Ateneo de Davao University

Senior High School

Applied Economics
Handout

TOPIC 7 - Principles, Tools, and Techniques in Creating a Business

A household faces many decisions. It must decide which household members do which tasks and
what each member receives in return: Who cooks dinner? Who does the laundry? Who gets the
extra dessert at dinner? Who gets to drive the car? In short, a household must allocate its scarce
resources (time, dessert, car mileage) among its various members, taking into account each
member’s abilities, efforts, and desires.

Like a household, a society faces many decisions. It must find some way to decide what jobs will
be done and who will do them. It needs some people to grow food, other people to make
clothing, and still others to design computer software. Once society has allocated people (as well
as land, buildings, and machines) to various jobs, it must also allocate the goods and services they
produce. It must decide who will eat caviar and who will eat potatoes. It must decide who will
drive a Tesla and who will take the bus.

Economics is the study of how society manages its scarce resources. In most societies, resources
are allocated not by an all-powerful dictator but through the combined choices of millions of
households and firms. Economists, therefore, study how people make decisions: how much they
work, what they buy, how much they save, and how they invest their savings. Economists also
study how people interact with one another. For instance, they examine how the multitude of
buyers and sellers of a good together determine the price at which the good is sold and the
quantity that is sold. Finally, economists analyze the forces and trends that affect the economy
as a whole, including the growth in average income, the fraction of the population that cannot
find work, and the rate at which prices are rising. The study of economics has many facets, but it
is unified by several central ideas.

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Ten Principles of Economic Decision Making

When we are talking about the Philippines' economy or the whole world, an economy is just a
group of people dealing with one another as they go about their lives. Because the behavior of
an economy reflects the behavior of individuals who make up the economy. In this lesson, we
look at the facets and ideas of economics by diving into the ten principles of Economics.

Principles of Individual Decision-Making

1. People Face Trade-Offs – “There is no such thing as a free lunch.” Grammar aside, there
is much truth to this saying. To get something that we like, we usually must give up
something else we want. Making decisions requires trading off one goal against another.

In Economics, a perfect society or economy cannot have both efficiency and equality.
• Efficiency means that the economy or the society is getting the maximum benefits
from its scarce resources or the economy is getting the most it can from scarce
resources.
• Equality means that the benefits of resources are distributed uniformly among the
members of the economy.

Example: If you and your group of friends were to buy a pizza and one of your friends
does not have money to chip in to buy pizza, would you still offer him some pizza?

If Yes, there is no Efficiency because you are not maximizing the full benefit of what
you paid for the pizza.

If No, there is no Equality because although you are maximizing what you paid for,
you have one friend who cannot experience the benefit of eating the pizza.

2. The Cost of Something Is What you Give up to Get it. - Making decisions requires
comparing the costs and benefits of alternative courses of action. In many cases,
however, the cost of an action is not as obvious as it might first appear.

Example: Consider the decision to go to college. The main benefits are intellectual
enrichment and a lifetime of better job opportunities at the cost of saving up the money
you spent for college for any future investments, and the time you spend in college
listening to lectures and reading textbooks can be used to find a job.

• Opportunity Cost - Whatever must be given up to obtain some item. When making
any decision, decision-makers should know the opportunity costs accompanying
each possible action.

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3. Rational People Think at the Margin - Economists typically assume people are rational.
Rational people know that decisions in life are rarely black and white but usually involve
shades of gray. Economists use the term marginal change to describe a slight incremental
adjustment to an existing action plan. Remember that margin means “edge,” so marginal
changes are adjustments around the edges of your actions. Rational people often make
decisions by comparing marginal benefits and marginal costs.

• Rational People – People who systematically and purposefully do their best to

achieve their objectives.
• Marginal Change – a small incremental adjustment to a plan of Action.
• Marginal Cost- Added costs to the decision-maker
• Marginal Benefit – Added benefits to the decision-maker
• Sunk Cost – Costs that have been already incurred and cannot be recovered.

Example: You have an exam the next day at 8 a.m., but you decide to play video games
for a while, time passes, and you don’t notice it's already 8:00 p.m. and you plan to
go to sleep at 12:00 a.m. You are now deciding whether to continue playing for an
hour or start studying for your exam.

Your marginal change is whether you should continue playing for an hour or start
studying. Your Marginal Cost is to continue playing video games for an hour, and your
Marginal benefit is studying for three hours until 12:00 a.m. Finally, your sunk cost is
the number of hours you've spent playing video games before 8:00 p.m.

4. People respond to Incentives. - An incentive is something that induces a person to act.

Because rational people make decisions by comparing costs and benefits, they respond
to incentives.

• Negative Incentives - Negative Economic Incentives punish people for taking

certain actions. This is a way of encouraging specific actions without making them
compulsory. Rational people are more likely to respond to negative incentives.

Example: Students are more likely to attend a seminar or a lecture if a negative

incentive is implicated, like deductions from their final grades, if they choose not
to attend these activities.

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Principles of Economic Interactions

5. Trade can Make Everyone Better Off – Trade allows each person to specialize in the
activities they do best. By trading with others. People can buy a greater variety of goods
and services at a lower cost.

6. Markets are Usually a Good Way to Organize Economic Activity – Most Economies that
practice the Central Economy have abandoned the system and are instead practicing the
Market Economy. In a Market Economy, the decision of a central planner is replaced by
the decision of millions of firms and households. Firms decide whom to hire and what to
make. Households decide which firms to work for and what to buy with their income.

7. Governments can Sometimes Improve Market incomes – Classical Economists might say
that the invisible Hand Theory is enough for the economy to strive. Still, Keynesian
Economists differ, saying that government interventions are important to the economy
because the invisible hand can only do too much and has its limitations. Another reason
why we need government is that the invisible hand can do much better if the government
enforces the rules to maintain the market economy.

Principles on the Economy as a Whole

8. A Country's Standard of Living Depends on its Ability to Produce Goods and Services –
The standard of living between countries heavily depends on how productive a country
is, that is, the amount of goods and services produced by each unit of labor input. In
nations where firms or workers can produce a large number of outputs per hour, they can
enjoy a high standard of living compared to nations that produce less.

9. Prices Rise When the Government Prints Too Much Money – Inflation is an increase in
the overall level of prices in the economy. Inflation happens when there is a growth in the
quantity of money. When the government creates large quantities of the nation’s money,
the value of money falls.

10. Society faces a Short-Run Trade-off between Inflation and Unemployment – Most
economies describe the short-run effect of monetary injection as:

• Increasing the amount of money in the economy stimulates the overall level of
spending and the demand of goods and services.

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 • Higher demand may, over time, cause firms to raise their prices, but in the
meantime, it also encourages them to hire more workers and produce a larger
quantity of goods and services.

• More hiring means lower unemployment.

Specializations: Comparative Advantages and Absolute Advantage

Specialization in economics is the process of an organization concentrating its labor and

resources on a specific type of production to be more efficient and create a comparative
advantage for an economy. By focusing on a particular activity, skill, or process, specialization in
the labor force can increase productivity and expertise.

Absolute Advantage

Absolute Advantage is the ability to produce a good using fewer inputs than another producer.
Economists use the term absolute advantage when comparing the productivity of one person,
firm, or nation to that of another.

Example: Below is the production of Planes or Ships of Company A and B for 1 day.

Planes Ships
Company A 20 2
Company B 12 2

Company A has the absolute advantage of making Planes because they can make more planes
than Company B in a day.

Comparative Advantage

The opportunity cost of some item is what we give up getting that item. Economists use the term
comparative advantage when describing the opportunity costs two producers face. It is the ability
to produce a good at a lower opportunity cost than another producer.

Example: Below is the production of Planes or Ships of Company A and B for 1 day.

Planes Ships
Company A 20 2
Company B 12 2

First, we must find the Opportunity Costs of both companies when they produce one good. This
can be found by dividing the costs of having a good and the gain of having a good (Costs/Gains).

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Company A

Say Company A focuses on producing 20 Planes for 1 day, so they give up on producing 2 Ships.
So, the cost of producing 20 planes is 2 ships. Therefore, the opportunity cost of producing 1
plane is 2 ships divided by 20 Planes (2/20).

Now let's say Company A focuses on producing 2 ships for 1 day, so they give up on producing 20
planes. So, the cost of producing 2 ships is 20 planes. Therefore, the opportunity cost of
producing 1 ship is 20 planes divided by 2 ships (20/2).

Company B

Say Company B focuses on producing 12 planes for 1 day, so they give up on producing 2 ships.
So, the cost of producing 12 planes is 2 ships. Therefore, the opportunity cost of producing 1
plane is 2 ships divided by 12 Planes (2/12).

Now let's say Company B focuses on producing 2 ships for 1 day, so they give up producing 12.
planes. So, the cost of producing 2 ships is 12 planes. Therefore the opportunity cost of producing
1 ship is 12 planes divided by 2 ships (12/2).

Opportunity Cost Table

Planes Ships
Company A Opportunity cost of producing 1 Opportunity Cost of producing 1
plane is 1/10 or 0.1 of a ship (2 ship is 10 planes (20 Planes / 2 Ships)
ships / 20 planes)
Company B Opportunity cost of producing 1 Opportunity Cost of producing 1
plane is 1/6 or 0.1667 of a ship (2 ship is 6 planes (12 planes / 2 Ships)
ships / 12 planes)

Company A should specialize in producing planes because they have the lowest opportunity cost
of 1/10 or 0.1 compared to Company B, whose opportunity cost is 1/6 or 0.1667.

Company B should specialize in producing ships because they have the lowest opportunity cost
of 6 compared to Company A, whose Opportunity cost is 10.

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Marginal Utility

Marginal utility is the additional satisfaction gained by consuming one additional unit of a good
or service. The formula for marginal utility is the change in total utility divided by the change in
the total number of units consumed. “Utility" is an economic term used to represent satisfaction
or happiness.

You can calculate marginal utility by dividing the change in total utility (TU) by the change in
number of units (Q).

Marginal utility = ∆TU/∆Q

Change in total utility is found by subtracting the previous total utility from the current total
utility (TU2-TU1). Change in number of units is found by subtracting the previous number of units
from the current number of units (Q2-Q1).

Pizza (in Total Utility (in rate of Marginal Utility (in rate of
Quantity) satisfaction) satisfaction)

1 20 20

2 25 5

3 27 2

4 27 0

5 26 -1

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Law of Diminishing Marginal Utility

The law of diminishing marginal utility states that all else equal, as consumption increases, the
marginal utility derived from each additional unit declines. Marginal utility is the incremental
increase in utility that results from the consumption of one additional unit.

In simple terms, the law of diminishing marginal utility means that the more of an item that you
use or consume, the less satisfaction you get from each additional unit consumed or used.

Pizza (in Total Utility (in rate of Marginal Utility (in rate of
Quantity) satisfaction) satisfaction)

1 20 20

2 25 5

3 27 2

4 27 0

5 26 -1

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Law of Diminishing Marginal Returns

The extra output produced from an additional unit of capital falls. In other words, when workers
already have a large quantity of capital to use in producing goods and services, giving them an
additional unit of capital increases their productivity only slightly.

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