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Economics 11

Topic 1
Introduction
U-PRIMO E. RODRIGUEZ
Dept. of Economics
UPLB

WHAT IS ECONOMICS?
Oikonomia (Greek) household

management
Defn: A social science that deals with
the allocation of scarce resources to
satisfies unlimited human wants
Key words
Science
Social science
Scarcity

Economics as a science
Science
Systematic observation of natural events and
conditions in order to formulate laws and principles
Systematic body of knowledge

Methodology of science (and economics!)


Scientific method: seeks to explain events in a
reproducible way, and to use these reproductions to
make useful predictions
Steps

Hypothesis/questions
Procedure: experimentation or observation
Assumptions, models, statistical techniques
Formulate conclusions

Economics as a social science


Fields of science
Natural science focuses on natural
phenomena, including biological life
Social science focuses on human behavior
and societies

Sociology, psychology, political science,


anthropology, history, economics, etc

What differentiates economics from the


other social sciences? Answer: Focus on
scarcity!
Question: What do we mean by scarcity?

Scarcity
Easier to understand scarcity by recognizing
the unlimited human wants

ContScarcity
and human wants evolve over time

Scarcity cont
Scarcity exists because our resources are
not enough to satisfy all human wants

MAIN BRANCHES OF ECONOMICS


Microeconomics
-

studies behavior of individual economic units


households, firms, markets

Macroeconomics
-

Focus is on the whole/aggregate economy

Examples of indicators: GNP, GDP, inflation,


unemployment

POSITIVE vs NORMATIVE ECONOMICS


Positive Economics
Answers the question: What is?
The price of gasoline is about Php 60/liter.
The population growth rate is 2.3%.
11 million Filipinos live on $1 a day.

Normative Economics
Answers the question: What should be?
The price of gasoline should be Php 20.0/liter
The population growth rate must only be at 2 %.
Filipinos ought to live on at least $5 a day

ECONOMICS AND MODELS


Economists use models in conducting
analyses
Models: A model is a simplified
representation of reality
Often represented by mathematical equations
and/or diagrams

Why use models


Allows us to organize our thoughts
Allows us to focus on the essential elements of
an economic relationship
WAKAS

Economics 11

Topic 2
Economic Problem
U-PRIMO E. RODRIGUEZ
Dept of Economics
UPLB

Scarcity and choice


Scarcity = problem of choice
I.e. how do we allocate scarce resources?

Examples
Time: How much time should be spent between
studying, watching TV, friends?
Land: What do we plant? Do we even want to plant?
Budget of the national govt: Should it go to education
and health or to national defense?
etc

Basic Economic Questions


3 Questions: What, how and for
whom?
What to produce?
Do we produce everything?
Do we produce a few goods and
import the rest? If so, which goods?

How to produce?
What inputs are used to produce
goods?
What techniques?

ContHow to produce?
Example: In agriculture

or

or

Do we want to use fertilizers and/or pesticides in farms?

For whom to produce?


Who benefits?

Production Possibilities Frontier (PPF)


Useful tool for illustrating the choices
available to society and its constraints
PPF (defn): all the possible
combinations of the maximum
amounts of two goods and services
that can be produced with a given
amount of resources

Assumptions about the PPF


Only two goods are produced: food (F)
and clothing (C)
The society has limited resources (in
fixed supply)
Aside # 1: can assume that the resources
are land, labor, and capital
Aside # 2: capital physical capital like
machinery, buildings, etc.

Example of a PPF for a given technology


Interpretation: If the economy
uses its resources properly and
employs all of its resources,
then it can produce:
0 units of food and 1000
units of clothing
Alternative:
200 units of food and 850
units of clothing
Alternative: ?

Trade-off: To produce
more food, need to
produce less clothing
Option A: Economy
specializing in clothing
Option F: Economy
specializing in food

PPF

B
C
D

Specializing
in clothing
A

Specializing
in food

B
C
D

Negative slope
captures the trade-off

Infeasible
point
A

B
C
D
E

Inefficient use
of resources
and/or
unemployed
resources

Opportunity cost and the PPF


Defn: value of the best foregone
alternative
Applied to the current example:
The opportunity cost (O.C.) of producing
food is the quantity of clothing that needs
to be given up
Question: What is the O.C. of clothing?

OC using the table for the PPF


Preliminary calculations:

Preliminary calculations:

Interpretation
Between points A
and B, the O.C. of
producing an
extra unit of food
is half a unit (0.5)
of clothing

Increasing opportunity costs

OC of producing
food increases as
more food is
produced. Explains
the concave shape
of the PPF

The PPF & the Basic Econ Questions?


What to produce?
Shown by 2 goods on axes of PPF
Location on the PPF how much to
produce

How to produce?
Use technology that will enable
economy to produce goods represented
by points along PPF

For whom to produce?


Not shown by PPF

Shifts in the PPF


Technological improvement
Better production techiques

Changes in resource endowments


More workers, more capital
Improvements in the quality of resources

Water, Land, Forests, etc

The changes above cause an outward shift


in the PPF

Shifts in PPF
C

resources and/or
techno improvements
in the production of F and C
Aside: balanced
Question: Can the PPF shift
inward?

Shifts in PPF

Improvements confined
to clothing only

Improvements
confined to food
only

10

Economic systems & the Basic


Economic Questions
2 extreme economic systems
Complete command economy

Decisions made by authorities

Completely unregulated market economy

Markets determined the answers to the


questions

Actual economies fall somewhere in


between

WAKAS

11

Economics 11
Topic 3

Supply, Demand and Market Equilibrium

U-PRIMO E. RODRIGUEZ
Dept. of Economics
UPLB

THE ROAD AHEAD


This lecture discusses the basic concepts
behind supply and demand analysis.
Topics
What is a market?
Demand side of the market
Supply side of the market
Market equilibrium

WHY STUDY SUPPLY & DEMAND?


Helps explain movements in prices and
quantities
A useful tool for analyzing a wide range of
topicsexamples:
How do govt policies affect consumers and
producers?
Price controls
Taxes and subsidies

Oil price increase, appreciation of the peso


Market shortages
Global warming and agricultural prices

WHAT IS A MARKET?
Market = an institution that facilitates
transactions between buyers and sellers
Markets as we know it:

But..

a market does not have to be a place

DEMAND SIDE
Demand - refers to the various quantities of
a good or service that users/consumers are
willing to purchase at alternative prices,

ceteris paribus.
Captures the desire for the commodity and
capacity to pay. Willing and able!
Emphasizes the relationship between quantities
of a good that people want to buy and prices of
that good

Law of demand
Asserts that the quantity demanded
of a good (Qd) is inversely related
to its own price (P)

Why is there a negative relationship?


Substitution effect

When price of a good decreases, the


consumer substitutes the lower priced good
for the more expensive ones.

Income effect

When price decreases, the consumers real


income (or purchasing power) increases, so
he tends to buy more.

3 ways to present the Law


of Demand
Table
Graph
Equation

Table: Demand schedule for Denim pants


Price of Denim Pants
(in pesos)

Quantity Demanded
(No. of pairs)

50

100

150

200

250

300

350

400

Demand curve

Note: Values here


were taken from the
table in the previous
slide

Price (in pesos)

400
300
200
100

D
0

Quantity

Equation
Qd is expressed as a mathematical
function of the price
Qd = a b P

a = horizontal intercept ~ indicates quantity


demanded when price is zero
-b = slope of the function ~ indicates the
change in Qd for a one unit increase in P

Equation for the previous example

Qd = 8 0.02 P

Change in quantity demanded vs change in


demand
Change in quantity demanded is a movement
along the same demand curve, due solely to a
change in price, i.e., all other factors held
constant.
Change in demand is a shift in the entire
demand curve (either to the left or to the right)
as a result of changes in other factors affecting
demand (later).

Change in quantity demanded

Price (in pesos)

P1

P2

D
0

Q1

Q2

Quantity

Change in demand

Increase in demand (rightward shift)

Price (in pesos)

P1
D2
D1
0

Q1

Q2

Change in demand

Decrease in demand (leftward shift)

Price (in pesos)

P1
D1
D2
0

Q2

Q1

The price is not the only factor that affects


demand.
Other factors affecting demand (OFAD)
Prices of related commodities
Consumer incomes
Tastes and preferences
Number of consumers
Price expectations

Changes in these (other) factors cause the


demand curve to shift

OFAD: Income
Normal goods: higher income leads to
higher demand (rightward shift in the
demand curve)

Most goods are normal

Inferior goods: higher income leads to


lower demand (leftward shift in the
demand curve)

Few examples but these exist

OFAD: Prices of related goods


Substitutes = goods which are substitutable for
each other

Eg. Coffee and tea, gin and rum


An increase in the price of a substitute raises the
demand for a good

Complement = goods which are used or


consumed together

Eg. Left and right shoe, coffee and sugar, beer and
sisig, paper and pencil
An increase in the price of a complement reduces the
demand for a good

OFAD: Consumer tastes and preferences


When consumer tastes shift towards (away
from) a good, then the demand for the good
increases (decreases)
E.g. higher preference for small products

Increase in demand for IPods

Lower demand for large stereo systems

E.g. preference for faster communication

Increase in demand for internet services (email)


Decrease in demand for traditional postal services
(snail mail)

10

OFAD: Consumer expectations


Expectations about future prices and income affect our
current demand for goods and services.
Expectation of higher prices increases current demand

queues in gasoline stations in anticipation of higher gas prices

Expectation of lower prices redeuces current demand

Postponing purchases in anticipation of a sale (lower prices)

OFAD: Number of consumers


More consumers/users of the good tends to
raise the demand for a good
Eg. Higher population leads to higher demand
for food, housing, etc
Eg. More health conscious people leads to higher
demand for the facilities provided by gyms

Let us now shift to the other side of the


marketSupply

11

SUPPLY SIDE
Supply refers to the various quantities of a
good or service that producers/firms are
willing to sell at alternative prices, cet. Par
Law of Supply states that quantity sold of
a good or services is positively related to its
own price
Higher price more good/service will be sold
Lower price less good/services will be sold

3 ways to present the Law


of Supply
Table
Graph
Equation

12

Table: Supply Schedule for Denim Pants


Price of Denim Pants
(in pesos)
0
50
100
150
200
250
300
350
400

Quantity Supplied
(No. of pairs)
0
1
2
3
4
5
6
7
8

Graph: Supply Curve


P
S

400
300
200
100
0

13

Equation
Quantity supplied (Qs) is expressed as a
mathematical function of price (P). The supply
function may thus be written as:

Qs = c + d P

c = indicates the value of Qs when P = 0

d = slope of the function

Applied to example: Qs = 0 + 0.02 P

Change in quantity supplied vs change in


supply
Change in quantity supplied is a movement
along the same supply curve, due solely to a
change in price, i.e., all other factors held
constant.
Change in supply is a shift in the entire supply
curve (either to the left or to the right) as a
result of changes in other factors affecting
supply (later).

14

Change in quantity supplied

P
P2

P1

Q1

Q2

Change in supply

Increase in supply (rightward shift)


P

S1

S2

P1

Q1

Q2

15

Change in supply

Decrease in supply (leftward shift)


P

S2

S1

P1

Q
Q2

Q1

The price is not the only factor that affects


supply.
Other factors affecting supply (OFAS):
Prices of resources/inputs
Prices of related commodities
Technology
Number of producers
Price expectations

Changes in these other factors cause the


supply curve to shift.

16

OFAS: resource/input prices


Higher input prices lead to a reduction in
supply (leftward shift in the supply curve)
Reason: Higher input prices make it more
expensive to produce the good or service
Example: Barber shop inputs are labor
(time of the barber), electricity, baby
powder, gel, razor blades, etc

OFAS: Prices of related goods in production


Resources can be used to produce several types
of goods
Example

Agriculture: Land can be used to grow rice, corn, etc.


Higher corn prices may lead to lower supply of rice
Land for housing and farming .
Corn is an input for producing food or biofuel.
Question: What could happen to the supply of food if
the price of biofuels increase?

17

OFAS: Technology
Improved production techniques tend to shift the supply
curve the right

Reason: Lower production costs for each unit of output

OFAS: Producer expectation


Expectations about future output and input prices affect
the supply of a good today.
If firms expect prices to rise in the future, then current
supply might fall.

OFAS: Number of sellers


More sellers in the market tend to raise the supply of a
good

MARKET EQUILIBRIUM
Market equilibrium is a state in which the
quantities that firms want sell is equal to the
quantities that users want to buy.
Equilibrium = state of rest
Equilibrium condition: Qs = Qd
Defines equilibrium price (P*) and equilibrium
quantity (Q*)

Three ways of presenting the concept


Table, Graph, Equations

18

Table: (Uses information provided earlier)


Price
(P)

Quantity
Demanded
(Qd)

Quantity
Supplied
(Qs)

50

100

150

200

250

300

350

400

Equilibrium

P* = 200
Q* = 4

Price above P*
Qs > Qd
Surplus or excess supply
Not equilibrium: There is pressure for the price
to fall.

Price below P*
Qs < Qd
Shortage or excess demand
Not equilibrium: There is pressure for the price
to rise.

19

Shortage and surplus


Price
(P)

Quantity
Demanded
(Qd)

Quantity
Supplied
(Qs)

50

100

150

200

250

300

350

400

Shortage (Qd>Qs)
=4

Surplus
(Qd<Qs) = 6

Graphical treatment

400
300
P*

200

Equilibrium

100

D
0

Q*

20

Surplus

surplus

400

300
P*

200
100

D
0

Q*

Shortage

400
300
P*

200
shortage

100
0

Q*

21

Rice shortage in RP?

Caption : WHAT SHORTAGE? People line up to buy NFAs subsidized rice on Friday
at its central office warehouse along Visayas Avenue in Quezon City. Each person
is allowed Only 3 kilos. A kilo costs P18.85. JOAN BONDOC

Source : Philippine Daily Inquirer, March 28, 2008, front page

Algebraic derivation
Equations

Solution

22

Our example
Equations

Solution

23

Equilibrium and an increase in demand


Possible sources:

Higher income (if good is normal)

Lower income (if good is inferior)

Higher price of a substitute

Lower price of a complement

Increased preference for the good

More consumers

If supply is upward sloping,

Higher equilibrium quantity

Higher equilibrium price

24

P*1
P*0

D1
D0
0

Q*0

Q*1

Do on your own:

Decrease in demand
Increase/decrease in supply
Simultaneous change in the supply and demand curves

WAKAS

25

Economics 11
Topic 4
Supply and Demand: Elasticities and Policy

U-PRIMO E. RODRIGUEZ
Department of
Economics
UPLB

THE ROAD AHEAD


Elasticity concepts
Meaning of elasticity
Own price elasticity of demand
Cross price elasticity of demand
Income elasticity of demand

Applications of Supply and Demand


Floor price
Price ceiling
Tax incidence

Welfare measures
Consumer surplus
Producer surplus

MEANING OF ELASTICITY
If Y = f(X), the elasticity measures the
responsiveness of Y to changes in X
Percentage change in Y in response to a
one percent change in X
Formula:

Interpretation: = 0.75 means that a 1%


change in X leads to a 0.75% change in Y
Range of elasticity values (in absolute
value)

OWN PRICE ELASTICITY OF DEMAND


Own price elasticity of demand =
responsiveness of quantity demanded of
a good to its own price
Formula:

Two ways of measuring elasticity


Point elasticity - elasticity is measured

for a single point on the demand curve

More precise since elasticity can be different


at every point on a demand curve
Can be obtained if demand function is known

Arc elasticity computed for two


points along a demand curve

Implemented if there are a limited number of


observations

Point elasticity
P

P1

D
0

Q1

Arc elasticity
P

P1

A
B

P2
D
0

Q1

Q2

With numbers
P

30

A
B

20
D
0

100

200

Elasticity along a linear demand


curve
Linear demand curve = constant
slope
Elasticity = falls as you move down
the demand curve. Hint: examine
the formula for the point elasticity

Elastic
Unit Elastic

P1
P2

Inelastic

D
0

Q1

Q2

Example: Elasticity along a linear demand curve


Price

Quantity

Slope

Elasticity

10

-2

-2

-9.00

-2

-4.00

-2

-2.33

-2

-1.50

10

-2

-1.00

12

-2

-0.67

14

-2

-0.43

16

-2

-0.25

18

-2

-0.11

20

-2

0.00

Uses formula
for the point
elasticity of
demand

Special Case: Perfectly inelastic demand


curve
P

A vertical demand curve


implies that any change in
price will not lead to a
change in quantity
demanded.

Special case: Perfectly elastic demand curve


A horizontal demand
curve implies that a very
small change in price
will lead to an infinitely
large change in quantity
demanded.

Elasticity and total revenue


Total revenue is equal to the quantity sold
multiplied by the price.
TR = P x Q
It is of interest to the seller to see what
happens to TR if there is a change in the
price.

What happens to TR when P increases?


Answer: It depends!
If demand is elastic, higher price leads to
lower TR
If demand is inelastic, higher leads to
higher TR
If demand is unit elastic, higher price does
not affect TR

Elastic:

Q=

TR

Inelastic:

Q=

TR

Unit Elastic:

Q=

no TR

Determinants of the price elasticity


Availability of substitutes

More substitutes, more elastic

Price of the good relative to purchasing power

Larger share of the budget, more elastic

Time frame under consideration

Longer period, more elastic

Location along the demand curve

Recall previous points.

CROSS-PRICE ELASTICITY OF DEMAND


Cross-price elasticity of demand =
responsiveness of quantity demand of a
good to changes in the price of another
good
Formula:
Sign
+ for substitutes
- for complements

INCOME ELASTICITY OF DEMAND


Income elasticity of demand =
responsiveness of quantity demanded of a
to a change in income
Formula:
Values
+ normal
Greater than 1: luxury
Less than 1: necessity

- inferior

FLOOR PRICE
Aka minimum price policy
This is a lower limit on a price.
E.g. Floor price = 10 pesos. Means that the price
at which the good/service is sold cannot go below
10 pesos.
Examples: minimum wages
To be effective, this must be set above the
equilibrium price.
Consequence: surplus

10

Floor Price
P
S

surplus
Price floor
P*

D
0

Q*

PRICE CEILING
Aka maximum price policy
This is an upper limit on a price.
E.g. Price ceiling = 10 pesos. Means that the price
at which the good/service is sold cannot exceed 10
pesos.
Examples: jeepney fares
To be effective, this must be set below the
equilibrium price.
Consequence: shortage

11

Price Ceiling
P

P*
Price

ceiling

shortage
0

Q*

TAX INCIDENCE
Concerned with the effects of government
taxes on consumption and production.
Specific/excise tax vs ad valorem tax
Specific/excise tax = tax per unit of the product
Ad valorem = tax as a percentage of the selling
price

Question: Who pays for such taxes? Is it the


consumer? Or is it the producer?
Answer: likely to be both
Reason: Producers cannot raise the price by the
amount of the tax.

12

Case: Specific Tax (t)


Specific tax shifts the supply curve up by the
S1
amount of the tax
S0

P0+t

P0
Q0

but producers are likely to be unable to


raise prices by the amount of the tax
S1
P0+t
S0
P1
P0

D0
Q1

Q0

13

For each unit of the


good, this is the
component of the tax
that is paid for by the
producer

S1

P0+t

For each unit of the


good, this is the
S0 of the tax
component
that is paid for by the
consumer

P1
P0

D0
Q0

Q1

Numerical example:

Tax = 15 pesos/unit

Original equilibrium price = 10 pesos per unit


New equilibrium price = 14 pesos per unit
Burden:
Consumer pays 4 pesos/unit of the tax
Producer pays 11 pesos/unit of the tax

S1

25

S0

14
10

D0
Q1

Q0

14

Special case: Perfectly inelastic demand


D0
S1
P1 = P0+t
S0
Entire tax is
passed to
consumers

P0

Q0

Special case: Perfectly elastic demand


Entire tax is is
borne by
producers

S1
S0

D0

P1 = P0

Q1

Q0

15

CONSUMER SURPLUS
P
S
Consumer surplus:
difference between
what a consumer is
willing to pay and
what he actually pays
for the good.

P*
D
0

Q*

Decline in the market price raises the consumer


surplus

P
S0

P0
P1
D
0

Q0

Q1

S1

Increase in
consumer
surplus

16

PRODUCER SURPLUS
P
S
Producer surplus:
difference between
what a producer
receives and the
amount that will
motivate him to sell
the product

P*
D
0

Q*

The producer surplus is going to rise if there


is an increase in the price of the product

P
S
P1

Increase in
producer
surplus

P0
D1
D0
0

WAKAS

17

ECONOMICS 11
TOPIC 5
CONSUMER BEHAVIOR

U-PRIMO E. RODRIGUEZ
Dept. of Econ., UPLB

THE ROAD AHEAD


Consumer behavior and utility
Utility concepts
Consumer equilibrium

Consumer behavior and utility


Useful for understanding the demand side of
the market.
Eg. Consumer behavior can help explain why
the demand curve is downward sloping

Utility - amount of satisfaction derived from


the consumption of a commodity
measurement units = utils

UTILITY CONCEPTS
Approaches
cardinal utility - assumes that we can
assign values for utility, (Jevons, Walras,
and Marshall). E.g., derive 100 utils from
drinking a bottle of beer

ordinal utility - does not assign values,


instead works with a ranking of
preferences. (Pareto, Hicks, Slutsky)

Example
Q
0
1
2
3
4
5
6
7

TU
0
20
27
32
35
35
34
30

MU
--20
7
5
3
0
-1
-4

TU
0
20
27
32
35
35
34
30

Marginal utility (MU)


MU = TU/ Q

If TU is increasing,
MU > 0

TU, in general, increases


with Q

Example
Q
0
1
2
3
4
5
6
7

Total utility (TU)

MU
--20
7
5
3
0
-1
-4

At some point, TU can start


falling with Q (see Q = 6)
From Q = 1 onwards, MU is
declining principle of
diminishing marginal utility
As more and more of a
good is consumed, the
process of consumption will
(at some point) yield
smaller and smaller
additions to utility

Total utility curve


Total utility(in utils)

TU
35
30
25
20
15
10
5
0

3 4 5
Quantity

Marginal utility curve

Marginal utility (in utils)

MU
20
15
10
5
0
-5

Q
1

Consumer Equilibrium
So far, we have assumed that any amount of
goods and services are always available for
consumption
In reality, consumers face constraints :
Limited consumers income or budget
Goods can be obtained at a price

Simplifying assumptions
Consumers objective: to maximize
his/her utility subject to income
constraint
2 goods (X, Y)
Prices Px, Py are given
Consumers income (I) is given

Definition
Marginal utility per peso = additional utility

derived from spending the next peso on the


good

Optimizing condition (maximizes utility):

Spend more on good X if (not yet optimal)

Example:
Note: PX = 2, PY = 10
Qx

TUX

MUX

QY

TUY

MUY

30

30

15

50

50

39

4.5

105

55

5.5

45

148

43

4.3

50

2.5

178

30

54

198

20

56

213

15

1.5

2 potential optimum positions


Combination A:

X = 3 and Y = 4

TU = TUX + TUY = 45 + 178 = 223

Combination B: X = 5 and Y = 5

TU = TUX + TUY = 54 + 198 = 252

The presence of two optimal conditions


suggests the need to consider income.
Preparatory work: calculate spending with
each combination

Total expenditure = PX X + PY Y

Combination A: 3(2) + 4(10) = 46

Combination B: 5(2) + 5(10) = 60

Scenarios

If the consumers income is 46, then the optimum is


given by combination A. Combination B is simply not
affordable.
If the consumers income is 60, then the optimum is
given by Combination B. Combination A is affordable
but it generates a lower level of total utility.
WAKAS

ECONOMICS 11
TOPIC 6
PRODUCTION AND COST

U-PRIMO E. RODRIGUEZ
Dept. of Econ., UPLB

THE ROAD AHEAD


The focus here is on the behavior of the
firm.
Firm: entity concerned with the employment of
resources in the production of goods/services

Contents
Production function
Production analysis with one variable input
Costs of production and related concepts
Costs: Short run
Costs: Long run

The Production Function


The production function refers to the

physical relationship between the inputs of


a firm and their output of goods and
services at a given period of time, ceteris

paribus.

Purely technological relationship no


economics!
Inputs resources that contribute to the
production of a good/service. E.g. Land, labor,
capital

ContProduction function
Fixed and variable inputs

Fixed inputs resources used at a constant amount


in the production of a commodity
Variable inputs resources that can change in
quantity depending on the level of output being
produced

Fixed and variable inputs over time

Over a longer planning period, the distinction


between fixed and variable inputs disappears
All inputs are variable in the long run

Production Analysis with One Variable Input


Imagine a production function in which there is
only one input, say labor (L), used to produce
output. Alternatively, there are many inputs but
only one input is variable.

Total product (TP or Q) refers to the total amount


of output produced in physical units (may refer to,
kilograms of sugar, sacks of rice produced, etc)

Production Analysis with One Variable Input


The marginal product (MP) refers to the change in
output for a one unit change in the quantity of an
input, holding all other inputs constant.

Production function of a hypothetical


farmer
Quantity of
Labor (L)

Total Product
(QL or TPL)

12

20

26

30

32

32

30

10

26

Total product curve (uses the info in the


previous table)
Q

QL

Integrating marginal product


Quantity of
Labor (L)

Total Product
(QL or TPL)

12

20

26

30

32

32

30

-2

10

26

-4

Marginal Product
(MPL)

Some points
Observe that the marginal product initially

MPL

beyond this point, the marginal product

declines, reaches zero, and subsequently

other inputs fixed), a point will eventually

-2

10

-4

be reached at which the resulting additions

increases, reaches a maximum level, and

becomes negative.
The law of diminishing returns states
that "as the use of an input increases (with

to output decrease"

Graphical presentation
L

MPL

-2

10

-4

MP

L
MPL

MP and the TP curve

For a given level of L, MP is the slope of the line


that is tangent to the TP curve

Slope of this
line is MP at
L0

QL

L0

MP and the TP curve


Q
MP = 0

QL
Inflection point:
MP highest at this
point

L0

MP and the TP curve


MP = 0

MP < 0

MP>0 and falling

QL
Inflection point
MP>0 and rising

L0

Law of Diminishing Marginal Returns


As more and more of an input is added (given a
fixed amount of other inputs), total output may
increase; however, as the additions to total output
will tend to diminish.
Counter-intuitive proof: if the law of diminishing
returns does not hold, the worlds supply of food
can be produced in a hectare of land. Hint: Just
keep on adding more workers or other inputs in
that one hectare of land.

Average Product (AP)


Average product is a concept commonly
associated with efficiency.
The average product measures the total output
per unit of input used.
The "productivity" of an input is usually expressed in
terms of its average product.
The greater the value of average product, the higher
the efficiency in physical terms.

Formula:

Working with our numerical example.


Labor (L)

Total product of
labor (TPL)

Average product of
labor (APL)

0
1
2
3
4
5
6
7
8
9
10

0
2
6
12
20
26
30
32
32
30
26

2
3
4
5
5.2
5
4.5
4
3.3
2.6

Graphical derivation: Generic


The slope of the line from the origin is a measure of
the AVERAGE
Y

L1

Applied to the production function:


AP highest at pt. b

Total
Product
Q

AP at pt. c is less than at pt. a.


AP at pt. d is less than at pt. c.
b

c
d
QL

AP and MP curves
AP,MP

At Max AP,
AP = MP
Max
MPL

Max
APL

APL

L1

L2

L3

MPL

10

TP

TPL

L1

L2

MP>AP
AP increasing

Stage II

Stage I
AP,MP

L3
Stage III

MP<AP
AP decreasing
MP still positive

MP<0
AP decreasing

A
B
0

L1

L2

APL

L3

L
MPL

In Stage I
APL is increasing so MP>AP.
All the product curves are increasing
Stage I stops where APL reaches its maximum
(point A)
MP peaks and then declines at point C and
beyond, so the law of diminishing returns
begins to manifest at this stage

11

Stage II
starts where the APL of the input begins to
decline.
QL still continues to increase, although at a
decreasing rate, and in fact reaches a maximum
Marginal product is continuously declining and
reaches zero at point D, as additional labor
inputs are employed.

Stage III
Starts where MP < 0
All AP and MP product curves are falling
TP curve shows that hiring more inputs actually
reduces output

COSTS OF PRODUCTION
Opportunity Cost Principle - the economic
cost of an input used in a production process
is the value of output sacrificed elsewhere.
The opportunity cost of an input is the value
of foregone income in best alternative
employment.
Implicit vs. Explicit Costs
Explicit costs costs paid in cash
Implicit cost imputed cost of self-owned or self
employed resources based on their opportunity
costs.

12

Short run: 7 Concepts of costs


Total Fixed Cost
(TFC)
Total Variable Cost (TVC)
Total Cost (TC=TVC+TFC)
Average Fixed Cost (AFC=TFC/Q)
Average Variable Cost (AVC=TVC/Q)
Average Total Cost (AC=AFC+AVC)
Marginal Cost
(MC= TC/Q)
Long run: all costs are variable
TFC = AFC = 0
TVC = TC
AVC = AC

Costs: Short run


Total fixed cost (TFC)
Aka sunk cost or overhead cost
Component of cost is independent of the
level of output produced
Examples: include the payment or rent for
land, buildings and machinery.

13

Total variable cost (TVC)


Component of cost that changes with
the level of output

TVC = 0 if Q = 0

TVC increases as Q increases

Examples - purchases of raw


materials, payments to workers,
electricity bills, fuel and power costs

Total cost (TC)

sum of total fixed cost and total


variable cost
TC=TFC+TVC
As the level of output increases,
total cost of the firm also increases.

Numerical example of TFC, TVC


and TC of a hypothetical firm in
the next slide

14

Total
product
TP or Q

Total
Fixed
Cost

Total
Variable
Cost

Total
Cost

TFC

TVC

TC

0
1
2
3
4
5
6
7
8
9
10

Total
product
TP or Q

0
1
2
3
4
5
6
7
8
9
10

10
10
10
10
10
10
10
10
10
10
10

0
30
50
60
65
75
95
125
165
215
275

Total
Fixed
Cost

Total
Variable
Cost

TFC

TVC

10
10
10
10
10
10
10
10
10
10
10

10
40
60
70
75
85
105
135
175
225
285

Total
Cost
TC

0
10
30
40
50
60
Highlights the point
60 incur costs 70
that firms
75
even if 65
nothing is
produced.
75
85
95
105
Value does not change
125 of the firms135
regardless
175
output165
215
225
275
285

15

Total
product
TP or Q

0
1
2
3
4
5
6
7
8
9
10

Total
Fixed
Cost

Total
Variable
Cost

Total
Cost

TFC

TVC

TC

10
10
10
TVC = 0 if firms
produce10
nothing.
10 the
Rises with
firms 10
output

0
30
50
60
65
75
10
95
10
125
TC= TFC10+ TVC
165
TC = TFC if Q=0
10
215
Rises as Q increases
10
275

10
40
60
70
75
85
105
135
175
225
285

Cost curves
Pesos Doyo: relate this to the table
TC
(Total Cost)

TVC
(Total Variable Cos

TFC
(Total Fixed Cost)

16

Average fixed cost


AFC = TFC / Q
Declines as Q
increasesbut
never becomes
zero
Example with our
table
Graphical
derivation
provided in the
recit class

AFC

17

Average variable cost


AVC = TVC / Q
As Q increases, AVC
declines initially and
then rises

AVC falling
as
Q increases

Example with our table


This generates a U
shaped curve (next
slide)
Note: Graphical
derivation provided in
recit class

AVC rising
as
Q increases

AVC

18

Average cost
AC = TC / Q

AC = AFC + AVC

AC falling as
Q increases

Follows a similar pattern


to the AVC curve
Example with our table
Note: Graphical
derivation provided in

AC rising as
Q increases

recit class

AC

19

AC and AVC curves


AC > AVC

Reason: AC = AFC +
AVC

Gap between AC and


AVC narrows as Q
increases

Reason: declining AFC

AC
AVC

AFC

20

Marginal cost
Shows the change in
total cost for a unit
change in output

MC falling as
Q increases

Follows a similar pattern


to the AVC curve
Example with our table
Note: Graphical

MC rising as
Q increases

derivation provided in
recit class

MC

21

MC, AVC, AC
All 3 curves are U
shaped
MC intersects the AVC
and AC curves at their
lowest points
MC intersects the AVC
curve first (will become
clearer later)

MC

AC
AVC

AC is falling if MC < AC and rising if MC > AC.


AVC is falling if MC < AVC and rising if MC > AVC.

Closer look at intersections: see next slide

22

On closer inspection..
Minimum
point of
AC curve

MC

AC
AVC

Minimum
point of AVC
curve
Q

Costs: Long run


All costs are variablei.e. no fixed costs
PhP

LTC
Long
run
total
cost
cuve

23

Long run average costs (LAC)


ATC = LTC/Q
The LAC curve is an envelop curve of all
possible plant sizes. Also known as planning
curve
It traces the lowest average cost of producing
each level of output.
It is U-shaped because of
Economies of Scale
Diseconomies of Scale

PhP

LAC
SAC1
SAC2

24

Deriving the LAC curve


Let SAC1 correspond to plant size 1. With this plant size the
cost of producing Q0 units of output is C0. In the long run,
the firm can adjust the plant size (corresponds to a new SAC
curve) so that production costs are lower (see next slide)
Php
SAC1

LAC

C0

Q0

Potentially lower costs with plant size 2 (represented by


SAC2). ..can repeat this exercise for all other levels of
output

Php
SAC1
SAC2

LAC

C0

Q0

25

Long run marginal cost (LMC) curve


LMC

Php

LAC

Minimum point
of LAC curve

Q1

Constructing the LMC curve


Php
SMC1 SAC

LAC

First point on LMC


curve
0

Q1

26

Constructing the LMC curve


Php
SMC1 SAC

LAC

SMC10
SAC10

Another point on
LMC curve
0

Q1

Q10

Constructing the LMC curve


Another point on
LMC curve

Php

SMC1 SAC

SMC100

SAC100

SMC10

LAC

SAC10

Q1

Q10

Q100

27

Connecting the dots

SMC100

LMC

SMC1

Php

SAC100

SAC1 SMC10

LAC

SAC10

Q1

Q10

Q100

Cleaning-up

LMC

Php
LAC

Q1

Q10

Q100

28

The road ahead


We have just seen the cost side of
production.
But firms do not just look at costs in
making decisions. They also need to
examine the demand side..Abangan!

WAKAS

29

ECONOMICS 11
TOPIC 7
PERFECTLY COMPETITIVE
MARKETS
U-PRIMO E. RODRIGUEZ
Dept. of Econ., UPLB

MARKETS
the market is a system where buyers and
sellers exchange goods or services
allocates goods and services with the help of
prices

Markets for commodities and inputs


Commodities rice, clothes, etc
Inputs labor, land, etc

Markets may have different structures


Number of sellers or buyers
Control in the market
etc

GENERAL TYPES OF MARKETS


Perfect competition [features later]
Imperfect competition
Monopoly one firm
Oligopoly two or more firms. Few firms
Monopolistic competition many firms selling
differentiated products

Note: This topic focuses on perfect


competition. Imperfect competition will be
discussed in the next topic.

FIVE FEATURES OF A PERFECTLY


COMPETITIVE MARKET
1. Smallness of buyers and sellers relative to
the market
2. Homogeneous product
3. Absence of artificial restraints or controls
4. Free entry or exit
5. Perfect information

The Demand Curve Faced by the Firm


In a perfectly competitive market, no
individual firm can influence the market
price.
Implication: the firm in perfect competition
faces a perfectly elastic demand curve
P
d

MARKET vs FIRM DEMAND


Market

Price
D

Price

Firm

P*

0
Equilibrium price is determined
in the market

P*

Once determined, a firm can sell


as much as it wants at that price

Changes in market conditions can affect the


price at which the firm sells its output
Market
Price

Firm
Price

D2
D1

P2

P2

P1

P1

Revenues of the Firm


Total revenue (TR) is the firm's gross income from
the sale of its product
TR =P x Q
Marginal revenue (MR) is the additional revenue
earned from each additional unit of output sold.
MR=TR/Q
Average revenue (AR) is total revenue divided by
output.
AR=TR/Q

NUMERICAL EXAMPLE
Q

TR

MR

AR

200

200

200

200

200

200

400

200

200

200

600

200

200

200

800

200

200

200

1000

200

200

Under perfect competition, P = MR = AR

How the table was constructed


Q

TR

MR

AR

200

200

200

200

200

200

400

200

200

200

600

200

200

200

800

200

200

200

1000

200

200

PxQ

TR/ Q

TR/ Q

Graphical representation
TR

600
400

MR =
AR

P = 200

HOW MUCH OUTPUT WILL THE


FIRM PRODUCE?
Assumption: The objective of the firm
is to maximize profits
Profits () = Total revenue (TR)
Total Cost (TC)

Table in the next slide integrates cost


into the analysis (note: MR and AR
eliminated temporarily)

NUMERICAL EXAMPLE
Output

Price

Total
Revenue

Total
Cost

Profit

(Q)

(P)

(TR)

(TC)

()

200

500

-500

200

200

591

-391

200

400

668

-268

200

600

737

-137

200

800

804

-4

200

1000

875

125

200

1,200

956

244

200

1,400

1,053

347

200

1,600

1,172

428

200

1,800

1,319

481

10

200

2,000

1,519

481

11

200

2,200

1,784

416

12

200

2,400

2,119

281

13

200

2,600

2,529

71

14

200

2,800

3,019

-291

Maximum profits
The firm produces
10 units of output

Graphical representation: details in next slide


TR,TC

TC

Total Revenue, Total


Cost

TR

Maximum
profits

Maximum
profits

Profit

Q0

Q*

Q1

Profit curve

Output

TR,TC

TC

Total Revenue, Total


Cost

TR

Highest
profits

0
Q0

Q*

Q1

Profit

Profits or losses are measured by the vertical distance between the


TR and TC curves
Q = Q0 or Q = Q1: TR intersects TC. Means zero profits.
Q0 < Q0 < Q1: TR above TC curve. Firm is making Q
profits
Q0
Q*
Q
Other values of Q, TR below
TC so firm is 1experiencing losses
(negative profits)

Output

TR,TC

TC

Total Revenue, Total


Cost

TR

Highest
profits

Q
Q0

Q*

Q1

Profit

Highest profits correspond to point in which the slopes of the TR and


TC curve are equal.
Note:
0
Q
Q0
Q* (MR)
Q1
Slope of TR = Marginal
revenue
Slope of TC = Marginal cost (MC)
Output
Implication: MR = MC
at maximum profits!

Completing the table


Output

Price

Total
Revenue

Marginal
Revenue

Total Cost

Marginal
Cost

(Q)

(P)

(TR)

(MR)

(TC)

(MC)

()

200

500

-500

200

200

200

591

91

-391

200

400

200

668

77

-268

200

600

200

737

69

-137

200

800

200

804

67

-4

200

1000

200

875

71

125

200

1,200

200

956

81

244

200

1,400

200

1,053

97

347

200

1,600

200

1,172

119

428

Profit

200

1,800

200

1,319

147

481

10

200

2,000

200

1,519

200

481

11

200

2,200

200

1,784

265

416

12

200

2,400

200

2,119

335

281

13

200

2,600

200

2,529

410

71

14

200

2,800

200

3,019

490

-291

MC
200

AC

P =MR = AR

AVC

150
100

Q*

Optimizing condition: MC = MR = P
Optimizing position: point A
Profits maximizing level of output: Q*

MC
P = MR = AR
200

AC
AVC

150
100

Q*

Total revenues = PxQ = area 0FAQ*


Total cost = ACxQ = area OCBQ*
Profits = TR-TC = CFAB

What happens to output when price falls


from P0 to P1? Output falls to Q1.
MC

AC

AVC

200

P0= MR0

150

P1 = MR1

100

Q1 Q0

10

Break-even point:
P = MR = MC at the minimum of AC
Zero profits

MC

AC

AVC

P2 = MR
100

Q*

Firm experiencing losses


P = MR = MC below the minimum of AC
MC

AC
AVC

P3 = MR

Q*

11

Firm experiencing losses: Loss = GABC


Will the firm quit? No!
MC

AC
AVC

G
F

P4 = MR

E
Q

Q*

If continue producing, the loss is GABC


If stop producing, the loss is FABE (Fixed cost)
GABC < FABE

MC

AC
AVC

G
F

P4 = MR

Q*

12

When will the firm quit? (Shut down point)


When P = MR = MC at minimum of AVC
MC

AC
AVC

P5 = MR

Q*

Lessons:
The firm maximizes profits at the point
where P = MR = MC.
The firm will continue production even if it
is experiencing losses.

Will not quit the market if the loss from


leaving the market (TFC) is bigger than the
loss from operating

The firm will shut down in P = MR = MC


at the minimum point of the AVC curve

13

Supply curve of the firm


Corresponds to the firms MC curve that
is above the minimum point of the AVC.
The MC curve here indicates how much
the firm will produce at alternative
prices.
See next slide

Supply curve of the firm: MC curve above


the minimum point of the AVC curve
MC

AC
AVC
P1
P2
P3
P4
P5

Q*

14

Cleaning-up
When P = MR = MC at minimum of AVC
MC
AVC
Supply curve

Q*

Long Run Equilibrium


Suppose that the price level
(determined by D-S) is such that it is
profitable for firms to operate.
Positive profits will attract new firms
into the industry.
Supply curve will shift to the right
Price will decline until profit is driven
down to zero.

15

However, it is not profitable to


operate, then
negative profits will make some firms
leave the industry.
Supply curve will shift to the left
Price will increase until profit is no longer
negative.

EQUILIBRIUM AT FIRM & MARKET LEVELS


P

SAC
MC

S0

LAC
P0

MR

P0

Q0

At P0, firms are making profits. This encourages other


firms to enter the market. As this happens, the supply
curve shifts down and pushes the equilibrium price
downwardsee next slide

16

EQUILIBRIUM AT FIRM & MARKET LEVELS


P

MC
D

S0

LMC

S1

LAC
P0

P0

P1

P1

Q1

Q0

The entry or exit of firms will stop only when profit is


reduced to zero. This is at the lowest point of the LAC
curve.

A CLOSER LOOK AT THE INDUSTRY


LMC

COST

LAC

SMC1

SAC1

0
Long Run Equilibrium of the Industry: P = LMC = SMC,
LAC = SAC

MR,
AR
Q
P=

17

THREE TYPES OF INDUSTRIES


Industries differ in their long run
response to a change in demand
Types
Constant cost industry
Increasing cost industry
Decreasing cost industry

Long run effects of an increase in demand


Assumption: initially starting at zero profits
(long run equilibrium)
Increase in demand raises the equilibrium price
(short run)
Positive profits encourages the entry of first and
shifts the supply curve to the right
Rightward shift in the supply curve makes the
effect on the price ambiguous
See diagram in next slide

18

P
P0

D1

P0
D0

Q0

Constant cost industry

Supply curve shifts such that the price is


unaffected
S0
S1

P0
P0
D0
Q0

D1

19

This implies a long run supply curve that is


horizontal

S0

S1

P0

Long
run
supply
curve

P0
D0

D1

Q0

Increasing cost industry

Supply curve shifts such that the price is


higher
S0
S1

P1
P0
D0
Q0

D1

20

This implies a long run supply curve that is


upward sloping

S0

S1

Long
run
supply
curve

P1
P0
D0
Q0

D1

How did this happen? Effectively the entry of firms


Has shifted the LAC schedule up.

COST

LAC1

LAC0

P1
P0
0

MR,
AR
Q

21

Decreasing cost industry

Supply curve shifts such that the price is lower

S0

S1

P0
P1
D0

D1

Q0

Implies a long run supply curve that is


downward sloping

S0

S1

P0
P1
D0

D1

Long
run
supply
curve

22

How did this happen? Effectively the entry of firms


has shifted the LAC schedule down.
LAC0

COST

LAC1

P0
P1
0

Where do we go from here?


In practice, it is hard to find markets
that are perfectly competitive.
imperfect competition

WAKAS

23

ECONOMICS 11
TOPIC 8
IMPERFECT COMPETITION

U-PRIMO E. RODRIGUEZ
Dept. of Econ., UPLB

What is imperfect competition?


Imperfect competition is a situation where
individual firms have a measure of control
over the price of the commodity in an
industry.
a firm that can affect the market price of its
output can be classified as an imperfect
competitor.
arises when an industry's output is supplied
only by one or a relatively small number of
firms.

Important points
While a firm may have some control over
the price, but this power is not absolute!
Why?

It has to consider the demand for its output!

Aside from discretion over price, imperfect


competitors may or may not have product
differentiation/variation.

Demand curve faced by firm


The firm under an imperfect market faces the
market demand curve or part of it.
In either case, the firm faces a downward sloping
demand curve
This implies that if the firm wants to sell more, it should
lower the price; if it wishes a higher price, it should
restrict output.
In contrast, a perfectly competitive firm, since it has no
control over price, faces a horizontal demand curve.

Sources of market imperfection


Imperfect competition often arises when an
industrys output is supplied by one or a small
number of firms.
This may be traced to the existence of barriers to
entry and the existence of significant differences
or advantages in cost conditions.

Barriers to entry natural or artificial constraints


that prevent other firms from entering the
industry
legal restrictions like patents and exclusive franchises;
existence of advantages in cost conditions demand
for commodity may be too small, firms production
function may exhibit increasing returns to scale (LAC
curve shows economies of scale over all profitable
output levels).

MC

AC

Market demand

TYPES OF IMPERFECT MARKETS


Monopoly one seller in the market
e.g., Meralco is sole distributor of electric power in
Metro Manila
Oligopoly market structure with few sellers;
e.g., cement and automobile industries,
firms operating in an oligopolistic market situation
may either collude or act independently
Monopolistic competition occurs when there are many
sellers producing differentiated products
firms have slight control over the price of the
commodity

MONOPOLY
Note: Other forms of imperfect competition will
not be covered in the course
Some points about monopolies
being a monopolist does not ensure the firm instant
profit;
it is not true that the firm can impose any price it
wants; maximum price is dictated by market demand;
and
a monopolist cannot maximize profit at the inelastic
portion of the market demand curve.

Monopoly: Market demand curve and


marginal revenue (MR)
P

MR

Demand for output, P, TR and MR of a monopolist.


Q

TR

MR

200

198

198

198

196

392

194

194

582

190

192

768

186

190

950

182

188

128

178

186

1302

174

184

1472

170

182

1638

166

10

180

1800

162

11

178

1958

158

12

176

2112

154

Note:
MR =
TR/ Q
Also, P>MR
for Q>1

Important points:
Note that P MR, unlike perfect competition.
P is also the AR curve, hence as price drops,
MR is less than price
On a linear demand curve, MR decreases
twice as fast as the demand curve.

Short run profit maximization


Maximum profit is at the largest vertical
difference between total revenue TR and total
cost TC.
At maximum vertical difference, slopes of TR
and TC are equal. Hence, MR=MC.
Firm will produce (at MR=MC) unless price
falls below AVC.

Profit max at MR = MC
Q

TR

MR

TC

MC

200

500

-500

198

198

198

589

89

-391

196

392

194

660

71

-268

182

1638

166

1168

114

470

10

180

1800

162

1330

162

470

11

178

1958

158

1550

220

408

12

176

2112

154

1850

300

262

13

174

2262

150

2262

412

Monopolist sells 10 units and charges


180 pesos/unit
Q

TR

MR

TC

MC

200

500

-500

198

198

198

589

89

-391

196

392

194

660

71

-268

182

1638

166

1168

114

470

10

180

1800

162

1330

162

470

11

178

1958

158

1550

220

408

12

176

2112

154

1850

300

262

13

174

2262

150

2262

412

Profit max at MR = MC (pt A).


Firm produces Q* and
charges P*
MC

AC

P*

A
0

D=AR

Q*
MR

Profits = EP*CB
P
MC
AC

P*
B

E
A

D=AR

Q*
MR

Is the MC curve the supply curve?


No.
The MC curve of the monopolist does not reflect
the short run supply curve since the monopolist
does not produce output at the levels where MC
=P
It produces output at MR=MC to maximize
profit. But MR is generally less than P.

Does a monopolist always make a profit?


P

Loss

MC

P*

AC

No!
D=AR

Q*
MR

Inefficiency of a monopolist
The price set by monopolist is greater
compared to that under competition.
Hence some consumers are unable to
purchase the commodity, implying some
welfare loss.
The level of output under monopoly is
lower compared to that under perfect
competition.

10

Pricing at marginal cost


P
MC
PM
P0

D=AR

QM

Q0
MR

Regulation of a monopoly
Lump sum tax is a fixed amount of tax levied on a
producer
The tax increases the firms fixed cost but not the variable cost
The firms marginal cost is not affected (does not change)
The change in fixed cost however affects total cost and average
cost

Specific tax is a tax proportional to level of output


produced.
Affects the firms variable cost, average cost and marginal cost

Price regulation a set price imposed by the


government to enhance the welfare of the consumers,
a regulatory body can impose a price equal to MC.

11

Monopolist charged a lump-sum tax


(LST): still sell Q* and charge P*

MC
AC w/ LST
P*

AC

A
0

D=AR

Q*
MR

P
MC
P*

F
G

But profits lower:


Old profits = P*EBG
New profits = P*ECF
Tax = FCGB
AC w/ LST

AC

C
B
A

D=AR

Q*
MR

12

Specific tax: higher price and lower


quantity

MC w/ ST
MC

P1
P0

AC w/ ST
AC

A
D=AR

Q1 Q0
MR

Government can force monopolist to


charge a price equal to MC. Tends to
reduce the price and raise output.
MC

PM
P0

D=AR

QM

Q0
MR

13

Where do we go from here?


We will now switch gears and go to
macroeconomics

WAKAS

14

ECONOMICS 11
TOPIC 9
NATIONAL INCOME ACCOUNTING

U-PRIMO E. RODRIGUEZ
Dept. of Econ., UPLB

INTRODUCTION
National income accounting (NIA) refers to the
measurement of indicators of national output or
income; e.g. GDP, GNP
The road ahead
Circular flow diagram
Gross Domestic Product
Measuring GDP
National accounts of the Philippines
Refinements to GDP
Important considerations
Digression: price indices and the inflation rate

CIRCULAR FLOW DIAGRAM


summarizes the transactions between
the different economic agents
agents: households, firms (business),
government, and foreigners (rest of
the world)

Assumption: The economy composed


of households and firms only
Households: own factors of production,
consume goods and service
Firms: hire factors of production to
produce goods and services

payments for goods and services

Goods and services


FIRMS

HOUSEHOLDS
Factor services (labor,
capital, land

factor payments
(wages, interest, rent, profit)

payments for goods and services

Goods and services


FIRMS

HOUSEHOLDS
Factor services (labor,
capital,
land
upper loop
represents

The
the
transactions in the market for
goods and services

The lower loop


represents
transactions in the
market for factors
FIRMS

HOUSEHOLDS
Factor services (labor,
capital, land

factor payments
(wages, interest, rent, profit)

Extension: Accounting for


government and foreign agents
a.

b.

c.

d.

e.

f.

Government purchases of goods and


services.
Government payments for factor
services (wages, rent, interest).
Transfer payments between different
agents (more in the next slide)
Firms and households pay taxes to
government.
Taxes paid on income, property, goods
and services.
Transactions with the foreign sector
(more in the next slide)

Transfer payments
Transaction for which the receiving party is not
obliged to deliver a good/service in return for a
payment
E.g., donations, unemployment benefits, gifts

Transactions with the foreign sector


Sales of goods and services, assets and transfers
between domestic and foreign agents
Exports sales of domestic goods/services to other
countries
Imports domestic purchases of goods/services
produced overseas

GROSS DOMESTIC PRODUCT (GDP)


GDP, along with GNP, is commonly
used as a measure of the output of an
economy.
The GDP measures the market value of
all final goods and services produced
within an economy in a given period.

Some points regarding GDP


Only measures final goods
Goods which are not purchased for the
purpose of producing other goods or resale
Example: Rice

Example: coconut

Final good if bought for the purpose of


consumption
Not a final good (intermediate good) if
purchased for re-sale in a restaurant
Final good if bought for the purpose of
consumption
Intermediate good if used for making buko pie

Helps avoid double counting

Some points regarding GDP

cont.

Usually expressed in the currency


of particular country
Peso for RP
Allows us to add different goods
Market value of good i = Pi Qi

Qi = quantity of final good i produced


Pi = price of good i

Some points regarding GDP cont.


Only measures current production. Does
not include:
Does not include transfer payments
Does not include current sales of goods
produced in other periodse.g. secondhand
goods

MEASURING GDP
Note: There are always two sides to every
transaction (purchase)
Eg. Pedro buy 50 pesos worth of rice from
Juan
1 transaction = 50 pesos
Pedros viewpoint: expenditure = 50 pesos
Juans viewpoint: income = 50 pesos

Lesson: If the 50 pesos worth of rice is to


be included in GDP, then we can measure
it from Pedros (expenditure) or Juans
(income) perspective.

Three equivalent approaches for measuring


GDP:
expenditure
income
value added

Expenditure approach
GDP = sum of expenditures on final goods
Example: 2 final goods ice cream and buko
pie
Numerical example in the next page

Good
Ice Cream
Buko pie

Price per unit

Q sold

Expenditure

100
50

10
5
GDP

1000
250
1250

Income approach
GDP = sum of payments for the different
factors of production
GDP = wages + rent + interest + profits

Value added approach


Value added measures the
contribution of the different
factors of production to the
value of a good
GDP = sum of value added of all
productive activities
Formula: Value added = sales
purchases from other firms
(POF)
Numerical example:
Value added = 1,000 300 =
700

Item
Sales

Value
(Php)
1,000

Costs
Wages

100

Interest 100
Rent

100

POF

300

Profits

400

Equivalence of the approaches


Expenditure and income

Every transaction is an expenditure from the


viewpoint of one party and an income from the
viewpoint of the other party

Income and value added

Value added = Sales purchases from other firms


= wages + rents + interest profits = components of
the income approach
To verify this, see the table in the previous slidethe
textbook also provides an example

NATIONAL ACCOUNTS OF
THE PHILIPPINES
The actual accounts retain the principle
that the three approaches generate the
same value for GDP. However, some
adjustments are made to accommodate
the realities of modern economies.
Strategy:
Values presented are based on the textbook
Will present more recent data later

Expenditure approach
GDP = C + G + I + X M + SD
GDP of the RP, 1998, million pesos
Item
Personal Consumption Expenditure

Symbol
C

Value
1,980,088

Government Consumption Expenditure

354,981

Gross Domestic Capital Formation

541,233

Exports of Goods and Services

1,478,016

Less: Imports of Goods and Services

1,577,727

Statistical Discrepancy

SD

-109,483

GDP

2,667,108

Gross Domestic Product

10

Spending of households and private non-profit institutions


on goods & services.
Includes durable and non-durable goods.
Main items: Food, beverages, clothing and footwear, fuel,
light and water, transport/communication, household
furnishings, household operations, miscellaneous
Item
Symbol
Value
Personal Consumption Expenditure

1,980,088

Government Consumption Exp.

354,981

Gross Domestic Capital Formation

541,233

Exports of Goods and Services

1,478,016

payments
for its
Less: Governments
Imports of Goods
and Services
workforce and purchases of
Statistical Discrepancy
goods and services

1,577,727

SD

-109,483

GDP

2,667,108

Gross Domestic Product

Investment spending of domestic agents. Its


major components are Fixed Capital and

Changes in Stocks

Item
Personal Consumption Expenditure

Symbol
C

Value
1,980,088

Government Consumption Exp.

354,981

Gross Domestic Capital Formation

541,233

Exports of Goods and Services

1,478,016

Less: Imports of Goods and Services

1,577,727

SpendingDiscrepancy
of foreigners on goods and non-SD
Statistical
factor services produced in the Philippines.
Gross
Product because C+I+G
GDP
AddedDomestic
into the calculations
just represents the expenditures of domestic
residents only.

-109,483
2,667,108

11

Philippine purchases of goods and nonfactor services produced in other countries.


Subtracted because C+I+GSymbol
includes
Item
Value
imports
and
these
should
not
beCincluded 1,980,088
in
Personal Consumption Expenditure
RP GDP.
Government Consumption Exp.
G
354,981
Gross Domestic Capital Formation

541,233

Exports of Goods and Services

1,478,016

Less: Imports of Goods and Services

1,577,727

Statistical Discrepancy

SD

-109,483

Gross Domestic Product


GDP
2,667,108
Captures accounting and reporting errors
inserted to ensure that the 3 approaches
generate the same value for GDP

Value added approach


Aka GDP by Industrial Origin
Classified by major sector

Includes crops like palay, corn, coconut, sugarcane,


bananas, livestock, poultry, agri activities and services,
other crops, fishery, forestry

12

Includes mining & quarrying, manufacturing (food


and non-food), construction, electricity-gas-water

Includes: Transport-communication-storage, trade


(wholesale and retail), ownership of dwellings &
real estate, private services, government services

Income approach
GDP = COE + NOS + Depreciation + IBTS
Depreciation and IBTS are adjustment items
ITEMS

SYMBOLS

VALUE

Compensation of Employees

COE

725,261

Net Operating Surplus

NOS

1,468,612

Depreciation

236,845

Indirect Business Taxes less Subsidies

IBTS

236,390

Gross Domestic Product

GDP

2,667,108

13

This captures wages in the theoretical


presentation
ITEMS

SYMBOLS

VALUE

Compensation of Employees

COE

725,261

Net Operating Surplus

NOS

1,468,612

Depreciation

This
captures
rent,
profits
Indirect
Business
Taxes less
Subsidies

and IBTS
interest
in the theoretical presentation

Gross Domestic Product

GDP

236,845
236,390
2,667,108

wear and tear of physical capital


D is treated as a business cost and is not
ITEMS
SYMBOLS
VALUE
included in NOS. Added here
because the
investment
item in the expenditure
accounts
Compensation
of Employees
COE
725,261
includes depreciation.
Net Operating Surplus
Depreciation

NOS

1,468,612

236,845

Indirect Business Taxes less Subsidies

IBTS

236,390

Gross Domestic Product

GDP

2,667,108

Includes taxes on the use/purchase/production of


goods and services and grants from governments to
firms
Examples: value added tax (VAT), specific taxes

14

Summary
Items

Expenditures

Primary
items

C
I
G
X
(less) M

Adjustments
Total

Value added Income


AFF
Industry
Services

SD
GDP

COE
NOS

IBTS
Depn
GDP

GDP

GDP and GNP


Aside: Gross National Product (GNP) is also
known as Gross National Income (GNI).

Source: Albert, J.R. (2013) Understanding Income as


Measured from GDP, GNI and NDI, National Statistics
Coordination Board, http://www.nscb.gov.ph/
sexystats/2013/SS20130626_incomegdp.asp, posted
on 28 June

GNP = GDP + Net factor income from abroad


(NFIA)
NFIA = earnings of Philippine residents in other
countries earnings of foreigners in the RP

15

GDP and GNP continued


Implication:
GDP = value of output in the Philippines, regardless
of who makes it
GNP = value of the output of Filipinos, regardless of
where it is made

To help you remember the difference:


GDP = Gawa Dito sa Pilipinas
GNP = Gawa Ng Pinoy

Example: 2006, billion pesos

Additional indicators available


Quarterly accounts
Estimates of GDP, GNP and their components for
each quarter the year

Gross Regional Domestic Product


GDP of different regions in the Philippines

16

Possible sources of data:


National Statistics Coordination Board (NSCB): www.nscb.gov.ph
NEDA: www.neda.gov.ph
World Bank (World Development Indicators):
http://data.worldbank.org/data-catalog/world-developmentindicators
ADB (ADB Key Indicators for Asia and the Pacific):
http://www.adb.org/publications/series/key-indicators-for-asiaand-the-pacific
IMF (World Economic Outlook):
http://www.imf.org/external/pubs/ft/weo/2013/01/weodata/index.
aspx

REFINEMENTS TO GDP
(and GNP)
GDP estimates are usually refined (or
adjusted) to enhance their usefulness for
analysis.
Analysis over time
Analysis across economies

Refinements:
Price changes or differences
Population

Note: All adjustments to GDP also apply to


its components and to GNP.

17

Nominal and real GDP


GDP at current prices or nominal GDP = GDP
measured using the prices for the year in
which it is calculated

Example

Incorrect conclusion: Output went up in


Year 2 because GDP is higher.
Why incorrect? Look at the quantities of
buko pie and ice cream!

18

Real GDP or GDP at constant prices= measures


GDP using prices of a pre-selected year (base
year)

Example: Using Year 1 as the base year

REAL GDP

Conclusion based on real GDP: The output of


the country did not change between Years 1
and 2

Lesson: Real GDP eliminates the impacts of


changing prices.
In practice, the formula is

GDP deflator a price index that allows us


to convert nominal GDP into real GDP.
[note: more on the price index later]

19

Some numbers for RP

The nominal GDP in 2006 is about 11 times larger


than its counterpart for 1984. However, Real GDP
(valued at 1985 prices) in 2006 is only about 2 times
larger than its counterpart for 1984. Why? Because
prices have risen.

The GDP deflator shows that prices as a whole are 4.7


times higher in 2006 than in 1985.

GDP per capita


GDP per capita measures how much
output or income was produced or
received, on the average, by an
individual in an economy
Formula

20

Actual data for the Philippines

Population projection
for 2006 (medium
assumption) of the
NSO

GDP for cross-country comparisons


Convert to a common currency using the
exchange rate
GDP domestic currency/Exchange rate
Easier to understand and compare values

Use per capita estimates

Bigger countries (in terms of population)


likely to have bigger GDPs. However, does
not mean that per capita GDP is higher.

21

Example: 2012 data from the IMF, World


Economic Outlook

Brunei:
GDP = US$ 17 B, population = 0.4 M
persons, GDP per capita = US$ 41,703
Ethiopia:
GDP = US$ 42 B (2.5 times larger than
Brunei), population = 86.8 M persons
(217 times larger than Brunei), GDP per
capita = US$ 483 (1% of Brunei)

More examples in Annex 1

PPP adjusted GDP

Adjusts for the fact that one dollar spent in one


country does not buy the same quantity of goods
as in another country
Price of Big Macs in selected countries

Country

Price of a Big Mac (US$)

Price relative to US

Ukraine

1.86

0.4

China

2.45

0.6

Philippines

2.80

0.6

United States

4.33

1.0

Norway

7.06

1.6

Source: The Economist, July 2012

PPP adjusted GDP (see Annex 2)

22

Aside: Growth rates


Growth rate formula:

Applied to many variables: GDP, GNP,


components of GDP/GNP, etc..
Why use growth rates? Gives us a sense
of how fast has a variable is rising or
falling

IMPORTANT CONSIDERATIONS
REGARDING GDP/GNP
Main point: High values of GDP do not always
correspond to high standards of living. At best
GDP is an imperfect measure of output
GDP does not capture
Income distribution, poverty
Costs of achieving high levels of output: pollution,
time for leisure, etc
Transactions to that do not go through
organized/formal markets: e.g. household chores,
helping friends.
Illegal activities

23

Some values in GDP are imputed


Imputing refers to the process of approximating
values of certain activities
E.g. owner-occupied houses

DIGRESSION: PRICE INDEX


A price index indicates the change in the cost of
purchasing a given bundle of goods in one year
relative to another (base year). In other words, it
measures how prices, on the average, differ across
observations.
Interpretation:
Price index for 2007 is 160 and the base year is 2005
This means that prices in 2007 are, on the average,
60% higher than in 2005.
Note: If the base year is 2005, then the price index for
2005 is 100.

24

Consumer price index


One of the most commonly used indicators
of the general price level
Measures changes in the cost of purchasing
a given bundle of goods that are bought by
the average household.
Weights are based on the shares of goods
and services in the spending of the average
household. Example provide in the next
slide for the CPI with 2000 as the base year

25

Inflation rate
measures the rate of change in the general
price level
indicates how fast prices are, on the
average, rising or falling over a given
period.
Formula:

Example:

Let CPI1998 = 137.9 and CPI1997 = 125.1

Interpretation: Prices in 1998 are, on the


average, 10.2% higher than in 1997

Note: A lower inflation rate does not


mean lower prices.
WAKAS

26

Annex 1
GDP and population estimates for 2012
Rank

1
2
3
4
5
181
182
183
184
185
10
20
65
93
113
127
140
144
157
159
11
13
87

Country

GDPpercapita
(US$)
HighestpercapitaGDP
Luxembourg
107,206
Qatar
99,731
Norway
99,462
Switzerland
79,033
Australia
67,723
LowestpercapitaGDP
Liberia
436
Niger
408
Burundi
282
Malawi
253
DRCongo
237
SoutheastAsia
Singapore
51,162
BruneiDarussalam 41,703
Malaysia
10,304
Thailand
5,678
Indonesia
3,592
Philippines
2,614
Vietnam
1,528
LaoP.D.R.
1,446
Cambodia
934
Myanmar
835
Others(selected)
UnitedStates
49,922
Japan
46,736
China
6,076

GDP Population
(BUS$) (mpersons)
57
183
501
632
1,542

0.5
1.8
5.0
8.0
22.8

2
7
2
4
18

4.0
16.1
8.8
16.6
74.7

277
17
304
366
878
250
138
9
14
53

5.4
0.4
29.5
64.4
244.5
95.8
90.4
6.4
15.3
63.7

15,685
5,964
8,227

314.2
127.6
1,354.0

Source of basic data: IMF, World Economic Outlook


Note: GDP estimates at current prices

Annex 2
Per capita GDP of selected countries, 2012
Country

US$
PPPadjusted US$/PPPadjusted
Lowestratios(GDPinUS$/PPPadjustedGDP)
The Gambia
503
1,864
0.3
Kiribati
1,646
5,973
0.3
Malawi
253
858
0.3
Timor-Leste
3,730
9,873
0.4
Tanzania
599
1,567
0.4
Highestratios(GDPinUS$/PPPadjustedGDP)
Zimbabwe
756
559
1.4
Denmark
56,202
37,657
1.5
Australia
67,723
42,640
1.6
Switzerland
79,033
45,418
1.7
Norway
99,462
55,009
1.8
Memo:
Philippines
United States
Global average

2,614

4,430

49,922 49,922
13,431 14,874

Source: IMF, World Economic Outlook Database

0.6
1.0
0.6

ECONOMICS 11
TOPIC 10
DETERMINATION OF NATIONAL INCOME

U-PRIMO E. RODRIGUEZ
Dept. of Econ., UPLB

OBJECTIVE
Explain fluctuations in national income
Helps understand changes in national income
Helps in formulating policy and business
decisions

The road ahead


Basic framework
Consumption and income
Two sector economy
Three sector economy

BASIC FRAMEWORK
Tasks
Define aggregate expenditure and
equilibrium income
Describe how the economy adjusts to
equilibrium
Explain how changes in aggregate
expenditure affect equilibrium income

Aggregate expenditure (AE)


total amount that all economic agents
want/plan to spend on domestic
goods/services

Agents: households, firms, govt, foreigners

Common formulation
AE = C + I + G + X M
C = consumption, I = investment, G = govt
spending, X = exports, M = imports
Note: AE is not the same as GDP.

AE = planned spending
GDP = actual spending/output

AE and National output (Y)


There is no reason to expect that Y and AE are
equal.
Firms formulate production plans armed only with an
estimate of how much economic agents want to buy.
If AE is not equal Y, then firms adjust production

AE > Y, increase production


AE < Y, decrease production

Discrepancies between AE and Y reflected in


unintended inventories
AE > Y, firm inventories fall
AE < Y, firms accumulate inventories

Equilibrium: Y = AE
Why? No longer an incentive to adjust
production

Illustration
Assume AE does not respond to changes in
income
Horizontal line in (Y,AE) space (AE schedule)
Highly unrealistic but sufficient for now

450 line: illustrates all potential equilibrium


positions (Y = AE)
Equilibrium: intersection of the 450 line and AE
schedule

AE

Equilibrium
E0

AE

20

45
20
Y*

AE > Y
raise production

AE

E0

AE

20

45
20
Y*

AE

AE < Y
Reduce production

E0

AE

20

45
20
Y*

Higher AE raises equilibrium income (Y*)


AE
E1
30
AE1
E0

20

AE0

45
0

20
Y0

30
Y1

CONSUMPTION AND INCOME


Keynes (1936)
suggested that
consumption
spending tends to
increase with
income
Higher income leads
to higher
consumption
spending

Low levels of Y
C>Y
Break-even level:
C=Y
High levels of Y
Y>C

Income Consumption
(Y)
0
200
400
600
800
1,000
1,200
1,400
1,600

(C)
200
350
500
650
800
950
1,100
1,250
1,400

Y
0
200
400
600
800
1,000
1,200
1,400
1,600

C
200
350
500
650
800
950
1,100
1,250
1,400

Autonomous
consumption
Marginal propensity
to consume (mpc) =
change in
consumption
spending for a one
peso increase in
income
mpc = C / Y

Example
C = 500 350 = 150
Y = 400 - 200 = 200
mpc = C / Y
= 150/200 = 0.75

a 1 peso increase in
Y leads to 75 centavo
increase in C
Note: 0 < mpc < 1

Y
0
200
400
600
800
1,000
1,200
1,400
1,600

Y
0
200
400
600
800
1,000
1,200
1,400
1,600

C
200
350
500
650
800
950
1,100
1,250
1,400

C
200
350
500
650
800
950
1,100
1,250
1,400

Completing the table


Y
0
200
400
600
800
1,000
1,200
1,400
1,600

C
200
350
500
650
800
950
1,100
1,250
1,400

200
200
200
200
200
200
200
200

150
150
150
150
150
150
150
150

C/Y
_
0.75
0.75
0.75
0.75
0.75
0.75
0.75
0.75

Consumption schedule (based on values


in the previous table)
C

1600
1400

Slope is the
mpc

1200
1000
800
600

Autonomous
consumption

400
200
0

400

800

1200

1600

Drawing a 450 line helps identify some


important regions
450
1600
1400

Y<C

1200
1000

Y>C

800
600

Breakeven

400
200
0

400

800

1200

1600

Mathematical representation:
Consumption function

Autonomous
consumption

Example consistent with the


numbers in the table:
C = 200 + 0.75 Y

TWO-SECTOR MODEL
Two sectors: Households and firms
No govt and no foreign trade

Implication
AE = C + I

Assumption: I is autonomous and equal to


100
Next slide: Integrate to previous table on
consumption and income

AE = C + I
investment

AE

400

500

100

600

600

650

100

750

800

800

100

900

1,000

950

100

1,050

1,200

1,100

100

1,200

1,400

1,250

100

1,350

10

Equilibrium: Y = AE
Example, equilibrium income (Y*) = 1,200
Y

AE

400

500

100

600

600

650

100

750

800

800

100

900

1,000

950

100

1,050

1,200

1,100

100

1,200

1,400

1,250

100

1,350

Graphical treatment: Revised AE

11

Graphical treatment: Equilibrium

Experiment: What
if I investment
rises from 100 to
200? I.e. I =
100
Equilibrium
income rises from
1,200 (our original
value) to 1,600

AE

400

500

200

700

600

650

200

850

800

800

200 1000

1,000

950

200 1150

1,200

1,100 200 1300

1,400

1,250 200 1450

1600

1400

200 1600

1800

1550

200 1750

12

Graphical treatment

Summary: The 100 peso increase in


investment led to a 400 peso
increase in equilibrium income.
Question: Why is the increase in Y
bigger than the increase in I?
The answer lies in the notion of the

multiplier.

13

Multiplier ()
Measures the change in income for a
unit change in an autonomous
component of aggregate expenditure

investment in the previous experiment

Mathematical representation for the


change in investment

How is the multiplier calculated?

Applied to our example:

14

Using the multiplier to infer the


effects of a change in investment:

This explains why a 100 peso increase


in investment led to a 400 peso
(=4*100) increase in Y*

Why is the multiplier greater than 1?


Initial increase in
investment
Round

1
2

0
mpc[100]

100
0

100
mpc100

mpc [mpc100]

mpc2100

mpc[ mpcn-2100]

mpcn-1100

15

Mathematical derivation

Algebraic treatment of income


determination
Key equations

16

Substituting the consumption and


investment equations into the
equilibrium condition:

Solving for Y:

Applied to our example


Key equations

17

Substituting the consumption and


investment equations into the
equilibrium condition:

Solving for Y:

Question: Where in all this is


saving?
Saving represents that component of
income which is not spent on consumption
(i.e. S = Y-C)
The story on how savings fits into the
current topic will be discussed in another
course (Econ 101).

WAKAS

18

ECONOMICS 11
TOPIC 11
GOVERNMENT AND THE
MACROECONOMY
U-PRIMO E. RODRIGUEZ
Dept. of Econ., UPLB

THE ROAD AHEAD


Government Budget
Government and
national output:
The three-sector
model
Fiscal policy

GOVERNMENT BUDGET
Government budget: indicates the public sectors
expenditures and sources of income
Net budgetary position
Budget surplus: revenues > expenditures
Budget deficit: revenues < expenditures
Balanced budget: revenues = expenditures

Some sources of information


Philippine Statistical Yearbook
Bureau of Treasury (www.treasury.gov.ph)
Budget of Expenditures and Sources of Financing
(BESF) of the Department of Budget and Management
(www.dbm.gov.ph) very detailed

Revenues & expenditures of the Phil.


national government (billion Php)
Item

2011 2012

Revenues

1,360

1,535

Expenditures

1,558

1,778

-198

-243

Surplus
(Deficit)

Source: Bureau of Treasury


(http://www.treasury.gov.ph/statdata/yearly/yr_
corsum.pdf), downloaded 22 August 2013

Expenditures by sector of the national


government (2012, % of total)
Economic services (includes agriculture, trade and
natural resources) = 24%
Social services (includes health and education
spending) = 34%
General public services = 18%
Defense = 5%
Debt service interest payments = 18%
Net Lending = 1%
Source of raw data: DBM (2013) Budget of

Expenditures and Sources of Funds

Expenditures by object of the national


government (2012, % of total)
Personal services = 33%
Maintenance and Other Operating Expenses =
52%
Capital outlays = 14%
Net Lending = 1%
Source of raw data: DBM (2013) Budget of

Expenditures and Sources of Funds

Government Revenues 2012


ITEM
Tax Revenues
Taxes on net income and profits
Taxes on property
Taxes on goods and services
Taxes on intl trade & transactions
Non-Tax Revenues
TOTAL

% share
91.5
43.0
0.2
44.1
4.2
8.5
100.0

Source of raw data: DBM (2013) Budget of

Expenditures and Sources of Funds

GOVERNMENT & NATIONAL OUTPUT


How do changes in government
spending and taxation affect
aggregate output?

Revisions to the basic model


Disposable income (YD) - income that households
are free to spend and save.
YD = Y T + Net transfers to households

where: Y = income, T = taxes

Examples of transfers: unemployment benefits


(other countries), conditional cash transfers
(Philippines)

Aside: for convenience, let net transfers = 0.


Implication: YD = Y T

Consumption now depends on disposable


income

Revised consumption function

Implies higher T leads to lower C

Revised AE
AE = C + I + G

Revised equilibrium condition


Y = AE = C + I + G

Numerical example

Y
1,100
1,300
1,500
1,700
1900
2,100

T
100
100
100
100
100
100

YD
1,000
1,200
1,400
1,600
1,800
2,000

C
950
1,100
1,250
1,400
1,550
1,700

I
100
100
100
100
100
100

G
200
200
200
200
200
200

AE
1,250
1,400
1,550
1,700
1,850
2,000

Equilibrium income (Y = AE): 1,700


Y

YD

1,100 100 1,000 950

AE

100

200 1,250

1,300 100 1,200 1,100 100

200 1,400

1,500 100 1,400 1,250 100

200 1,550

1,700 100 1,600 1,400 100

200 1,700

1900

100 1,800 1,550 100

200 1,850

2,100 100 2,000 1,700 100

200 2,000

Algebraic Treatment

Graphical treatment:

Government spending and equilibrium


income
Main point: G AE Y*
How large is the change in income?

If

G = 200
then,

Y* = (4).(200) = 800

Graphical treatment

Income taxes and equilibrium income


Main point: T C AE Y*
How large is the change in income?

Graphical treatment

Balanced budget multiplier


It commonly asserted that the balanced
budget multiplier is 1.
Implication: If the government raises its
spending by the same amount as its taxes,
then equilibrium income will increase by
the same amount as the increase in
government spending.
That is,

10

Using the values in previous slides

Shock

Impact (Y*)

G = 200

800

T = 200

-600

Total effect

200

Algebraic derivation:

11

Fiscal Policy
Fiscal policy - a collective term that refers
to the use of taxation and government

spending to influence the level of income


Expansionary fiscal policy - spending and
taxation aimed at increasing income;
e.g. , G or T
Contractionary fiscal policy - spending and
taxation aimed at decreasing income;
e.g., G or T

Define: Yf = full-employment level of


output
Inflationary gap
Exists when AE >Y at Yf
There is pressure for an increase in the
general price level (inflation) because it
is not possible to produce beyond Yf.

12

Can eliminate the inflationary gap through a


contractionary fiscal policy

13

Deflationary gap
Exists when AE < Y at Yf
There is pressure for a decrease in
output.
Implies unemployment

14

Can eliminate a deflationary gap by an


expansionary fiscal policy

WAKAS

15

ECONOMICS 11
TOPIC 12
OPEN ECONOMY MACROECONOMICS

U-PRIMO E. RODRIGUEZ
Dept. of Econ., UPLB

Meaning of Open Economy


Most modern economies do
not operate in isolation.
Countries rely in varying
degrees on trade with other
countries on goods and
services for their
consumption and production
needs.

The transactions among


countries extend to
transfer payments, sales
and purchases of assets,
borrowing and lending,
etc.
A country that engages in
such transactions is called
an open economy

Balance of Payments
Balance of Payments (BOP) - a summary
of the transactions between residents and
non-residents of a country over a given
period
It records transactions in goods, services,
assets and transfers.
Keeps track of the country's transactions with
the rest of the world.
The information helps in analyses that could
assist in the formulation of economic policies
and decisions.

BOP Acct of the Phil, 2012 (preliminary, million USD)


Item

Values

Sub-totals

Current Account (CA)

7,177

Goods & services


Exports

69,721

Imports

-80,845

Income (net)
Transfers (net)

-871
19,172

Capital Account (KA, net)

181

Financial Account (FA)


Direct Investment (net)

5,520
341

Portfolio Investment (net)

3,523

Others (net)

1,656

Net unclassified items (NUC)


Overall BOP Position (CA + KA + FA + NUC)
Reserves and Related Assets (RRA)

-3,642
9,236
-9,236

Source: Bangko Sentral ng Pilipinas, www.bsp.gov.ph

Current Account
The Current Account
reflects the flow of the country's transactions in
goods and services, investments as well as
current transfer payments.
Inflows = earnings of residents from nonresidents
Outflows = payments of residents to nonresidents

Capital Account
Capital Account
the sum of the Capital Account and Financial

Account
represents capital transfers, changes in the
resident claims on non-residents (changes in
assets), and changes in non-resident claims on
residents (changes in liabilities).

Financial Account
The Financial Account captures transactions
in equity and other financial assets.
It is classified into
Direct Investment represents transactions in

equity capital, reinvested earnings, etc.


Portfolio Investment represents transactions in
equity securities and debt securities (bonds and

notes, money market instruments, etc.).


Other Investment (net) includes trade credits,

short to long term loans, currency and other


deposits

Reserves and Related Assets


Reserves and Related Assets are composed of
Exceptional Financing, Use of Fund Credit and
Loans and Reserve Assets.
Reserve Assets represent changes in the assets of
the monetary authorities that can be used for
balance of payments purposes. It is composed of
Monetary Gold, Special Drawing Rights (SDR),
Foreign Exchange and Other claims.

Net Unclassified Items


Theoretically, the sum of the Current Account, Capital
Account, Financial Account and Reserves and Related
Assets must be zero, i.e.,
CA+KA + FA + RRA = 0.
The myriad of transactions between residents and nonresidents poses difficulties for recording and compiling
entries. These eventually cause the sum of the to be nonzero.
To capture the presence of such a discrepancy, the practice
is to present it as a separate item in the BOP accounts - Net

Errors and Omissions.

ECONOMICS 11
TOPIC 13
MONEY
U-PRIMO E. RODRIGUEZ
Dept. of Econ., UPLB

Significance
Some of the more controversial economic
issues involve the conduct of monetary
policy as it is used to deal with inflation,
budget deficits, unemployment, incomes,
international economic relationships, etc.
Monetary policy has profound effects on our
jobs, incomes, livelihood, and career
choices.
This lesson, therefore, introduces the role
and functions of money in the economic
system

The Road Ahead


evolution of money and modern payment
systems
basic insights as to why people and firms
hold money (demand for money).
money supply

Definition of Money
Economists have not really agreed on a single
definition but they agree that money supply
refers to all things generally acceptable in
payment of debt (store of value) and as payment
for goods and services (medium of exchange)
whatever its legal status may be.

Functions of Money
Money serves a

medium of
exchange.

This means that


money is an
accepted means
of payment for
goods and
services.

Functions of Money (cont)


Money serves as a unit of account
Money represents an item with which the
values of all other goods and services are
expressed or quoted.

Functions of Money (cont..)


Money serves as a store of value (and a

standard of deferred payment).

Money can be kept today (i.e., stored) and spent at a


later period. It also implies that goods can be bought
today and paid for at a later date (deferred payment).
However inflation, may decreases the ability of money to
act as a store of value and deferred payment.

Evolution of Money
Autarky refers to a family or tribal
group, which, in the absence of
trade, produces that level of goods
and services equal to their
consumption. Money is not used.

Barter system involves trading of


goods and services for other goods
and services. Money is not used but
the barter system requires a double

coincidence of wants.

Evolution of Money (cont)

Commodity Money - overcame the inconveniences

that went with barter system by using uncoined metals


like gold, silver or copper.
had the advantage of ease of transport and durability.
new set of problems came up with the use of uncoined metals
such as adulteration (impurities in content) and short weighing
by unscrupulous traders.

Evolution of Money
Coinage solved the

problem of
adulteration and short
weighing, with the
king's seal being
stamped on the metals
for authentication.
However, some more
problems came up like
storage, theft, costly
and risky transport,
and so on.

Evolution of Money
IOU's tend to minimize risk in transport since coins were left to a
reputable person with "vault or safekeeping" means. IOU's ("I owe
you") were simply written on paper/receipt instead of going to the
safekeeper to transact.

Bank note involves the promise to pay a debt (IOU) which is

evidenced by a piece of paper backed by specie.


Specialized Bankers evolved because it was observed that not all
people who "deposited" their money were demanding payment at
the same time. Hence, there was no need to hold all the gold/silver
pieces all the time. The idea of lending out a portion of the
entrusted money for a fee while holding on to the rest for safekeeping paved the way for fractional reserve banking.
Electronic Funds Transfer System (EFTS)- Electronic money
make use of computer terminals for transactions and automated
computer clearing house that does away with a physical medium of
exchange.

Demand for Money Why to


people hold money?
Transactions demand
for money
Precautionary demand
for money
Speculative demand
for money

Transactions Demand for Money -

arises from the need of households and


firms to have money for the regular
payments of goods and services

Precautionary Demand for Money


People want to hold money for unexpected
events

Speculative or Portfolio Allocation


Motive
the speculative demand stems from the
preference of households and firms to hold
other assets that are "perfectly liquid and
perfectly free from risk of depreciation in
terms of money" in order to "take advantage
of market movements."

Demand for Money


Demand for money is primarily determined by
the level of real output or income and the

interest rate.

Other factors:
(a) credit availability and affordability;
(b) expectations on future income;
(c) expectations on prices;
(d) risk and expected returns on alternative assets;
and
(e) financial innovations that allow easy movement
of funds from less liquid to more liquid forms.

Supply of Money
M1 consists of items used as medium of exchange
such as currency or coins in circulation and demand
deposits.

M2 consists of M1, plus savings and small time


deposits.

M2 =M1+

Savings &
small
time
deposits

M3 refers to money supply, peso savings,


negotiable order of withdrawals (NOW accounts),
time deposits and deposit substitutes of moneygenerating banks.

RM or reserve money represents liabilities of the


Bangko Sentral ng Pilipinas (Central Bank) to the
public sector in the form of currency in circulation
and to the banking sector inthe form of cash
reserves.

Adios!!!
WAKAS

10