia.As students of economics, you will be aware that labour is one of the key economic resources available in any economy. Changes to market conditions will affect the allocation of resources (including labour) between markets. In particular, as the economy experiences a significant restructuring, the question has been raised as to where the jobs will come from to replace those lost to the declining manufacturing industry.Read the following extract from an SPCA Media Release from early February and an extract from a speech about Australia’s manufacturing future made by the Prime Minister in December2013, and answer the questions that follow.“… Our employees are aware of the critical and urgent need to transform our business and the majority have responded in practical and financial ways to lift productivity to help secure our long term in future in the Goulburn Valley… We have been assessing work practices for many months, and have made significant improvements in productivity… We are doing our best to reduce all costs across the business, however the serious problems that have beset SPCA have not been because of labour costs … . The business has been severely damaged in recent times by a ‘perfect storm’ created by external economic factors- the high Australian dollar, which appreciated more than 50% from 2009 to 2013, has both enabled the flood of cheap imported product to be sold in Australia below the cost of production here, and also decimated the company’s export markets. In that period market share of private label canned fruit grew to 58% today, while SPC Ardmona canned fruit share declined to 33%. Our export market volumes declined by90% in the past five years.”

Peter Kelly, Managing Director of SPC Ardmona, quoted in a Media Release from the company, 4th February 2014.

“I believe that manufacturing is a vital part of a strong economic future for our country, and yes, we’ve got the problem in the motor industry that we’re dealing with specifically today, but in sector after sector, Australian manufacturing is continuing to do well. A couple of illustrations that I want to make… you look at the boots that myself and my friend and colleague, the Industry Minister, are wearing – Australian made… and exported to many countries. There’s that factory in west Gosford that … is making 10% of the world’s aerosol springs. A little workshop in west Gosford that is sending its product right around the world, which is competing in a mass market product with the workshops of Asia, because they are smart, innovative and adaptive… Our manufacturing can do well. And our challenge as a government is to try to get the conditions right for it to do even better in the future…We’ll be looking at new options to reduce the costs of energy, new options to encourage innovation, such as employee share schemes and commercialisation programmes, because it is important to give manufacturing – new manufacturing, manufacturing for the future, not just

for the past – the best possible deal…I accept that, particularly for older workers who spent a lifetime in a particular industry, it’s very difficult to move and to adapt when the business for which you have worked for many years fundamentally changes… (for the people currently at Ford and Holden, when manufacturing stops) … Some of them will find it difficult, but many of them will probably be liberated to pursue new opportunities…”

Extracts from a press conference - Prime Minister Tony Abbott, speaking about the $100m plan to help Holden workers, December 18th 2013, http://www.abc.net.au/news/2013-12-18/abbott-announces-support-package-for-holden-workers/5163950



Questions/tasks1. Explain what is meant by the term ‘productivity’.2. Describe how the improvements in

productivity at SPC Ardmona could be considered a favourable supply factor for the company.

3. Explain why it is important for companies (and the economy as a whole) to improve their productivity in order to secure their long term future.

4. Construct a fully labelled demand and supply diagram that shows the likely impact of improving productivity on the market for SPC’s canned fruit products. Explain how the equilibrium price and quantity would adjust in response to the improvement in productivity at SPC.

5. Explain what SPC means by the ‘perfect storm’ affecting the company.

6. Describe why the persistently high Australian dollar has been considered an unfavourable demand factor for SPC.

7. Construct a fully labelled demand and supply diagram that shows the impact of the persistently high dollar on the market for SPC’s canned fruit products. Explain how the equilibrium price and quantity would adjust in response to the impact of the high AUD at SPC.

8. According to the Prime Minister, what is the challenge facing manufacturing in Australia?

9. In his statement, the PM refers to retrenched workers being ‘liberated to pursue new opportunities’. Explain how the restructuring of Australia’s economy will lead to a reallocation of labour resources between sectors.

10. As a student who has been studying and observing the Australian economy, where do you believe the ‘industries of the future’ may lie for Australia?

Every effort has been made to trace and acknowledge copyright. The author and CPAP would like to thank the RBA for use of charts used throughout this Update. The publisher would welcome any information from parties who believe that copyright infringement has occurred. CPAP Updates purchased by schools include a copyright licence permitting one CPAP Update to be copied for each student in that class. In the case of two classes, a second licence must be purchased. In the case of three classes, a third licence must be purchased.

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