BASIC

ECONOMICS
Reform)

(with Taxation and Agrarian

COMPILATION

INTRODUCTION

MEANING OF ECONOMICS

Adam Smith the forefather of the economists regarded economics as a science which
studies the process of production, Consumption, distribution and exchange of wealth. According
to him, Economics inquires into the factors those determine wealth of a country and its growth.
According to Prof. Marshall, economics is the study of mankind in the ordinary business
of life. It examines that part of individual social action which is not most closely connected with
the attainment and use of material requisites of well being.
Prof. Lionel Robbins gave his definition of economics in his book Nature and
significance of Economic Science in the year 1932 .He defined economics as the science that
studies human behavior as a relationship between ends and scarce means which have alternative
uses.
Economics is the study of how man and society choose, with or without the use of money
to employ scarce productive resources, which could have alternative uses, to produce various
commodities over time and distribute them for consumption now and in the future among various
people and groups of society. Professor Samuelsons definition of economics

MANIFESTATION OF ECONOMICS AS A SUBJECT MATTER

The above mentioned definitions of economics accorded by the well known

economists agreed on all the three important aspects: scarce resources, unlimited wants, and
maximum satisfaction.
Scarcity is the fundamental economic problem of having seemingly unlimited
human wants in a world of limited resources. It states that society has insufficient productive
resources to fulfill all human wants and needs. A common misconception on scarcity is that an
item has to be important for it to be scarce. However, this is not true, for something to be scarce,
it has to be hard to obtain, hard to create, or both. Simply, the production cost of something
determines if it is scarce or not. For example, although air is more important to us than

diamonds, the former is cheaper because the production cost is zero. Diamonds on the other hand
have a high production cost. They have to be found and processed, both which require a lot of
money. Additionally, scarcity implies that not all of society's goals can be pursued at the same
time.
The idea of want can be examined from many perspectives. In secular societies, want
might be considered similar to the emotion desire, which can be studied scientifically through the
disciplines of psychology or sociology. Want might also be examined in economics as a
necessary ingredient in sustaining and perpetuating capitalist societies that are organized around
principles like consumerism. Alternatively, want can be studied in a non-secular, spiritual,
moralistic or religious way.
In economics, a want is something that is desired. It is said that every person has
unlimited wants, but limited resources (economics is based on the assumption that only limited
resources are available to us from the infinite universe). Thus, people cannot have everything
they want and must look for the most affordable alternatives.
Wants are often distinguished from needs. A need is something that is necessary
for survival such as food and shelter, whereas want is simply something that a person would like
to have. Some economists have rejected this distinction and maintain that all of these are simply
wants, with varying levels of importance. By this viewpoint, wants and needs can be understood
as examples of the overall concept of demand.

SIGNIFICANCE OF ECONOMICS

As we mentioned earlier that economics is concerned with the satisfaction of human

wants. Economics is related to production, consumption and distribution of resources in the
economy among individuals. Nowadays, economics touches every one, whether you are a
worker, a business owner, a teacher, a lawyer, a banker or a student. The study of economics
point out two important advantages: theoretical and practical advantages.

As theoretical advantages, it helps us to understand the concept of national income,

employment, consumption, savings, capital formation, investment, price mechanism, demand
and supply and so forth. In addition, it also enables us to create and develop logical thinking
towards various economic problems.

As practical advantages, economics provides a vital role for the following sections of our
society such as:

Significance for the consumers

Significance for the producers
Significance for workers
Significance for politicians
Significance for academicians
Significance for administrators
Effective manpower planning
Helpful in fixing price
Solving distribution problems

BASIC ECONOMIC PROBLEMS

The basic economic problem is one of the fundamental economic theoretical principles
in the operation of an economy. It asserts that there is scarcity; that is, that the
finite resources available are insufficient to satisfy all human wants and needs. As such, the
following questions must be considered:

What goods and services must be produced?

How to produce the goods and services?
For whom to produce?

What to produce is a question of the types of goods society desires. Will a country produce
rice, coconuts, and corn or manufacture bags and ready to wear clothing? Or if a country is
preparing for war, should it concentrate on the manufacture of ammunitions? Since resources are
scarce, no economy can produce every product desired by the members of the society.

How to produce is a question on the technique of production and the manner of combining
resources to come up with the desired output. Since a good can be produced with different factor
combination and different techniques, the problem is which of these to use. The economy that
had decided on the production of bags will also have to come up with the decision on how the

bags will be manufactured. What materials will be used? Will production involve the use of more
labor or the use of more machinery? How will the available resources be combined to come up
with most efficient output of bags?
For whom to produce refers to the market to which the producers will sell their products.
It refers to how much of the wants of each consumer are to be satisfied. Will the bags be sold to
high income earners or to low income earners? Will the target market be males, females, or
children? Will the bags manufactured be exported or strictly to be sold within Philippines? This
is a problem since resources and goods are scarce and no society can satisfy all the wants of its
entire people.
Hence, an economic system, in answering the needs of the society, has the function of
determining what goods and services to produce as well as the order of their importance. This
will naturally depend on the needs of the economy as well as its goals and objectives.
In addition, the economic system has to perform the task of organizing productive efforts
to produce the selected goods and services in the proper quantities.
Lastly, it must determine how these goods and services should be shared among the
members of the society.

TYPES OF ECONOMIC SYSTEM

The economic systems are classified as follows:

1. Traditional is an economic system in which each new generation retains the

economic position of its parents and grandparents. Traditional economies rely on the
historic success of social customs.
2. Capitalism is an economic system in which trade, industry, and the means of
production are largely or entirely privately owned and operated for profit. It is also
known as market economy, free enterprise economy, or laissez faire economy.
Capitalism consists of two forms: pure capitalism and modified capitalism. The
former means that all economic decisions are made without government intervention

while the latter means that the government intervenes and regulates business to a certain
extent.
The essential characteristics of capitalism are the following:

Private property
Profit
Economic freedom
Free competition

3. Communism is an economic system in which the government owns all the nations
resources. It is exactly the opposite of capitalism. It is also known as command
economy.
The essential characteristics of communism are as follows:

No private property
No free competition
No economic freedoms
No profit motive
Presence of central planning

4. Socialism is an economic system where the major and strategic industries are owned
and managed by the government. Examples are telecommunication, transportation,
water services, and banking and selected manufacturing businesses. Private
individuals are allowed, however to own and operate small businesses. Socialism is a
combination of capitalism and communism. Therefore, it contains the characteristics
of both capitalism and communism.

THE MIXED ECONOMY

A mixed economy is an economic system in which economic activity is directed by a
mixture of private firms and the government.
In a mixed economy, some parts of the economy known as the private sectors are left
to private firms and individuals, whereas other parts, such as education and the military, are
controlled by the government. The activity controlled by the government is known as the public
sector.

Mixed economies are the most common form of economic system used around the world,
with most developed countries dividing economic activity between the private and public
sectors.
It is seldom that an economic system exists in its pure form. While the economy of the
United States of America is basically market oriented, there exists some form of government
regulation and control. On the other hand, the Peoples Republic of Chinas economy is
command in nature, yet it cannot use the price system at all.
The Philippine economy is a mixture of three forms of economic systems. In the
mountains and isolated barrios, most farmers are still traditional in their production methods.
While most buyers and sellers are influenced by the price system, it cannot be denied that the
government plays a significant role in decision- making with regard to production, business, and
industry. The existence of price control, strict government regulations, government support, and
subsidy programs are proofs of the importance of government participation in decision- making
in the countrys production activities. In a mixed economy like ours, the question of what to
produce and how to produce, answered predominantly through the price mechanism, is modified
through government intervention in the form of direct controls, taxes, and subsidies.

The problem of for whom to produce is also solved by the price mechanism coupled
with different forms of government regulation. The economy will produce those commodities
that will satisfy the wants of those people who have the money to pay for them. Predominantly,
the Philippine economy is a free enterprise in nature, but the best way to describe our economic
system is a mixed economy.

ECONOMIC GOALS

Economic growth
Employment
Economic efficiency
Price level stability
Economic freedom
Equitable distribution of income
Economic security
Balance of trade

THE ECONOMIC RESOURCES

Economic resources are the goods or services available to individuals and businesses
used to produce valuable consumer products. It includes land, labor, capital, and
entrepreneurship.

Land is the economic resource encompassing natural resources found within a nations economy.
This resource includes timber, land, fisheries, farms and other similar natural resources. Land is
usually a limited resource for many economies. Although some natural resources, such as timber,
food and animals, are renewable, the physical land is usually a fixed resource. Nations must
carefully use their land resource by creating a mix of natural and industrial uses. Using land for
industrial purposes allows nations to improve the production processes for turning natural
resources into consumer goods.

Labor represents the human capital available to transform raw or national resources into
consumer goods. Human capital includes all able-bodied individuals capable of working in the
nations economy and providing various services to other individuals or businesses. This factor
of production is a flexible resource as workers can be allocated to different areas of the economy
for producing consumer goods or services. Human capital can also be improved through training
or educating workers to complete technical functions or business tasks when working with other
economic resources.

Capital has two economic definitions as a factor of production. Capital can represent the
monetary resources companies use to purchase natural resources, land and other capital goods.
Monetary resources flows through a nations economy as individuals buy and sell resources to
individuals and businesses
.
Capital also represents the major physical assets individuals and companies use when producing
goods or services. These assets include buildings, production facilities, equipment, vehicles and
other similar items. Individuals may create their own capital production resources, purchase them
from another individual or business or lease them for a specific amount of time from individuals
or other businesses.

Entrepreneurship is also considered an economic resource because individuals are responsible

for creating businesses and moving economic resources in the business environment. These
economic resources are also called the factors of production. The factors of production describe
the function that each resource performs in the business environment.

DIVISION OF ECONOMICS

Macroeconomics (from the Greek word makro- meaning "large" and economics) is a
branch of economics dealing with the performance, structure, behavior, and decision-making of
an economy as a whole, rather than individual markets. This includes national, regional, and
global economies.
Macroeconomists study aggregated indicators such as GDP, unemployment rates, and price
indices to understand how the whole economy functions.
Macroeconomists develop models that explain the relationship between such factors
as national income, output, consumption, unemployment, inflation, savings, international trade
and international finance.

Microeconomics (from Greek word mikro- meaning "small" and economics) is a branch
of economics that studies the behavior of individuals and small organizations in making
decisions on the allocation of limited resources. Typically, it applies to markets where goods or
services are bought and sold. Microeconomics examines how these decisions and behaviors
affect the supply and demand for goods and services, which determines prices, and how prices,
in turn, determine the quantity supplied and quantity demanded of goods and services.
One of the goals of microeconomics is to analyze market mechanisms that establish relative
prices amongst goods and services and allocation of limited resources amongst many alternative
uses. Microeconomics analyzes market failure, where markets fail to produce efficient results,
and describes the theoretical conditions needed for perfect competition. Significant fields of
study in microeconomics include general equilibrium, markets under asymmetric information,
choice under uncertainty and economic applications of game theory. Also considered is
the elasticity of products within the market system.

CIRCULAR FLOW OF ECONOMIC ACTIVITY

In economics, the term circular flow refers to a simple economic

model which
describes
the
reciprocal
circulation
of
income
between producers and consumers. In the circular flow model, the inter-dependent
entities of producer and consumer are referred to as firms and households
respectively and provide each other with factors in order to facilitate the flow of
income. Firms provide consumers with goods and services in exchange for
consumer expenditure and factors of production from households.

BASIC ECONOMIC ACTIVITIES

Production is the use of economic resources in the creation of the goods and services
for the satisfaction of human wants.
Consumption in economics, the use of goods and services by households.

TWO ECONOMIC UNITS

Household is the basic consuming unit.

Firm is the basic producing unit.

STOCK AND FLOW CONCEPTS

Stock refers to the measure of quantity at a point of time.

Flow refers to the measure of movement of quantity over a period of time.

Illustration:
If you deposit 1,000 at the end of every month into your bank account, you would have a
balance of 12,000 (1,000 x 12 months) at the end of the year. The monthly deposits are flows
and the year-end balance is a stock which accumulates the flows. We can call the monthly
deposits saving as flows and the year-end balance savings as stocks.

Flows: GDP, consumption, investment, saving, trade deficit and surplus, budget deficit and
surplus, aggregate demand and supply.
Stocks: Debt, infrastructure, buildings, wardrobes, memories, library, circulating currency,
computer software and hardware, databases, cars in your garages, antiques.

THE CIRCULAR FLOW OF GOODS, SERVICES, AND INCOME

ECONOMIC RESOURCES

HOUSEHOLDS

FIRMS

GOODS AND SERVICES

FIGURE 1
PRODUCTION PROCESS

The process of producing goods and services.

Involves households and firms.
Economic resources such as: land, labor, and capital are provided by the households.

Economic resources are processed and produced by firms.

Produced goods and services are delivered to households for consumption.

THE FLOW OF OUTPUT BETWEEN FIRMS AND HOUSEHOLDS

RAW MATERIAL
PRODUCERS

INTERMEDIATE
GOODS PRODUCERS

HOUSEHOLDS

FINAL GOODS
PRODUCERS

FIGURE 2

The above mentioned illustration provides us and idea about the flow of raw materials,
intermediate goods and final goods. Raw materials are goods which are still unprocessed like
wood, sand and gravel, and iron ore. These goods are produced by raw materials producers.
Intermediate goods are partially processed goods like steel bars used for construction and flour
used in baking. These goods are produced by intermediate goods producers. Final goods are
processed goods that are ready for final consumption like ready to wear clothing, appliances, and
gadgets. These goods are produced by final goods producers.

THE CIRCULAR FLOW OF GOODS AND INCOME AMONG PRODUCERS

AND HOUSEHOLDS

HOUSEHOLDS

RESOURCES

RAW MATERIALS
FIRMS

RESOURCES

INTERMEDIATE
GOODS FIRMS

RESOURCES

FINAL GOODS
FIRMS

FIGURE 3
The circular flow of goods and income among producers and households describes the
distribution of economic resources made by the households among the various types of
producers or firms. In return, the respective producers (raw materials firms, intermediate firms,
and final goods firms) will provide payments to households for the use of the economic
resources.
In relation thereto, once the goods are finally processed, these goods are delivered to the
households for consumption. In this case, the households will give payments to the respective
producers.
(See Figure 3)

THE CIRCULAR FLOW OF INCOME BETWEEN HOUSEHOLDS AND

FIRMS
INCOME FLOW (e.g.
salaries, rentals, and interests)

HOUSEHOLDS

FIRMS

INCOME FLOW (e.g. purchase

of goods and services)

FIGURE 4

FIGURE 5

The circular flow of income between households and firms is a theory that describes the
movement of expenditure and income.
For example, households provide factors of production such as land, labor, and capital to
firms. Firms use these factors to produce goods and services which they sell to the households.
The households then spend money on the goods and services produced by local firms. This
money is then used by firms to pay the households for their land, labor, and capital. The
households in this case will earned rental income, salaries, and interest income. This process
repeats itself and forms the circular flow of income.
However, not all income generated will be spent. In reality, some of the income is being
saved, used to pay government taxes, and or used to purchase imported goods from other
countries. Therefore savings, taxation and imports are leakages in the circular flow of income.
Leakages are the non-consumption uses of income, including saving, taxes, and imports.
Likewise, sometimes there is extra spending in the economy, from investment, government
expenditures and payments for exports, which will be added to the circular flow of income.
These are called injections. Injections come from investment, government spending and export
sales.

THE CONCEPT OF EQUILIBRIUM

The economy will be in equilibrium if the amount received by firms from

households is equal to the amount received by households from firms. Disequilibrium happens
when either households or firms do not spend all their incomes. If households, for one reason or
another, reduce their purchases, firms will receive a reduced amount of income resulting to their
inability to maintain current levels of purchases from households. When firms actually reduce
their purchases of economic resources, some laborers will lose their jobs, and some land and
physical capital will become idle. The result is a corresponding reduction in the income of
households.

BASIC ELEMENTS OF DEMAND AND SUPPLY

This chapter discusses the interaction between buyers and sellers in a market economy.
Properly framed, almost any economic question can be approached from a supply and demand
perspective; because resources are limited but wants are unlimited, the magic of the market is to
direct signals between people who are looking to consume and people who are looking to
produce. Our implicit assumption is that prices carry this information between buyers and sellers,
and hence prices are discussed as the most important factor determining behavior on both sides
of the market.

THE MARKET
A market is one of the many varieties of systems, institutions, procedures, social
relations and infrastructures whereby parties engage in exchange. While parties may exchange
goods and services by barter, most markets rely on sellers offering their goods or services
(including labor) in exchange for money from buyers. It can be said that a market is the process
by which the prices of goods and services are established.
For a market to be competitive there must be more than a single buyer or seller. It has
been suggested that two people may trade, but it takes at least three persons to have a market, so
that there is competition in at least one of its two sides.

MARKET DEMAND
Market demand refers to the buyers willingness and ability to pay a sum of money for
some amount of a particular good or service. However, the quantity demanded of goods or
services will depend on factors such as needs, preferences, income level, and expectation about
the future, the prices of related commodities, the buyers situation and so forth. The most
important consideration, however, is the price. The relationship between price and quantity
demanded is the subject of the law of demand.

The law of demand states that other factors being constant (ceteris paribus), price and
quantity demand of any good and service are inversely related to each other. When the price of a
product increases, the demand for the same product will fall.

Other factors that can influence demand:

1. Income - Generally, as income increases, we are able to buy more of most goods.
Demand for a good increases, when incomes increase, we call that good a normal
good. When demand for good decreases when incomes increase, then that good is
called inferior goods.
.
2. Price of related products - Related goods come in two types, the first of which are
substitutes. Substitutes are similar products that can be used as alternatives. Examples
of substitute goods are Close Up and Colgate, and Safeguard soap and Bioderm soap.
Usually, people substitute away to the less expensive good. Other related products are
classified as complements. Complements are products that are used in conjunction
with each other. Examples of complements are pencil and eraser, left and right
sandals, and coffee and sugar.
3. Tastes and preferences - Tastes are a major determinant of the demand for products.
People of different cultures vary in taste and preferences. A large ethnic group, for
instance, has a taste for mixing their food with strong dose of spices. Some group of
people prefers to spend a large part of their incomes on luxuries even if basic
necessities are not satisfied.
4. Size of the market The demand curve is affected by the number of people living in
a given area. A market with a big population like Metro Manila tends to buy more
appliances and electricity than a less populated region like Cagayan Valley.
5. Special Influences There are certain developments that influence demand for
certain goods and services. Heat and humidity, for instance, contribute to the demand
for air conditioning equipment and light clothing.
6. Expectations about future economic conditions - When you expect the price of a
good to go up in the future, you tend to increase your demand today. This is another
example of the rule of substitution, since you are substituting away from the expected

relatively more expensive future consumption. E.g. expectations about a forthcoming

war or typhoon.

DEMAND SCHEDULE AND DEMAND CURVE

Demand schedule shows the quantity of the product demanded by a consumer or an

aggregate of consumers at any given price. From our daily experience of buying and selling, we
know that the higher prices influence people to buy less. Therefore, the demand function shows
how the quantity demanded of a particular good responds to price change. In addition, the
demand schedule must specify the time period during which the quantities will be bought. This is
best illustrated in Table 1.

Table 1
Price of X
(per kilo)
45
40
35
30
25
20

Quantity Demanded
( in kilos)
100
150
200
250
300
350

The quantity demanded values are rates of purchases at alternative prices. It can be seen
from Table 1 that at lower prices of X, people get attracted to buy more.
The demand curve is a graphical presentation of the demand schedule and therefore,
contains the same prices and quantities presented in the demand schedule. Plotting the data from
Table 1, we now arrive at figure 6.

The normal demand curve slopes downward from left to right. Any point on the demand
curve reflects the quantity that will be bought at the given price. The price per unit is represented
in the vertical axis, while the quantity demanded for each price level is indicated in the
horizontal axis.

45
40
Price

35
30
25
20

100

150

200

250

300

350

Quantity demanded (in kilos)

FIGURE 6

CHANGES IN DEMAND vs. CHANGE IN QUANTITY DEMANDED

Changes in demand refer to changes in the determinants of demand like income,
population, price expectation, and so forth. For instance, an increase in population also increases
demand for goods and services, or a decrease in income also reduces demand. In a graph, an
increase in demand shifts the demand curve to the right while a decrease in demand shifts the
demand curve to the left as shown in figure 7.

PRICE

D3 D1 D2

QUANTITY
Changes in quantity demanded indicate the movement from one point to another point
(from price- quantity combination to another price- quantity combination on a fixed demand
curve). This means the demand curve does not change its position like that of the demand curve
in the changes in demand. The change in quantity demanded is brought about by changes in
price. Whenever there is a change in price (increase or decrease), there is corresponding change
in quantity demanded. For example, lower price results to more units of goods. In the case of
change in demand, it caused by changes in the determinants of demand. Change in quantity
demanded is graphically illustrated in Figure 8.

Demand

Quantity

MARKET SUPPLY

Supply is the quantity of a good or service that a producer is willing and able to supply
onto the market at a given price in a given time period.
The law of supply states that as the price increases, the quantity supplied also increases,
and as the price decreases, the quantity supplied also decreases.

SOME FACTORS AFFECTING SUPPLY:

1.

Costs of production

A fall in the costs of production leads to an increase in the supply of a good because the
supply curve shifts downwards and to the right. Lower costs mean that a business can supply
more at each price. For example a firm might benefit from a reduction in the cost of imported
raw materials.
If production costs increase, a business will not be able to supply as much at the same price this will cause an inward shift of the supply curve. An example of this would be an inward shift
of supply due to an increase in wage costs.
2.

Changes in production technology

Technology can change very quickly and in industries where the pace of technological
change is rapid we expect to see increases in supply (and therefore lower prices for the
consumer)
3.

Government taxes and subsidies

Government intervention in a market can have a major effect on supply. A tax on

producers causes an increase in costs and will cause the supply curve to shift upwards. Less will
be supplied after the tax is introduced.
A subsidy has the opposite effect as a tax cut. A subsidy will increase supply because a
guaranteed payment from the Government reduces a firm's costs allowing them to produce more
output at a given price. The supply curve shifts downwards and to the right depending on the size
of the subsidy.
4.

Climatic conditions

For agricultural commodities such as coffee, fruit and wheat the climate can exert a great
influence on supply. Favorable weather will produce a bumper harvest and will increase supply.
Unfavorable weather conditions such as a drought will lead to a poor harvest and decrease
supply. These unpredictable changes in climate can have a dramatic effect on market prices for
many agricultural goods.
5.

Change in the price of a substitute

A substitute in production is a product that could have been produced using the same
resources. Take the example of barley. An increase in the price of wheat makes wheat growing
more attractive. This may cause farmers to use land to grow wheat and less to grow barley. The
supply of barley will shift to the left.

6.

The number of producers in the market

The number of sellers in a market will affect total market supply. When new firms enter a
market, supply increases and causes downward pressure on the market price. Sometimes
producers may decide to deliberately limit supply by controlling production through the use of
quotas. This is designed to reduce market supply and force the price upwards.
The entry of new firms into a market causes an increase in market supply and normally
leads to a fall in the market price paid by consumers. More firms increase market supply and
expand the range of choice available.

SUPPLY SCHEDULE AND SUPPLY CURVE

The supply schedule is the relationship between the quantity of a good supplied and its
price. If the quantities offered are only of one seller, then it is an individual supply schedule. The
aggregate supply quantities of a group of sellers are presented as a market supply schedule.
Let us look at following market supply schedule:

TABLE 2
Price (per kilo)
45
40
35
30
25
20

Quantity Supplied (per kilo)

350
300
250
200
150
100

From the given schedule, we can see that higher prices serve as incentives for the sellers
to offer more X for sale, while low prices discourage them from offering more quantities to sell.
The supply schedule can be depicted as a supply curve. The supply curve contains the
exact prices and quantities in the supply schedule. In effect, it is the graphical representation of
the supply schedule.
The supply curve is upward sloping from the left to right. Any point on the supply curve
reflects the quantity that will be supplied at that given price.

After analyzing the above relationship, we can now state that as price increases, the
quantity supplied of a product tends to increase and as price decreases, quantity supplied instead
decreases.

Figure 9
45
40
Price

35
30
25
20

100

150

200

250

300

350

CHANGES IN SUPPLY vs. CHANGES IN QUANTITY SUPPLIED

Changes in supply pertain to changes in the determinants of supply. For
example, a decrease in the cost of production increases supply. More subsidies
result to more supply. Through graphical presentation, an increase in supply shifts
the supply curve to the right while a decrease in supply shifts the supply curve to
the left. Figure 10 illustrates changes in supply:
PRICE

S3

S1

S2

QUANTITY
Changes in supply show the shifting of the supply curve to the right if there is an increase
in supply and to the left if there is a decrease in supply. Such changes are caused by changes in
the determinants of supply.

Changes in quantity supplied show the movements from one point to another point on a
constant supply curve. Change in quantity supplied is brought about by change in price. For
example, if the price increases from P3 to P4, there is a corresponding increase in quantity
supplied as shown in Figure 11.

Demand

Quantity

Change in quantity supplied show an increase in price also increases quantity supplied.
This supply curve has not changed its position. Only the points on the same supply curve move.

MARKET EQUILIBRIUM
Market equilibrium is a market state where the supply in the market is equal to the
demand in the market. The equilibrium price is the price of a good or service when the supply
of it is equal to the demand for it in the market. If a market is at equilibrium, the price will not
change unless an external factor changes the supply or demand, which results in a disruption of
the equilibrium.

If the market price is above the equilibrium value, there is an excess supply in the
market a surplus, which means there is more supply than demand. In this situation, sellers will
tend to reduce the price of their good or service to clear their inventories. They probably will also
slow down their production or stop ordering new inventory. The lower price entices more people
to buy, which will reduce the supply further. This process will result in demand increasing and
supply decreasing until the market price equals the equilibrium price.
If the market price is below the equilibrium value, then there is excess in demand
supply shortage. In this case, buyers will bid up the price of the good or service in order to
obtain the good or service in short supply. As the price goes up, some buyers will quit trying
because they don't want to, or can't, pay, the higher price. In addition, sellers, more than happy to
see the demand, will start to supply more of it. Eventually, the upward pressure on price and
supply will stabilize at market equilibrium. Figure 12 illustrates the law of demand and supply
through graph:

THEORY OF CONSUMER BEHAVIOR

Consumer behavior is the study of individuals, groups, or organizations and the processes
they use to select, secure, use, and dispose of products, services, experiences, or ideas to satisfy
needs and the impacts that these processes have on the consumer and society.
Consumer behavior focuses on how individuals make decisions to spend their available
resources (time, money, effort) on consumption-related items that includes what they buy, why
they buy, when they buy it, where they buy it, how often they buy it, how often they use it, how
they evaluate it after the purchase and the impact of such evaluations on future purchases, and
how they dispose of it.

Who is a consumer?

Person or group of people, such as a household, who are the final users of products or
services.
One who pays to consume the goods and services produced.
The consumer forms part of the chain of distribution.
Consumer considered as a king in a market economic system.

GOODS AND SERVICES

Good is something that you can use or consume. Like for instance, food, car, books, ready
to wear, etc.
Service is something that someone does for you. Like for instance, haircutting, food
catering, banking transaction, telecommunication services, etc.

NECESSITY GOODS vs. LUXURY GOODS

NECESSITY GOODS

LUXURY GOODS

Type of normal goods

Type of superior goods

Goods that are necessary in our daily existence

Goods that are may or may not necessary to

our daily existence as human being.

e.g. food, water, shelter, clothing, medicine,

etc.

e.g. luxury cars, jewels, expensive gadgets, etc.

ECONOMIC GOODS vs. FREE GOODS

ECONOMIC GOODS

FREE GOODS

Goods that have an opportunity cost.

Zero opportunity cost

Relatively scarce and have a price.

Unlimited supply and for free.

e.g. water distributed by ORWASA and

electricity distributed by LEYECO V

e.g. air that we breathe and sunlight

coming from the sun.

CONCEPT OF UTILITY
Utility may be defined as the satisfaction derived from the consumption of a commodity
which determines consumption and demand behavior.

Total Utility refers to the total amount of satisfaction one obtains from the consumption of
goods and services

THREE CHARACTERISTICS OF THE CONCEPT OF UTILITY

Utility and Usefulness are not synonymous.

Utility is subjective.
Utility is difficult to quantify.

TWO WAYS IN MEASURING UTILITY

Cardinal Utility Approach refers to the measurement of utility by assigning numerical

values, referred to as utils. E.g. 1 util , 140 utils, and -70 utils.

Ordinal Utility Approach measures utility in terms of ranks, such as those indicating
levels from most satisfying to least satisfying, best to worst, and highest to lowest.

CONCEPT OF MARGINAL UTILITY

The satisfaction provided by a certain good or service is the main purpose of using the
same. By this reason, consumers obtain satisfaction at increasing levels as they continuously
consume good or service. It simply means that the total satisfaction of the good or service
increases as more units are being consumed. In economics, this increase is called marginal utility.
Marginal Utility refers to the additional satisfaction obtained from the consumption of an
additional unit of goods and services.
To better explain the concept, here is an example, a chocolate bar. Let's say that after
eating one chocolate bar your sweet tooth has been satisfied. Your marginal utility (and total
utility) after eating one chocolate bar will be quite high. But if you eat more chocolate bars, the
pleasure of each additional chocolate bar will be less than the pleasure you received from eating
the one before. Probably because you are starting to feel full or you have had too many sweets
for one day. To provide a numerical example, refer to Table 3:

Chocolate bars
1
2
3
4
5
6
7

Total Utility (in utils)

40
70
90
100
80
50
10

Marginal Utility (in utils)

40
30
20
10
-20
-30
-40

This table shows that total utility will increase as marginal utility diminishes with each additional
bar. The first chocolate bar gave you a total utility of 40 utils. The second chocolate bar, on the
other hand provides an additional satisfaction of 30 utils thereby making your total utility of 70
utils. The third chocolate bar adds 20 utils of utility, hence the total utility is already 90 utils. The
fourth chocolate bar gave you a total utility 100 utils but with additional utility of 10 utils. Notice
that when you had your fifth up to seventh chocolate bars, your total utility declined resulted to
negative marginal utility. It is important to take note that the marginal utility decreases as more
bars of chocolate are consumed. This is an illustration of the law of diminishing marginal utility.
The graphical illustrations of the law of diminishing marginal utility are presented in figures 13
and 14 respectively.

Figure 13
TOTAL UTILITY CURVE

TU

100
90
80
70
60
50
40
30
20
10
0
1

Quantity

Figure 14
MARGINAL UTILITY CURVE
MU

40
30
20
10
0
-10
-20
-30
-40
1

Quantity

CONSUMER EQUILIBRIUM
When consumer makes decisions on the basis of choosing the quantity of goods or services
to consume, the presumption is that the consumers objective is to maximize total satisfaction. In
maximizing total satisfaction, the consumer is faced with the following realities:
Consumers limited income or his purchasing power, and
The prices of the goods and services that the consumer wishes to consume.
The consumers effort to maximize total satisfaction, subject to the following realities, is
referred to as the consumers problem and the solution to the said problem which entails about
how much the consumer will consume of a number of goods or services, is referred to us
consumer equilibrium.

UTILITY MAXIMIZATION
A theory used in economics that holds the belief that when individuals purchase a good or a
service, they strive to obtain the most amount of value possible, while at the same time spending

the least amount of money possible. When combined, the consumer is attempting to derive the
greatest amount of value from their available funds.
To better explain the theory here is an example: Let us assume that Mr. Jose is determining
what combination of two goods, hamburger and special siopao, must he purchase for him to
obtain maximum satisfaction with his limited fund of one hundred pesos. Jose is confronted with
the price of hamburger and special siopao at P20 and P15 respectively. From Joses point of
view, the utility of the two goods in various quantities are shown in Table 4.

Quantity
Consumed
0
1
2
3
4
5
6

THE UTILITY OF TWO GOODS

Table 4
Amount of Utility (in utils)
From Hamburger
From Siopao
Total
Marginal
Total
Marginal
0
0
0
0
14
14
9
9
22
8
17
8
24
2
24
7
24
0
27
3
21
-3
29
2
10
-11
30
1

From Mr. Joses point of view, the total utility of the 1 hamburger, 2 hamburgers, and 3
hamburgers are 14, 22, and 24 utils respectively. The illustration provides that the TU goes up as
more hamburgers are consumed until it reaches the highest TU. In addition, Mr. Joses TU
declines when he consumed 5 up to 6 hamburgers. This is so, because his need is fully satisfied.
The marginal utility for consuming 1 hamburger is 14 utils which is the highest and it
declines with the 2 and 3 hamburgers. However, by consuming 5 and 6 hamburgers, the MU goes
down as it registers negative figures. This means that Mr. Jose is only willing to consume up to
the point of maximum satisfaction from where an additional unit of consumption no longer
yields additional satisfaction. Beyond this point, the additional dissatisfaction begins to incur
simply decreases total satisfaction.

Note: The highest TU for siopao is with 6 pieces but the lowest MU is also derived
from 6 pieces of siopao.

With the budget constraint of P100, only 6 combinations of hamburgers and siopao are
possible. Shown in Table 5 are the various combinations.

SCHEDULE OF COMBINATIONS FOR JOSES UTILITY MAXIMIZATION

Figure 5
Combination
Quantity
Total Price
Total Utils
Hamburgers + Siopao
1
1
5
P95
43
2
2
4
100
49
3
3
2
90
41
4
4
1
95
33
5
5
0
100
21
6
0
6
90
30

INDIFFERENCE ANALYSIS
The word indifference means showing no bias or neutral. Supposing there are five
combinations of two products (like ice cream and chocolate) the first combination constitutes 5
cones of ice cream and 1 bar of chocolate, and so on. Since all combinations provide the same
level of satisfaction, the consumer would be indifferent as to which combination he receives.
This means any combination would be desirable for him. He has no particular choice. Table 6
illustrates an indifference schedule showing the various combinations of ice cream and
chocolate.
Table 6
Combinations
Cones of ice cream
Bars of chocolate
A
5
1
B
4
2
C
3
3
D
2
4
E
1
5

Figure 15
A consumers indifference curve shows different combinations of two goods which yield the
same level of satisfaction.

Ice cream

0
1

Chocolate

SUBSTITUTION
Most often, consumers use substitute goods to satisfy their wants or needs. Commodities
which can be used or consumed in place of other goods are referred to as substitute goods. The
substitution option is exercised by the consumer when there are available goods and services
which yield the same level of satisfaction but at lower costs. A consumer, for instance, may
prefer to consume mangoes. However, if he is confronted by the high price of mangoes, he will
consider looking for a substitute. Let say, he finds the bananas as the only lower- priced fruit,
then he may decide to consider the same as a substitute for mangoes. As a result of his action, the
demand for bananas will increase.

TYPES OF SUBSTITUTE GOODS

Close substitutes
Weak substitutes

A close substitute provides almost or equal level of satisfaction as that of the substituted
good or service. Like for instance, mango may be considered as a close substitute for banana.
A weak substitute provides a lower level of satisfaction than the substituted good or service.
Like for instance, a weak substitute for mango is a rice cake when used as a dessert during meals.

BUDGET LINE
A budget line or consumption possibility line indicates the various combinations of two
products which can be purchased by the consumer with his income, given the prices of the
products. A consumer has a fixed budget, and he has to spend his money wisely to be able to
maximize his satisfaction. He has several combinations of two products to choose. However, his
choice is confined within the limits of his budget.
As an example, unit price of both products A and B is P25. The budget of the consumer is
P150. It is possible for him to buy 5 units of product A and 1 unit of product B, or 5 units of B
and 1 unit of A. He can also choose 4 units of B and 2 units of A. Any of these combinations is
worth P150.
Table 7 shows a budget line schedule showing the various combinations of two products with a
fixed budget of P150 and the unit price of both products at P25.
Product A (in units)

Product B (in units)

5
4
3
2
1
Figure 16

Total expenditures
P125 + P25
= P150
P100 + P50
= P150
P 75 + P 75
= P150
P50 + P100
= P150
P25 + P125
= P150

1
2
3
4
5

Graphical illustration of budget line

A
5
4
3
2
1
0
1

REVIEW QUESTIONS
1. What is meant by the term utility?
2. Is there any difference between total utility and marginal utility?
3. How is utility measured? Why is measuring utility an important exercise?
4. Explain the concept of consumer equilibrium.
5. Explain the theory of utility maximization.
6. What is meant by indifference analysis?
7. What is meant by substitute goods?
8. What are two types of substitute goods? Give an example.
9. Explain the concept of substitution.
10. Explain the concept of budget line.

CONCEPT OF ELASTICITY
Based on the law of demand, buyers are willing and able to purchase more goods and
services at lower prices than at higher prices. These are natural reactions of buyers. However,
such reactions vary depending on the importance and availability of the goods and services.
These varying reactions are known as demand elasticity.
In the case of sellers, they tend to sell more goods and services when prices are higher.
Their reactions also vary depending on their ability to produce in a given time. For instance, they
cannot take advantage of higher prices if they cannot produce the goods and services. Such
varying reactions of producers are known as supply elasticity.
DEMAND ELASTICITY
Demand elasticity refers to the reaction or response of the buyers to changes in price of
goods and services.
Classification of Demand Elasticity:
Price elasticity of demand
Income elasticity of demand

Cross elasticity of demand

Price Elasticity of Demand

Price elasticity is used to determine the responsiveness of demand to changes in the price of
the commodity. It may be calculated with the use of the formula below:
Ep = percentage change in quantity demanded
percentage change in price

Where:

(QD2-QD1)/QD1 / (P2-P1)/P1

Ep
Q2
Q1
P2
P1

= Coefficient of arc price elasticity

= New quantity demanded
= Original quantity demanded
= New price
= Original price

Example:
Year
2012
2013

Quantity demanded
10,000 kg.
16,000 kg.

Price
P5/kilo
P4/kilo

Solution:

Ep

(16,000-10,000)/ 10,000
(4-5) / 5

0.6 / -0.2

-3

Analysis:
-3 means that for every one percent decrease in the price of a commodity, the quantity
demanded will increase by 3 percent. The consumer is said to be highly responsive (elastic) to
changes in the price of the commodity.

As you may have observed, price elasticity is always negative, although when we analyze
and interpret the coefficient, we ignore the negative sign thus only the absolute value is
interpreted. What could be the reason for this? It is always negative due to the very nature of
demand: if price increases, less quantity of good is demanded therefore quantity change is
negative, leading to a negative price of elasticity of demand. Conversely, if price falls, this
negative value will lead to a negative price elasticity of demand value.

Note: If elasticity coefficient (answer) is:

More than 1 = elastic demand
Less than 1 = inelastic demand
Equal to 1 = unitary demand

FIVE TYPES OF DEMAND ELASTICITY

1. Elastic demand. A change in price results to a greater change in quantity demanded. For
example, a 20% change in price (decrease or increase) creates a 60% change in quantity
demanded (increase or decrease). This shows buyers are very sensitive to price change.
They are easily discouraged to buy the products if their prices increase. However, they
are easily encouraged to buy the same products if their prices decrease. Such products are
not very important to them, but they provide comforts and pleasures to the consumers.
These are the luxury goods like stereo, radio, camera, television set, etc.
2. Inelastic demand. A change in price results to a lesser change in quantity demanded. For
example, a 50% change in price creates only a 5% change in quantity demanded. This
means buyers are not sensitive to price change. Products under this category are very
essential to buyers. They cannot live without them; it is hard to live without such
products like rice, medicine, or shelter. People have to buy said products even if there is a
big increase in their prices. However, a big decrease in the prices of the aforementioned
goods has a very little increase in quantity demanded. For example, a great decline in the
prices of rice and medicine does not encourage people to eat more rice or take more
medicine. They only buy as much as the requirement of their normal consumption. But if
the price of rice is very high and many people cannot afford such price, they are forced to
eat only twice a day, or mix rice with corn. Many extremely poor people are doing this.

3. Unitary demand. A change in price results to an equal change in quantity demanded. For
example, a 25% change in price produces a 25% change in quantity demanded. Goods or
services under this category are considered semi-luxury or semi-essential goods.
Examples are the branded ready to wear apparels like Jag, Lee, Guess, Levis, and
Penshoppe.
4. Perfectly elastic demand. Without change in price, there is an infinite change in quantity
demanded. Such demand applies to a company which sells in a purely competitive
market.
5. Perfectly inelastic demand. A change in price creates no change in quantity demanded.
This is an extreme situation which involves life or death of an individual. Regardless of
price, he has to buy the product like medicine with no substitute.

Figure 17: Types of demand elasticity showing the various degrees of reactions of buyers
brought about by price change.
P

P
D
----------------------------------

----------------------------------------

Q
Elastic demand

D
--------------------

Q
Inelastic demand

Q
Unitary demand

--------------------------------D

Perfectly elastic demand

Q
Perfectly inelastic demand

Income elasticity of demand

Income elasticity of demand refers to the determination of the responsiveness of demand
to a change in consumer income.
FORMULA: Ey = Percentage change in quantity demanded
Percentage change in income
= (QD2- QD1) / QD1 / (Y2-Y1) Y1
Where

Ey = Income elasticity of demand

Y2 = New income
Y1 = Original income

When elasticity is greater than 1, demand is said to be income elastic.

When it is less than 1, it is income inelastic.
When it is equal to 1, it is unitary elastic.

Cross elasticity of demand

The demand for a certain good may be affected a change in the price of another good.
From the economic standpoint, it is very useful for a person to know this relationship between
goods.
The responsiveness of the quality demanded of a particular good to changes in the price of
another good is referred to as cross elasticity of demand. It is measured by computing the
percentage change in the quantity demanded of the first good and dividing it by the percentage
change in the price of the second good. The mathematical representation of this relationship is as
follows:
Ec

=
Where

Percentage change in quantity demanded for product X

Percentage change in the price of related commodity
(QA2 QA1) / QA1 / (PB1 PB2) / PB1
Ec
QA2
QA1
PB2
PB1

= Cross elasticity of demand

= New demand for product X
= Original demand for product X
= New price of related commodity
= Original price of related commodity

Analysis:
If cross elasticity is positive, the goods are substitutes. For example, the 2% increase in
the price of rice causes a 0.66% increase in the demand for pan de sal.
If cross elasticity is negative, the goods are complements. For example, if tuition fee
increases results to a decrease in the demand for dormitories.

DETERMINANTS OF DEMAND ELASTICITY

The demand elasticity of goods and services are not similar; some are elastic and some are
inelastic. This is so because of certain factors or determinants.
1. The price of goods in relation to the consumers budget. Consumers are more sensitive
to price changes of goods that take a big amount of their budget. For instance, a change in
the price of cars drives consumers to think seriously about buying. However, a change in
the price of toothpicks; let say, from 50 centavos per box to 75 centavos per box are taken
in stride.

2. The availability of substitutes. The demand elasticity of a good is affected by the

availability of substitute. The more and the closer substitutes are, the more people will
switch to substitutes, when the price of the good rises.
3. The type of a good. The demand elasticity of a good is affected by its type, whether it is
luxury or a necessity. For instance, the demand for rice is inelastic since consumers can
scarcely avoid buying them. On the other hand, magazines and comics are luxuries and
their demand is elastic because people can avoid them when their price rises.
4. The time under consideration. The demand for a good becomes more elastic over a
longer period of time. For instance, if the price of rice rises, people may consider
switching to bread, corn, or other cereals. Switching will be slow; however, can be
achieved when a longer period is considered.
ELASTICITY OF SUPPLY
Supply elasticity refers to the reaction or response of the sellers or producers to price
change of goods. Based on the law of supply, producers are willing and able to offer more goods
at a higher price, and fewer goods at a lower price. However, such responses of producers vary in
accordance with the kind of goods they produce. For instance, there are goods which are
impossible to produce in a short time in order to take advantage of increasing prices. These are
the farm products which cannot be increased in just a month. In fact, some crops take several
years to bear fruits like coconut. In the case of industrial goods, it takes a shorter period to
increase their supply. Factories can respond to price increases by an overtime schedule of their
workers. The mathematical formula for determining elasticity of supply is:
Es = Percentage change in quantity supplied
Percentage change in price
= (QS2 QS1) / QS1 / (P2- P1)/ P1
Where

Es = Price elasticity of supply

QS2 = New quantity of supplied
QS1 = Original quantity supplied
P2 = New price
P1 = Original price

Example:
Year
2012

Quantity supplied
10,000

Price
P5 / kilo

2013

18,000

P6 / kilo

Solution:
Es

= (18,000- 10,000) / 10,000 / (6-5)/ 5

= .80 / .20

Es

=4

Analysis:
Supply price elasticity = 4 means that for every one percent increase in the price of
commodity X, the quantity supplied will increase by 4 percent. The seller is said to be highly
responsive (elastic) to changes in the price of the commodity.
Note: Elastic supply is where the quantity supplied is affected greatly by changes in the price.
The change is greater than the elasticity coefficient of 1. When the quantity supplied is not
affected greatly by changes in the price, supply is said to be inelastic. The elasticity coefficient is
less than 1. When the percentage change in the quantity supplied is equal to the percentage
change in price, supply is unitary elastic. The elasticity coefficient is equal 1.
FIVE TYPES OF ELASTICITY SUPPLY

1. Elastic supply. A change in price results to a greater change in quantity supplied. This
means producers are very responsive to price change. For instance, with a 10 % increase
in price, they increase their quantity supplied by 20 %. Such reaction similarly applies if
there is a decrease in price, quantity supplied is expected to decrease even bigger.
Examples are those goods which can be produced immediately or in a short period of
time. Such as products produced by manufacturing firms.
2. Inelastic supply. A change in price results to a lesser change in quantity supplied. This
shows that producers have a very weak response to price change. With a high price, they
like to increase their quantity supplied, but they cannot do it at once. For instance, if the
price of coconut increases, producers cannot respond immediately in a short period of
time. It takes about 5 years or more to produce the same. By that time, price of coconuts
would be most likely different.
3. Unitary supply. A change in price results to an equal change in quantity supplied. For
instance, a 15% change in price creates a 15% change in quantity supplied. This is a

borderline case between elastic and inelastic supply. Example of these goods is semiindustrial or semi- agricultural products.
4. Perfectly elastic supply. Without change in price, there is an infinite (without limit)
change in quantity supplied. For instance, in a poor country where massive
unemployment prevails, an unlimited number of jobless individuals are willing to work at
a fixed wage even if such wage is very low, which is the general situation in the rural
areas of the less developed countries.
5. Perfectly inelastic supply. A change in price has no effect on quantity supplied. An
example of this is land in a community. Land area is fixed regardless of price. The big
increase in population has tremendously increased the price of land. There are products
which cannot be increased immediately or in a short run period for lack of machinery,
raw materials, or money.

Figure 18. Types of supply elasticity showing the various degrees of reactions of sellers
or producers brought about by price change.
S
P
P
S
------------------

----------------

-------------

-------0

Elastic supply

Inelastic supply

--------------------------

-----------------------------S

Unitary supply

Q
Perfectly elastic supply

Q
Perfectly inelastic supply

DETERMINANTS OF SUPPLY ELASTICITY

1. The feasibility and cost of storage. Regardless of price, perishable goods like vegetables
must be brought to the market. If storage cost is high, even if it is available, the sellers
have no choice but to sell at prevailing prices. Supply in this case is inelastic.
2. The ability of producers to respond to price changes. If the producers can easily increase
or decrease output when prices fall, supply is elastic.
3. Time. With the passage of time, especially for long periods, supply tends to be elastic. If
there is a rise in prices, the producers may not be able to make adjustments quickly, but
given sufficient time, they may be able to produce more.

REVIEW QUESTIONS

1. What is meant by elasticity?

2. Enumerate the classifications of elasticity of demand.
3. Discuss the implications of price elasticity of demand.
4. What are determinants of demand elasticity?
5. When is supply said to be elastic?
6. How do substitutes affect demand elasticity?
7. What products or services may be considered with inelastic demand?
8. What products or services may be considered with elastic demand?
9. Differentiate unitary elastic demand and unitary elastic supply.
10. Explain the determinants of supply elasticity.

PRODUCTION AND COST

Production is the transformation of inputs into outputs. The factors of production are
called the inputs of production. On the other hand, outputs are the goods and services that have
been created using the production inputs.
Factors of production are classified into:
Fixed factors these are those remain constant regardless of the volume or quantity of
production. This means that whether you produce or not, the factors of production is
unchanged.
Variable factors these are those that vary in accordance to the volume or quantity of
production. If there is no production, then there is no variable.
The various inputs consist of the following:

Capital it includes raw materials, supplies, tools, machinery, equipments, etc.

Labor combines and process the various materials.
Land where the space allotted for processing is located.
Entrepreneurial or managerial talent This performs functions like supervision,
planning, controlling, coordinating, and leadership.

CATEGORIES OF PRODUCTION ACTIVITIES

1. Unique product production. This type of production activity has its output made to
order goods and services. A business production strategy that typically allows
consumers to purchase products that are customized to their specifications. The made to
order (MTO) strategy only manufactures the end product once the customer places the
order. This creates additional wait time for the consumer to receive the product, but
allows for more flexible customization compared to purchasing from retailers'
shelves. Examples are those tailored made dress, customized gadgets, services of public
relations firm, custom-built homes, charter flight airlines, etc.
2. Rigid mass production. This production activity involves the manufacture of uniform
products in large quantity using well- defined, proven, and inflexible technology. The
tools, materials, and parts used are standardized which make movements and outcomes
highly economical.
3. Flexible mass production. This type of production activity is done in two stages. The first
stage involves mass production of standardized components. In the second stage, the
components are assembled into final products that appear different from one another. For
example, in the manufacture of refrigerators, a company produces standardized parts and
assembles them into different sizes and models that will suit different consumer
requirements. Flexible mass production clearly has the cost efficiency advantage in
addition to its ability to cater consumers needs.
4. Flow Production. A continuous flow of outputs is the feature of process or flow
production. Integrated technology is employed to move a continuous flow of raw material
inputs through the system. This production activity is highly automated and mechanized,
resulting to high production efficiency when operated at high capacity. Let say, 24 hours
continuous process of production.

PRODUCTION FUNCTIONS

The output of a production process will depend on the quality and quantity of inputs used.
Various combinations of inputs will result to different quantities and qualities of output. For
instance, to produce 200 sacks of rice, the following must be considered: the use of a farming
technology on a given hectare of land with certain characteristics, the use of a certain quantity
and quality of seeds and a given number of bags of fertilizer, the use of specified tools and
machinery, and the application of a certain amount of labor will all be part of the requirements.
The relationship between the amount of inputs required and the amount of output that can be
obtained is referred to as the production function.

Another example of production function is the number of college graduates a school can
produce. It has been said that the quantity and quality of college graduates will depend on the
quality and quantity of teachers and students, the number and types of buildings, classrooms,
availability of library, laboratory facilities, etc.
Production function is a schedule (a table or mathematical equation) showing the
maximum amount of outputs that can be produced from any specified set of inputs given the
existing technology. The production function, in effect, is a catalog of output possibilities.

ANALYSIS OF THE PRODUCTION PROCESS

In the analysis of the process of production, the following must be considered:
1.
2.

The classes of inputs, and

The time frame references.

Inputs are classified as either fixed or variable. A fixed input is one whose quantity cannot be
readily changed when market conditions indicate that a change in output is desirable. Examples
of fixed inputs are buildings, machineries, and managerial personnel. These inputs cannot be
readily increased or decreased. On the other hand, variable input is one whose quantity can be
readily changed when a change in output is desired. Examples are direct labor, raw materials, and
supplies.
The time frame references consist of the short run and the long run production analysis.
The production function relates the quantity of factor inputs used by a business to the amount
of output that result. We use three measures of production and productivity.

Total product (or total output). In manufacturing industries such as motor vehicles and
DVD players, it is straightforward to measure how much output is being produced. But in
service or knowledge industries, where output is less tangible it is harder to measure
productivity.

Average product measures output per-worker-employed or output-per-unit of capital.

Marginal product is the change in output from increasing the number of workers used by
one person, or by adding one more machine to the production process in the short run.

Short Run Production Function

The short run is a time period where at least one factor of production is in fixed supply. A
business has chosen its scale of production and must stick with this in the short run

We assume that the quantity of plant and machinery is fixed and that production can be
altered by changing variable inputs such as labor, raw materials and energy.

The time periods used differ from one industry to another; for example, the short-run in
the electricity generation industry differs from local sandwich bars. If you are starting out
in business with a new venture selling sandwiches and coffees to office workers, how
long is your long run? It could be as short as a few days enough time to lease a new van
and a sandwich-making machine.

Diminishing Returns

In the short run, the law of diminishing returns states that as we add more units of
a variable input to fixed amounts of land and capital, the change in total output will
at first rise and then fall.

Diminishing returns to labor occurs when marginal product of labor starts to fall. This
means that total output will be increasing at a decreasing rate.

What might cause marginal product to fall? One explanation is that, beyond a certain point, new
workers will not have as much capital equipment to work with so it becomes diluted among a
larger workforce. In the following numerical example, we assume that there is a fixed supply of
capital (20 units) to which extra units of labor are added.

Initially, marginal product is rising e.g. the 4th worker adds 26 to output and the 5th
worker adds 28 and the 6th worker increases output by 29.

Marginal product then starts to fall. The 7th worker supplies 26 units and the 8th worker
just 20 added units. At this point production demonstrates diminishing returns.

Total output will continue to rise as long as marginal product is positive.

Average product will rise if marginal product > average product.

Table 8

The Law of Diminishing Returns

Capital Input

Labor Input

Total Output

Marginal Product

Average Product of Labor

20

20

16

11

20

30

14

10

20

56

26

14

20

85

28

17

20

114

29

19

20

140

26

20

20

160

20

20

20

171

11

19

20

10

180

18

Figure 19

Average product rises as long as marginal product is greater than the average e.g. when the
seventh worker is added the marginal gain in output is 26 and this drags the average up from 19
to 20 units. Once marginal product is below the average as it is with the ninth worker employed
then the average must decline.
Terms to remember:

Total output refers to the amount of output produced in physical units.

Average product refers to the total output divided by the quantity of the variable inputs
under consideration.

Marginal product is the additional output attributed to the increase in the quantity of the
variable inputs under consideration.

Long Run Production Function

In terms of the microeconomic analysis of production and supply, a period of time in which
all inputs under the control of a firm used in the production process are variable. In the long run,
labor and capital are variable inputs. The long-run analysis of production reveals the key role
played by returns to scale. This is one of four production time periods used in the study of
microeconomics. The other three are short run, very long run, and very short run (or market
period). The long run is also a time period designation used in the macroeconomic analysis of
economic growth and full employment.
In microeconomic analysis, the long run is concerned with the adjustment of factory or
plant size and is often termed the planning period. In the long run, a firm is able to change the
quantities of all resource inputs such as labor, capital, land, and entrepreneurship. Nothing under
the control of the firm is fixed. If the current factory is too small, then a larger one can be built in
the long run. If the existing retail store has excess space, then a smaller building can be acquired
in the long run.

RETURN TO SCALE
The guiding principle in the microeconomic analysis of the long run is returns to scale. This
concept indicates how production changes relative to equal proportional changes in all inputs. A
doubling of all inputs might, for example, also lead to an exact doubling of production. Or
production might increase by more or less than an exact doubling.

This suggests three alternative returns to scale:

Constant Returns to Scale: This results in the long run if a proportional increase in all
inputs under the control a firm leads to an equal proportional increase in production. That
is, a ten percent increase in labor, capital, land, and entrepreneurship also generates a ten
percent increase in production.

Increasing Returns to Scale: This results in the long run if a proportional increase in all
inputs under the control a firm leads to a greater than proportional increase in production.
That is, a ten percent increase in labor, capital, land, and entrepreneurship generates more
than a ten percent increase in production.

Decreasing Returns to Scale: This results in the long run if a proportional increase in all
inputs under the control a firm leads to a less than proportional increase in production.
That is, a ten percent increase in labor, capital, land, and entrepreneurship generates less
than a ten percent increase in production.

In the long run, all factors of production are variable. How the output of a business
responds to a change in factor inputs is called returns to scale. Table 9

Numerical example of long run returns to scale

Units of
Capital

Units of
Labor

Total
Output

% Change in
Inputs

% Change in
Output

Returns to Scale

20

150

3000

40

300

7500

100

150

Increasing

60

450

12000

50

60

Increasing

80

600

16000

33

33

Constant

100

750

18000

25

13

Decreasing

When we double the factor inputs from (150L + 20K) to (300L + 40K) then the
percentage change in output is 150% - there are increasing returns to scale.

When the scale of production is changed from (600L + 80K0 to (750L + 100K) then the
percentage change in output (13%) is less than the change in inputs (25%) implying a
situation of decreasing returns to scale.

Increasing returns to scale occur when the % change in output > % change in inputs.

Decreasing returns to scale occur when the % change in output < % change in inputs.

Constant returns to scale occur when the % change in output = % change in inputs

In the long run businesses will be looking to find an output that combines labor and capital
in a way that maximizes productivity and therefore reduces unit costs towards their lowest level.
This may involve a process of capital-labor substitution where capital machinery and new
technology replaces some of the labor input.
In many industries over the years we have seen a rise in the capital intensity of production good examples include farming, banking and retailing.

THE COSTS OF PRODUCTION

Since the general goal of companies is to maximize profit, it's important to understand the
components of profit. On one side, firms have revenue, which is the amount of money that it
brings in from sales. On the other side, firms have the costs of production. Let's examine
different measures of production cost.

Total cost (TC) = the sum of total fixed costs and total variable costs.
Formula: TC = TFC + TVC

Total cost, not surprisingly, is just the all-inclusive cost of producing a given quantity of
output. Mathematically speaking, total cost is a function of quantity.
One assumption that economists make when calculating total cost is that production is being
carried out in the most cost-effective way possible, even though it may be possible to produce a
given quantity of output with various combinations of inputs (factors of production).

Total fixed costs and total variable costs

Fixed costs are upfront costs that don't change depending on the quantity of output produced.
For example, once a particular plant size is decided upon, the lease on the factory is a fixed cost
since the rent doesn't change depending on how much output the firm produces. In fact, fixed
costs are incurred as soon as a firm decides to get into an industry and are present even if the
firm's production quantity is zero. Therefore, total fixed cost is represented by a constant number.
Variable costs, on the other hand, are costs that do change depending on how much output
the firm produces. Variable costs include items such as labor and materials, since more of these
inputs are needed in order to increase output quantity. Therefore, total variable cost is written as
a function of output quantity.

Sometimes it's helpful to think about per-unit costs rather than total costs. To convert a total
cost into an average or per-unit cost, we can simply divide the relevant total cost by the quantity
of output being produced. Therefore,

Average Total Cost, sometimes referred to as Average Cost, is Total Cost divided by
quantity.
Formula: ATC = TC/Q or AFC + AVC

Average Fixed Cost is Total Fixed Cost divided by quantity.

Formula: AFC = TFC/Q

Average Variable Cost is Total Variable Cost divided by quantity.

Formula: AVC = TVC/Q

Marginal cost is the cost associated with producing one more unit of output.
Mathematically speaking, marginal cost is equal to the change in total cost divided by the change
in quantity.
Marginal cost can either be thought of as the cost of producing the last unit of output or the
cost of producing the next unit of output. Because of this, it's sometimes helpful to think of
marginal cost as the cost associated with going from one quantity of output to another, as shown
by q1 and q2 in the equation above. To get a true reading on marginal cost, q2 should be just one
unit larger than q1.

For example, if the total cost of producing 3 units of output is P15 and the total cost of producing
4 units of output is P17, the marginal cost of the 4th unit (or the marginal cost associated with
going from 3 to 4 units) is just (P17-P15)/(4-3) = P2.
Formula: MC =

TC /

ACCOUNTING COSTS vs. ECONOMIC COSTS

The fundamental concept that should be learned is the difference between economic cost
and accounting cost. Economic costs are forward looking costs, meaning economists are in
tune with future costs because these costs have major impact on the potential profitability of the
firm. Economists are also giving emphasis on the so- called opportunity cost, or costs that are
incurred by not putting the resources to optimum use.
If opportunity costs are measurable, it should be included in the decision making
process, even though it is expensive to do so. But there some costs that should not be used in
decision- making such as sunk costs, because these are costs that are irretrievable due to the fact
that these are already incurred and do not affect a firms decision.
Accounting costs tend to be retrospective; they recognize costs only when these are made
and properly recorded. They do not adjust these costs even if opportunity costs change.
Therefore, the difference between economic costs and accounting costs is opportunity cost.

EXPLICIT COSTS vs. IMPLICIT COSTS

Explicit costs refer to the actual expenses of the firm in purchasing or hiring the inputs it
need, such as, when a firm purchases a machine worth one million pesos or rents a building
worth one hundred thousand pesos per month.
Implicit costs refer to the value of inputs being owned by the firm and used in its own
production process. Example, the owner of the business is an accountant; if he will work for
another company he could earn thirty thousand pesos. However, he chose to be the accountant of
his business. His thirty thousand peso salary that he could earn for another company is his
implicit cost. These two costs are included in economic cost.

BUSINESS PROFIT vs. ECONOMIC PROFIT

Business profit refers to the difference between total revenue and explicit costs, while
economic profit is the difference between total revenue and both the explicit and implicit costs.
For example, suppose a firm gives an account on its business profit of one million pesos during a
calendar year. The owner could have earned three hundred thousand pesos if he managed another
firm, and earned one hundred thousand pesos if he loaned his capital to other firms with
corresponding interest. For an economist, his profit is only six hundred thousand pesos taking his
opportunity costs (implicit costs) of three hundred thousand pesos for his salary and one hundred
thousand pesos for his unearned interest in his capital.

REVIEW QUESTIONS
1.
2.
3.
4.

What is meant by production?

What do you mean by inputs of production?
Explain the two classifications of inputs of production.
What are the four categories of production activities? How is unique product
production undertaken?
5. Differentiate rigid mass production from flexible mass production.
6. What important concept is pointed out by the law of diminishing returns?
7. What is total cost? How may it be derived?
8. Differentiate fixed costs from variable costs.
9. What examples of variable cost may be provided?
10. Differentiate accounting costs from economic costs.
11. Is there any difference between explicit cost and implicit cost? Explain your
answer.
12. What is business profit? How about economic profit?
13. How to derived average cost?
14. What is marginal cost? How may it be derived?
15. Explain the concept of production function.

MARKET STRUCTURES
Market structure is defined by economists as the characteristics of the market. It can be
organizational characteristics or competitive characteristics or any other features that can best
describe a goods and services market. The major characteristics that economist have focused on
in describing the market structures are the nature of competition and the mode of pricing in that
market. Market structures can also be described as the number of firms in the market that
produce identical goods and services. The market structure has great influence on the behavior of
individuals firms in the market and will affect how firm price their products and services.
KINDS OF MARKET STRUCTURES
1. Pure or perfect competition is a market situation where there is a large number of
independent sellers offering identical products.
Characteristics:
1. Many sellers: there are enough so that a single sellers decision has no impact on market price.
2. Homogenous or standardized products: each sellers product is identical to its competitors.
3. Firms are price takers: individual firms must accept the market price and can exert no
influence on price.
4. Free entry and exit: no significant barriers prevent firms from entering or leaving the industry.
2. Pure or perfect monopoly. It exists when a single firm is the sole producer of a product for
which there are no close substitutes. Examples are public utilities and professional sports
leagues.

Characteristics:
1. A single seller: the firm and industry are synonymous.
2. Unique product: no close substitutes for the firms product.
3. The firm is the price maker: the firm has considerable control over the price because it can
control the quantity supplied.
4. Entry or exit is blocked.
3. Monopolistic competition. It refers to a market situation with a relatively large number of
sellers offering similar but not identical products. Examples are fast food restaurants and clothing
stores.
Characteristics:
1. Lot of firms: each has a small percentage of the total market.
2. Differentiated products: variety of the product makes this model different from pure
competition model. Product differentiated in style, brand name, location, advertisement,
packaging, pricing strategies, etc.
3. Easy entry or exit.
4. Oligopoly. It exists where few large firms producing a homogeneous or differentiated product
dominate a market. Examples are automobile and gasoline industries.
Characteristics:
1. Few large firms: each must consider its rivals reactions in response to its decisions about
prices, output, and advertising.
2. Standardized or differentiated products.
3. Entry is hard: economies of scale, huge capital investment may be the barriers to enter.

CONSTITUTIONAL PROVISION
The State shall regulate or prohibit monopolies when the public interest so requires. No
combinations in restraint of trade or unfair competition shall be allowed. Sec. 19, article XII,
Philippine Constitution

MEANING OF MONOPOLY
Monopoly refers to a market condition whereby an individual or a group controls prices
regardless of the normal economic pressures of supply and demand.

REGULATIONS OR PROHIBITION OF PRIVATE MONOPOLIES

The government may either regulate or prohibit private monopolies when required by
public interest. In the first case, they are not prohibited if properly regulated. Certain monopolies
are beneficial to the public as in the case of business enterprises providing essential services to
the public. Examples of these are Meralco, PLDT, and transportation companies. The
Constitution recognizes that unregulated competition among them may, in the long run, harm
public interest. Under existing laws, the government determines the amounts they can charge for
their services.
MEANING OF RESTRAINT TRADE
The phrase restraint of trade refers to practices which interfere with normal production
and supply of commodities by restraining competition. It includes the restriction, by means of an
agreement, of the right of a person to engage in business or profession.
MEANING OF COMPETITION
Competition refers to independent efforts of rival parties to get the business patronage of a
third person (or buying public) by offering more beneficial terms as incentive to such patronage.
MEANING OF UNFAIR COMPETITION
Unfair competition refers to practices which injure the goodwill or business reputation of a
business rival through various methods, particularly the use by a person of the name, symbols, or
devices employed by such rival so as to induce the purchase of the goods of such person under a
false belief that they are the goods of the rival.
COMBINATIONS IN RESTRAINT OF TRADE OR UNFAIR COMPETITION PROHIBITED
In prohibiting such evil trade practices, Section 19 seeks to preserve and maintain
competition in a free atmosphere so that there will be no monopoly through unfair, unjust, or
oppressive means.
Note that what the Constitution prohibits is not mere competition but unfair competition.
Rival manufacturers may lawfully compete for the patronage of the public through the quality
and pricing of their goods, advertising, employment of agents, etc.
OUTPUT AND PRICE UNDER PURE COMPETITION

The price of the product in a pure competition cannot be influenced by any seller or buyer.
This is so because the quantity held by any individual seller is only a small fraction of the total
quantity produced. Changing the price will not be a cause for retaliation from competitors. If a
seller lowers his price, buyers will probably flock to his store. But since his stock is limited, he
can only serve a few buyers. Those buyers that are not served by the said seller will be forced to
buy from the other sellers at a prevailing retail price. In this case, the said renegade seller will
be the sole loser because his total revenue is reduced.
To illustrate, assume that there are 200,000 farmers producing rice at an average
production of 300 sacks per farmer. If the prevailing market price of rice is P1, 500 per sack and
a farmer lowers his price from P1, 500 to P1, 200, the said farmer will be able to dispose all his
300 sacks of rice. In this case, many buyers will be attracted to his offered price however he can
only sell limited quantity of rice. This will hardly affect the market price of remaining
59,999,700 sacks of rice. He must realize that even if he does not reduce his price, he will still be
able to sell his output at the prevailing market price.
On the other hand, if the farmer raises his price to P1, 600 per sack, he may not be able to
dispose even a single sack of rice because the buyers still have an alternative of 199,999 sellers.
In pure competition, the actual market price is determined by a combination of the independent
actions of the sellers and buyers. No individual buyer or seller can set the market price, it is the
interaction between total demand and total supply.
A sample demand schedule of an individual seller is shown in Table 10. This is graphically
depicted in Figure 20.
Table 10
DEMAND SCHEDULE OF A FARMER IN PURE COMPETITION
PRICE
QUANTITY DEMANDED (PER SACK)
P1,000
Infinite
1,100
Infinite
1,200
Infinite
1,300
Infinite
1,400
Infinite
1,500
Infinite
1,600
0
1,700
0
1,800
0
1,900
0
2,000
0
Figure 20
DEMAND CURVE FACING THE FARMER IN PURE COMPETITION

Price

P1, 500 ----------------------------------------------------- D

Quantity
PRICE AND OUTPUT DETERMINATION UNDER MONOPOLY
Since the monopolist is the sole seller in the market, his demand curve is also the
industrys curve. When he raises his price, the quantity he disposes will be reduced. When he
lowers his price, the reverse happens. This relationship is illustrated in a hypothetical demand
schedule (Table 11). This is graphically depicted in Figure 21.
Table 11
DEMAND SCHEDULE OF A HYPOTHETICAL MONOPOLIST
PRICE
P10
9
8
7
6
5
4
3
2
1
Figure 21
DEMAND CURVE OF A MONOPOLIST
Price
10

9
8

QUANTITY SOLD (in unit)

100
200
300
400
500
600
700
800
900
1000

7
6
5
4
3
2

1
100 200 300 400 500 600 700 800 900 1000 Quantity
FIXING THE MONOPOLY PRICE
The monopolist will naturally seek the price and quantity combination that will bring him
the greatest amount of profits. In pursuing this objective, he faces three possible cost situations:
1. Constant costs
2. Increasing costs
3. Decreasing costs
The constant costs behavior indicates that per unit cost of the monopolist remains
unchanged even if the quantity sold is increased or decreased. Table 12 shows that monopolist
will earn maximum profit if he sells his products at P 5.00 per unit.
Table 12
PRICE AND PROFITS IN A MONOPOLY WITH CONSTANT COSTS
Price per unit

Quantity sold

Total receipts

Cost per unit

Total cost

P1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
9.00
10.00

900
800
700
600
500
400
300
100
50
0

P900
1,600
2,100
2,400
3,000
2,400
2,100
800
450
0

0.75
0.75
0.75
0.75
0.75
0.75
0.75
0.75
0.75
0.75

P675
600
525
450
375
300
225
75
37.50
0

Monopoly
profits
P225
1,000
1,575
1,950
2,125
2,100
1,875
725
412.50
0

Increasing costs mean that the cost of production increases as quantity produced is
increased. Table 13 shows an example of such relationship. Maximum profit is realized when

price is set at P5.00 per unit. Lowering his price will cause an increase in sales volume, but it
will not improve his profits. Raising his price will drive away buyers and will not result into
great changes of profit to be earned.
Table 13
PRICE AND PROFITS IN A MONOPOLY WITH INCREASING COSTS
Price per unit

Quantity sold

Total receipt

Cost per unit

Total cost

P10
9
8
7
6
5
4
3
2
1

0
50
100
300
400
500
600
700
800
900

0
450
800
2,100
2,400
2,500
2,400
2,100
1,600
900

P0.50
0.55
0.60
0.65
0.70
0.75
0.80
0.85
0.90
0.95

0
P27.50
60
195
280
375
480
595
720
855

Monopoly
profits
0
P422.50
740
1,905
2,120
2,125
1,920
1,505
880
45

In a decreasing costs situation, the monopolists cost of production decreases as the

quantity produced is increased. Table 14 indicates that the monopolist maximizes his profits
when price is set at P6.00 per unit. Profits decline when price is set above or below P6.00 per
unit.
Table 14
PRICE AND PROFITS IN A MONOPOLY WITH DECREASING COSTS
Price per unit

Quantity sold

Total receipt

Cost per unit

Total cost

P10
9
8
7
6
5
4
3
2
1

0
50
100
300
500
600
700
800
900
1000

0
P450
800
2,100
3,000
3,000
2,800
2,400
1,800
1,000

P1.00
0.95
0.90
0.85
0.80
0.75
0.70
0.65
0.60
0.55

0
P47.50
90
255
400
450
490
520
540
550

PRICE AND OUTPUT DETERMINATION UNDER OLIGOPOLY

Monopoly
profits
0
P402.50
710
1,845
2,600
2,550
2,310
1,880
1,260
450

In setting the price of products, the seller under oligopoly faced the following situations:
1. If he reduces his price, competitors will retaliate and will not gain anything, but
short- term profits from his initial move. His long run profit (and that of his
competitors) will be reduced.
2. If he raises his price, his customers will move to his competitors. His sales
volume and revenue will decline.
Table 15 shows demand schedule under oligopoly and a graphical illustration in Figure 22.

Table 15
DEMAND SCHEDULE UNDER OLIGOPOLY (When seller raises or lowers his price)
Price per unit
P9.00
8.00
7.00
6.00
5.00 prevailing price
4.00
3.00
2.00
1.00
Figure 22
Price 10
9

8
7
6
5 ----------------------- E
4

Quantity sold (in units)

100
200
300
400
500
550
600
650
700

Total receipts
P900
1,600
2,100
2,400
2,500
2,200
1,800
1,300
700

3
2
1

F
100 200 300 400 500 600 700 800 900 1000 Quantity

Point E is the prevailing price and it appears as kink in the demand curve DF.
Line DE denotes low sales when seller under oligopoly raises price.
Line EF indicates limited sales gain when seller under oligopoly lowers price.
PRICE DETERMINATION UNDER MONOPOLISTIC COMPETITION
The firm in a monopolistic competition strives to differentiate its products from that of
its competitors. If it is successful in maintaining a sizable group of loyal customers, it will
attempt to maximize profits, observing the law of supply and demand. If the profits generated
by the firm are big enough, it will invite competitors. The ensuing moves by the competing
firms will wipe out profits caused by price cutting and additional promotional expenses.

REVIEW QUESTIONS
1.
2.
3.
4.
5.
6.
7.

What are the characteristics of pure monopoly?

What are the characteristics of pure competition?
What are the characteristics of monopolistic competition?
What are the characteristics of oligopoly?
Is there a need to advertise products under pure competition? Explain your answer.
Explain section 19, article XII, Philippine Constitution.
Can a monopolist set a high price for his product and still enjoy a high level of demand?