ECONOMIC MODELS

Microeconomics makes extensive use of modeling, comparative statics,

and mathematics. Economic Models are composed of a series of
statements of assumptions or given and statements of implications or
deductions. The statement describes the essential features of an item or
process and the interrelationships between factors or varialbles model.

Among the best known economic models is the competitive market or

“supplu and demand.” The supply -and-demand situations developed
and explained in economics books are actually examples of economic
models. THe market model is an example of comparative static analysis.
The supply and demand relationships can be expressed in three
different froms:
A) Verbal ( or logical ),
B) Mathematical
C) Graphical.

Verbally, the Law of Supply can be expressed in the following words.

Supply is a schedule of prices and quantities that a supplier or suppliers
are willing to offer for sale at each price per period of time. These
suppliers would be encouraged to sell more at higher prices and would
sell less at lower prices. This is because higher prices, other things being
constant, mean higher profits, and lower prices mean lower profits.
Thus, prices and quality offered for sale are directly related, that is, the
higher the price the more supply; the lower the price, the less supply.

The verbal explanation of the Law of Supply can be expressed in

mathematical notations too. Mathematical notation are shorcut
representation of verbal explanations. The Law of Supply can be
expressed succinctly ( briefly) in an equation.

Qs = 500P

The equation Qs = 500P means that if the price is say P1, quantity
supplied (Qs) would be P500 (500 X 1 = 500 ); if the Price is P3, quantity
supplied would be P1, 500 ( 500 X 3 = 1,500); if the price is P6, quantity
supplied would be P 3,000 ( 500 X 6 = 3,000). Thus we can see that there
is a direct relationship between the price and the quantity supplied as
explained.
 Table 1
Supply Schedule
Price Quantity Supplied
1 500
2 1,000
3 1,500
4 2,000
5 2,500
6 3,000

MODELS ARE ABSTRACTIONS

Based on our previous discussion, a common feature of all models is that
they focus only on the essential elements of an object of process. In our
example, we analyzed the behavior of supply only from the point of view
of varying prices. We mentioned that if prices are high, quanlity
supplied will also be high. Clearly, we know that supply of commodities
is affected by other factors.

Models that consistently predict a broad range of real world phenomena

are classified as theories. Not all models are theories, however, most of
the modls encountered in our text are regarded as theories. When
there is a correspondence between the conditions described in the
assumptions of a model and the conditions in the economy, the model
may be applied to predict or forecast events in the economy. The test of
a theory is the consistency of its prediction.

From our discussion, we can say that microeconomics is concerend

with these types of models.

1. Models to explain the resource allocation or “choice” decisions of

individual household, producers, and firms.

2. Models to explain how prices and quantities exchanged are

determined in various types of marked structures.

3. Models to examine the market economy as an interrelated system

( general equilibrium model ).

An Example of a Model

Intervention in the energy industry has been practiced by government in

at least four forms, price and tax administration, licensing, rationing, and
corporate participation in the industry. One can attempt a theoretical
construct to derend government presence in an oligopoly industry like
oil refining and marketing. It has been demonstrated in earlier works in
oligopoly theory that a government purchase entry into an oligopoly
industry can improve short-run market performance by inducing an
increase in total industry output.

Borrowing from those pioneering works and using simplifying

assumptions, it can be illustrated that government presence in the
petroleum refining/marketing sector should be able to maximize
industry output relative to a purely private oligopoly situation that
operates in the fashion of a joint monopoly. In the Philippine context, it
can perhaps be argued that the oil multinationals had never operated as
a joint monopoly and that therefore the need for government entry may
be ill-advised. This contention does not detract from the validity of the
arguments suggested by theory. At least, government presence will still
provide a useful deterrent or threat to any such occurence.

Assume a petroleum product demand function that can be expressed as:

Qt = a - bP
Where: Qt is total industry sales;
P represent the selling price of the private firm acting jointly;
And
a and b are positive coefficients.

Start with three firms of equal sizes acting initially as a joint monopoly
with identical unit variable cost of k. Profit will be maximized when:

P = ( a + bk )
2
And the resultant sales would be:

Qt = ( a + bk )
2

Then, allow government entry through a buy out of existing capacity

( perhaps one of the three firms ). Presume that the government firm
has been mandated to engineer the highest possible industry output
without inflicting losses on the private firms and that prices are set so
that there is never unsatisfied demand at those price levels.

One can conveive of two sales policy options that government can take.
We can call one a sales neutral strategy in the sense that regardless of
the price it sets, it leaves the elasticity of demand facing the private
firms the same as before the entry of government.

The other is a discriminatory sales policy in the sense that it elects to

sell the product to buyers who are prepared to pay higher prices for the
commodity. THis can happen only if it is the low price seller in the
market and is so telerated by the private firms.

In turn, the private firms can follow any of the three price strategies in
reaction to the price set by the government firm.

STRATEGY A: Select a price level that will maximize joint monopoly

profits after allowing the government firm to sell all it can at the price
that it selects. Private firms will end up pricing above the government’s
price level.

STRATEGY B: Price within the government firm’s price level and sell all
that the market will clear up to the extent of its (private) capacity.

STRATEGY C: Match government price in cooperative fashion and share

the maket proportionately.

The “residual” demand curves that private oil firms will be left with after
government entry can be derived from any combination of strategies
pursued by government and private industry, respectively.
Corresponding industry output at profit-maximizing price strategies by
the private firms can then be estimated for any price level the
government set. Likewise, private profit resulting from a joint monopoly
decision mode can then be expressed as a function of the government
price strategy.

If we analyze this example, we can see that this model satisfies the three
type of models microeconomics is concerned with resource allocation
decisions, pricing decisions, and market economy as interrelated system
found in a market model called “oligopoly”.

CORPORATE STATICS VS DYNAMIC ANALYSIS

Comparative statics focuses on the shift in equilibrium positions (statics)

for an individual decision unit, a market, or an economic system.
Microeconomics extensively uses comparative statics analysis.

Equilibrium refers to a state in which there is a balance of internal forces

and no tendency for the situation to change unless outside forces
intervene. A system in such equilibrium may also be termed “static”.
Let us say in a competitive market, supply and demand for a commodity
reach equilibrium at the price of P20 per unit. IF demand exceeds supply
because of an increase in poulation and an effective advertising
program, it is possible that price would go up to P22 per unit.
Comparative statics is applicable here because there is a shift In
equilibrium brought about by an increase or shift in demand. Thus, price
would go up from P20 to P22 per unit.

Dynamic analysis focuses on the patterns and rate of change for some
variables between points in time. In the static model, the initial price of
P20 was predicted to go up to P22 without informing the consumers
when or how much time it would take for the price to increase. If the
model tells us that the price of the commodity would go up in a week’s
time, then the dynamic analysis is used.

PARTIAL VS GENERAL EQUILIBRIUM

Partial equilibrium analysis compares equilibrium changes for one

decision unit or one market independent of related changes in the
economic system. It assumes for the purpose of analysis that other
factors will remain the same ( I.e.: ceteris paribus assumption )

For example, we know that the demand for a commodity depends on its
price ( other things being constant). Demand for the commodity can
thus be expressed as:

Qd = f(P)

General equilibrium analysis recognizes the interdependence of all

decision units and all markets in the economic system. It examines
changes within the context of the entire system. All variables are
allowed to adjust in response to the inital change. The changes are then
incorporated into the calculations.

For examples, we know that the demand for a commodity depends not
only on itsprices (p), but also on income (Y), population (P e), price
expectations (Po), advertising and promotion (A d), among other things.
This attempts to include all possible variables that would affect demand
all under the general equilibrium analysis. A more realistic demand
equation can now be expressed as:

Qd = f ( P,Y,Po, Pe, Ad )

AN OVERVIEW OF THE ECONOMY

The Ciircular Flow of Economic Activity

Within the economy, the basic activities of production, consumption,

employment, and income generation take place through the
interrelationship existing between the basic consuming unit, which is the
household, and the basic prdoucing unit, which is the firm.

A simplified model of this circular flow of economic activity is being

shown below.

The top loop in the diagram show the business firm supplying the
household with goods and services to exchange for payments
representing consumption expenditures. On the other hand, the
business firm has to use economic resources consisting of land, laobr,
capital, and entrepreneur to produce these goods and services. The
househol provides the firms these resources in exchange for payments
in the form of rent, interest, wages or salary, and profit.

The circular flow also shows the flow of money and the flow of goods
and services in both directions., THe financial flow, which is the money
flow, depicted in the money payment by the firm to the household of its
money income, and by the household to the firm for its purchase of
goods and services. On the other hand, the physical flow, which is the
goods flow, is depicted in the flow of economic resources from the
household to the firm and in the flow of goods and services from the
firm to the household.

GOODS AND SERVICES

 PAYMENTS

HOUSEHOLD BUSINESS FIRM

MODEL OF ECONOMIC CIRCULAR FLOW

BASIC ECONOMIC PROBLEMSRENT, INTEREST, WAGE OR SALARY & PROFIT

All nations, big or small developed and underdeveloped, have to find

LAND, LABOR,CAPITAL & ENTREPRENEUR
answers to the following economic problems:

1. What to produce?
2. How much to produce?
3. How to produce?
4. For whom to produce?

WHAT TO PRODUCE is a quesiton of the type of goods society desires.

Will a country produce rice, coconuts, bananas, or manufacture bags,
shoes, and garments? Or if a country is preparing for war, should it
concentrate on the manufacture of ammunitions, rocket ships, nuclear
weapons, and the like? Since resources are scarce, no economy can
produce every product desired by the members of society.

HOW MUCH TO PRODUCE refers to the quantity of each good that the
economy will have to produce to make up the total output. Suppose
that a country has decised to manufacture shoes. How many pairs
should be manufactured? Or, if rice production is decided on, how much
should be the total output?
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 combinations and
different techniques, the problem is which of these to use. The
economy that decides on the production of shoes will also have to come
up with the decision on how the shoes 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 the most efficient output of shoes.

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 is to be satisfied. Will the shoes be sold to high income
groups or to low income buyers? Will the market be males, females, or
children? Will the shoes manufactured be sold to domestic consumers
or to foreign markets? This is a problem since resources and goods are
scarce and no society can satisfy all the wants of the 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 seelcted goods and services in the proper
quantities. Lastly, it must determine how these goods and services
should be shared among the members of society.

TYPES OF ECONOMIC SYSTEM

Economic Systems may be classified as traditional, command,or market

systems.

In TRADITIONAL ECONOMIC SYSTEM, production decisions are made

according to customs and traditions. A farmet engaged in the
production of rice does exactly what his father did when he planted rice
20 years ago. This system, while simple and easy, does not allow
progress to be introduced in the production techniques. The producers
simply employ methods that have been used years before by his
ancestors. These methods are therefore antiquated as they do not allow
the producers to adjust to changes dictated by time. This is usually
practiced in underdeveloped regions and in mountainous areas where
transportation and communications are practically nonexistent.

In COMMAND ECONOMY, the answers to the basic economic problems

are dictated by the goverment through the head of the nation or a group
of men designated by the head to make decisions. This system is
socialistic as the government owns and controls the factors of
production. The government plans what to produce and how resources
should be allocated. The system works under the principle that the
interest of society should prevail over that of the individuals. In such a
case, the consumer’s freedom of choice is curtailed and the system does
not enable him to participate in the decision-making process with regard
to the answers to society’s basic economic problems. Furthermore,
decisions regarding the distribution of goods lie in the hands of the
government, and hence, individual preferences are not considered at all.
Consumers buy what is available and may have to do without what they
want or what they need.

The MARKET SYSTEM deals with the economic problems by considering

consumer’s choices. The indicators are consumers’ demand in the
market as reflected in the prices of goods and service. The market prices
seve as signals to the producers about what goods to produce and how
much of these goods ashould be produced. High prices indicate that
goods are in demand and serve as go signals for production. However,
prices tend to fall when goods are not in demand and serve as a red light
to decrease or limit production. THe problem of production is therefore
solved by the price mechanism. The best technique to use is one that
results in the least cost in production.

THE MARKET SYSTEM AND THE ENTERPRISE

The market systems is best described as a free enterprise where

individuals enjoy the right of private property. The economy operates
on a system of voluntary exchange and cooperation among private
individuals and organizations. It places a high value on individual
freedom and allows self interes to be the motivating force.

Under the free enterprise system, the individual is free to do any of the
following:
1. Purchase goods and services of his choice within the limits of his
income.
2. Offer his economic resources for sale in exchange for a financial
remuneration.
3. Establish a business enterprise of his choice for the production and
sale of a desired product.

Under the market economy, the consumer is free to buy goods of his
choice as long as he has the purchasing power to do so. He may buy any
quantity of a good within his income as long as there is an unlimited
supply of that good in the market.

The individual is also ffree to offer his resources for use by other people
in order to earn income. He may decide to render service as an
employee in a big firm and earn wages and salaries. The owner of a big
space of land may lease the proerty and earn rent income. The owner of
idle capital may lend it to an investor and earn interest. An
enterpreneur who may decide to gather resources and organize them
for the production of goods and services will do so because he can earn
profit from such a venture.

Any individual with sufficient captial, proper motives, and

entrepreneurial skills is also free to set up a business of his own to
provide consumers with goods and services of their choice.

The Market Economy is an economy where individuals exercise free

enterprise.

THE MIXED ECONOMY

It is seldom that an economic system exists in its pure form. While the
economy of the United States is basically market oriented, there exist
forms of government regulations, and control. On the other hand the
People’s Republic of China’s economy is bassically command in nature,
yet it cannot be said that it does not use the price system at all.

The Philippine economy is a mixture of the three forms of economic

systems. In the mountains and isolated barrios, most farmers are still
traditiona 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 regards to
production, business and industry. The existence of price control, strict
government regulations, government support, and subsidy programs are
proofs of theimportance of government participation in decision making
in the country’s production activities.

In a mixed economy like ours, the questions of what 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
form them. Predominantly, the Philippine economy is free enterprise in
nature, and the best way to describe our economic system is mixed
economy.

SUMMARY:

Economics studies how prices of land, labor and capital are determined,
and how these prices are used to allocate scare resources.

ECONOMICS IS CLASSIFIED INTO:

1. Positive Economics - concerned with the way economic relationships
are
2. Normative Economics - concerned with what ought to be

THREE ELEMENT OF HUMAN ECONOMIC ACTIVITY

1. Human wants
2. Use of aresources
3. Technique of production

TOOLS OF ECONOMICS
1. Logic
2. Statistics
3. Mathematics

STEPS IN CONSTRUCTION OF ECONOMIC THEORY

1. Specification and defintion of its postulates
2. Observation of “facts” concerning the activity about which we want to
theorize
3. Application of the rules of logic to the observed facts
4. Testing of hypotheses
“hypoteses- tentative statements of cause and effect relationships

DIVISION OF ECONOMICS

MACROECONOMICS - treats the economic system as a whole rather than

individual econimc units of which it is composed

MICROECONOMICS - concerned primarily with the market activities on

individual economic units.

Best known economic model is the “Law of Demand and Supply” as

expressed in three different forms. Verbal/logicak, mathematical, and
graphical.

THREE TYPES OF ECONOMIC SYSTEM

1. Traditional economi system - production decision is based on customs
and tradition.
2. Command Economy - answers to economic problems are dictated by
the goverment.
3. Market System - deals with the economic problems by considering
consumer’s choices.

Basic Microeconomics/aat
1st sem 2021