Chapter 1

The Basics of Economics

Learning Outcomes: At the end of this chapter, students are expected to:
1. Define Economics
2. Demonstrate understanding in the basic concepts like scarcity, choice
and opportunity costs.
3. Differentiate the 4 economic resources
4. Define production possibilities curve
5. Explain the basic problems in economics
6. Identify characteristics of the four economic systems.
7. Enumerate and explain the economic goals
8. Relate the basic economics goals to the Sustainable Development
Goals and AmBisyon Natin 2040.

What is Economics all about?

What is the single word that comes up in your mind when you hear the word Economics
? Is it MONEY? Well to some extent it’s true because economics usually pertains to man’s
material welfare. All goods and services needed by mankind have to be paid for, this can’t be
taken for free, that is why these are called economic goods. Free goods or zero price-goods,
like air and rain water, which do not need to be paid for, are not so much of a concern to
economics. To better understand economics which is more than just a study of money, herewith
is the definition of economics adapted from the book, Economics (Sicat,1983).

“Economics is a scientific study which deals with how individuals and society generally
make choices. Individuals and groups in society have innumerable wants. To satisfy those wants,
there are resources that can be used. These resources are not freely available. They are therefore
scarce and they have alternative uses. Such uses may also apply between now (today) and
tomorrow (future). Therefore, a dimension of choice includes present and future use of available
resources. Moreover, the uses of these resources carry with them cost and corresponding
benefits. Concern with cost and benefits requires efficiency in resource use.”

Choice and Concept of Opportunity Cost

Economics is a field of social science which deals with how individuals and groups of
people generally make choices. People are never satisfied (insatiable), wants and needs arise
one after another (unlimited) yet those material things that may satisfy wants are limited and have
to be paid for. This a fact of life, so individuals have to make a choice. Choices that individuals
make involve benefits and corresponding sacrifices. One’s decision to wake up early for school
involves benefits – not being late for school, but the decision to wake up early has a corresponding
sacrifice – the supposedly additional hours of sleep that are lost.
Yes, whatever action that people make entails a choice, but are they aware if they made
the right decisions, because the choices that they make involve sacrifices since there are other
things that they could have done instead.

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 One’s choice to spend money for a movie involves a sacrifice as he/she will instead spend
his/her money to buy a book or to buy a snack for the entire family.
Opportunity cost measures the things that must be given up when one chooses an
alternative over another. It also measures the foregone opportunity or the alternative benefits
that one could have gained. Opportunity cost is sometimes called the second- best choice.

Resources and the Concept of Scarcity

Resources whether human or non-human are considered scarce, such that goods and
services that can be produced by them are also limited and scarce. Scarcity limits people’s
options to choose because everything has to be paid for. “There is no such thing as a free
lunch” is the core philosophy of economics.

The concept of scarcity poses a reason why we need to study economics. The
fundamental problem in economics is scarcity of resources, take it out, and there may be no need
to study economics. Here are some indicators of scarcity:

1. Products and services have prices.

2. Resources have ownership and as such, there are people who own these and people
who don’t ;this is the reason why there are rich and poor in society.
3. Man needs to work to earn a living or to maintain a living standard.
4. Natural resources are gifts from God which need to be conserved for a good life.

Two major branches of economics: microeconomics vs macroeconomics

Microeconomics is concerned with the study of the behavior of an consumer, firm or

industry.

Macroeconomics is concerned with the study of the aggregate economy or the economy
as a whole. It includes the study of GNP, the employment level, the general price level, the
exchange rate, etc.

Classifications of Resources

Economists call all the resources that are used to produce other goods and services as
factors of production or simply the inputs of production. These resources are classified into human
and non- human resources and further classified as land, labor, capital, and the entrepreneur.
Since these resources are scarce, the use of these demand payment. The payments for the
factors of production are referred to as factor payments

Land refers to the God-given resources used in production. It includes all natural
resources, such as mineral deposits, water resources, wild animals, and trees from
the forest. Payments for the use of land are called rents.

Labor refers to the physical and mental exertions of man to produce goods and
services. Wages is a general term used for the payment for the use of labor.

Capital are man –made resources used to produce other goods. These include all
types of structures used in the process of production such as buildings, equipment,
machineries, raw materials, land improvements such as the site of the Mall of Asia and
PICC. Interest is the payment for the use of capital.

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 The Entrepreneur is the person who combines land, labor, and capital to produce
goods and services. He is also the manager, the supervisor, or the innovator. He
hires employees so he can determine the best person to work for him. To keep good
employees in his company, he has to pay them well so that they will work well and will
not leave their jobs for another that pays them better. The factor payment for the
services of the entrepreneur is called normal profit.

The Production Possibilities Curve (PPC)

The concept of the PPC helps the student of economics to better understand and
appreciate the significance of scarcity, choice, and opportunity cost.

The Production Possibilities Curve (PPC) is a curve which depicts the trade-off between
two commodities. Whatever points found on the PPC shows the combinations of two goods that
can be produced by the full utilization of available resources.

The following assumptions are considered in analyzing the PPC.

1. Two goods. The economy produces only two commodities.
2. Fixed resources. The quantity and quality of the factors of production are fixed.
3. Fixed technology. The state of technology is constant.
4. Full employment. The economy is employing all of its available resources.

Figure 1.1
The Production Possibilities Curve

Given Figure 1.1 , Point A, B and C are points on or along the Production Possibilities
Curve that indicate efficient production. Take for example point B, using all the available
resources, the economy produces 12 units of good Y and 2 units of good X; at point C, the
economy decides to use all inputs in the production of good X and none of good Y, while at point
A, the economy uses all its inputs in the production of good Y and none on good X.

On the other hand, points inside the PPC like points E and F are attainable for the
economy but these indicate inefficient production because of the economy’s failure to use all the
available inputs ; i.e., some of the available inputs ae unemployed or underemployed.

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 Points G and H are points that indicate impossible production levels because the
resources available are not enough to produce such levels and thus do not permit the economy
to produce at these levels.

Terminologies in Economics

To reiterate, economics being a science, is a systematic body of knowledge. It uses

scientific methods in gathering data, analyzing data, and drawing conclusions from these data.
Data may come from primary or secondary sources.

Descriptive economics involves compiling data or gathering of data relevant to a particular

problem. Data may come from primary or secondary sources.

• Primary data are collected for one’s present purposes using direct observation,
surveys, and interviews.

• Secondary data are collected from statistical agencies like data on prices,
employment. Interest, and national income or the Gross Domestic Product.

Economic theory is a generalization based on facts about why or how an economic event occurs.
Theory is a generalization because it explains how economic variables generally behave when
certain conditions exist.

Economic policy is formulated, typically implemented and administered by the government.

Examples of economics policies include decisions made on government spending and taxation.

Positive Economic Analysis attempts to describe the economy in terms of an economic

problem, event or concern based on factual information. This can be tested or confirmed based
on facts or statistical data.

Normative economics involves the use of value judgement to assess economic issues and
policies and therefore cannot be tested or confirmed. What is good or not good depends on
society’s value system and orientation.

THE BASIC PROBLEMS IN ECONOMICS

The fundamental problem of economics is scarcity of resources, hence ,any society is

confronted by the following basic economic problems:

1. What to produce? This is a decision as to the type and kind of goods and services society
desires or needs (consumption).
2. How to produce? This is a question on the technique of production and the manner of
combining resources to come up with the desired output.(production).
3. For whom to produce? This is a question on the allocation of goods and services among
members of society (distribution)

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ECONOMIC SYSTEMS

An economic system is a set of economic institutions that dominates a given economy.

The objective of an economic system is to solve the basic economic problems.

1. Traditional Economic System. In the traditional economic system, economic decisions

on what, how, and for whom to produce, are based on a society’s customs and traditions.
The economy generally repeats the decisions made at an earlier time or by an earlier
generation.
2. Market economy or the Free Enterprise Economy or Capitalism. The basic problems
on what, how, and for whom to produce are decided upon by the market system or simply
by demand and supply conditions. The factors of production and their distribution are
owned and managed by private individuals or corporations. The essential characteristics
of this economic system are private ownership of property and resources, presence of
competition, freedom of enterprise, and a profit- motivated mode of production.
3. Command system or the Centrally Planned Economy or Socialism / Communism.
This economic system relies on the government to decide what to produce, how to
produce, and for whom to produce.The essential characteristics of the command economy
is that resources are owned by the state and therefore there is no private ownership of
these resources, hence there is equal distribution of income among members of society.
No individual competition exists but rather a collective effort among individuals is present.
Production is not profit motivated but is done for the general welfare of society.
4. Mixed System. This economic system is a combination of a market economy and a
command economy. Generally, most countries in the world, like the Philippines, have
adopted a mixed economy. Countries recognize the advantages of a market system
because of competition; competition makes the market efficient while the command
economy recognizes the importance of government interventions in directing the activities
performed in the economy especially at times of emergencies and / or crises, like the one
that the whole world currently faces .

ECONOMIC GOALS

Economic policies are developed for certain goals which the economy would like to achieve.
The following are the goals or objectives of any society which may minimize economic and social
problems.

1. Economic growth - an increase in the total output produced in the economy as

measured by the country’s Real Gross Domestic Product (RGDP).
2. Equitable distribution of income- is present when no group of people in societyis
suffers from extreme poverty while others enjoy abundance and prosperity.
3. Price stability- the avoidance of continuous increases in the general price level
known as inflation, or continuous decreases in the general price level known as
deflation.
4. Full employment - the provision of suitable jobs for all citizens who are willing and
able to work.
5. Economic freedom – a guarantee that businesses, workers, and consumers enjoy
a high degree of freedom in their choice of economic activities that will make them
earn a living.
6. Economic Security- the provision of a secured life or a decent life for everyone
including the disabled, chronically ill, and the aged.

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The Millennium Development Goals

At the start of the 21st century, leaders from both developed and developing countries
gathered and agreed to achieve a set of concrete, measurable development objectives by 2015
through the adoption of the Millennium Declaration. These objectives, sknown as the Millennium
Development Goals (MDGs) are associated with the United Nations development agenda.

Source: www.un.org

To help attain the MDGs, various government projects in the recent years were initiated
like that of the Pantawid Pamilyang Pilipino Programs (4Ps), the Alternative Learning System
(ALS), projects of the DOH, TESDA, DEPED and many other government agencies to attain the
MDGs.

Sustainable Development Goals (SDGs)

In September 2015, the Philippines, together with 192 other United Nations (UN) member
states, committed to achieving the 17 Sustainable Development Goals (SDGs) and their 169
targets by 2030. The SDGs, also called the Global Goals, have a range of economic, social,
environmental, and governance targets and there was recognition, early on, that these need to
be achieved in order to attain the long-term vision as articulated in AmBisyonNatin 2040.

Source: www.un.org

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 The SDGs are the blueprint to achieve a better and more sustainable future for all. They
address the global challenges that we face, including those related to poverty, inequality, climate
change, environmental degradation, peace and justice. The 17 Goals are all interconnected, and
in order to leave no one behind, it is important that we achieve them all by 2030.

The SDGs present a bold commitment to finish what has been started through the
Millennium Development Goals (MDGs) in 2015. The Philippines affirms its commitment to
achieve the SDGs by 2030, if not sooner, especially as the Global Goals are in sync with the
country’s development plans and long-term aspirations for 2040.

Goal 1. No Poverty — Donate what you don't use.

Goal 2. Zero Hunger — Avoid throwing away food. Over 1/3 of world's food is wasted.
Goal 3. Good Health and Well-Being — Vaccinate your family to protect them and improve
public health.
Goal 4. Quality Education — Help children in your community to read.
Goal 5. Gender Equality — Call out sexist language and behavior.
Goal 6. Clean Water and Sanitation — Avoid wasting water. Water scarcity affects more than
40% of world's population.
Goal 7. Affordable and Clean Energy — Use energy-efficient appliances and light bulbs.
Goal 8. Decent Work and Economic Growth — Buy from green companies that they are
equal opportunity employers.
Goal 9. Industry, Innovation, and Infrastracture — Think of innovative new ways to
repurpose old materials.
Goal 10. Reduced Inequality — Raise your voice against discrimination.
Goal 11. Sustainable Cities and Community — Bike, walk, or use public transportations
to keep our cities' air clean.
Goal 12. Responsible Consumption and Production — Recycle paper, plastic,
glass, and aluminum.
Goal 13. Climate Action — Educate young people on climate change to put them on a
sustainable path early on.
Goal 14. Life Below Water — Avoid plastic bags to keep the oceans safe and clean.
Goal 15. Life on Land — Plant a tree and help protect environment.
Goal 16. Peace, Justice, and Strong Institutions — Use your right to elect the leaders
in your country and local community.
Goal 17. Partnerships — Revitalize the global partnership for sustainable development

Course Materials:
Read: Payumo, C., et al, (2012), Understanding Economics
Watch: https://www.youtube.com/watch?v=3ez10ADR_gM&t=554s Introduction to Economics: Crash Course
https://www.youtube.com/watch?v=djPFUgUOujY Economics – Economy Systems

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AmBisyon Natin 2040

This represents the collective long-term vision and aspirations of the Filipino people for
themselves and for the country in the next 25 years. It describes the kind of life that people want
to live, and how the country will be by 2040.

Source: www.neda.gov.ph

AmBisyonNatin 2040 is a picture of the future, a set of life goals and goals for the country.
It is different from a plan, which defines the strategies to achieve the goals. It is like a destination
that answers the question “Where do we want to be?”. A plan describes the way to get to the
destination; AmBisyonNatin 2040 is the vision that guides the future and is the anchor of the
country’s plans.

AmBisyonNatin 2040 is the result of a long-term visioning process that began in 2015.
More than 300 citizens participated in focus group discussions and close to 10,000 answered the
national survey. Technical studies were prepared to identify strategic options for realizing the
vision articulated by citizens. The exercise benefitted from the guidance of an Advisory Committee
composed of government, private sector, academe, and civil society.

The life of all Filipinos in 2040: Matatag, Maginhawa at Panatag na Buhay

Matatag Maginhawa Panatag

• Family is together
• Time with friends
• Work-life balance
• Volunteering
• Free from hunger and • Enough resources for
poverty day-to-day needs,
• Secure home unexpected expenses
ownership and savings
• Good transport • Peace and Security
facilities • Long and healthy life
• Travel and vacation • Comfortable
retirement

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 Chapter 2

The Market Mechanism

Learning Outcomes: At the end of this chapter, students are expected to:
1. Illustrate the circular flow model for microeconomics and identify the
product market and factor market
2. Describe the market and distinguish the law of demand and law of
supply
3. Illustrate differences in the demand and supply function, schedule,
and curve
4. Analyze the determinants of demand and determinants of supply
5. Compute and explain the equilibrium price and equilibrium quantity
and illustrate effect of government intervention through its price ceiling
and price support
6. Classify and explain four kinds of elasticity
7. Identify and give example of product with different elasticities

CIRCULAR FLOW FOR MICROECONOMICS

Figure 2.1
Circular Flow Diagram

Source:

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 Figure2.1 in the upper loop is a flow model showing the exchange between businesses
(producer) and households (consumer) in the resource market. The households, as shown, are
the providers of inputs/resources (land, labor, capital, and entrepreneurs); hence, the households
receive payment from businesses called money income. The outflow of money from the
businesses in exchange for the inputs/resources is called cost of production as businesses
make the payment.
On the other hand, the lower loop shows the exchange of output between businesses and
households in the product market. Businesses produce goods and services which households
demand to satisfy their wants. Businesses provide the goods and services and the households
pay for these goods and services, which is shown by the outflow of money from the households.
The money that households pay for the goods is called expenses of the consumer while this
same money received by businesses is called the revenue of the producer.

DEFINITION OF MARKET

Markets bring together buyers and sellers, whether these are the product market or the
resource market . A market exists as long as there are buyers and sellers who agree on the
price, hence transaction takes place. The agreed- upon price is called the market price or
equilibrium price.

Figure 2.2
3 Elements of the Market

Buyers Sellers

Transaction Equilibrium price

Take note that a market does not exist in a definite place only, it can exist anywhere as
long as there are buyers and sellers who agree on the price. A market exists even without a face-
to- face contact because even by phone or by mail alone there can be a market like the on-line
market.

THE LAW OF DEMAND

The law of demand states that “the higher the price of the good, the lesser the quantity
demanded” of that good or “as price declines, quantity demanded increases” all other things
constant or equal. This law can be presented in 3 ways: as a demand function, a demand
schedule and as a demand curve.

The Demand Function is expressed in terms of a mathematical equation as follows:

Qd = 100 - 2 P
where Qd is quantity demanded and P is the price

The above function shows that Qd is dependent on P, or this shows that there is an
inverse relation between Qd and P; as price increases, Qd declines.

The Demand Schedule is expressed in a tabular form, this is done thru substitution in the given
demand function and can be represented as follows:

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 Table 2.1
Demand Schedule

Price per kilo of Quantity Demanded

rice (in pesos) of Rice (in kilos)

20 60

25 50

30 40

35 30

40 20

The table above shows the inverse relationship of price and quantity demanded; that as
the price gets higher the quantity demanded gets lower.

The Demand Curve is a line plotted on the graph which represents the demand schedule; see
Figure 2.3.

Figure 2.3
Demand Curve

Fig. 2.3 shows the demand curve representing Qd = 100-2P. Notice that the demand
curve is downward sloping which reflects an inverse relation between quantity demanded and
price. At point A, the quantity demanded is 20 units and the price is P40.00 and as price goes
down to P35.00 at point B, quantity demanded increases from 20 to 30 units.

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DETERMINANTS OF DEMAND

1. Income – (direct relation to demand for normal goods and inverse for inferior goods)
. An increase in income increases the demand for a normal good; if the product is
an inferior good , an increase in income deceases the demand for it.
Normal goods are goods whose demand increases as income increases.

Inferior goods are goods whose demand increases as income declines like that
of eggs, sardines and dried fish.

2. Tastes and preferences. (direct relation to demand) If one’s taste is in favor of the
product, the higher will be the demand; if one’s taste does not favor the good, the lower
will be its demand.

3. Prices of related goods and services. For substitute goods like rice and bread , the
relation of this determinant to demand is direct. As price of rice increases , the
demand for bread will increase. For complementary goods like bread and butter, the
relationship is inverse; as the price of bread increases the demand for butter will
decrease.

4. Buyer's expectations about future prices (direct relation to demand). If price is

expected to increase, people tend to buy more, hence demand increases. This leads
people to resort to panic-buying because they try to avoid the future increase in prices.

5. Number of Buyers(direct relation to demand). The more the number of buyers, the
higher the demand.

Change in Quantity Demanded vs Change in demand

A change in quantity demanded occurs when there is a change in the price of the good itself.
Figure 2.4 below shows that an increase in price from P30 to P35 results to a decrease in
quantity demanded from 40 units to 30 units, represented by a movement along a given demand
curve from point c to point b.

Fig. 2.4
Change in Quantity Demanded

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 Change in demand. A change in demand is represented by a shift of the demand curve
to the right or to the left which is caused by a change in any of the determinants of demand .

Let us assume that there is an increase in income, other things remaining constant ; the
demand for a normal good increases which is shown by a shift of the demand curve to the right:
D to D1. Conversely, if income declines, the demand curve will shift to the left from D1 to D .

Figure 2.5
Change in Demand

LAW OF SUPPLY

The law of supply states that as the price of a good increases, quantity supplied
increases, all other things constant or equal. This can be represented by a function, a schedule
or by a curve.

Supply Function: Given the supply function as follows:

Qs = -20 + 2P
where Qs is quantity supplied P is the price

The above function shows that there is a direct relation between price and quantity
supplied as shown by the positive coefficient of price which is +2.

Supply Schedule: The above supply function: Qs = -20 + 2P can be expressed in tabular form
and through substitution in the supply function; the table/schedule is shown as:
Table 2.2
Supply Schedule
Price of Rice Quantity Supplied
of Rice

20 20,000

25 30,000

30 40,000

35 50,000

40 60,000

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 The illustration above shows that if the price is P20.00, sellers would sell 20,000kilos of
rice, and if the price increases to P25.00, Qs increases to 30,000 kilos; further increases to
60,000kilos at price P40.

Supply Curve: The line plotted on the graph is the supply curve of the given supply schedule.

Figure 2.6
Supply Curve

As price increases from P20.00 to P25.00, Qs also increases from 20,000 to 40,000 kilos
of rice which shows that there is direct relation between price and quantity supplied, all other
things remaining constant or equal.

Change in Quantity Supplied

A change in quantity supplied occurs when there is a change in the price of the good.
In Figure 2.7, increasing the price from P20.00 to P25.00 (from point h to point i) increases
quantity supplied from 20,000 to 30,000 kilos of rice. A change in quantity supplied is reflected
by a movement from one point to another point along a given supply curve and this movement is
due to a change in price of the good.

Fig. 2.7
Change in Quantity Supplied

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Change in Supply

Figure 2.8
Change in Supply

A change in supply occurs whenever any of the non-price determinants of supply

changes. An increase in supply is represented by a shift in the supply curve to the right, a shift
from S to S1. Alternatively, a decrease in supply is represented by a shift of the supply curve to
the left , a shift from S1 to S.

Determinants of Supply

Aside from the price of the product there are other factors that determine or affect its
supply.
1. Cost of production (inverse relation to supply). An increase in the production cost
discourages producers to produce more, hence a decrease supply.
2. Technology (direct relation to supply). An improved technology encourages producers
to produce more, hence an increase in supply.
3. Subsidy (direct relation to supply). An increase in government subsidy for fertilizers
used by farmers encourages them to plant more, hence increases supply for their
products.
4. Price of competing products (inverse relation to supply). Consider palay and corn
as competing products for farmers. An increase in the price of corn will decrease the
supply of palay since farmers will plant corn rather than palay to take advantage of
the increase in the price of corn.
5. Price expectations (inverse relation to supply) If the price of rice is expected to
increase, businessmen tend to hoard rice, hence supply decreases.
6. Number of sellers(direct relation to supply). The more the sellers in the market, the
higher the supply.

MARKET EQUILIBRIUM

We can now combine our analysis of demand and supply and see how the market clears
or how a market equilibrium is attained. The market clears when supply matches demand leaving
no surplus or shortage in the market. The term equilibrium means that all forces in the market are
in balance. Market equilibrium is attained when demand is equal to supply.

Finding the equilibrium price and quantity in tabular form

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 Table 2.3
Demand and Supply Schedule

Quantity Quantity
Demanded Price per Supplied Shortage or
Kilo Surplus
(in kilos) (in kilos)

60,000 20 20,000 Shortage

50,000 25 30,000 Shortage

40,000 30 40,000 Equilibrium

30,000 35 50,000 Surplus

20,000 40 60,000 Surplus

The above table shows that the equilibrium price can be determined by comparing Qd and
Qs. The equilibrium price (Pe) is P30.00 and equilibrium quantity (Qe) is 30,000 units. Any price
above P30.00, Qs >Qd would create a surplus in the market.

Finding the equilibrium price and quantity through graphical analysis

Figure 2.9
Equilibrium Price and Quantity

In Figure 2.9, the intersection of the demand curve and supply curve at point E indicates
that the equilibrium price is P30.00 and equilibrium quantity is 40,000 units.

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 A surplus is the excess of quantity supplied over quantity demanded. For example, at
P40, quantity demanded in the market is 20,000 units, but producers have produced and offered
60,000 units. The difference brings a surplus of 40,000 units. The surplus would push down price
as sellers would compete to enable them to sell their product, and in so doing, reduce quantity
supplied and increase quantity demanded until equilibrium is achieved.

When quantity demanded is higher than quantity supplied, there is a shortage of the
product. At price P25.00, buyers demand 50,000 units but producers are willing to sell only 30,000
units, hence a shortage of 20,000 units. The shortage in the market is due to a lower price and
would drive prices up as buyers would compete among themselves to get hold of the available
product and in so doing, may increase Qs and decrease Qd until Qs = Qd.

Price ceiling vs Price Support

A price ceiling is also called a price control. It is the maximum legal price fixed by the
government on consumer goods like rice, oil , sugar, etc. to keep prices from further rising.

For the government to be successful in its program of protecting the consumers through
price fixing, it must be able to assure a continuous supply of the goods by price monitoring.

A price support or floor price is the minimum price regulated by the government on
producer goods to keep prices from further decline.

The most prevalent use of price floors is seen thru the prices set by the government for
agricultural products usually palay and corn. The government usually attempts to stabilize or
raise farm incomes by maintaining the prices of farm commodities above their equilibrium values
using its power to alter the price.

As a result of the price floor, there is usually a surplus for agricultural products. The
problem of a surplus can only be solved if the government commits to buy from the farmers
whatever is not bought by traders.

Price Elasticity of demand and of supply

In general, elasticity measures the degree of responsiveness of the dependent variable;

Quantity Demanded (Qd) or Quantity Supplied (Qs) to independent variable; either price, income
or price of related goods all other things constant or equal.

Price elasticity of demand (Ep) measures the degree of responsiveness of quantity demanded
to changes in the price of the good itself, other things constant.

Price elasticity of supply (Es) measures the degree of responsiveness of quantity supplied to
changes in the price of the good itself, other things constant.

Income elasticity of demand (Ey) measures the degree of responsiveness of quantity

demanded to changes in consumers income, other things constant. The coefficients can be
positive or negative depending on the type of product. For a normal good, income elasticity of
demand is positive and for an inferior good, this is negative.

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Cross Elasticity of demand (Ec) measures the degree of responsiveness of quantity demanded
to changes in the price of related goods, other things constant. It is positive when the goods and
services under study are substitutes and is negative when the goods are complementary.

Formula:
∆Q Q2 – Q1
% ∆Q Q1 Q1
Ep = ----------
= ---------- = ----------
% ∆P ∆P P2 – P1
P1 P1
Illustrative example: P₁= 10, Q₁= 20, P₂= 5, Q₂= 50

∆Q 50 – 20 1.5
% ∆Q Q1 20
Ep = ---------- = ---------- = ---------- = ----------------- = -3
% ∆P ∆P 5– 10 5
P1 10

Interpreting the price elasticity of demand

Quantity demanded can be very responsive, not so responsive or does not respond to
changes in the price of the good itself. This is determined by the value of the price elasticity of
demand (Ep).

Economists, however, consider the absolute value of price elasticity of demand (Ep) and
price elasticity of supply (Es) for interpretation purposes.

1. Elastic or Relatively Elastic: Ep > 1 , or when %∆Q > %∆P

Fig. 2.10
Relatively Elastic Demand

A relatively elastic demand curve has a flatter demand curve. To increase total revenue
(TR), sellers may decrease the price. Examples of products are those luxury items like clothes
and bags , shoes .

2. Unitary or Unit Elastic Demand: Ep = 1 ; %∆Q=%∆P

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 Fig. 2.11
Unitary Demand

Demand is unitary if the price elasticity coefficient is equal to one. Total Revenue remain
constants even sellers increases or decreases the price

3. Inelastic or Relatively Inelastic Demand: Ep < 1 ; %∆P>%∆Q

Figure 2.12
Relatively Inelastic Demand

A relatively inelastic demand is a steep curve as shown above. To increase total revenue,
price must be increase. Example of products are basic goods like sugar, rice and salt.

Figure 2.13
Perfectly Elastic and Perfectly Inelastic Demand

Perfectly Inelastic Demand Perfectly Elastic Demand

Ep = 0, (vertical demand curve) Ep = ∞ (demand cure)

29
 A Perfectly Inelastic (PI) demand is a vertical demand curve whose Ep = 0. It
shows that at any price, quantity demanded remains constant. example can be an anti-rabies
vaccine, regardless of price if one is bitten by cat, if doctor prescribe a certain dosage it
needs to be bought because it is a matter of life and death.

A perfectly elastic demand (PE) is a horizontal demand curve, its Ep = ∞ which shows
that at any quantity bought or sold, the price remains constant just like the demand curve for the
firm under pure competition.

Course Materials:
Read: Payumo, C., et al, (2012), Understanding Economics
Watch: https://www.youtube.com/watch?v=g9aDizJpd_s Supply and Demand: Crash course

Supply and Demand: Crash course

30
 Chapter 3

The Theory of Production and Cost

Learning Outcomes: At the end of this chapter, students are expected to:
1. Define and explain the production function
2. Illustrate and explain the law of diminishing marginal returns
3. Explain the types of inputs and three production periods
4. Differentiate explicit and implicit cost
5. Define the different cost concepts
6. Illustrate different cost in mathematical and graphical form

Introduction

The topic on the theory of production looks at the behavior of the firm in its endeavor to
use wisely its resources or inputs to produce output. This includes topics in understanding the
concepts of the production function, the different production periods, the law of diminishing
returns, the stages of production, of economic cost, and of other types of cost.

Production Function

The production function shows the technical relationship between the firm‘s inputs and its
output (goods or services).

This can be expressed in mathematical form:

Output = f ( inputs)

Classification of inputs

Fixed inputs are inputs whose quantity used cannot be changed by the firm.

Variable inputs are inputs whose quantities that can be readily changed like labor and
raw materials.

Production Periods

1. Very short-run period or the immediate period is a production period in which all inputs
used by the firm are fixed.
2. Short-run period is a production period in which the firm uses a combination of fixed
inputs and variable inputs.
3. Long-run period is a production period in which the firm’s inputs of production are all
variable inputs.

36
The Law of Diminishing Marginal Returns

The law states that as successive units of a variable input are added to a fixed input, total
product increases at an increasing rate, continuously increases at a decreasing rate, and at a
certain point, starts to decline.

Table 3.1
Total Product, Marginal Product and Average Product

Labor Total Marginal Average

Land (Worker) Product Product Product
(TP)) (MP) (AP)
1 0 0 --- --

1 1 10 10 10

1 2 22 12 11

1 3 32 10 10.7

1 4 40 8 10
1 5 46 6 9.2

1 6 50 4 8.3

1 7 52 2 7. 4

1 8 52 0 6.3

1 9 50 -2 5.5

Table 3.1 exhibits the Law of Diminishing Marginal Returns. The table shows that given
a hectare of land (fixed input) and with no labor hired, the total product is 0, but as 1 labor is
employed the TP= 10. As the number of workers continuously increases, total product
continuously increases until it reaches 52 sacks at 7 and 8 units of labor then declines to 50 with
9 laborers.

Total Product (TP) is the total amount produced by all the factors of production employed over
ta given time period.

Average Product (AP) is the total product per unit of the variable input.
AP = TP / Labor

Marginal Product (MP) is the additional or extra product produced given an increase in the used
of the variable input.
MP = ∆TP / ∆L

37
 Figure 3.1
The Law of Diminishing Marginal Returns and
the 3 Stages of Production

The Three Stages of Production

The stages of production will be best understood given Fig. 3.1and Table 3.1. These
show the behavior of the total product (TP), average product (AP), and the marginal product (MP)
curves in the 3 stages of production which have been delineated by the broken lines in the figures
shown above.

I. Stage of Increasing Returns. This is the production stage where total product (TP)
increases at an increasing rate. Stage I is where the production level is not yet efficient
because this is a stage where the fixed input(land) is underutilized by the variable
input(labor).

II. Stage of Decreasing Returns. This is the stage that occurs as the producer
continuously employs more labor inputs to a fixed land, where total product still
increases but at a slower rate until it reaches the maximum production level of 52 units.

38
 III. Stage of Negative Returns. This is a stage where the total product starts to decline.
An added increase in labor from 8 to 9 units will decrease TP from 52 to 50 units.

The 3 stages of production exhibit the Law of Diminishing Returns which states that as
one employs more and more of a variable input (labor input in the illustration) to a fixed input
(land), total product increases at an increasing rate (Stage 1), and continuously increases at a
decreasing rate ( Stage II)until it reaches a maximum and then starts to decline (Stage III).

ECONOMIC COST

Economic cost are payments for the inputs that the firm uses in the production of goods
and services (output) categorized into explicit and implicit cost

Explicit cost are monetary expenditures paid to resource owners who supply the inputs
while implicit cost is cost of self-owned and elf-employed resources.

Table 3.2
Mathematical Definition of cost Functions

Explicit cost are monetary payments made by the firm to outsiders who supplied the
inputs used to produce the output.

Implicit cost is the cost of self-owned or self-employed resources.

Total Fixed Cost (TFC) is the cost that does not vary with output like rent ( which is the payment
for the use of land or a building) and that this amount would be the same even if output produced
changes.

Total Variable Cost (TVC) is the cost that varies directly with output like the cost of labor and
raw materials.

Total cost (TC)is the sum of the total fixed cost and total variable cost.

39
 Figure 3.2
Graphical Presentation of Cost Curves

Figure 3.2 shows the comparison of the different cost curves in the 3 production periods.

Average Fixed Cost (AFC)is fixed cost per unit of the product/output. The AFC declines as output
increases; it is an asymptotic curve along the horizontal axis.

Average Variable Cost (AVC) is total variable cost per unit of output. It initially decreases,
reaches a minimum, and starts to rise as output further expands.

Average Total Cost (ATC) is total cost per unit of output. It decreases as output increases,
reaches a minimum, then increases. The ATC and AVC are U shaped curves. ATC = AFC + AVC.

Marginal Cost is the additional or the extra cost associated with the additional unit of the good
produced. MC first declines and then continuously rises as output is increased and is a J-shaped
curve.

Course Materials:
Read: Payumo, C., et al, (2012), Understanding Economics
https://www.youtube.com/watch?v=CE5eJbaHL8s When you should learn economics

40
 Chapter 4

Market Structure

Learning Outcomes: At the end of this chapter, students are expected to:
1. Compare similarities and distinguish differences of the various
markets and structure
2. Analyze the behavior of firms and how the degree of competition can
explain market outcomes
3. Differentiate the two approaches of profit maximization and loss
minimization

INTRODUCTION

The previous part of the study on the theory of production and cost has made us
understand the behavior of producers towards the efficient use of productive inputs since the use
of inputs is associated with economic cost, be it explicit or implicit cost. Efficient use of resources
means proper identification of the extent of use of land, labor, capital, and entrepreneur. These
should not be under-utilized as seen in 1st stage or overutilized as seen in the 3rd stage of
production and hence, cost associated with its production level is minimized.

This chapter examines a broad range of markets and explains how pricing and output
decisions of firms depend on the market structure and the behavior of competitors.

The determination of the output to be produced is not only dependent on the questions of
efficient utilization of productive inputs but also dependent on whether the quantity produced can
be bought (demand facing the firm) and at what price. Of course a higher price is preferred by
the firm, but this pricing scheme is dependent on the type of market structure to which the firm
belongs: pure competition, pure monopoly, oligopoly, or monopolistic competition.

Table 4.1 shows the characteristics of these four market structures based on their
features, such as: the number of sellers or firms in an industry, the extent of product
differentiation, and the type of product produced by the industry, the ease of entry and exit into
and from the industry, and the pricing structure as shown by the demand curve facing the firm.

CHARACTERISTICS of PURE COMPETITION

• There is a very large number of independent sellers in the industry.

• Products are homogenous or exactly alike.
• There is freedom of entry into or exit from the industry.
• Buyers and sellers are price takers; thus, individual firms or buyers exert no control over
the product price.
• The demand curve facing the industry is downward sloping but that facing a single firm is
perfectly elastic.

44
• Agricultural products like atis, mangoes, eggplants, okra, squash and even galunggong
are products sold in a purely competitive market.

Table 4.1
Comparative Characteristics of Four Market Structures

45
 Figure 4.1
Demand Curve for the Industry and the Firm
under Pure Competition

Figure 4.1 on the left shows the demand facing an industry which is downward sloping
(relatively inelastic). An entire industry can affect price by changing industry output but the
individual firm cannot dictate the price as shown by the perfectly elastic demand curve, on the
right of Figure 4.1.

An industry is the sum of all firms producing the same product and in pure competition it
is composed of an infinite or a very large number of sellers/firms. The demand curve facing the
firm is perfectly elastic (see above figure on the right) indicating that no seller or buyer can dictate
the price, hence, each buyer or seller is a price taker.

CHARACTERISTICS of PURE MONOPOLY

• There is only one seller in the industry; the firm is also the industry.
• The product produced has no close substitute.
• There is blocked entry into the industry. Barriers are in the form of government franchises
and patents.
• Demand curve facing the firm is relatively inelastic.
• The product of a monopolist are important like water, electricity, and utilities.
• The firm in pure monopoly is a price setter; the firm dictates the price in the market.
• The firm in pure monopoly practices price discrimination which occurs when a firm is able
to charge different prices to different customers.

46
CHARACTERISTICS of OLIGOPOLY

• There are few sellers in the industry; a few giant firms are found in the industry.
• Products produced are homogenous, others are differentiated.
• Entry of new firms into the industry can be very difficult; competition is too stiff.
• Demand facing the firm is shown by a kinked demand curve. This indicates that price is
rigid; that firms cannot just deviate from the price in relation to their competitors just to
attract buyers because this will only result to a decrease in total sales.
• Few firms in oligopoly can dictate the price too but they have to consider the possible
reactions of their competitors to their pricing decisions.
• There is mutual interdependence among firms in the market.The actions of the
oligopolistic firms may lead to collusion or price war.
• Crude oil/refined oil, car, telecommunication (Globe, Smart, Sun Cellular) companies are
examples of firms operating in an oligopolistic environment.

CHARACTERISTICS of MONOPOLISTIC COMPETITION

• There is a relatively large number of firms in the industry.

• Firms compete by selling differentiated products that are highly substitutable for one
another but are not perfect substitutes.
• Products may differ in brand name, image making, advertising, which are forms of product
differentiation.
• It is relatively easy for new firms to enter the market with their own brands and for existing
firms to leave if their products become unprofitable.
• The demand curve facing the firm is downward-sloping (highly elastic) because the
product produced by firms has a lot of substitutes.
• Firms in monopolistic competition can dictate the price but can only do so with a slight
change in price, since demand may markedly decrease due to the presence of close
substitutes.
• Soap, shampoo, deodorants, and shoes are some of the items sold in monopolistic
competition.

Two Approaches in Profit Maximization and Loss Minimization

1. Total Revenue – Total Cost Approach

Profit = TR – TC

To obtain the profit maximizing output, simply look for the output at which total
revenue exceeds total cost by the largest amount .

47
 2. Marginal Revenue = Marginal Cost (MR=MC) Approach

Marginal Revenue (MR) is the additional revenue derived from the additional units of
a good produced. Marginal Cost (MC) is the additional cost incurred from the
additional units of a good produced. The firm maximizes profits or minimizes losses
by producing at that point where MR =MC.

Equilibrium, Break-even, and Shut-down Conditions for a Firm

Equilibrium condition : MR =MC. An equilibrium condition is where profit is

maximum or loss is minimum. At a high price, a firm can maximize its profit, but with a
low price, a seller especially in pure competition, can only minimize its losses; otherwise
it has to exit from the industry.
All market structures strive to produce where they are efficient and that is where
MR =MC. If MR >MC the firm has to increase its production level to increase profit while
if its MC> MR, it has to decrease its production level to increase profit or decrease losses.

Break-even condition : Price = ATC. The break -even condition occurs when the
firm is producing at a level of output where its total revenue is equal to its total cost
(TR=TC). At break-even, the firm is advised to continue to produce since all expenses
are paid for including the payment for the entrepreneur which is called normal profit.

Shut-down condition : Price = AVC. Shut down condition occurs when the firm
produces where its total revenue is equal to total variable cost (TR=TVC), with its losses
equal to its total fixed cost. The firm is advised to stop producing to avoid incurring more
losses in the future.

Course Materials:
Read: Payumo, C., et al, (2012), Understanding Economics

48
 Chapter 5

Measuring National Income and Output

Learning Outcomes: At the end of this chapter, students are expected to:
1. Demonstrate understanding on the circular for macroeconomics.
2. Analyze how the total output of an economy is being measured
3. Explain the different approaches of Gross Domestic Product and
discuss how to compute it
Introduction

Macroeconomics is a major branch of economics that deals with the study of the aggregate
economy or the economy as a whole. It seeks to obtain an overview of the economy such as the
economy’s total output, employment level, the general price level, aggregate expenditures;
consumption, investment, government expenditures, import and exports, etc.
This chapter discusses the Gross Domestic Product, Gross National Income, National
Income, and the other measures of an economy’s performance. Also included in this chapter is
the measurement of GDP using the three approaches in order to better understand the workings
of the economy. The transactions that are excluded in the computation of GDP and its
shortcomings are also discussed.
Figure 5.1
Circular of Income and Expenditure (Macroeconomics)

51
 Figure 5.1 shows that the household sector (HS) receives income (Y) from the business
sector (BS) and uses it for consumption expenditure (C); the business sector (BS) makes
investment (I); the government sector (GS) makes government purchases (G), and the foreign
sector (FS) exports (X) and imports (M).
The income received by the household sector leaks through savings (S), taxes (T) ,and
imports (M). Injections, on the other hand, are in the form of investment (I), government purchases
(G), and exports (X).

The two stabilization policies that can be implemented by the government are: Monetary
Policy (MP) and Fiscal Policy (FP). To implement a monetary policy, money supply can be
manipulated through monetary instruments: interest rate, legal reserve requirements, open
market operations, and moral suasion; while fiscal policy uses government expenditures (G) and
taxes (T) to stabilize the economy.

Measuring National Income and Output

Gross Domestic Product (GDP) or “Nominal” GDP measures the total market value
of all output ( goods and services ) produced in the economy in a given period of time.

GDP = ∑ Pi Q i
where: P is price , Q is ioutput
=1 produced

Real GDP or GDP at Constant Prices is an inflation- adjusted measure of the total
output produced in the economy in a given period of time. Real GDP disregards changes in
prices as it uses the prices of a chosen base year.

Current GNP
Real GNP = ---------------------------- x 100
Price deflator

Comparing GDP, at both constant and current prices, enables us to distinguish between
changes in GDP that are caused by actual changes in output (GDP at constant prices) and
changes in GDP that are simply the result of changes in prices (GDP at current prices).

Per Capita GDP

In order to take account of population growth, another important concept is the real GDP
per capita that is, the amount of goods and services produced per person

Real GDP
Real Per Capita GDP = ---------------
Population

52
 The per capita RGDP is often used as a measure of welfare and as a basis for classifying
poor countries and rich countries.

Three Approaches in Estimating Gross Domestic Product

1. Expenditure Approach sums up all types of spending on finished goods and services
from the household, business, government and the foreign sector.

GDP = C + I + G + (X – M)

A. Personal Consumption Expenditure (C) represents almost all purchases by

households on durable consumer goods, nondurable consumer goods, and
consumer expenditures for services.

B. Gross Domestic Capital Formation (I) or what is called “domestic investment”, has
two primary components which are : first, fixed capital which includes new
construction and durable equipment , and second, increase in stocks (inventories).

Increase in stocks consists of finished products for sale but not yet sold, raw
materials for intermediate consumption but not yet used, work in progress, and
livestock being used for slaughter.

C. Government Consumption Expenditures (G) includes all governmental spending

on the finished products of business, all direct purchases of resources by
government.

Not all government payments are included. Excluded are transfer payments like
social security payments, veterans payments, and welfare payments.

D. Net Exports (Xn) is the difference between exports and imports of goods and
services. Imports are subtracted from exports to arrive at the net effect of foreign
trade on GDP in the economy.

If exports exceed imports, “net exports” will be positive. If imports exceed exports,
“net exports” will be negative.

2. Factor Income Approach adds up income derived from the factors of production such as
land, labor, capital, and entrepreneur.

GDP = NY + Indirect Business Taxes less subsidies + Depreciation +

Net Primary Income

53
 Components of National Income

A. Compensation of Employees
• Includes wages and salaries paid to employees; also includes wage and salary
supplements, payments by employers into social insurance and into a variety of
private pension, health, and welfare funds for workers.
B. Rental income
• Consists of the income received by the households and businesses that supply
property resources.
C. Interest income
• Consists of the money paid by private businesses to the suppliers of money capital.
D. Normal Profit
• The sum of Proprietors’ Income and Corporate Profits
o Proprietor’s Income consists of the net income of sole proprietorships,
partnerships and other unincorporated businesses.
o Corporate Profits are the earnings of owners of corporations.

Three Components of Corporate Profit:

1. Corporate income taxes
2. Dividends
3. Undistributed corporate profit

National Income (NY) = compensation of employees + rental income + interest income

+ normal profit
Indirect Business Taxes (IBT) are those taxes that can be shifted from seller to
buyer by an increase in price. Example of IBT are sales tax and entertainment tax
Subsidy is a government expense to assist an industry so that the price of their
product may remain low or competitive like farm subsidy.
Depreciation (D) = Gross Investment - Net Investment

Net Factor Income from Abroad or Net Primary Income (NPY)

• Net Factor Income from abroad is the difference between the aggregate flow of
factor payments from (+) and to (-) the rest of the world.
NPY = inflows - outflows
The inflow (+) consists of payments for the use of the economy’s resources from
the rest of the world like salary remittances of Filipinos working abroad.
The outflow (-) consists of payments for the use of the economy’s resources by
foreign investors which are flowed back into their mother countries for their
investment in the Philippines.

3. Industrial Origin Approach reflects the sectoral contributions to economic activities. It i

adds together the gross value added originating in various industries or sectosr into which
the economy is divided.

54
Other National Accounts

Net Domestic Product (NDP)

• NDP is simply GDP adjusted for depreciation. It measures the total annual output
that the entire economy can consume without impairing its capacity to produce in
ensuing years. NDP = GDP - D

National Income (NY)

• The total of all income earned by factors of production. Thus, NI is the sum of
wages, rent, interest, and profit earned by the suppliers of labor, land, capital, and
entrepreneurship. Alternatively, National Income can be computed as:

NY = GDP – (Net Primary Income + D + IBT)

Personal Income (PY)

PY = NY – (undistributed corporate profit + corporate income tax +

SSS/GSIS contribution) + ( transfer payments)

Personal Disposable Income (PDY)

• Is derived by subtracting personal taxes from personal income, thus :

PDY = PY – Personal Tax

PDY= Consumption + Saving

Shortcomings of GDP estimation

Nonmarket Activities
• Productive activities that do take place in any market never show up in GDP which
measures only the market value of output. GDP understates a nation’s total output
because of a lot of nonmarket activities, but which are productive i.e., services of
a housewife, that are excluded.

Leisure activities
• Increase in leisure time clearly has a positive effect on overall well-being. But the
system of national income accounting understates well-being by ignoring leisure’s
value.

Improved Product Quality

• Because GDP is a quantitative measure rather than a qualitative measure, it fails
to take into account the value of improvements in product quality.

55
 Underground Economy
• Most participants in the underground economy engage in perfectly legal activities
but choose not to report their full income. The value of these transactions does not
show up in GDP.

GDP and Environment

• The growth of GDP is inevitably accompanied by “gross domestic products”. The
social costs of the negative by-products reduce our economic well-being. Since
these costs are not deducted from total output, GDP overstates our national well-
being.

Composition And Distribution of Output

• The composition of output is undoubtedly important for the measurement of well-
being. The distribution of output is important as well since it could make a big
difference for society’s overall well-being.

Noneconomic Sources of Well-Being

• The connection between GDP and well-being is problematic for another reason: a
nation’s GDP does not measure society’s total well-being.

Exclusions from GDP

An increase in the expenditure in the economy such as C, I, G and X-M as well as an

increase in income from land , labor, capital, and entrepreneur, increase GDP.

Examples of productive non- market activities which are not included in the GDP are as
follows:
1. Housewife services
2. Consumption of home- grown food
3. Production in the underground economy or informal sector
Activities done in the underground economy are not always illegal. This includes activities
of people who belong to the informal sector of the economy who do not pay taxes like sidewalk
vendors, and jeepney and trycycle drivers.

Examples of expenditures excluded from the GDP:

1. Purely financial transactions like the purchase or sale of bonds and stocks.
2. Payment of government transfers such as pensions, grants, and aid provided by donor
agencies for social services.
3. Second hand sales.
4. Debt repayment

Course Materials:
Read: Payumo, C., et al, (2012), Understanding Economics
Watch: https://www.youtube.com/watch?v=BnrBRuoVefY GDP and Circularflow – Macrotopic: Jacob Clifford
56