Module 1 - 1 The Economic Problem: Scarcity and Choice

Economics

● The study of how individuals and societies choose to use scarce resources

● Behavioral or social science

Why Study Economics?

● To understand society

● To understand global affairs

● To be an informed citizen/voter

● To learn a way of thinking that helps us make decisions

Opportunity Cost

● The best alternative that we forgo or give up when we make a decision

Marginalism

● Process of analyzing the additional or incremental costs or benefits arising from a

decision

Sunk Costs

● Costs that cannot be avoided since they have already been incurred

Efficient Market
 ● Market in which profit opportunities are eliminated almost instantaneously

How people interact

● People respond to incentives

● Trade can make everyone better off

● Markets are usually a good way to organize economic activity

● Governments can sometimes improve market outcomes

How the economy as a whole works

● A country’s standard of living depends on its ability to produce goods and services

Prices rise when the government prints too much money

● Society faces a short-run trade off between inflation and unemployment

The Scope of Economics

Microeconomics

● Examines the functioning of individual industries and the behaviour of individual

decision-making units – firms and households

Macroeconomics

● Examines the economic behaviour of aggregates – income, employment, output, etc. on

a national scale
The Method of Economics

● Positive Economics

○ Seeks to understand behavior and operation of systems without making

judgements

○ Describes what exists and how it works

○ 2 types
 ■ Descriptive Economics

● Compilation of data that describe phenomena and facts

■ Economic Theory

● Attempts to generalize data and interpret them

● Normative Economics

○ Analyzes outcomes of economic behavior, evaluates them as good or bad

○ May prescribe courses of action; also called policy economics

● Model

○ Formal statement of a theory, usually a mathematical statement of a presumed

relationship between 2 or more variables

● Variable

○ Measure that can change from time to time or from observation to observation

● Because all models simplify reality by stripping part of it away, they are abstractions

● Critics of economics often point to abstraction as a weakness

● Most economists, however, see abstraction as a real strength

● Abstraction is a powerful tool for exposing and analyzing specific aspects of reality,

however it is possible to oversimplify

○ Appropriate amount of simplification and abstraction depends on the use

○ Ockham’s Razor

■ “Irrelevant detail should be cut away

● Whatever you want to explain with a model depends on more than one factor or

variable
 ○ Very often we need to isolate or separate the effects of different factors or

variables

● Ceteris paribus

○ a device used to analyze the relationship between two variables while the values

of other variables are held unchanged

● Economists usually express models in 3 ways

○ Words (intuitively)

○ Graphs (graphically)

○ Equations (mathematically)

Module 1 - 2 The Economic Problem: Scarcity and Choice

The Three Basic Questions WHAT HOW WHO

1. What gets produced?

a. Resources

2. How is it produced?

a. Producers

3. Who gets what is produced?

a. Household

Production

● The process that transforms scarce resources into useful goods and services (OUTPUT)

● Factors of production (INPUTS/RESOURCES)

○ The inputs into the process of production

 ○ 3 Categories:

■ Capital

● Things that are produced and then used in the production of other

goods and services

■ Labor

● Manpower

■ Land, Inputs, or Resources

● Anything provided by nature or previous generations that can be

used directly or indirectly to satisfy human wants

Scarcity, Choice, and Opportunity Cost

● Scarcity and Choice in a One-Person Economy

○ Opportunity Cost

■ Concepts of constrained choice and scarcity are central to the

discipline of economics

■ Opportunity cost

● The best alternative that we give up or forgo when we

make a choice or decision

● Absolute Advantage

○ When a producer can produce a product using fewer resources than

another

● Comparative Advantage
 ○ When a producer can produce a product at a lower opportunity cost

Scarcity and Choice in an Economy of Two or More: SPECIALIZATION, EXCHANGE, and

COMPARATIVE ADVANTAGE

● Theory of comparative advantage:

○ Ricardo’s theory that specialization and free trade will benefit all trading parties,

even those that may be “absolutely” more efficient producers.

○ Specialization in production of the good wherein a producer’s comparative

advantage lies
Monthly Production in AUTARKY

● AUTARKY: State where no exchange/trade occurs

● Assumptions:

○ 1 month = 30 work days

Module 1 - 3 The Economic Problem: Scarcity and Choice

Scarcity, Choice, and Opportunity Cost

● Scarcity and Choice in an Economy of Two or More

○ Societies continuously face decisions with crucial trade-offs

■ Capital Goods and Consumer Goods

● Consumer Goods

○ Produced for present consumption

● Capital Goods

○ Already been produced for the purpose of producing other

things

● Investment

○ Process of using resources to produce new capital

● A society trades present for expected future benefits when it devotes a portion of its

resources to research and development or to investment in capital.

○ Capital is anything that has already been produced that will be used to produce

other valuable goods or services over time

○ Building capital means trading present benefits for future ones.

 ○ Bill and Colleen might trade gathering berries or lying in the sun for cutting logs

to build a nicer house in the future.

○ In a modern society, resources used to produce capital goods could have been

used to produce consumer goods—that is, goods for present consumption.

○ Heavy industrial machinery does not directly satisfy the wants of anyone, but

producing it requires resources that could instead have gone into producing

things that do satisfy wants directly—for example, food, clothing, toys, or golf

clubs.

● Capital does not need to be tangible

○ Human Capital – investing in developing skills (education)

● Investment

○ Creation of capital that ideally yields future benefits to offset its present cost

Production Possibilities Frontier

● On the Y-axis, we measure the quantity of capital goods produced.

● On the X-axis, we measure the quantity of consumer goods.

● All points below and to the left of the curve (such as point D within the shaded area)

represent combinations of capital and consumer goods that are possible for the society

given the resources available and existing technology.

● Points above and to the right of the curve, such as point G, represent combinations that

cannot be reached.

● If an economy were to end up at point A on the graph, it would be producing no

consumer goods at all; all resources would be used for the production of capital.

● If an economy were to end up at point B, it would be devoting all its resources to the

production of consumer goods and none of its resources to the formation of capital.

● Points that are actually on the ppf are points of both full resource employment and

production efficiency.

● Resources are not going unused, and there is no waste. Points that lie within the shaded

area but that are not on the frontier represent either unemployment of resources or

production inefficiency.

● An economy producing at point D can produce more capital goods and more consumer

goods, for example, by moving to point E.

● This is possible because resources are not fully employed at point D or are not being

used efficiently.
● Point G: beyond production capabilities of economy

● Point D: within frontier, but not the most efficient way, not full employment of resources

● Scarcity

○ There is a limit to what an economy can produce

● Employment

○ Employment of people and use of resources

● Opportunity Cost

○ Increasing marginal rate of transformation

● The law of increasing opportunity cost

○ y axis decreases as x increases

○ Sacrifice more capital goods production to consumer goods production

○ Marginal Rate of Transformation

● Negative Slope and Opportunity Cost

○ As we have seen, points that lie on the ppf represent points of full resource

employment and production efficiency.

○ Society can choose only one point on the curve.

○ Because a society’s choices are constrained by available resources and existing

technology, when those resources are fully and efficiently employed, it can

produce more capital goods only by reducing production of consumer goods.

○ The opportunity cost of the additional capital is the forgone production of

consumer goods.

○ The value of the slope of a society’s ppf is called the marginal rate of

transformation (MRT).
The Law of Increasing Opportunity Cost

● Negative slope of the ppf indicates the trade-off that a society faces between two goods

● We can learn something further about the shape of the frontier and the terms of this

trade-off

Economic Systems and the Role of the Government

● Command Economies

○ Central government either directly or indirectly sets output targets, incomes,

and prices
 ● Laissez-Faire Economies (Free Market Economies)

○ Individual people and firms pursue their own self-interest without central

direction or regulation

○ Market

■ Institution through which buyers and sellers interact and engage in

exchange

○ Consumer sovereignty

■ Consumers ultimately dictate what will be produced by choosing what to

purchase

○ Free enterprise

■ Freedom of individuals to start and operate private businesses for profit

Module 1 - 4 Output Markets: Demand and Supply

Demand, Supply, and Market Equilibrium

Market

● Institution through which buyers and sellers interact and engage in exchange of goods

and services

● Not necessarily a tangible area, can be an intangible domain where goods and services

are traded

Firms and Households: Basic Decision-making Units

● Firm

○ Organization that transforms resources (inputs) into products (outputs)

○ Primary producing units in a market economy

 ○ Entrepreneur

■ Person who organizes, manages and assumes the risks of a firm

● Households

○ The consuming units/entities in an economy

Firms and Households interact in 2 basic kinds of markets

● Product or Output Market

○ Markets in which goods and services are exchanged

● Input or Factor Markets

○ Markets in which resources used to produce goods and services are exchanged

Circular Flow Diagram

● Output Markets:

○ Firms supply goods and services

○ Households demand goods and services

● Input Markets:

○ Households supply resources (inputs/factors of production)

○ Firms demand such resources

○ Factors of production are Land, Labor, and Capital

Input/Factor Markets

● Labor Market

○ Households supply work for wages to firms that demand labor

● Capital Market

○ Households supply savings in exchange for interest or claims to future profits to

firms that demand funds to buy capital goods

 ● Land Market

○ Households supply land or other real property in exchange for rent

Output Markets

● Prices are determined by the interaction between demanders and suppliers

● Understand how product prices influence the behavior of demanders and suppliers

Output Markets: Demand Side

● Quantity demanded

○ Amount (number of units) of a product that a household would buy in a given

period if it could buy all it wanted at the current market price

● The amount of product that households purchase depends on the amount of product

available on the market

● The expression “if it could buy all it wanted” is critical to the definition of quantity

demanded because it allows for the possibility that quantity supplied and quantity

demanded are unequal

● Relationship between market price and quantity demanded

● Analyze the likely response of households to changes in price using ceteris paribus or

“all else equal”

○ Derive a relationship between quantity demanded and price by holding other

factors constant

● Changes in price affect the quantity demanded

● Changes in any other factor affect demand

● Demand Schedule

○ Table showing the demand of a product at different prices

● Demand Curve

○ Graph illustrating the demand of a product at different prices

○ Y-axis: price

○ X-axis: quantity

○ Downward/Negative slope always – Negative relationship between price and

quantity demanded

○ As Price increases, Demand decreases

○ As Price decreases, Demand increases

○ Represent the behavior households are likely to exhibit if faced with varying

prices

● Utility

○ We consume goods and services because they give us utility

○ As we consume more of a product within a time period, each additional unit will

yield successively less utility (Law of Diminishing Marginal Utility)

 ○ If each successive unit is worth less, you will not be willing to pay as much for it,

as such, the demand curve is sloped downward for this exact reason

Module 1 - 5 Output Markets: Demand and Supply

Factors that influence a household’s demand for a product

● Income

○ Sum of all a household’s wages, salaries, profits, interest revenue, and other

forms of revenue in a given period of time

○ Flow measure

○ Normal Goods

■ Goods for which demand increases when income is higher and for which

demand decreases when income is low

○ Inferior Goods

■ Goods for which demand tends to decrease when income increases

● Amount of accumulated wealth (net worth)

○ Total value of what a household earns minus what it owes at a given point in

time

○ Stock measure

● Prices of other products available (alternatives)

○ The price of any one good affects the demand for other goods and services

○ Substitutes

■ Goods that can serve as replacements for another

■ When the price of one increases, demand for substitutes increase

 ○ Complements

■ Goods that complement each other

■ Decrease in the price of one results in an increase in demand for the

other and vice versa

● Household’s tastes and preferences

○ Income, Wealth, and Price determine the combination of goods and services

that a household is able to purchase

○ Decision also depends on the tastes and preferences of the household

○ Preferences influence demand within the constraints of price and income

● Household’s expectations about future income, wealth, and prices

Shift of Demand vs Movement Along a Demand Curve

● Shift of Demand (Change in Price-Quantity relationship)

○ Change in a demand curve corresponding to a new relationship between price

and quantity demanded

○ Shift is caused by a change in price and quantity demanded

● Movement Along a Demand Curve (Change in Demand due to Change in Price)

○ Change in quantity demanded caused by a change in price

Market Demand

● Sum of all the quantities of a good or service demanded per period by all the

households buying said good or service in the market

Output Markets: The Supply Side

Quantity Supplied

● Amount of a particular product that a firm would be willing and able to offer for sale at a

particular price during a given time period

Supply Schedule

● Table showing the supply of a product at varying prices

Supply Curve

● Graph illustrating the supply of a product at varying prices

Law of Supply

● Upward/Positive Slope – Positive relationship between price and quantity supplied

 ● Increase in market price leads to an increase in quantity supplied

● Decrease in market price leads to decrease in quantity supplied

Factors that Affect Supply

● Cost of producing the product

○ Depends on

■ Price of inputs/factors of production (land, labor, capital)

■ Technology that can be used to produce the product

○ Prices of related products

Shift of Supply vs Movement Along a Supply Curve

● Shift of Supply (Change in relationship between Quantity supplied and Price)

○ Change in supply curve corresponding to new relationship between quantity

supplied and price

○ Caused by a change in quantity supplied and price

● Movement Along a Supply Curve (Change in Supply due to Change in Price)

○ Change in quantity supplied caused by a change in price

Module 1 - 6 Output Markets: Demand and Supply

Output Markets: Demand and Supply

● The operation of the market depends on the interaction between suppliers and
demanders
● One of 3 conditions prevail in every market
○ Equilibrium
○ Excess Demand (Shortage)
○ Excess Supply (Surplus)

Equilibrium
● When quantity supplied and quantity demanded are equal
● At equilibrium, there is no tendency for price to change
Excess Demand or Shortage
● Exists when quantity demanded exceeds quantity supplied at the current price
● Point in demand curve lies to the right of point in supply curve – Demand > Supply
● Tendency for price to increase as demanders compete against each other for the limited
supply
● When price increases, quantity demanded decreases and quantity supplied increases
until an equilibrium is reached and both are equal
Excess Supply or Surplus
● Exists when quantity supplied exceeds quantity demanded at the current price
● Point in supply curve lies to the right of point in the demand curve – Supply > Demand
● Tendency for price to decrease as sellers cut prices in order to generate sales
● When price decreases, quantity demanded increases and quantity supplied decreases
until an equilibrium is met and both are equal

Consumer & Producer Surplus

1. Compute equilibrium price (P)
2. Compute equilibrium quantity (plug in P)
3. Get y intercepts (isolate price)
4. Compute area of triangles formed
No Free Lunches: Propagating solidarity economy (Dr. Habito)

Questions to ask when dealing with Shifts in Demand/Supply Curve

● Which side of the market is affected by a change in a factor other than price? Supply or
Demand side?
● To what direction will the shift be? Left or Right?
● How is equilibrium price affected? Does it increase or decrease?
● How is equilibrium quantity affected? Does it increase or decrease?
● Does the analysis make intuitive sense?
Module 1 - 7 Demand and Supply Applications

Law of Supply and Demand

● Interaction between the supply of a resource and its corresponding demand
● Effect of availability and desire on the price of a product
● Low Supply & High Demand – High Price
● High Supply & Low Demand – Low Price

Price Controls
● In an unregulated market system, market forces establish equilibrium prices and
quantities
● Equilibrium doesn’t mean that everyone is satisfied
● Most often rationale is fairness
○ It is not fair to let x do y
○ It is not fair for x to run up the price of y
○ It is not fair for x to charge y
● Perceptions of Injustice with equilibrium
○ Overpricing is bad
○ Income is unfairly distributed
○ Some items are necessities and should be priced ‘reasonably’
2 Types of Price Controls (Usually set by government)
● Price Ceiling
○ Legal Maximum on the price at which a good can be sold
● Price Floor
○ Legal Minimum on the price at which a good can be sold

Price Ceiling Outcomes

● Price ceiling is not binding if set above equilibrium price
○ Making a product more expensive than it already is
● Price ceiling is binding if set below equilibrium price, leading to a shortage
○ Forces the price below equilibrium, making it cheaper: Demand > Supply
Price Floor Outcomes
● Price floor is not binding if set below equilibrium price
○ Making a product cheaper than it already is
● Price floor is binding if set adobe equilibrium price, leading to a surplus
○ Forces the price above equilibrium, making it more expensive: Supply > Demand

Non-price Rationing Systems

● Queuing
○ Waiting in line as a means of distributing goods and services
● Favored customers
○ Those who receive special treatment from dealers during situations of excess
demand
● Ration Coupons
○ Tickets or coupons that entitle individuals to purchase a certain amount of a
given product per month
■ Black market
● Market in which illegal trading takes place at market-determined
prices
Supply and Demand and Market Efficiency
● Consumer Surplus
○ Difference between the maximum amount a person is willing to pay and its
current market price
● Producer Surplus
○ Difference between the current market price and the full cost of production for
the firm
Deadweight Loss

● Total loss of producer and consumer surplus from underproduction or overproduction

Module 1 - 8 Elasticity

Elasticity
● Used by economists to measure responsiveness
● Used to quantify the response in one variable when another variable changes
● If a variable A changes in response to changes in another variable B, the elasticity of A
with respect to B is equal to the percentage change in A divided by the percentage
change of B

Price Elasticity of Demand

● Ceteris Paribus:
○ When prices rise, quantity demanded can be expected to decline
○ When prices fall, quantity demanded can be expected to rise
● Negative relationship between price and quantity demanded is reflected in the
downward slope of the demand curve

Price Elasticity of Demand: Slope and Elasticity

● Slope of a demand curve roughly reveals the responsiveness of the quantity demanded
to price changes
● Slope can be misleading – it is not a good formal measure of responsiveness
Price Elasticity of Demand: Slope and Elasticity
● Numerical value of slope depends on the units used to measure the variables on the
axes
● Must convert the changes in price & quantity into percentages

Price Elasticity of Demand

● Ratio of the %change in quantity demanded to the %change in price
● Measures the responsiveness of quantity demanded to changes in price

● %change should always be either positive or negative (+ or -)

● Law of demand implies that price elasticity of demand is nearly always negative:
○ Price increases (+) lead to decreases in quantity demanded (-), and vice versa
● Numerator and denominator should have opposite signs resulting in a negative ratio

Types of Elasticity
● Perfectly Inelastic Demand (Coefficient of 0) |
○ Quantity demanded does not respond to a change in price
● Perfectly Elastic Demand (Coefficient of +infinity) –
○ Quantity demanded drops to 0 at slightest increase in price
○ Quantity demanded is entirely dependent on price
● Elastic Demand (| Coefficient | > 1)
○ %change in quantity demanded > | %change in price |
● Inelastic Demand (| Coefficient | < 1)
○ Demand does not respond that much to changes in price
● Unitary Elasticity (| Coefficient |= 1)
○ %change in quantity demanded is the same as | %change in price |
Calculating Elasticities: Calculating Percentage Changes
Module 1 - 9 Elasticity
Calculating Elasticities: Midpoint Formula

1. Compute %change of quantity demanded (numerator)

2. Compute %change of price
3. Divide
4. Get Absolute Value x:
In order of responsiveness of demand to %change in price
(High elasticity = High Responsiveness)
a. X = undefined (Perfectly Elastic)
b. X > 1 (Elastic)
c. X = 1 (Unit Elastic)
d. X < 1 (Inelastic)
e. X = 0 (Perfectly Inelastic)
Calculating Elasticities: Elasticity and Total Revenue
Total Revenue = Price * Quantity
Effects of Price Changes on Quantity Demanded:
Scenarios:

● Price increases by 1%; quantity demanded decreases by less than 1% (say, 0.5%).
Total revenue increases

● Price increases by 1%; quantity demanded decreases by more than 1% (say, 1.5%).
total revenue decreases

● Price decreases by 1%; quantity demanded increases by less than 1% (say, 0.5%).
Total revenue decreases

● Price decreases by 1%; quantity demanded increases by more than 1% (say, 1.5%).
Total revenue increases

Other Important Elasticities of Demand

Income Elasticity of Demand

● a measure of the responsiveness of demand to changes in income

Cross-price Elasticity of Demand

● a measure of the response of the quantity of one good demanded to a change in the
price of another good
Elasticity of Supply
● A measure of the response of quantity of a good supplied to a change in price of that
good (likely to be positive in output markets)

Elasticity of Labor Supply

● a measure of the response of labor supplied to a change in the price of labor

Module 2 - 1 Household Behavior and Consumer Choice

Household Choice in Output Markets

● Constrained Choice
○ Decisions that we make under constraints that exist in the marketplace
○ Constrained by income, wealth, and existing prices
● Every household must make 3 basic decisions
○ How much of each product, or output to demand
○ How much labor to supply
○ How much to spend today and how much to save for the future
● Income, Wealth, and Prices define Household Budget Constraint
○ The limits imposed on household choices by income, wealth and product prices
The Budget Constraint
● Choice Set or Opportunity Set
○ Set of options that is defined and limited by a budget constraint
Preferences, Tastes, Tradeoffs, and Opportunity Cost
● Households’ choices are governed by their individual preferences and tastes
● Spending on one thing means you forgo spending on another thing
● Change in price of a single good can change the entire budget allocation; demand for
different goods and services may fluctuate
● The real cost of any good or service is the value of the other goods and services that
could have been purchased with the same amount of money
● The real cost of a good or service is its opportunity cost, and opportunity cost is
determined by relative prices.
● If a price or a set of prices falls but the income stays the same, the opportunity set gets
bigger and the household is better off
○ Real income
■ Set of opportunities to purchase real goods and services available to a
household as determined by prices and money income
■ “Real Income” can increase even if household income doesn’t – it
increases as a set of opportunities gets bigger
● When money income increases and prices stay constand, the opportunity set likewise
expands
● When prices go up to the point that the opportunity set gets smaller, then a household’s
“Real Income” has fallen
The Budget Constraint Equation

Express in terms of y (isolate y)

Module 2 - 2 Household Behavior and Consumer Choice

The Basis of Choice: Utility

● Utility
○ The satisfaction a product yields (measured in “units”)
○ Impossible to measure, inapplicable to people
○ Helps us understand the process of choice
● Marginal Utility (MU)
○ Additional satisfaction gained by the consumption or use of one more unit of a
good or service
● Total Utility
○ Total amount of satisfaction obtained from consumption of a good or service
● Law of Diminishing Marginal Utility
○ The more of any one good consumed in a given period, the less satisfaction
(utility) generated by consuming each additional (marginal) unit of the same
good
Income Effect
● When price of a product decreases, we are better off, and likely to purchase more of
said product in addition to other products thanks to the leftover income due to the price
decrease
Substitution Effect
● Low price means “cheaper relative to substitutes” thus we are likely to buy more of it
and less of its substitutes
Both Income and Substitution Effect imply a Negative Relationship between price and
quantity demanded

Module 2 - 3 The Production Process: The Behavior of Profit-Maximizing Firms

The Behaviour of Firms
● Firms purchase inputs (land, labor, capital) to produce and sell outputs (goods &
services)
● They demand factors of production in input markets and supply goods and services in
output markets
● Production
○ Process by which inputs are combined, transformed, and turned into outputs
● 3 Decisions firms must make:
○ How much output to supply (quantity of product to produce)
○ How to produce that output (which production technique/technology to use)
○ How much of each input to demand
● A profit-maximizing firm chooses the technology that minimizes its costs for a given
level of output
Profits and Economic Costs
● Profit (Economic Profit)
○ Difference between total revenue and total cost
● Total Revenue
○ Amount received from the sale of the product
○ Number of units sold (q) * price per unit (P)
● Total Cost (Total Economic Cost)
○ Total of out-of-pocket costs and opportunity costs of all factors of
production
● Out-of-pocket Costs (Explicit Costs)
○ Accounting costs
○ Costs as an accountant would calculate them
● Economic Costs (Implicit Costs)
○ Includes the opportunity cost of every input

Economic Profit = Total Revenue - Total Economic Cost

Considering Economic Costs in Calculating Economic Profit

● To analyze the behavior of firms from the standpoint of a potential investor or
competitor
● Considering the FULL costs of production
● Most important opportunity cost is the opportunity cost of capital
● Add a normal rate of return to capital as part of economic cost
● When someone starts a firm, they must commit resources – invest in capital
● These capital investments stay tied up in the firm as long as it operates

Profits and Economic Costs

● Even longstanding firms must continue to invest
○ Plant and equipment depreciate over time and must be replaced
○ New capital is required for expansion
● There is an opportunity cost when resources are used to invest in a business
● Ex. Instead of opening a shop, you could invest in government bonds, etc.
● Rate of Return
○ Annual flow of net income generated by an investment
○ Expressed as a percentage of the total investment
○ Ex. P 100,000 investment in a store and said store produces a flow profit of P
15,000 per year: rate of return is 15%
● Normal Rate of Return
○ Rate of return on capital that is sufficient to keep owners and investors satisfied
 ○ Should be the same as the interest rate on risk-free investments (gov. bonds)
● A normal rate of return is considered part of the total Economic cost of a business
● When a firm earns a normal rate of return, it is earning zero economic profit
● If the level of profit is positive, the firm is earning an above-average normal rate of
return on capital

Find Total Revenue and Total Cost

Revenue = P 700,000 (200 bags sold at P 3,500 each)

Total Cost = P 600,000 (Cost of 200 bags bought at P 3,000 each) + labor cost of P 96,000 for a
total cost of P 696,000

Accounting Profit = P 4,000 (P 700,000 - P 696,000)

4,000 / 800,000 = 0.5% < 0.875 % (normal rate of return)

Total Economic Cost = P 703,000 (P 696,000 + P 7,000 [Normal Rate of return])
Economic Profit = P 700,000 - P 703,000 = - P 3,000
Economic Profit
● Positive level of economic profit = firm is earning more than is sufficient to retain the
interest of investors
○ Positive profits = expansion
● Negative level of economic profit = firm is earning at a rate below what is required to
keep investors happy (Economic Loss)
● Even if a firm is earning a rate of return of 10%, it is still earning a below-normal rate of
return (Economic Loss) if a normal rate of return for its industry is 15%

Module 2 - 4 The Production Process: The Behavior of Profit-Maximizing Firms

Short-Run versus Long-Run Decisions
● Short Run
○ Time Period with the conditions:
■ Firm is operating under a fixed scale (fixed factor) of production
■ Firms can neither enter nor exit the industry
● Long Run
○ Time Period with the conditions:
■ No fixed factors of production
■ Firms can increase or decrease the scale of operation
■ New firms can enter and existing firms can exit
The Bases of Decisions
● In the language of economics, a firm needs to know 3 things
○ Market price of output
○ Techniques of production that are available
○ Prices of inputs
● Optimal method of production
○ Minimize Cost
The Production Process
● Production : Process through which inputs are combined and transformed into
outputs
● Production technology
○ Quantitative relationship between inputs and outputs
○ Labor-intensive Technology
■ Relies heavily on human labor instead of capital
○ Capital-intensive Technology
■ Relies heavily on capital instead of human labor
Production Functions
● Mathematical expression of a relationship between inputs and outputs
● Total product as a function of units of inputs
● Marginal Product
○ Additional output that can be produced by adding one more unit of a specific
input
● Average Product
○ Average amount produced by each unit of a variable factor of production
Law of Diminishing Returns
● When additional units of a variable input are added to fixed inputs, after a certain point,
the marginal product of the variable input declines
● Lack of space in the production facility, etc.
● Each staff has a smaller amount of capital to work with
● When more units of a variable input are added to a fixed input (scale of the production
plant)
● Always applies in the short run (all firms eventually face diminishing returns as they
approach maximum production capacity)
Average Product vs Marginal Product
● Average product “follows” marginal product but doesn’t change as quickly
● If marginal product > average, average increases
● If marginal < average, average decreases
Capital and Labor are complementary inputs
Added capital raises the productivity of labor—that is, the amount of output produced per
worker per hour

Choice of Technology
● Inputs can be substituted for one another depending on cost
○ Use capital if labor is expensive and vice versa
● Choose the technology that minimizes the cost of production given current market input
prices