Business Economics

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Running head: BUSINESS ECONOMICS
Business Economics
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1BUSINESS ECONOMICS
Table of Contents
Part A: Externality...........................................................................................................................2
Question 1.1.................................................................................................................................2
Question 2.2.................................................................................................................................2
Question 1.3.................................................................................................................................4
Part 2: Inflation................................................................................................................................6
Question 2.2.................................................................................................................................6
Question 2.2.................................................................................................................................7
Question 2.3...............................................................................................................................10
Part 3: Minimum wage..................................................................................................................11
Question 3.1...............................................................................................................................11
Question 3.2...............................................................................................................................12
Question 3.3...............................................................................................................................15
References......................................................................................................................................17

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Part A: Externality
Question 1.1
Negative externalities occur when a production and consumption activity imposes an
external cost on the third party and is not accounted by either party of transaction (Kreps 2019).
In case of Melbourne airport, the negative externality is associated with the discourage of
harmful chemical named as per and poly fluoroalkyl chemicals (PFAS) in the nearby water in
Maribyrnong River. The chemical if discharged in excessive quantity can lead immune
dysfunction, certain types of cancer or hormonal interference. Until 2010, the PFAS substances
were found in the foams used in the airport for emergency training and for the purpose of
firefighting. Aqueous film forming foams are used in aircraft hangars for the purpose of deluge
system. These substances release from the airport and mix with the water degrading the water
quality (Cuthbertson 2018). Use of the polluted water harms farmers and people of the region
imposing an external cost. Thus Melbourne airport is responsible for creating negative
externalities in the nearby region.
Question 2.2
Negative externality and market failure
Among various reasons responsible for hampering efficient functioning of market,
presence of externality is one primary factor causing a market failure. The main problem with
externality is that direct agents involved in the activity do not account for the external cost or
external benefit (Cowell 2018). As a result, market demand and market supply curve only
represent private marginal cost or private marginal benefit. Socially efficient outcome thus is
different from free market outcome.

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In case of negative externalities, the production activity imposes an external cost on the
society. As private party does not consider the external cost, the private marginal cost is lower
than social marginal cost of production. Socially efficient outcome occurs where social marginal
cost matches with marginal social benefit. Because of underestimation of actual cost of
production, free market produces larger than socially optimal quantity resulting in market failure
(Friedman 2017). This is illustrated in figure 1.
Figure 1: Negative externality and market failure
(Source: as created by author)
In the above figure, demand and supply in the private market are shown as the respective
curves named as DD and SS. If negative externality presents in production such as the harmful
consequences of the use of AFFF containing PFAS, the social marginal cost is higher than
private marginal cost of production. The supply curve SS shows private marginal cost. The
marginal social cost (MSC) curve lies above the marginal private cost (MPC). The demand curve

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as usual reflect both marginal private and marginal social benefit. Private market equilibrium at
EP where the demand curve and MPC cuts. The private market produces QP and charges a price
of PP. Socially optimal outcome is where marginal social cost and marginal private cost cut that
is at point ES. Socially efficient output is QS and that of socially efficient price is PS. With
externality, goods are thus over-produced and price is also lower than socially desirable (Baumol
and Blinder 2015). There is a welfare cost to the society because of the extra units produced at a
lower price. The welfare cost or deadweight loss is shown by the shaded region.
Question 1.3
Market based solution to negative externality
Market based solution aims to internalize the negative externality by using market
instruments of demand, supply and price. The two market base solutions that can internalize
negative externalities are tax and tradable permits.
Transferable permit
The policy of transferable permit is a market-based approach that sets the maximum limit
of emission. The limit of emission under this approach tends to be achieved at a lower cost than
relative to other available measures. Firms emitting harmful substances have the freedom to trade
permits among themselves. Firms who can lower pollution to the set limit at a lower cost sell
their permits. Those firms facing a higher cost of lowering emission buys permits (Cowen and
Tabarrok 2015). Exchange of tradable permit creates a market where supply of permits is fixed
while demand varies depending on cost involve in reducing emission.

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Figure 2: Market of tradable permit and negative externality
(Source: as created by author)
Tax
The market based approach of tax imposition to internalize the externality first estimates
the maximum cost of adapting control measures of the identified externality. This provides
polluters an incentive to reduce the external cost at a cost relatively lower than proposed tax.
This policy does not put any restriction on maximum amount of emission. The quantity of
emission reduction depends on the chosen rate of tax (Mochrie 2015). In order to internalize the
externality completely a tax is imposed equivalent to the difference between marginal social cost
and marginal private cost. The figure below shows the impact of a proposed tax to internalize the
externality.

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Figure 3: Impact of tax in a market with negative externality
(Source: as created by author)
In the above, with externality the free market equilibrium is at point E. The market
equilibrium quantity QM is larger than socially efficient quantity at QE. Imposition of tax
equivalent to the difference between marginal social cost and marginal private cost shifts the
market supply curve or MPC curve by the tax amount. The MPC curve now coincides with the
marginal social cost. This helps to attain socially desirable quantity at QE at a socially desirable
price at PE.
Part 2: Inflation
Question 2.2
Difference between monetary targeting and inflation targeting in monetary policy
The monetary targeting policy is because price level in the long-run affects increase in
supply of money. The objective is to attain sufficient growth in targeted monetary aggregate. The

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most important characteristics of targeting monetary aggregate include selection of monetary
aggregate, range of target and control of selected unit. In contrast, inflation targeting refers to a
monetary policy regime of central bank where the bank sets target to achieve specific policy
goal. The central bank here adjusts interest rate to keep the inflation within targeted range.
Experienced of monetary targeting policy suggests that the policy though has successfully
stabilize price level in countries such as Switzerland and Germany, the success is subject special
economic condition in the two countries (worldbank.org 2019). These conditions are unlikely to
be satisfied in most other nation that adapts the monetary policy to improve domestic economic
condition. The experience of most of the industrial economies suggests that inflation targeting
policy is more successful in controlling inflation. Unlike monetary targeting, the inflation
targeting policy can weaken the effect of shocks in inflation trend. The policy successfully fights
against inflationary shocks in countries such as Canada, Australia, UK and Sweden. The inflation
targeting is more successful in reducing inflation because of greater transparency and
communication with public. The traditional monetary targeting policy is time-inconsistent
(Gittins 2016). The time inconsistent behavior of monetary targeting policy occurs due to
political pressure on the central bank to an over expansionary monetary policy. One advantage of
inflation targeting policy over monetary targeting is that it addresses and focuses on the political
debate of what a central bank can achieve (control inflation) in the long run rather than what it
cannot achieve (increased economic growth and permanent growth in employment). By
increasing accountability and transparency, the inflation targeting policy promotes independence
central bank. The inflation targeting policy differs from monetary targeting policy in many
aspects (Mishkin 2000). Inflation targeting policy does not follow a rigid rule. There is no loss of

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credibility under inflation targeting policy. The inflation targeting policy does not avoid
traditional stabilization objectives.
Question 2.2
Causes of inflation
The two main causes leading to inflation are demand-pull and cost-push. General price
level in the economy can increase because of both factors. However, the working mechanism of
demand-pull and cost-push inflation to influence the price level is different. Demand-pull
inflation occurs when increased demand from different consumer increases price (Goodwin et al.
2015). Cost-push inflation in contrast occurs when increased production cost reduces supply and
increase price level.
Demand-pull inflation
The most common cause of increase in price level is the increased demand in the
economy. This is a situation where consumers increase their demand for different goods and
services such that demand exceeds supply. Producers are unable to increase production to meet
the increased demand within the shirt notice. The condition of excess demand creates upward
pressure on price resulting in an increase in price level or inflation. There are different reasons
that lead to demand pull inflation. The first is economic expansion. In a growing economy,
people experience a higher income that induce them to spend more. Positive expectation about
future inflation also encourages people to consume more today in fear of further increase in price
in future (Uribe and Schmitt-Grohe 2017). Discretionary fiscal policy that aims to stimulate
economic growth results in a higher demand and inflation. Innovation of new technology and
marketing mechanism contribute to inflation by increasing demand for specific products.

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Excessive growth of money is another factor responsible for demand –pull inflation. The money
supply does not only refer to cash but loans, credit and mortgages. For all the above-discussed
reasons, aggregate demand in the economy expands causing price level or inflation to increase.
Figure 4: Demand-pull inflation
(Source: as created by author)
Cost-push inflation
The second major cause of inflation is the cost-push. This kind of inflation occurs due to
a shortage of supply in combination with a steady demand. There are several contributors of
cost-push inflation. Among them the first inflation in wage. As wage increases, employers have
to give a higher wage to the labors leading to a higher cost of production. This reduces aggregate
supply in the economy leads to a rise in prices. The monopoly power of a firm often leads to
cost-push inflation (Heijdra 2017). As monopolists control entire, it can create artificial supply
shortage leading to inflation. Natural disaster by destroying productive resource hampers

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production creating supply shortage and inflation. Other factors that might lead to cost push
inflation include taxation or government regulation and the policy to lower currency exchange.
Figure 5: Cost-push inflation
(Source: a created by author)
Question 2.3
Effect of a cut in cash rate
When RBA lowers the cash rate, it affects all other interest rate in the economy. With a
fall in cash rate, the lending rate in the economy reduces. The most direct consequence of lower
interest rate is the increase in level of investment (Debelle 2018). Interest rate is the opportunity
cost of holding money. As interest rate reduces people tend to reduce saving and increase
spending on consumption. The lower interest rate is a bad news for foreign investors. The lower
return induces them to withdraw funds from Australia and investment in other nation yielding a
relatively higher return. This in turn reduces value of Australian dollar in global market. As

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Australian dollar depreciates, export from Australia becomes cheaper while import becomes
expensive. The lower dollar value increase export of Australia and reduces import. Increase in
export earnings along with a decline in import improves trade balance of Australia (Johnson
2017). Following an increase in investment, consumption and net export aggregate demand
increases. This shifts the aggregate demand curve to the right. Because of expansion of aggregate
demand, GDP and price level increases. As economic activity expands, more jobs are created
which help to increase level of employment.
Figure 6: Effect of a decline in cash rate
(Source: as created by Author)
Part 3: Minimum wage
Question 3.1
Advantages of binding minimum wage to the employers

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Minimum wage is binding when minimum wage is set above the equilibrium wage in the
labor market. The binding minimum wage allows employees several advantages. Workers are
more productive when they have less worries and stresses about their personal life. A binding
minimum wage enable workers to get wage beyond their survival. Because of a higher minimum
wage, worker need not to worry about their necessities. This adds to higher productivity of
workers benefiting the employee and the economy.
Minimum wage helps to reduce worker turnover promoting greater stability of workforce.
In the absence of minimum wage, equilibrium wage is often too low that workers continue to
move from one place to another in search of higher pay package. Business cost of recruitment
and arrangement of training is costlier than the minimum wage (Meer and West 2016). The
binding minimum wage allows workers to continue their work in one particular job. This helps
them to gather more experience and increase skills, which in turn raises productivity.
Minimum wage create incentive to work for labors. In the presence of higher minimum
wage, workers receive a higher salary. This creates an incentive for workers to work instead of
getting on welfare program. A binding minimum wage makes it possible for workers to think of
starting saving. As minimum wage allows worker to earn beyond the survival, they can save the
excess earning. Minimum wage also encourages a higher economic growth. One important
advantage of setting a minimum wage is that it can help to achieve a robust economic growth.
The economy expands when people have more earnings to spend (Sorkin 2015). A minimum
wage also helps the economy in terms of promoting the equality within the society. Minimum
wage by boosting earing of poor promotes a greater sense of equality.
Question 3.2

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Disadvantage of binding minimum wage for employers and the economy
The policy of binding minimum wage has some adverse impact on employers and the
economy as a whole. Labor is one primary input in most businesses. A significant share of total
cost of any business is the cost for employees’ wage. A binding minimum wage per unit cost of
labor contributing to an overall increase in company’s cost of production. The higher cost of
production reduces profitability of businesses and discourages production activity. The excess
costs are wither pass onto consumers in the form of a higher price of goods or services or
absorbed by the company (Patty 2018). The former way passing on cost to the consumers result
in cost-push inflation in the economy while the latter has the consequence of reducing innovation
and creativity on the part of the company due to higher cost of labor.
A direct consequence of minimum wage to the economy is increasing the problem of
unemployment in the economy. If wages are set above the market clearing wage, then demand
for labor reduces because of a higher wage cost. The supply of labor in contrast increases with
the expectation of a higher income. The labor market thus suffers from an excess supply of labor
resulting in unemployment (Mitchell 2019). The figure below shows unemployment created due
to a binding minimum wage.

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Figure 7: Binding minimum wage and unemployment
(Source: as created by Author)
In the above figure the market clearing wage is at W* obtained from supply-demand
intersection in the labor market. Now, suppose policy sets minimum wage above the market
equilibrium at W1. At this wage, demand for labor reduces from L* to L1 while supply of labor
increases from L* to L2. As supply of labor exceeds that of its demand there exist unemployment
of the amount (L2 – L1).
Minimum wage does not always result in a reduction in poverty. Unemployment created
because of a binding minimum wage is mostly among unskilled poor workers. The problem if
unemployment or underemployment is more prevalent for poor workers. This problem when
combined with a stagnant economy might result in increasing poverty in the economy (Barany
2016). A higher minimum wage encourages employers to outsource or offshores production
leading to further job loss in the domestic economy.

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Question 3.3
The obvious consequence of a binding minimum wage is an increase in cost of
production lowering supply of the concerned product. The supply shortage in the market results
in a higher price and lower equilibrium quantity. The surplus to both consumers and producers
decreases because of this (Mankiw 2014). The figure below explains impact of a binding
minimum wage on equilibrium price, equilibrium quantity, consumer surplus and producer
surplus.
Figure 8: Effect of binding minimum wage on market equilibrium and consumer and
producer surplus
(Source: as created by Author)
In figure 8, DD and SS are the respective demand and supply curve of a particular product. The
initial market equilibrium occurs at point E. The equilibrium price and equilibrium quantity in
the market are P* and Q* respectively. The consumer surplus is the area A + B +C +D. The

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producer surplus is the area equals to F + G + H. Now because of an increase in minimum wage,
production cost increases. This causes a contraction in supply. The supply curve shifts to the left
to S1S1. In the product market the new equilibrium is at E1 (Nicholson and Snyder 2014).
Equilibrium price in the market increase to P1 while equilibrium quantity reduces to Q1. Because
of a higher price consumer surplus reduces to the triangle A only. The lower production and
sales lowers consumer surplus to B+ F.

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References
Barany, Z.L., 2016. The minimum wage and inequality: the effects of education and
technology. Journal of Labor Economics, 34(1), pp.237-274.
Baumol, W.J. and Blinder, A.S., 2015. Microeconomics: Principles and policy. Nelson
Education.
Cowell, F., 2018. Microeconomics: principles and analysis. Oxford University Press.
Cowen, T. and Tabarrok, A., 2015. Modern principles of microeconomics. Macmillan
International Higher Education.
Cuthbertson, D. 2018. Airport's toxic runoff leaves farmers unable to use water they bought.
[online] The Age. Available at: https://www.theage.com.au/national/victoria/airport-s-toxic-
runoff-leaves-farmers-unable-to-use-water-they-bought-20180927-p506c7.html [Accessed 21
May 2019].
Debelle, G. 2018. Twenty-five Years of Inflation Targeting in Australia | Speeches | RBA.
[online] Reserve Bank of Australia. Available at: https://www.rba.gov.au/speeches/2018/sp-dg-
2018-04-12.html [Accessed 21 May 2019].
Friedman, L.S., 2017. The microeconomics of public policy analysis. Princeton University Press.
Gittins, R. 2016. RBA independence on interest rates: a tick for a resilient economy. [online] The
Sydney Morning Herald. Available at: https://www.smh.com.au/business/rba-independence-on-
interest-rates-a-tick-for-a-resilient-economy-20160923-grmsde.html [Accessed 21 May 2019].
Goodwin, N., Harris, J.M., Nelson, J.A., Roach, B. and Torras, M., 2015. Macroeconomics in
context. Routledge.

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Heijdra, B.J., 2017. Foundations of modern macroeconomics. Oxford university press.
Johnson, H.G., 2017. Macroeconomics and monetary theory. Routledge.
Kreps, D.M., 2019. Microeconomics for managers. Princeton University Press.
Mankiw, N.G., 2014. Principles of economics. Cengage Learning.
Meer, J. and West, J., 2016. Effects of the minimum wage on employment dynamics. Journal of
Human Resources, 51(2), pp.500-522.
Mishkin, F.S., 2000. Inflation targeting in emerging-market countries. American Economic
Review, 90(2), pp.105-109.
Mitchell, W., 2019. Macroeconomics. Macmillan International Higher Education.
Mochrie, R., 2015. Intermediate microeconomics. Macmillan International Higher Education.
Nicholson, W. and Snyder, C.M., 2014. Intermediate microeconomics and its application.
Nelson Education.
Patty, A. 2018. Fair Work finds repeat offenders short-changing staff. [online] The Sydney
Morning Herald. Available at: https://www.smh.com.au/business/workplace/fair-work-finds-
repeat-offenders-short-changing-staff-20181108-p50epu.html [Accessed 21 May 2019].
Sorkin, I., 2015. Are there long-run effects of the minimum wage?. Review of economic
dynamics, 18(2), pp.306-333.
Uribe, M. and Schmitt-Grohe, S., 2017. Open economy macroeconomics. Princeton University
Press.

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worldbank.org 2019. From Monetary Targeting to Inflation Targeting: Lessons from
Industrialized Countries: Policy Research Working Papers. [online] Elibrary.worldbank.org.
Available at: https://elibrary.worldbank.org/doi/pdf/10.1596/1813-9450-2684 [Accessed 21 May
2019].