Republic of the Philippines

Bulacan State University College of Business Administration

AY 2023-2024

Learning Module on

Applied Business Economics

 Table of Contents
LESSON 1 ....................................................................................................
1 - 22
RESOURCES UTILIZATION AND ECONOMICS Factors
of Production The Circular Flow Model The Concept of Opportunity
Cost Positive and Normative Economics Types of Economic System
LESSON 2 ..................................................................................................
23 - 69
THE BASIC ANALYSIS OF DEMAND AND SUPPLY Methods of Demand
Analysis Forces that cause the demand curve to change Occasional
or seasonal products Substitute and complementary goods
Expectations of future prices Methods of Supply Analysis Change in
Quantity Supplied vs. Change in Supply Optimization in the use of
factors of production Changes in Demand, Supply, and Equilibrium

LESSON 3 ..................................................................................................
69 - 91

THE CONCEPT OF ELASTICITY

Elasticity of Demand Price elasticity of demand Interpretation of the

Elasticity Coefficient Income Elasticity of Demand Cross price
elasticity of demand Elasticity of Supply Extreme types of Supply
Elasticity

LESSON 4 ..................................................................................................
92 - 99

CONSUMER BEHAVIOR AND UTILITY MAXIMIZATION

Goods and Services

Consumer Goods
Essential or Necessity Good Vs. Luxury Goods
Economic and Free Good
Tastes and Preferences
Maslow’s Hierarchy of Needs
The Economics of Satisfaction
The Utility Theory
Marginal Utility
Total Utility
 Introduction

Applied Economics/Economics as an applied science-It is the

application of economics theories and models in real life. It consist of

learning how choices effect individual decision-making and how the

availability of factors aid decision workers craft sound judgment

The word economics came from the greek words,oikos which

meanshousehold andnomus which means management or oikonomus

/oikonomia which means household management.-It is the study of how we

make decisions in a world where resources are limited-It is thesocial

sciencethat studies the human behaviour of people in the societyon how

they make their choices

Importance of studying economics:

1.Economics analysis provides us with guidelines to wise action and

behavior

2.To prudently evaluate our choices before making a decision;

3.To understand why there is a need to save and invest;

4.To understand why government work hand-in-hand with the private sector.

Pre-Test

Questions:1.The central problem of economics is scarcity. What is your

understanding about limited resource but unlimited wants?
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2.Why do we need to study economics?

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LESSON 1:1RESOURCES UTILIZATION AND ECONOMICS

Topics : Introduction to Economics

Factors of Production

The Circular Flow Model

The Concept of Opportunity Cost

Positive and Normative Economics

Types of Economic System

Abstraction

Post Test
Activity Exercise

Duration : 9-hours (to include VMG orientation)

 RESOURCES UTILIZATION AND ECONOMICS

Economics Defined

Economics is defined in various ways. In fact, if we will ask you how you

understand the word, you will give us another definition which may be different in

language but would have the same meaning as the others. However, we can define

economics as the efficient allocation of the scarce means of production toward the

satisfaction of human needs and wants. You might be wondering what the definition

is all about. As you may have noticed, there are two important concepts in the

definition of economics.

The scarce means of production refers to our economic resources like land,

labor and capital, which we use to produce all the goods and services that we need

and want. But why do we produce and ultimately buy these goods and services?

Because they give us satisfaction!

The problem however is that we do not have enough resources to produce all

the goods and services that we desire. This is because our resources are limited or

scarce while our wants are generally unlimited. Given this condition, we cannot

produce everything that we want since there is scarcity or limitedness of resources.

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This is where economics comes in: we try to make the best of a lessthan-ideal

situations. In other words, we try to use our limited resources by efficiently

allocating them so that we are able to produce all the goods and services that will

maximize our satisfaction.

In the succeeding discussions, we take a closer look at the concepts of

resources, scarcity, and satisfaction of human wants.

Origin of the word “economics”

The two Greek roots of the word economics are oikos – meaning household

– and nomus – meaning system of management. Oikonomia or oikonomus

therefore means the “management of household”.

With the growth of the Greek society until its development into city-states,

the word became known or was referred to as “state management”.

Consequently, the term, “management of household” now pertains to the

microeconomic branch of economics, while the phrase “state management”

presently refers to the macroeconomic branch of the economic (Fajardo 1977).

Because of its far reaching significance, in the early year economics covered other

scholarly fields, such as religion, philosophy, and political science.

Scarcity: The Central Problem of Economics

Scarcity is the basic and central economic problem confronting every man

and society. It is the heart of the study of economics and the reason why you are

studying it now.

Authors have defined scarcity in different ways – some of which are

complexly stated while others are simplified exposition of the concept. One author

in particular defines scarcity as a commodity or service being in short supply,

relative to its demand (Kapur 1997) which implies a constant availability of a

commodity or economic resource relative to the demand of them. In

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quantitative terms, scarcity is said to exist when at a zero price there is a unit of

demand, which exceeds the available supply (Kapur 1997).

Scarcity can also be looked in to as the limited availability of economic

resources relative to man’s or society’s unlimited demand for goods and services.

Since human wants and needs are unlimited and the available resources are
finite, scarcity naturally results leaving the society with the problem of resources
allocation (See Figure 1.1)
Figure 1.1 Problem of Scarcity

Limited Resources Unlimited resources

Scarcity

The figure illustrates the interaction of limited resources available and the
unlimited wants of man and society. If limited resources fall short to meet the
unlimited wants of the society, it will eventually create a problem called,
“scarcity”.

If the problem of scarcity does not exist, there is no need for us to

economize. But since we know that our resources are limited and therefore we

cannot produce all the goods and services we cannot buy, then there is a need for

us to study economics and economist need to find other work.

You already know that individuals and groups within the society have

innumerable wants, there are available resources that can be utilized. However,

since these resources are limited, they are not freely available. Economics steps in

to assist individuals and societies in making proper choices – that is, the allocation

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and utilization of economic resources, with the end in view of satisfying human

wants for goods and services. Figure 1.2 illustrates the relationship between

available limited resources and unlimited wants of man and society and the role of

allocating these resources.

Figure 1.2 Economics

Limited Resources Unlimited Resources

Allocation

The figure depicts the relationship between available limited resources and
unlimited wants of man and society. It shows that when limited resources fail to
meet the unlimited wants of society, economics comes into play in order to
effectively and efficiently allocate resources.

Factors of Production. There are four economic resources which serve as

inputs in the production process. We refer to these resources as the factors of

production and they include the land labor, labor, capital, and entrepreneurship.

Below is a more comprehensive discussion of each factor.

Land. This broadly refers to all natural resources, which are given by, and

found in nature, and are, therefore, not manmade. It does not solely mean the soil

or the ground surface, but refers to all things and powers that are given free to

mankind by nature. In this sense, land comprises all the materials and things, which

are available beneath the soil or above it. It includes the forest, mountains, rivers,

oceans, minerals, air, sunshine, light, etc. Land can sometimes be classified as a

fixed resource. Land is the main source of raw materials like timber, mineral, ores,

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etc., which are utilized in the production of goods and services. The compensation

for use of land is called rent.

Labor. Refers to any form of human effort exerted in the production of goods and

services. Labor covers a wide range of skills, abilities, and characteristics. It

includes factory or construction workers who are engaged in manual or physical

work. It can also refer to an economist, nurse, doctor, lawyer, professor and other

workers and professionals who are mainly involve in mental work.

The supply of labor in a country is dependent on the growth of its population

and on the percentage of the population that is willing to join the labor force.

Naturally, a country with a high population growth rate is expected to come up with

a bigger labor supply, On the other hand, the younger the population structure the

higher will be the population who will join the labor force. The compensation for

labor rendered is salary or wage.

Capital. These are manmade goods used in the production of other goods and

services. It includes the building, factories, machinery, and other physical facilities

used in the production process.

Accordingly, a nation’s capital stock is dependent on its lever of saving.

Saving refers to that part of a person’s or economy’s income, which is not spent on

consumption. The reduction of productive capacity of capital is called depreciation.

The reward for the use of capital is called depreciation. The reward for the use of

capital is called interest.

At this point, we have to emphasize that money is not actually considered as

capital in economics as it does not produce a good or services but it is rather a form

of assets that is used mainly as a medium of exchange.

Entrepreneurship. A person who organizes, manages and assumes the risk of a

firm, taking a new idea or a new product and turning it into a successful business.

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Often times, the entrepreneur is not presented as a separate factor of production

but is classified as a part of labor. However, since an entrepreneur performs a

special type of work, which is creation of goods and services, it should not be

considered as part of labor.

Entrepreneurs also possess managerial skills needed in building, operating,

and expanding a business. Specially, he is one who decides what combinations of

land, labor, and capital are to be used in the production process. Entrepreneurship

is an economic good that commands a price referred to as

profit and lost.

The Circular Flow Model (WEEK 2)

Before we proceed further with our discussion, let us first look at how

these resources are utilized by the household and business sectors. We can

simplify this by illustrating it through the Circular Flow Model. The dynamics

of market economy creates continuous, repetitive flows of goods and

services, resources, and money. The circular flow diagram, shown in

Figure 1.3, illustrate the flow of resources and output from households

to businesses, and vice versa. Observe that the diagram we group private

decision makers into businesses and households and group markets into the

resource market and the product market.

The upper half of the circular flow diagram represents the resource

market: the place were resources, or the service of resource suppliers are

bought and sold. In the resource market, households sell resources (i.e., land,

labor, capital) and business and use them in the production of goods and

services. Households own all economic resources either directly as workers or

entrepreneurs or indirectly through their ownership of business corporations.

They sell their resources to businesses, which buy them because they are

necessary for producing goods and services. This is represented by the inner

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 arrow from the household sector going to the business sector. The funds that

businesses pay for resources are cost to businesses but are flows of income

in the form of wage, rent, interest, and profit to the households. This is

represented by the outer arrow from the business sector. Productive

resources therefore flow from households to business, and money flow from

business to household.

where goods and services produced by businesses are bought by the household. In

the product market, businesses combine the resources owned by the household

(i.e., land, labor, capital) to produce and sell goods and services. This is

represented by the inner arrow from the business sector going to the household

sector. In return, the households use the (limited) income they have received from

the sale of resources to buy goods and services that the business produced in the

form of consumption expenditure. This is represented by the outer arrow from the

household sector going to the business sector. The monetary flow of consumer

(household) spending on goods and services yields sale revenues for business.
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Businesses compare those revenues to their costs in determining profitability and

whether or not a particular good or service should continue to be produced and

sold.

The circular flow model depicts a complex, interrelated web of decision

making and economic activity involving business and households. For the economy,

it is the circle of life. Business and household are both buyers and sellers. Business

buy resources and sell products. Households buy products and sell resources. As

shown in Figure 1.3, there is a counterclockwise real flow of economic resources

and finished goods and services and clockwise money flow of income and

consumption expenditures.

What is the relationship between Economics and Scarcity?

If we will go back again to our previous discussion, we noted that the problem

of scarcity gave birth to the study of economics. Their relationship is such that if

there is no scarcity, there is no need for economics. The study of economics is

therefore essential in order to address the issue of resources allocation and

distribution, in response to scarcity. In the allocation of our limited resources

however, we have to give up something in order to get what we want. In other

words, we cannot have everything that we want because of the limited

resources therefore something must be given up or traded off. This brings us

now to the concept of opportunity cost, one of the most important economic

concepts that you need to know and understand very well since all of us try to apply

this concept everyday of our lives.

The Concept of Opportunity Cost

Because people cannot have everything they want, they are forced to make

choices between several options. In making a choice people face opportunity

cost. But what is opportunity cost? In economics, opportunity cost refers to the

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foregone value of the next best alternative. In particular, it is the value of what is

given-up is called the opportunity cost of one’s choice.

When you make choices, there is always an alternative that you have to give

up. Moreover, a producer. Who decides to produce shoes, give up other goods that

he could have produced like bags using same resources. If you bought this book

Microeconomics with your limited allowance, you gave up the chance of eating out

or watching movie or playing computer games.

Opportunity cost however I expressed in relative price. This means that the

price of one item should be relative to the price of another.

Example:

If the price of Coke is P20.00 per can and one piece of cupcake is P10.00,

then the relative price of Coke is 2 pieces of cupcake. Therefore, If a consumer only

has P20.00 and chooses to buy a bottle of Coke with it, then we can say that the

opportunity cost of that bottle of Coke was the 2 pieces of cupcake, assuming that

the cupcakes were the next best alternative. Figure 1.4 below further illustrates the

concept of opportunity cost.

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Figure 1.4 Opportunity Cost

Saving (Firm/Individual)

Credit (Interest) Investment (Profit)

This figure illustrates the concept of opportunity cost. The savings of the

firm/individual is subject to two choices between credit and investment. If the

savings of an individual will be put on credit, there is possibility of earning

interest or a bad debt (not getting the money back), on other hand, when

savings of an individual is invested, it may earn profit or may be subject to loss.

With this in mind, what do you think is the best choice or next best alternative?

Basic Decision Problems

Below are some decision problems that households, firms, the government, and

society must think about in order to properly manage their resources. Regarded as

economic activities.

1. Consumption

Members of society, with their individual wants, determine what types of goods

and services they want to utilize or consume, and the corresponding amounts

thereof that they should purchase and utilize. The choices range from food, to

shelter, to clothing, etc. There is also a choice between privately used goods or

those supplied by government, such as national security and defense,

infrastructure, or irrigation. Consumption is the basic decision problem that the

consumers must always deal with their day-to-day activities.

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2. Production

The problem of production is generally a concern of producers. They determine

the needs, wants, and demands of consumers, and decide how to allocate

their resources to meet these demands. Goods and services may be produced

by different methods of production, depending on the firm’s technological state, and

on the available resources within the society.

3. Distribution

This problem is primarily addressed to the government. There must be

proper allocation of all the resources for the benefit of the whole society. In a

market economy, though, absolute equality of every member, as to distribution

of resources, can never be achieved.

4. Growth over Time

This is the last basic decision problem that a society or nation must deal with.

Societies continue to live on. They also grow in numbers. On the one hand,

people have definite lives, but societies (or nations) have longer, if not infinite lives.

All the problems of choice, consumption, production, and distribution have longer, if

not infinite lives. All the problems of choice, consumption, production and

distribution have to be seen in the context of how they will affect future events.

Four Basic Economic Questions

To address the problem of scarcity and solve the basic decision problems, the

society must answer the four basic economic questions of what to produce?

For whom to produce? And How much to produce?

1. What to produce?

The question of what to produce tells us that an economy must identify what are

the goods and services needed to be produced for the utilization of the

society in the everyday life of man. A society must also take into account the

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resources that it possesses before deciding what goods or services to

produce.

For example, an island nation, blessed with agricultural resources and which does

not possess advanced technology should not opt to produce space shuttles or

satellites because its resources are incapable of producing these outputs. However,

it can take advantage of its natural resources and it can produce agricultural goods

and tourism services.

In market economy, what gets produced in the society is driven by prices.

Resources are allocated to the production of goods and services that have high

prices and low input prices relative to one another.

2. How to produce?

This questions tell us that there is a need to identify the different methods and

techniques in order to produce goods and services. In other words, the society

must determine whether to employ labor intensive production or capital

intensive production.

Labor intensive production uses more of the human resource or manual labor in

producing goods and services than capital resources. Generally, this kind of

production is advisable to a society with a large population. In countries where labor

resources are abundant and therefore there is high supply of labor, the cost of labor

is usually cheap, for instance the Philippines, Vietnam, and China.

On the other hand, capital intensive production employs more technology and

capital goods like machineries and equipment in producing goods and services

rather than using labor resources. This type of production is generally utilized by

countries with high level of capital stock and technology, and with scarce labor

resources, like Japan, Germany, and the USA.

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The decision of what form of technology is to be employed depends more on the

availability of cheaper resources and less more expensive inputs. Thus, if there is

abundant supply of labor (capital) then this resource will be cheaper and will cost

less so production will be labor (capital) intensive.

3. How much to produce?

The question of how much to produce identifies the number of goods and

services needed to be produced in order to answer the demand of man and

society. The optimum amount of production must be approximated by producers.

Underproduction (shortage) results to a failure to meet the needs and wants of the

society. On the other hand, overproduction result to excess (surplus) goods and

service going to waste.

4. For whom to produce?

This question identifies the people or sectors who demand the

commodities produced in society. Economist must determine the “target

market” of the goods and services which are to be produced to understand their

consumption behavior patterns. An understanding of these results to higher sales of

goods, and ultimately to increased profit. We can therefore say that for those who

can pay the highest price is for whom goods and services are produced.

There are 3 E’s in the study of Economics

Efficiency refers to productivity and proper allocation of economics

resources. I t also refers to the relationship between scarce factor inputs and

outputs of goods and services. This relationship can be measured in physical

terms (technological efficiency) or cost terms (economic efficiency) (Pass &

Lowes 1993). Being efficient in the production and allocation of goods and

services saves time, money, and increases a firm’s output. For instance, in the

production of commodity, a firm utilizing modern technology can improve the

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quantity and quality of its products, which ultimately translates into an increase in

revenue and

profit.

Effectiveness means attainment of goals and objectives. Economics therefore

is an important and functional tool that can be utilized by other field. For instance,

with the use of both productions (through manual labor or through technological

advancements), whatever the output is, it will be useful for the consumption of the

society and the rest of the world.

Equity means justice and fairness. Thus, while technological advancement may

increase production, it can also bear disadvantages to employment of workers. Due

to the presence of new equipment and machineries, manual labor may not be

necessary, and this can result in the retrenchment or displacement of workers.

Positive and Normative Economics

Positive economics is an economic analysis that considers economic conditions

“as they are”, or considers economics “as it is”. It uses objective or scientific

explanation in analyzing the different transactions in the economy. It simply answers

the question ‘what is’.

Example of positive statements:

▪ The economy is now experiencing a slowdown because of too much

politicking and corruption in the government.

▪ The economy is now on a slowdown because the world is experiencing a

financial and economic crisis. Other reasons are also due to the financial

problem of US, increase in the prices of crude oil and lack of investors or

capital deficiency.

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On the other hand, normative economics is an economic analysis which judges

economic conditions “as it should be” It is that aspect of economics that is

concerned with human welfare. It deals with ethics, personal value judgments and

obligation analyzing economic phenomena (Kapur 1997). It answers the question

‘what should be’ It is also referred to as policy economics because it deals with

the formulation of policies to regulate economic activities (Omas-as 2008).

Example of Normative Statements:

▪ The Philippine government should initiate political reforms in order to

regain investor confidence, and consequently uplift the economy.

▪ In order to minimize the effect of global recession, the Philippine

government should release a stimulus package geared towards

encouraging economic productivity.

Ceteris Paribus Assumption

In economic analysis however we cannot consider all the factors that affect

economic situations or phenomena. Therefore, economists have devised a way of

simplifying complex economic phenomena through the assumption of “Ceteris

Paribus.” This assumption is important in studying economics. Popularized by

economists, Alfred Marshall (1824-1942) meaning “all other things held

constant or all the else equal.” This assumption is used as a device to analyze

the relationship between two variables while the other factors are held

unchanged. It is widely used in economics as an exploratory technique as it allows

economist to isolate the relationship between two variables. For instance, with the

question: what is the impact of a change in the price of rice on consumption

behavior of the consumers, ceteris paribus (or other things remaining constant)? If

the price of the rice increases by 20 percent, how much consumption will there be,

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assuming no simultaneous change in other variables – that is, assuming that

income, number of family members, population, laws and so on all remain constant.

The remain constant. The setting of the other factor constant is what ceteris paribus

is all about since including the other factor in the analysis will make it complex and

difficult for an economist to explain the relationship between price and consumption

behavior.

Microeconomics and Macroeconomics We have been talking about

individuals, firms or business, households, and society. But how do they differ? In

order to distinguish each of this, economics has two major branches of study: one is

concerned with individual decision making (microeconomics); and the other is

involved in understanding the behavior of the society as a whole

(macroeconomics).

This learning module focused on Applied Economics which has the greatest

demonstration of Microeconomics is the branch of economics which deals with the

individual decisions of unit of the economy – firms and households, and how their

choices determine relative prices of goods and factors of production. In capitalist

economy, the market is the central concept of microeconomics. It focuses on its two

main players – the buyer and the seller, and their interaction with one another.

Microeconomics operates on the level of the individual business firm, as well

as that of the individual consumer. It concerns how a firm maximizes its profits, and

how a consumer maximizes his satisfaction.

Among the topics discussed in microeconomics are the principle of demand

and supply, elasticity of demand and supply, individual decision making, theories of

production, output and cost of firms, output and cost of firms, a firm’s profit

maximization objective, different types of business organizations, and kinds of

market structure. (Case 2003)

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Types of Economic System. To address economic problems, several economic

systems have been created and applied throughout history. Below is an

enumeration of these.

1. Traditional Economy is basically a subsistence economy. A family

produces goods only for its own consumption. The decisions on what,

how, how much, and for whom to produce are made by the family head, in

accordance with traditional means of production.

2. Command Economy is a type of economy, wherein the manner of

production is dictated by the government. The government decides on

what, how, how much, and for whom to produce. It is an economic

system characterized by collective ownership of most resources, and the

existence of a central planning agency of the state. In this system, all

productive enterprises are owned by the people and administered by the

state.

An ideology, Socialism is an economic system wherein key enterprises are

owned by the state. In the system, private ownership is recognized. However, the

state has control over a large portion of capital assets, and is generally responsible

for the production and distribution of important goods. In a socialist economy, the

main emphasis is on equitable distribution of income and wealth. As such, it is

considered as an economy bordering between capitalism and communism.

3. Market Economy or capitalism’s basic characteristic is that the resources

are privately owned, and that the resources are privately owned, and

that the people themselves make the decisions. It is an economic system

wherein most economic decisions and means of production are made by the

private owners. Under this economic system, factors of production owned

and controlled by individuals, and people are free to produce goods and

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 services to meet the demand of consumer, who, in turn, are also free to

choose goods according to their own likes.

4. Mixed Economy is economy is a mixture of market system and the

command system. The Philippine economy is described as a mixed

economy since it applies a mixture of tree forms of decision-making.

However, it is more market-oriented rather than command or traditional.

Important Economic Terms

Economic has its own unique language. Thus for student to truly understand

the different concepts and theories in economics, an understanding of these term

should first be achieved.

Wealth

Wealth refers to anything that has a functional value (usually in money),

which can be traded for goods and services. Accordingly, wealth is the stock of net

assets owned by individuals or households. In aggregate term, one widely used

measure of the nation’s total stock of wealth is that of the ‘marketable wealth’, that

is, physical and financial assets which are in the main relatively liquid. (Pass &

Lowes 1993).

Consumption

Consumption refers to the direct utilization or usage of the available goods

and services by the buyer (individual) or the consumer (household) sector.

Production

Production is defined as the formation or creation by firms of an output

(products or services). It is basically the process by which land, labor and capital

are combined in order to produce outputs of goods and services.

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 Exchange

This is the process of trading or buying and selling of goods and/or its

equivalent. It also includes the buying of goods and services either in the form of

barter or through market.

Distribution

This is the process of allocating or apportioning scarce resources to be

utilized by the household, the business sector, and the rest of the world. In specific

term, however, it refers to the process of storing and moving products to customers

often through intermediaries such as wholesalers and retailers (Pass & Lowes

1993).

Brief Classical, Keynesian and History: The Modern Economics

This brief historical introduction aims to give a background on most

profound names in the study of economics and their important contributions in

this field of study.

Birth of Economic Theory: Classical Economics

Economic theory saw its birth during the mid 1700s and 1800s. During this

era, two important economist emerged. First is Adam Smith of Scotland, who is

considered the most important personality in the history of economics – being

regarded as the “Father of Economics”. Among others, he was responsible for the

recognition of economics as a separate body of knowledge. His book,

“Wealth of the Nations”, published in 1776, became known as “the bible in

economics” for a hundred years (Fajardo 1977). One of his major contribution was

his analysis of the relationship between consumers and producers through demand

and supply, which ultimately explained how the market through the invisible hand.

Other important classical economist includes John Stuart Mill who was the

heir to David Ricardo, who developed the basic analysis of the political economy or

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the important of a state’s role in its national economy. The term political economy is

an older English term that applies management to an entire polis (state). Karl Max,

a German, also emerged during this period. He is much influenced by the condition

brought about by the industrial revolution upon the working classes. His major work,

Das Kapital, is the centerpiece from which major socialist thought was to emerge.

(Sicat 1983)

Neoclassical Economics (1870s)

Neoclassical Economics was believed to have transpired around the year

1870. Its main concern was market system efficiencies. It brought recognition to

such economist as Leon Walras, who introduced the general economic system, and

Alfred Marshall, who became the most influential economist during that time

because of his book Principle in Economics. Leon Walras developed the analysis of

equilibrium in several markets. On the other hand, Alfred Marshall developed the

analysis of equilibrium of a particular market and the concept of “marginalism”.

(Sicat 1939)

Keynes’ General Theory of Employment, Interest and Money

John Maynard Keynes is an English economist who offered an

explanation of mass unemployment and suggestions for government policy to cure

unemployment in his influential book: The General Theory of Employment,

Interest and Money (1936). Keynes’ concern about the extent and duration of the

worldwide interwar depression led him to look for other explanation of recession.

(Pass & Lowes 1993)

In particular, Keynes argued that classical political economists were

concerned with the relative shares in national output of the different factors of

production, rather than the forces which determine the level of general economic

activity, so that their theories of value and distribution related only to the special

case of full employment. Concerning upon the economic aggregates of National

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Income, Consumption, Savings and Investment, Keynes provided a general theory

for explaining the level of economic activity. He argued that there is no assurance

that savings would accumulate during a depression and depress interest rate, since

savings depend on income and with high unemployment incomes are low.

Furthermore, he argued that investment depends primarily on business

confidence which would be low during a depression so the investment would be

unlikely to rise even if interest rate fell, he argued that the wage rate would be

unlikely to fall much during a depression given its ‘stickiness’, and even if it did fall,

this would merely exacerbate the depression by reducing consumption.

Non-Walrasian Economics (1939)

During the Non-Walrasian Era, John Hicks was recognized for his analysis

of the IS-LM model, which is considered as an important macroeconomic model. IS

refers to the goods market for a given interest rate, while LM means money market

for a given value of aggregate output or income. The IS-LM model is theoretical

construct that integrates the real, IS (investmentsaving), and the monetary, LM

(demand for, and supply for money), sides of the economy simultaneously to

represent a determinate general equilibrium position for the economy as a whole

(Pass & Lowes 1993).

Post-Keynesian Economic (1940 and 1950s)

After World War II, the Post-Keynesian Period saw the development of

rules and regulations of different private and public institutions. This period

introduced major post-Keynesian, neoclassical economist, whose views are known

as the post-Keynesian “mainstream economics”. This period welcomed various

economist like Paul A. Samuelson, Kenneth J. Arrow, James Tobin and Lawrence

Klein, to mention some recognized leaders; and other are Joan Robinson and

Michael Kolechi. Another stream of thought was introduced by liberal market

post-keynesians, mainly the monetarists, led by Milton Friedman. (Sicat 1983)

21
 New Classical Economics

New classical Economics highlighted the importance of adherence to

national expectations hypothesis and analysis, which included various economic

phenomena in formulating different kinds of studies and new theories in economics.

This development in economics is applicable to concern for the growth for the

growth of developed countries. The great economist like Smith,

Ricardo and Malthus addressed this problem. (Sicat 1983)

LESSON 2: THE BASIC ANALYSIS OF DEMAND AND SUPPLY

Topics : Introduction

Methods of Demand Analysis

Forces that cause the demand curve to change

Occasional or seasonal products

Substitute and complementary goods

Expectations of future prices

Methods of Supply Analysis

Change in Quantity Supplied vs. Change in Supply

Optimization in the use of factors of production

Changes in Demand, Supply, and Equilibrium

Abstraction
Post Test

Activity Exercise

22
Duration : 15-hours
Lesson Proper

THE BASIC ANALYSIS OF DEMAND AND SUPPLY

Demand generally affected by the behavior of consumers, while supply is

usually affected by the conduct of producer. The interplay between these two is the

foundation of economic activity. Thus, the consumer identifies his needs, wants,

and demands, while producers address this accordingly producing goods and

services. In the end, the consumer gains satisfaction while the producer gain

profit.
As the economy cannot operate without this interaction between the

consumer and the produce, it is essential, therefore, that students understand the

different movements of the demand and supply curves, as well as the concept of

market equilibrium.

This chapter provides a discussion of the elements of demand and

supply. An understanding of these concepts is essential in the study of economics.

Demand

Demand pertains to the quantity of a good or service that people are

ready to buy at a given prices within a given time period, when other factors

besides price are held constant. Simply put, the demand for a product is the

quantity of a goods and service that buyers are willing to buy given its price at a

particular time. Demand therefore implies three things:

​ Desire to possess a thing (good and service);

​ The ability to pay for it or means of purchasing it (price); and 

Willingness utilizing it.

23
 Market

Take note that when there is demand for a good and service, there is a

market. A market is where buyers and sellers meet. It is the place where they both

trade or exchange goods or services – in other words, it is where their transaction

takes place. There are different kinds of markets, such as wet and dry. Wet market

is where people usually buy vegetables, meet etc. On the other hand, dry market is

where people buy shoes, clothes, or other dry goods. However, in economic

parlance, the term market does not necessarily refers to a tangible area where

buyers and seller could be seen transacting. It can represent an intangible domain

where goods and services are traded, such as the stock market, real estate market,

or labor market – where workers offer their services, and employers look for

workers to hire.

Methods of Demand Analysis

Demand can be analyzed in several ways. However, the most common

way of analyzing demand is through demand schedule, demand curve, and

demand function.

Demand Schedule

A demand schedule is a table that shows the relationship of prices and

the specific quantities demanded at each of these prices. Generally, the information

provided by a demand schedule can be used to construct a demand curve showing

the price-quantity demanded relationship in graphical form. Table

2.1 presents a hypothetical demand schedule for rice per month.

24
Table 2.1

Hypothetical Demand Schedule for Rice Per Month

Situation Price (P)/kg. Quantity (kg)

A 35 8
B 24 13
C 13 20
D 12 30
E 11 45

The table shows the various prices and quantities for the demand for rice per month. For
instance, at a given price of P35 the buyer is willing to purchase only 8 kilos of rice (situation A);
however, at a price of P11, he is willing to buy 45 kilos of rice (situation E).

Take note that as the prices goes up (down) the quantity of rice being

purchased by the consumer goes down (up). This implies that quantity demanded is

inversely related with price. In other words, consumers are not willing to purchase

more rice at higher prices but will consume more if prices are low.

Demand Curve

As we have said earlier, the demand curve is a graphical representation

showing the relationship between prices and quantities demanded per time period.

A demand curve has negative slopes thus it slopes downward from left to right. The

downward slope indicates the inverse relationship between price and quantity

demanded.

Observe that most demand curves slope downwards because (a) as the

price of the product falls, consumers will tend to substitute this (now relatively

cheaper) product for others in their purchase; (b) as the price of the product falls,

this serves to increase their real income allowing them to buy more products (Pass

& Lowes 1993). Figure 2.1 illustrates a normal demand curve.

25
 Let us assume that the price of good A is at price P0. At this price level,

quantity demanded for good A is at Q0 and therefore demand will be at point Do

along the demand curve D1. However, if price will increase to P1 quantity demanded

will decrease to Q1 and demand will move upward towards point D1 along the same

demand curve. The reason why quantity demanded decreased after the price

increased to P1 is because of the inverse relationship price and quantity demanded.

Thus, in such situation, consumers will purchase less of

good A at a higher prices than when it was at its original price P0.

But what will happen to quantity demanded if price will decline to say

P2? If you said quantity demanded will increase to Q2, then you are correct. Why?

Because as we can see in same figure, if price will decrease to P2 quantity

demanded will increase to Q2 and demand will therefore be at point D2. Observe

again that the reverse happened when price of good A declined to P2. In this case

quantity demanded increased to Q2. Why? Because consumers will purchase more

of Good A at a lower prices than when it was at its original price

P0.
26
 This bring us now to the Law of Demand which states that ‘if price goes

UP, the quantity demanded of a good will go DOWN’. Conversely, ‘if price goes

DOWN, the quantity demanded of a good will go UP ceteris paribus’. The reason

for this is because consumers always tend to MAXIMIZE SATISFACTION.

Demand Function

Demand can also be analyzed mathematically trough a demand function. A

demand function is also shows the relationship between demand for a commodity

and the factors that determine or influence this demand. These factors are – the

price of the commodity itself, prices of other related commodities, level of incomes,

taste and preferences, size and composition of level of population, distribution of

income, etc. Demand function is expressed as a mathematical function. Thus, we

can show our mathematical function for demand as:

QD = f (product’s own price, income of consumers, price of related goods,

etc.)

We can therefore come-up with the demand equation as:

QD = a – bP Where:

QD = quantity demanded at a particular price a

= intercept of the demand curve b = slope of

the demand curve

P = price of the good at a particular time period

We can now illustrate our demand function using a hypothetical example.

Let us assume that the current price of good A is P5.00. The intercept of the

demand curve is 3 while the slope is 0.25. If we want to determine how much of

good A will be demanded by consumer X, we can simply substitute the given values

to our equation, thus:

27
QD = 3 – 0.25 (5)

= 3 – 1.25

QD = 1.75 units of good A

But what if the price of good A will increase to P6.00? What will now be the

new quantity demanded by consumer X? If you say 1.5 units, then you are correct.

Again by simply substituting our values to our demand equation you will arrive at

the new quantity demanded. What happened to quantity demanded? There is a

decrease of 0.25 units because of the increase in price. Again, this is because of

the inverse relationship between price and quantity demanded.

Change in Quantity Demanded vs. Change in Demand

Before we go on further with our discussion of the concept of demand, let

us first distinguish change in quantity demanded and change in demand. This is

important since a change in quantity demanded must not be confused with a

change in demand.

Change in Quantity Demanded

We can say that there is change in quantity demanded (symbolized as

AQD) if there is a movement from one point to another point – or from one

pricequantity combination to another – along the same demand curve. A change in

quantity demanded is mainly brought about by an increase (a decrease) in the

product’s own price. The direction of the movement however is inverse considering

the Law of Demand. shifted downward or to the left (indicated by the arrow) from D

to D’. If price remains at the same level, demand for the product or service will

decrease (from Q0 to Q1).

Increase (decrease) in demand is brought about the factors other than

the price of the good itself such as tastes and preferences, price of the substitute

28
goods, etc. resulting in the shift of the entire demand curve either upward or

downward.

Forces that cause the demand curve to change

There are several reasons why demand changes and thus cause the

demand curve to move either upwards or downwards. The following are the more

general reasons for the change in demand.

Taste or preferences

Taste or preferences pertain to the personal likes or dislikes of consumers

for certain goods and services. If taste or preferences change so that people want

to buy more of a commodity at a given price, then an increase in demand will result

or vice versa.

As an illustration: Remember the craze for IPods? This came about in the

Philippines sometimes in 2006, and everyone just wanted to have one. At that time,

there were quite a number of MP3 player brands being sold in the market. However,

for some reasons consumers were just so engrossed with the thought of having an

iPod MP3 player, to the point that some shops had all their stocks sold out. This is a

clear example of consumer preferences when it came to MP3 players during that

time. Consumers preferred a certain brand because at that time, it was “in” to have

29
iPod. Consumer preference towards a certain product increases the demand for

that product. However, products were consumers do not prefer, suffer a decrease in

demand.

Changing incomes

Increasing incomes of households raise the demand for certain goods or

services or vice versa. This is because an increase in one’s income generally raises

his capacity or power to demand for goods

We can explain change in quantity demanded through a demand curve.

Figure 2.2 below illustrates the concept of change in quantity demanded.

We can see in this figure that the original price is at P and at this price level quantity

demanded is at Q0. The point of interaction between P0 and Qo is at point along the

demand curve. Now let us assume that price decreases to P1. As a result quantity

demanded will increase to Q1 because of the change in the product’s price. As a

result, quantity demanded will move to point b along the same demand curve

because of the decrease in price as shown by the arrow. The reverse however will

happen if price will increase.

We can therefore say that there is a change in quantity demanded if the

price of the good being sold changes. This is shown by a movement from one point
to another point along the same demand curve.

Figure 2.2 Change in Quantity Demanded

P0 a

P1
b

D 0
Q0 Q1 QD

The figure illustrates the concept of change in quantity demanded. Change in quantity demanded
occurs when price of the product changes, thus, resulting to a change in quantity demanded. This
is illustrated in the graph above where P0 declines to P1 resulting to change in Q0 to Q1 and a
movement along the demand curve from point a to point b.

30
 Change in Demand

There is a change in demand if the entire demand curve shifts to the right

(left) resulting to an increase (decrease) in demand due to other factors other than

the price of the good sold. At the same price, therefore, more amounts of a good or

service are demanded by consumers. Figure 2.3a illustrates an increase in

demand. In the figure, we can observe that the entire demand curve shifts upward

or to the right (indicated by the arrow) from D to D’. We can also observe that at the

same price P0 more goods will be demanded by consumers (from Q0 to Q1).

Conversely demand decreases or falls if the entire demand curve shifts

downward or to the left. Thus, at the same price level, less amounts of a good or

service are demanded by consumers. A decrease in demand is illustrated in Figure

2.3b. We can observe in the figure that the entire demand curve shifted downward

or to the left (indicated by the arrow) from D to D’. If price remains at the same

level, demand for the product or service will decrease (from Q0 to Q1).

Increase (decrease) in demand is brought about the factors other than

the price of the good itself such as tastes and preferences, price of the substitute

goods, etc. resulting in the shift of the entire demand curve either upward or

downward.

31
 Forces that cause the demand curve to change

There are several reasons why demand changes and thus cause the

demand curve to move either upwards or downwards. The following are the more

general reasons for the change in demand.

Taste or preferences
Taste or preferences pertain to the personal likes or dislikes of consumers

for certain goods and services. If taste or preferences change so that people want

to buy more of a commodity at a given price, then an increase in demand will result

or vice versa.

As an illustration: Remember the craze for IPods? This came about in the

Philippines sometimes in 2006, and everyone just wanted to have one. At that time,

there were quite a number of MP3 player brands being sold in the market. However,

for some reasons consumers were just so engrossed with the thought of having an

iPod MP3 player, to the point that some shops had all their stocks sold out. This is a

clear example of consumer preferences when it came to MP3 players during that

time. Consumers preferred a certain brand because at that time, it was “in” to have

iPod. Consumer preference towards a certain product increases the demand for

32
that product. However, products were consumers do not prefer, suffer a decrease in

demand.

Changing incomes

Increasing incomes of households raise the demand for certain goods or

services or vice versa. This is because an increase in one’s income generally raises

his capacity or power to demand for goods or services which he is not able to

purchase at lower income. On the other hand, a decrease in one’s income reduces

his purchasing power, and consequently, his demand for some goods or services

ultimately declines.

Take for example Juan who is receiving a monthly salary of Php 10,000.00.

He loves to buy shirts during payday. With his income, he could only buy 3 shirts

per month. After a year, however, he was promoted to a higher position. Due to his

promotion his salary increased to Php 20,000.00 per month.

Because of the increase in Juan’s salary he can now afford to buy more shirts, say

6 shirts per month. His capacity to buy more shirts (and other goods or services for

that matter) is simply the result of the increase in his monthly income.

Occasional or seasonal products

The various events or seasons in a given year also result to a movement of

the demand curve with the reference to particular goods. For example: During

Christmas season, demand for Christmas trees, parols, and other Christmas decors

increases. Moreover, demand for food items like ham and quezo de bola also

increases. Similarly, as Valentine’s Day approaches, the demand for red roses and

chocolates also arises. It should be noted, however, that after these events,

demand for these products returns back to the original level.

33
 Population change

An increasing population leads to an increase in the demand for some types

of good or service, and vise-versa. This simply means that more goods and

services are to be demanded because of rising population. In particular, increase in

population generally result to an increase in demand for basic goods, such as food

and medicines. On the other hand, a decrease in population results in a decline in

demand.

Substitute and complementary goods

Substitute goods are goods that are interchanged with another good. In a

situation where the price of a particular good increases a consumer will tend to look

for closely related commodities. Substitute goods are generally offered at cheaper

price, consequently making it more attractive for buyers to purchase. For instance,

Juan wants to buys a pair of Nike rubber shoes. But the price of the shoes that he

wanted was worth P5,000.00. Considering the price and his lower budget of

P3000.00 he opted for an alternative brand of shoes with a lower price, say

Converse shoes. In this situation, Nike and Converse shoes are lower

substitutes.
On the other hand, complementary goods are goods that compliment with

each other. In other words, one good cannot exist without the other good. For

instance, your pen cannot write if there is no ink in it or your cellphone cannot

function if you do not have a sim card or a load.

Expectations of future prices

If buyers expect the price of a good or service to rise (or fall) in the future, it

may cause the current demand to increase (or decrease). Also, expectations about

the future may alter demand for a specific commodity.

Take for example the fluctuation prices of rise. If households expect That a

drastic increase in the price of rice will happen after a week, their natural behavior

34
is to purchase and stock-up rice before the price goes up. Thus, at that given point

in time there will be an increase in demand for rice due to consumer stock piling

because of the expected increase in its future price.

Practical application of the concept of change in quantity demanded and

change in demand

Let us now consider some practical applications of the concept of change in

quantity demanded and change in demand, which you have earlier learned.

We already know that the price of gasoline in the domestic market tends to

change every now and then. Because of the price of gasoline in the domestic

market tends to change every now and then. Because of the price changes, private

car owners tend to lessen the consumption of gasoline during high prices by not

using their cars, but tend to increase their consumption during low prices by utilizing

more their cars.

On the other hand, because of the increase in the price of gasoline, the sale

of cars has declined. This is because cars and gasoline are complementary goods

so that the increase in the price of gasoline will result in a decline in the sale of

cars. Of course, cars will not run without gasoline so that the higher the price of the

gasoline. The reverse will happen if the price of gasoline will decrease to say

P30.00 per liter or even lower.

The first situation illustrates the concept of change in quantity demanded

because the only factor that causes the change was the price of gasoline. The

second situation, on the other hand, illustrates the concept of change in demand

since other factors made the demand to change.

Supply (Firm/Seller’s side)

We now go to the other side of the coin which is supply. Simply defined,

supply is the quantity of goods and services that firms are ready and willing to sell

35
at a given price within a period of time, other factors being held constant. It is the

quantity of goods and services which a firm is willing to sell at a given point in time.

Thus, supply is a product made available for sale by firms. It should be

remembered that sellers normally sell more at a higher price than at a lower price.

This is because higher results to higher profits.

Methods of Supply Analysis

Just like demand, supply can also be analyzed through a supply

schedule, supply curve, and supply function.

Supply Schedule

A supply schedule is a table listing the various [prices of a product and

the specific quantities supplied at each of these prices at a given point in time.

Generally, the information provided by a supply schedule can be used to construct

a supply curve showing the price/quantity supply relationship in graphical form.

Table 2.2 presents a hypothetical supply schedule for rice per month.

36
Table 2.2

Hypothetical supply schedule for Rice Per Month

Situation Price (P)/kg. Quantity

A 35 48

B 24 41

C 13 30

D 12 17

E 11 5

The table shows the various prices and quantities for the supply for rice per

month. For instance, at a given price of P35 the seller is willing to sell 48

kilograms of rice (situation A); however, at a price of P11, he is willing to sell 5

kilograms of rice (situation E).

Observe that as price increases quantity supplied also increases. For

instance, if the price of rice per kilo is P35.00, sellers will be willing to sell 48 kilos of

rice in the market. However, if the price of rice will decrease to P11.00, sellers will

be willing to sell 5 kilos of rice. As we have noted earlier, high prices provide

incentives to sellers to sell more because of the expected increase in their profits.

However, when prices decline, these become a disincentive on the sellers to sell

more goods and services in the market since their profits will be low.

Supply Curve

A supply curve is a graphical representation showing the relationship

between the price of the product sold or factor of production (e.g. labor) and the

37
quantity supplied per time period. The typical more (less) is supplied. This is

illustrated in Figure 2.4.

Let us assume that the price of good A is at P0. At this price level Quantity supplied

is at Q0 so that our supply it at S0 in our supply curve S. Suppose the price of good

A increases, say to the level of P1. Definitely, quantity supplied will also increase,

and in our illustration this will be up to the level of Q1. Therefore, supply will now be

at S1 in our supply curve. Take note that at the new price P1 quantity supplied has

increased to Q1. What is the reason behind this? Again because of the direct

relationship between price and quantity supplied. Of course the reverse will happen

if price will decrease to say P2. Under this new price, quantity supplied will only be

at Q2 so that supply will only be at S2 in the supply curve.

38
 This now brings us to the Law of Supply. The law states that if the price of a

good or service goes up, the quantity supplied for such good or service will also go

up; if the price goes down the quantity supplied will also go down, ceteris paribus.

The Law of Supply implies that higher price is an incentive for business firms to

produce more goods or services as it will minimize their profits.

In particular, given the higher price, producers or sellers normally increase

their supply of goods or services to increase their profits. As such, they will always

want that prices of their goods are high. On the other hand, at a lower price only

those producers or sellers who are more efficient in their operations will survive.

These producers or sellers are those who are able to minimize their sources, who

handle their budget well, and who know how to handle these kinds of situations.

Conversely other producers or sellers who are less-efficient and with bad budgeting

system will run the risk of losing profits or may even be removed in the market

(Sicat2003). This is what the Law of Supply means: that higher price entices

producers or sellers to supply more goods or services because of their profit motive

while lower price diminishes their goal of putting additional investment because of

the possibility of incurring a loss and taken out of the market.

Supply Function

A supply function is a form of mathematical notation that links the

dependent variable, quantity supplied (Qs), with various independent variables

which determine quantity supplied. Among the factors that influence the quantity

supplied are price of the product, number of sellers in market, price of factor inputs,

technology, business goals, importations, weather conditions, and government

policies. Thus, we can transform our statement in a mathematical function as

follows:

Qs = f (product’s own price, number of sellers, price of factor inputs,

technology, etc.)

39
 Given our supply function, we can now derive our supply equation:

Qs = a = bP

Where:

Qs = quantity supplied at a particular price a

= intercept of the supply curve b = slope of

the supply curve

P = price of the good sold

We can now illustrate our supply equation using a hypothetical

example. Suppose the price of good A is P5.00. The intercept of the supply curve is

3 and the slope of the supply curve is 0.25. If we want to know how much of good A

will be supplied by sellers, we can simply substitute the values in our supply

equation. Thus,

Qs = a + bP

= 3 + 0.25 (5)

= 3 + 1.25

Qs = 4.25 units

But suppose the price of good A increase to P6.00, what will now be the quantity of

goods to be supplied by the seller? If your answer is 4.5 units, then you are correct.

Why? Because, as we have noted earlier, higher prices induce seller to sell more,

so that in our hypothetical example, when the price of good A increased to P6.00

the quantity supplied increase to 4.50 units.

40
 Change in Quantity Supplied vs. Change in Supply

Before we go on further with our discussion of the concept of supply, let us

first distinguish change in quantity supplied and change in supply. This is important

since a change in quantity supplied must not be confused with a change in supply.

Change in Quantity Supplied

A change in quantity supplied occurs if there is a movement from one point to

another point along the same supply curve. A change in quantity supplied is

brought about by an increase (decrease) in the product’s own price. The direction of

the movement however is positive considering the Law of Supply.

Figure 2.5 illustrates the concept of change in quantity supplied. As you can see in

this figure, the original price is at P0 and the corresponding quantity supplied is at

Q0. The point of interaction between P0 and Q0 is point a along the supply curve S.

Now let us assume that price increases to P1. As a result, quantity supplied will

increase to Q1. Quantity supplied will therefore move from point a to point b along

the same supply curve because of the increase in price of the same product. The

reverse however will happen if price will decrease. A change in quantity supplied

therefore happens if the price of the good being sold in the market changes, and

this is illustrated by a movement from one point to another along the same supply

curve.

41
 Change in Supply

A change in supply happens when the entire supply curve shifts leftward

or rightward. At the same price, therefore, less (more) amounts of a good or service

is supplied by producers or sellers. Figure 2.6a illustrates an increase in supply. In

the figure, we can see that the entire supply curve moves rightward (indicated by

the arrow) from S to S’. We can therefore observe that at the same price P0 more

goods will be offered for sale by producers (from Q0 to Q1).

On the other hand, supply decrease if the entire supply curve shifts leftward.

At the same price, fewer amounts of a good or service are sold by producers. A

decrease in supply is illustrated in Figure 2.6b. We can see in the figure that the

entire supply curve shifts leftward (indicated by the arrow) from S to S’. We can also

see that at the same price P0, supply for the product will decrease (from Q1 to Q0).

42
 Increase (decrease) in supply is caused by factors other than the price of the

good itself such as change in technology, business goals, etc. resulting to the

movement of the entire supply curve rightward (leftward).

Figure 2.6 Change in Supply

P P
S S
S S
PO - - - - - - - - - ---------

Qs
Qs
0 Q0 Q1 0 Q0 Q1
a. Increase in Supply b. Decrease in Supply

The figure shows the two opposite movements of the supply curve when other

factors other than the price are the main causes. Figure 2.3a shows an increase in

supply, while Figure 2.3b illustrates a decrease or fall in supply.

Forces that cause the supply curve to change

Just like demand, there are also other factors that cause the supply curve to

change. Below are some of the factors that cause the supply curve change.

Optimization in the use of factors of production

An optimization in the utilization of resources will increase supply, while a

failure to achieve such will result to decrease in supply. Optimization in this sense

refers to the process or methodology of making or creating something as fully

perfect, functional, or effective as possible. Simply put, it is the efficient use of

resources. In business parlance, it can mean maximum production of output at

minimum cost.

Thus, the optimization of the various factors of production i.e., land, labor,

capital, and entrepreneurship) results to an increase in supply, in the vice versa

(Sicat 2003).
43
 Technological change

The introduction of cost-reducing innovations in the production technology

increase supply on one hand. On the other hand, this can also decrease supply by

means of freezing the production through the problems that the new technology

might encounter, such as technical trouble (Samuelson and Nordhaus 2004).

Take for example AST Motors Corporation, which uses Machine “A” in the

production if its cars. Machine “A” can produce 20 cars per week. However, after 3

years of production, AST Motors Corporation decided to replace Machine “B”, which

can fully produce 80 cars per week. Because of the introduction of this new

technology (Machine “B”), the quantity of cars supplied by AST Motors Corporation

increased from 20 cars per week to 80 cars per week. However, if

Machine “B” malfunctions and such was not fixed immediately, AST Corporation’s

production of cars would decrease and thus not meet the optimum level of

production using Machine “B”.

Future expectations

This factor impacts sellers as much as buyers. If sellers anticipate a rise in

prices, they may choose to hold back the current supply to take advantage of the

future increase in price, thus decreasing market supply. If sellers however expect a

decline in the price for their products, they will increase present supply.

For example: If MVB Meat Company expects a drastic increase in prices of

meat within the following week, it may opt to hold its supply of meat for the

meantime and sell it only upon application of the price increase, thus, reducing the

present supply of meat in the market.

Conversely, if NKR Company, a producer of pager, expects that its production

will be rendered obsolete after 2 years due to the introduction of cellular phones in

the market, it may decide to sell all its stock of pagers in order to presently earn

44
profit from their sale, rather than have them unsold in the following years,

considering its apparent obsoleteness in the near future.

Number of sellers

The number of sellers has a direct impact on quantity supplied. Simply put,

the more sellers there are in the market the greater supply of goods and services

will be available. For example, during the Christmas season, more tiangge more

sell t-shirts and RTWs resulting to an increase in the available shirts and RTWs in

the market. Moreover, if more farmers will plant rice instead of other crops , then the

supply of rice in the market will increase due to more production assuming that no

destructive calamities will strike the country.

Weather conditions

Bad weather, such as typhoons, drought or other natural disasters, reduces

supply of agriculture commodities while good weather has an opposite impact. For

instance, if a typhoon destroys the vegetable farm in Benguet Province, the supply

of vegetables particularly in the market of Metro Manila will decline.

Government policy

Removing quotas and tariffs on imported products also affect supply.

Lower trade restrictions and lower quotas or tariffs boost imports, thereby adding

more supply of goods in the market.

In order for imported products to be accepted in a country, there is a need

for importers to pay the government the required tariffs of duties and taxes.

Importers must also abide by the quota required by the government on certain

products. Quotas are limitation on the number or quantities of imported goods

which could enter a country. This is used in order to protect domestic or local

products.

45
 Market Equilibrium

From a separate discussion of demand and supply, we now proceed with

reconciling the two. The meeting of supply and demand results to what is referred

to as ‘market equilibrium’. As earlier said the market referred to here is a situation

‘where buyers and sellers meet’, while equilibrium is generally understood as a

‘state of balance’

Equilibrium

Market equilibrium generally pertains to a balance that exist when quantity

demanded equals quantity supplied. Market equilibrium is the general agreement of

the buyer and the seller in the exchange of goods and services at a particular price

and at a particular quantity. At equilibrium point, there are always two sides of the

story, the side of buyer and that of the seller.

For instance, given the price of P10.00 the buyer is willing to purchase 20

units. On the seller side, he is willing to sell the quantity of 20 units at a price of

P10.00. this simple illustration simply shows that the buyer and seller agree at one

particular price and quantity, that is P10.00 and units. This is the main concept of

equilibrium: that there is a balance between price and quantity of goods bought by

consumers and sold by sellers in the market.

Equilibrium market price

Equilibrium market price is the price agreed by the seller to offer its good or

service for sale and for the buyer to pay for it. Specifically, it is the price at which

quantity demanded of a good is exactly equal to quantity supplied of the same

good.

The equilibrium market price and quantity can best be depicted in graph.

As illustrated in figure 2.7, the demand curve depicts the quantity that consumers

are willing to buy at particular prices; the supply curve depicts the quantity that

46
producers are prepared to sell at particular prices. The equilibrium market price is

generated by the intersection of the demand and supply curves. A higher initial

price (say at P40.00) result in excess supply (QS = 200 units and QD = 100 units).

The excess supply is depicted by the area abc. In this case, the oversupply of 100

units forces price down in order to eliminate the excess supply. At lower initial price

(say at P20.00) result in excess demand of 100 units (QS=100 units and QD=200

units). This is depicted by the area cef. In this case price is forced up in order to

eliminate the excess demand. Only at price P30.00 are demand and supply

initiations fully synchronized.

What happens when there is market disequilibrium?

When there is market disequilibrium, two conditions may happen: a

surplus or a shortage may occur as shown in figure 2.7.

Surplus

Surplus is a condition in the market where the quantity supplied is more

the quantity demanded. When there is a surplus, the tendency is for sellers to lower

market prices in order for the good and services to be easily disposed from the

market. This means that there is a downward pressure to price when there is a

surplus in order to restore equilibrium in the market. This is depicted in Figure 2.7

by the arrow from point b going down to the equilibrium point.

Generally, a surplus happens when there are more products sold in the

market by sellers but few products are bought by the customers. This is because

the quantity of goods that buyer are willing to buy at a given price is less than the

quantity of goods that sellers are willing to sell at the same price. This is shown in

the illustration in Figure 2.7 where buyers are only willing to buy 100 units of good A

when the price is at P40.00 so that quantity demand is only at point a in our

demand curve D. On the other hand, at the same price level, sellers are willing to

sell 200 units so that quantity supplied is at point b of our supply curve S.

47
Considering that quantity supplied at 200 units is greater than quantity demanded at

100 units, there is an excess supply of 100 units of good A in the market that are

unsold. These unsold goods are the surplus in this particular situation, which is

illustrated by the point a, c, and b in our figure.

Now, how can be surplus of good A be eliminated? The way by which the

surplus can be eliminated in the market is by lowering the current price until it

reaches the equilibrium price, as shown by the arrow going down the equilibrium

point c. In our figure, the equilibrium price is P30.00 at point c and no other point in

the figure shows that quantity demanded is equal to quantity supplied. Under this

situation it is the seller that influences the lowering of the price until the equilibrium

price and quantity are attained.

48
Figure 2.7 Equilibrium Market Price and Quantity

P S

50 Surplus
a b
40 -------------------------------------------
Equilibrium

30 -----------------------------

20---------------------------------------------- shortage
e f

10
D
0 Q
50 100 150 200 250 300

The figure shows the equilibrium between quantity demanded and quantity supplied (where X axis
represents the prices and Y-axis the quantities). The market equilibrium is the point of intersection
between the supply (S) and demand (D) curves, that is, at P = Q = 150. Any change in the price and
quantity will result to market disequilibrium, thus, when quantity demanded is less than quantity
supplied a surplus occurs. On the other hand, if quantity demanded is greater than quantity
supplied, a shortage occurs.

Shortage

The reverse happens when shortage occurs in the market. Shortage is

basically a condition in the market in which quantity demanded is higher than

quantity supplied at a given price.

As you may have observed in Figure 2.7, a shortage exists below the

equilibrium point. In particular, a shortage happens when quantity demanded is

greater than quantity supplied at a given price. For instance, in our illustration at

price P20.00 quantity demanded for good A is at 200 units, which is at point f in our

demand curve D. But at the same price level quantity supplied for good A is only

100 units, which is at point e in our supply curve. Why is this so? Because in this

particular situation buyers are willing to buy more at a lower price but sellers will

49
only be willing to sell less since at lower price they will only gain less profit. The

shortage area in this situation is shown in the figure by the area cef.

So, what happens when there is a shortage of goods and services in the

market? When there is a shortage of goods and services in the market, what

happens is that there is an upward pressure on prices to restore equilibrium in the

market. In this particular situation, it is the consumers that will influence that price to

go up since they will bid up prices in order for them to acquire the good or services

that are in short supply. This is depicted by the arrow going up from point e to the

equilibrium point c. For as long as there is disequilibrium in the market, prices will

still go up until such situation is normalized.

Figure 8: Shortage in Demand and Supply

Changes in Demand, Supply, and Equilibrium

We already know that demand might change because of the factors other than the

prices of the goods and services sold like changes in consumers’ income, tastes

and preferences, and variation in the prices of related goods. Similarly, supply might

also change in response to changes in technology, cost of production, and

government policies. What effects will such changes in supply and demand have on

50
equilibrium price and quantity? This is now our concern here in this section: to show

to you the effects on equilibrium price and quantity when either demand or supply

changes because of the effect of the factors other than price.

Change in Demand

Supposed that the supply of some goods (say, bread) is constant and demand

increase (because of increase in income or change in the tastes and preferences of

consumers for example). This situation is illustrated in Figure 2.8. As you can

observe in the figure, the new intersection of the supply and demand curves is at

higher values on both the price and the quantity axes because of the shift of the

demand curve upwards. Thus, from the original E0 of P30.00 and 150 units, a new

equilibrium point E, takes place at price P40.00 and quantity at 200 units.

Clearly, an increase in demand with supply remaining constant raises both

equilibrium price and quantity. Conversely, a decrease in demand with supply

remaining unchanged lowers both equilibrium price and quantity, as shown in our

figure. (Of course, since you are already familiar with reading and interpreting

graphs, you can already figure out what will be the new equilibrium price and

quantity under this situation, all you need to do is to compare the original

equilibrium point and the new equilibrium point).

Figure 2.8 Change in Demand

51
 The figure shows the effect of an increase in demand D ‘ to the equilibrium

point, when supply S remains constant. Generally, an increase in demand D ‘

results to higher price and quantity, as shown by D2.

Changes in Supply

What happens if the demand for some good (say, rice) remains constant but supply

increase (maybe because of change in technology or government policies), as

shown in Figure 2.9? As you can see in the figure, the new intersection of supply

and demand is located at a lower equilibrium point E1 at price P20.00 and at the

higher equilibrium quantity at 200 units.

We can therefore say that an increase in supply, generally results to a decrease in

price but an increase in the quantity of goods sold in the market. In constant, if

supply decreases while demand remains constant, the equilibrium price

increases but the equilibrium quantity declines. (Definitely, you can already figure

out the new equilibrium price and quantity under this particular situation).

Figure 2.9 Change in Supply

52
The figure shows the effects of an increase in supply S’ to the equilibrium point, when demand D
remains constant. Generally, an increase in supply S’ results to lower price but a higher quantity, as
shown by E1.

Complex cases

When both demand and supply change, the effects is a combination of the

individual effects.

Case 1: supply increase: demand decrease. What effect will a supply

increase and a demand decrease for some good (say mangoes) have on the

equilibrium price? Can you figure it out? Both changes decrease equilibrium price,

so that the net results is a price decrease greater than that of the resulting decrease

from either change alone.

But, what about the effect on the equilibrium quantity? Here, the effects of the

changes is supply and demand are opposite: an increase in supply increases

quantity but a decrease in demand reduces it. The direction of the change in

quantity depends upon the relative sizes of the change in demand and supply. If the

increase in supply is greater that the decrease in demand, the equilibrium quantity

will increase. But if the decrease in demand is greater than the increase is supply,

the equilibrium quantity will decrease. (You can illustrate the situations in a graph so

that you can figure out whether these situations are correct).

Case 2: supply decrease; demand increase. A decrease in supply and

an increase in demand for some good (say gasoline) both increase price. Their

combined effect is an increase in equilibrium price more than that caused by either

change separately. But their effect on equilibrium quantity is again indeterminate,

depending upon the relative changes in supply and demand. If the decrease in

supply is greater than the increase in demand, the equilibrium quantity will decline.

In contrast, if the increase in demand is larger than the decrease in supply, the

53
equilibrium quantity will increase. (Can you illustrate the two situations in a graph?

How do they look like?)

Case 3: supply increase, demand increase. What if both supply and

demand for some good (for example cell phones) increase? A supply increase

lowers equilibrium price, while a demand increase boosts it. If the increase in

supply is larger than the increase in demand, the equilibrium price will fall. However,

if the opposite holds, the equilibrium price will rise.

The effect on equilibrium quantity is certain: the increase in supply and

in demand each raise equilibrium quantity. Therefore, the equilibrium quantity will

increase by an amount greater than that caused by either change alone. (have you

illustrated the situations in a graph? Have you observed the changes?)

Case 4: supply decrease; demand decrease. What about decreases in

both supply and demand for some good (say black and white TV)? If the decrease

in supply is larger than the change in demand, equilibrium price will rise. However,

the opposite is true if the decrease in demand is greater that the increase in supply.

Since decreases in supply and demand reduce equilibrium quantity, we

can be sure that equilibrium quantity will definitely fall under these situations.

Price controls

When the market is experiencing a surplus there is a possibility that

producers will lose. Conversely, when the market is encountering shortage, there is

likelihood that consumers will be abused. What happens if disequilibrium

(either due to surplus or shortage) in the market persists at longer period of time?

If this happens, the government may intervene by imposing price controls.

Price control is the specification by the government of minimum or

maximum prices for certain goods and services, when the government considers it

disadvantageous to the producer or consumer. The price may be fixed at a level

54
below the market equilibrium price or above it depending on the objective in mind.

In the former case, for instance, the government may wish to keep the price of

some goods (e.g. basic food) down as a means of assisting poor consumers. In the

latter case, the aim may be to ensure that producers receive an adequate return

(price support to farmers, for instance). More generally, price controls may be

applied across a wide range of goods and services as part of prices and income

policy aimed at combating inflation.

Price controls are classified into two types: floor price and ceiling price.

Floor price

A floor price is the legal minimum price imposed by the government on

certain goods and services. A price at or above the price floor is legal; a price below

it is not. The setting of a floor price is undertaken by government if a surplus in the

economy persists. For instance, the government may impose a minimum price on

producers’ commodities say at P40.00 as shown in Figure 2.10. Generally, this

policy is resorted to in order to prevent bigger losses on the part of the producers

(e.g. farmers). Floor price is a form of assistance to producers by the government

for them to survive in their business. Floor price are mainly imposed by the

government on agricultural products especially when there is bumper harvest or the

labor market by imposing minimum wages.

55
Observe in the figure that if the government imposes a price floor of say P40.00

producers will sell 200 units of goods but consumers will purchase only 100 units of

those goods. Ultimately it results to a surplus of 100 units. In the long run, therefore,

a floor price creates an excess supply of goods since producers are enticed to

produce more because of the higher price but consumers are restrained from

purchasing more of the good. A floor price in the long run therefore distorts

resource allocation and makes the product more expensive since a floor price is

imposed above the equilibrium price. Moreover, it makes taxes higher in the long

56
run since government has to finance its purchase of the surplus product from the

taxes collected from tax payers.

Price ceiling

A ceiling price is the legal maximum price imposed by the government. A price

ceiling is usually below the equilibrium price, for example at P20.00 as shown in the

figure 2.11. In most cases, a price ceiling is utilized by the government if there is a

persistent shortage of goods (e.g. basic commodities like food items and soil

products) in the economy. As such, the prices of goods affected by a shortage do

not increase persistently. Because of this, the government regularly monitors the

market and imposes a maximum price on commodities, which is to be strictly

followed by producers and sellers.

A price ceiling therefore is imposed by the government to protect consumers from

abusive producers or sellers who take advantage of the situation. This is usually

done by government after the occurrence of a calamity like typhoon or severe

flooding.

Take note however that in the long run, a ceiling price imposed by government

results to shortage of goods in the market. Why? Because at lower price producers

do not have enough incentive to produce more while consumers are encouraged to

purchase more of those goods. We can again illustrate this in the graph. For

instance, in Figure 2.11 when the ceiling price is set by the government at P20.00

producers are only willing to sell 100 units while consumers are enticed to buy more

at 200 units. Consequently, a shortage of 100 units occurs in the market. Now, if

government will continue to impose the price ceiling, in the long run it will create

greater shortage of the good in the market. As the situation worsens, producers will

now take advantage of the consumers by selling their products at the higher prices

in the illegal market (known as black markets). At this point, consumers have no

option but to buy the good at price higher than the ceiling set by the government.

57
Why can the producers increase their price (although illegally)? Because as more

consumers demand for the products, they will battle in out among each other in

buying the limited supply of goods available in the market brought about by the

shortage making the price go up. In other words, as the shortage of goods worsens

in the long run, more producers will sell their products at higher prices in the illegal

market.

Could you think of concrete examples of price ceilings and floor prices imposed by

government? What do you think are the reasons why government imposes such

price controls?

58
 Market Equilibrium: A Mathematical Approach

In the previous discussions, we have discussed and presented market equilibrium

through graphical presentation. In this section, we will try to apply mathematical

equation in determining the price and quantity equilibrium in the market.

You have already been introduced to the mathematical equation in determining

demand and supply when we presented this in our discussion of the demand and
supply functions. If you can still remember, the equation that we set are follows:

Demand equation: QD = a – b(P) (1)

Supply equation: QS = a + b(P) (2)
Equilibrium equation: QD = Qs (3)

Take note that in the said equations, there are three unknown variables: QD, QS, P

where QD is quantity demanded, QS is quantity supplied, and P is Price. Moreover,

the parameter in equations (1) and (2) is a and the coefficient is b.

Given these equations, we can now determine the equilibrium price and quantity.

Example:

Look for the PE and QE given the following information:

QD = 68 – 6P

QS = 33+10P

Solving the problem, we can simply state our equilibrium equation as: a –

b(P) = a + b (P)

Substituting our values, we have:

68 – 6(P) = 33 + 10 (P)

Solving for the unknown (P), we simply group like terms, thus

68 – 33 = 10P + 6P

35 = 16P

59
Dividing both sides by 16, we get

P= 2.19

Now we have determined the price of the good. The next problem for us is to

determine the equilibrium quantity. Since we already know the price, all we have to

do is substitute the value of the price to our previous equations, thus:

68 – 6 (2.19) = 33 + 10 (2.19)

Solving the equation, our QD = QS is equal to 54.8 or we can set the value in whole

number. Therefore, the equilibrium quantity is equal to 55 units and the equilibrium

price is P2.19.

Now, it is your turn to complete the following table by solving the quantity
demanded and quantity supplied given the price. After you have completed the
table you should also indicate whether there is a surplus or shortage at the
particular price level.
Price QD QS Surplus/

Shortage

LESSON 3: THE CONCEPT OF ELASTICITY

TOPICS: Elasticity of Demand

Price elasticity of demand

Interpretation of the Elasticity Coefficient

Income Elasticity of Demand

Cross price elasticity of demand

60
 Elasticity of Supply

Extreme types of Supply Elasticity

POST TEST

Duration 15 hours
Lesson Proper

THE CONCEPT OF ELASTICITY

You may have wondered why there are goods that you purchase more(less)

when price becomes less (more) while there are goods that even if prices become

too high

(low) still you purchase the same quantity of that good. If you have asked yourself

why and tried to look for an answer, you are actually trying to explain the concept of

elasticity.

In this chapter you will learn the meaning of elasticity. You will also learn

why this concept is very important to our everyday decision making as a consumer.

Elasticity of Demand

The law of demand tells us that we will buy more of a good or service if the

price declines and less when the price goes up. But how much more or less of good

or service will buy given the change in price? The amount varies from product to

product and over different price ranges for the same product. It may also vary

overtime and such variations matter. Of course, in order to answer the question,

economists have developed the concept of elasticity to explain how consumers

respond to changes in the factors that affect demand.

You may have first encountered the term elasticity in your Physics subject,

which refers to the expansion or contraction of a physical matter such as rubber

band. In economics however elasticity means responsiveness or sensitivity. In

general, elasticity is the ratio of the percent change in one variable to the percent
61
change in another variable. It is a tool used by economists to measure the reaction

of a function to changes in parameters in parameters in a relative way.

Demand elasticity, in particular, is a measure of the degree of

responsiveness of quantity demanded of a product to a given change in one of the

independent variables which affect demand for that product. We can classify

demand elasticity according to factors that cause the change. Thus,

Price elasticity of demand is the responsiveness of consumer’s demand to

change in price of the good sold.

Income elasticity of demand is the responsiveness of consumer’s demand to a

change in their income.

Cross price elasticity of demand is the responsiveness of demand for a certain

good, in relation to changes in price of other related goods,

Price elasticity of demand

When we speak of the price elasticity of demand, we are dealing with the

sensitivity of quantities bought by a consumer to a change in the product price.

Thus, this concept describes an action that is within the producer’s control (keat

and young 2006)

We can therefore define elasticity of demand as the percentage change in

quantity demanded caused by a 1 percentage change in price. Thus, we can derive
price elasticity of demand using the following equation:

Ed = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑

𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒

62
 You may have observed that the most common method used by economics

textbooks in the measurement of price elasticity of demand is the arc elasticity.

The formula for this indicator is:

Where:

Ep = Coefficient of arc elasticity (Elasticity Coefficient

Q1 = Original quantity demanded

Q2 = New quantity demanded

P1 = Original price

P2 = New price

The numerator of this coefficient (Q2 – Q1), indicates the percentage change

in the quantity demanded. the denominator, (P2 – P1), indicates the percentage

change in the price.

We can illustrate the concept of elasticity through the following example:

Suppose we have the following price and quantity schedule for good A.

P Q

6 0
4 10
2 20
0 30

Assuming that we want to determine how consumers would react if the price of

good A will decrease. For instance, applying the demand elasticity formula, we can

solve the elasticity coefficient assuming that price will decrease from P6.00 to P4.00

and quantity demanded increases from 0 to 10 units. Substituting the values to our

formula, we have

63
 10−0 4−6

EP

EP = - |5|

Now, try solving the elasticity coefficient for the other price and quantity

combinations. Do they have the same elasticity coefficient? If your answer is no,

then you are correct since as the price of and quantity demanded for the good

move from one level to another, the elasticity coefficients also change.

As you may have observed, the computed value of the price elasticity is

always negative, although when we analyze and interpret the coefficient, we ignore

the negative sign thus only the absolute value is interpreted. What could be the

reason for this? It is always negative due to the very nature of the relationship of

price and quantity demanded: if price increases, less quantity change is negative,

leading to a negative price elasticity of demand. Conversely, if price falls , this

negative value will lead to a negative price of elasticity of demand value.

Interpretation of the Elasticity Coefficient

For economics, solving the elasticity coefficient is only a tool rather than an

end in itself. What is important to them (and to you also) is to understand the

meaning of the computed elasticity coefficient. Our concern now is how to analyze

and interpret the elasticity coefficient. Actually there are only certain rules to

remember in analyzing and interpreting the elasticity coefficient as you will note in

the following discussion.

64
 Demand for a product is said to be inelastic if consumers will pay almost

any price for the product, while demand for a product may be elastic if consumers

will only pay a certain price, or a narrow range of prices, for the product. Inelastic

demand means that a producer or seller can raise prices without much hurting

demand for its product and elastic and will only buy it if the price rises by what they

consider too much.

We already know that a fall in the price of a good results in an increase in

the quantity demanded by consumers. However, the demand for a good is elastic

when the change in quantity demanded is less than the change in price. Thus, we

can say that demand is inelastic if the computed elasticity coefficient is less than 1

(EP < 1). Generally, goods and services for which there are no close substitutes are

inelastic. Basic food items (e.g. rice, pork, beef, fish, vegetables, etc.), medicines

(like antibiotics), and oil products, are some examples of goods that are inelastic.

Goods that are vices like cigarettes are likewise inelastic for the simple reason that

those who smoke cannot easily refrain from smoking so that if the price of

cigarettes has been increasing, still smokers consume them.

Conversely, demand for a good is elastic if the change in quantity demanded

is greater than the change in price. Therefore, we can say that demand is elastic if

the computed elasticity coefficient is greater than 1(Ep > 1). In general, goods and

services that have many substitutes which consumers may switch to are elastic.

Clothes, appliances, cars, among others, are examples of goods that are elastic.

Graphical illustration

The price elasticity of demand can also be analyzed graphically. Figure 3.1

illustrates an elastic demand curve while Figure 3.2 shows inelastic demand curve.

Take note the slope of the two demand curve.

We can observe in Figure 3.1 that the slope of an elastic demand curve is

flatter. Thus, the more the demand curve becomes horizontal the greater it

65
becomes elastic. This because the small change in price, say from P3.00 to P1.00.

results to a larger change in quantity demanded, say from 10 units to 35 units. Take

note that broken line ab is shorter than broken line bc.

This means that if demand is elastic more quantities of good is demanded

when price changes even by a small percentage. In this case, we can say that

consumers respond greatly to a small change in price.

On the other hand, we can see in Figure 3.2 that the slope of an inelastic

demand is steeper or more vertical. In fact, the more the demand curve becomes

steeper or vertical the greater it becomes it inelastic. This is so since the large

change in price, say from P3.00 to P1.00 results to a small change in quantity

demanded, say from 15 units to 20 units. As illustrated in the graph, we can

observe that the broken line ab is longer than broken line bc implying that less

quantities of a good is purchased even when there is a large change in price of the

good. Under this situation, we can say that consumers’ response in buying a good

is lesser than the change in price.

At the extreme, demand can be perfectly price inelastic, that is, price

changes have no effect at all on quantity demanded. A perfectly inelastic demand

curve is illustrated as a straight vertical line (see Figure 3.3a), thus as the figure

illustrate, even when price will increase by more than one hundred percent, still the

amount of good that will be bought will be the same. An example of good that may

be perfectly inelastic is the medicine for cancer patient.

On the other hand, demand can be perfectly price elastic, that is, any

amount will be demanded only at the prevailing price. However, if the price will

increase by even a miniscule amount or a very small percentage, consumers will

not anymore purchase good. A perfectly elastic demand is illustrated as a straight

horizontal line (See Figure 3.3) an example of a good that may be

perfectly elastic is a trip to the outer space.

66
 Now that we have described what elasticity is, let us examine the reason

why demand for some goods is elastic, whereas for others it is inelastic. The

question therefore is: what determi9ne elasticity? However, before we look into

these reasons, we have to remember that the elasticity for a particular product may

differ at different prices. For instance, although the demand elasticity for rice is low

as its current price, it may not be so inelastic at P70.00 to P75.00 per kilo.

Going back to our question: what determines elasticity? There are

important factors that influence demand elasticity including (a) ease of substitution;

(b) promotion of total expenditures; (c) durability of product which may include (i)

possibility of postponing purchase, (ii) possibility of repair, and (iii) used product

market; and (d) length of time period (Keat and Young 2006).

Accordingly, the most important determinant of elasticity of a produce is

ease of substitution. If there are many good substitute for the product sold in the

market, elasticity for that product will be high. Moreover, if the product itself is a

67
good substitute for other goods, its demand elasticity will also be high. However, the

broader the definition of a commodity, the lower its price elasticity will tend to

become because there is less opportunity for substitutes.

Another major determinant of demand of elasticity is the proportion of total

expenditures spent on the product. For example, if the current price of rice is P5.00

per kilo and it will increase to P6.00 per kilo, we may shrug off the P1.00 increase

since its effects on our total expenditure is very negligible. However, for products

like appliances, and techno gadgets like cell phones, computers, and iPod, the

situation may be entirely different. Hence, we can expect that the demand elasticity

for an air conditioning unit to be considerably high than that for rice. Another reason

for high elasticity of this products is that a new appliance purchased can be

68
postponed because there is a choice between buying and repairing. Faced with a

higher purchase price, a consumer may choose to repair his old appliance instead

of purchasing a brand new product.

Lastly, as market broaden, more and more products substitution becomes

possible. Advances in mode of transportation and communication accompanied by

decrease in their cost have increased the size of market overtime.

Consequently, the numbers of substitutes competing for consumers’ demand has

increased. In fact, market have not only widened on a national scale, they have

crossed national borders brought about by increase in international trade due

mainly to international agreements like the World Trade Organization (WHO) and

other regional trade blocks like the ASEAN Free Trade Agreement among

ASEAN member countries and Asia-Pacific Economic Cooperation (APEC).

69
product.

Though, perfectly elastic demand is a theoretical concept and cannot be applied in the
real situation. However, it can be applied in cases, such as perfectly competitive market
and homogeneity products. In such cases, the demand for a product of an organization
is assumed to be perfectly elastic.

From an organization’s point of view, in a perfectly elastic demand situation, the

organization can sell as much as much as it wants as consumers are ready to purchase
a large quantity of product. However, a slight increase in price would stop the demand.

Perfectly Inelastic Demand:

A perfectly inelastic demand is one when there is no change produced in the demand of

a product with change in its price. The numerical value for perfectly inelastic demand is

zero (ep=0).

In case of perfectly inelastic demand, demand curve is represented as a straight

vertical line, which is shown in Figure-3.3b

Figure 3.3b Perfectly elastic Demand

It can be interpreted from Figure-3.3b that the movement in price from

OP1 to OP2 and OP2 to OP3 does not show any change in the demand
of a product (OQ). The demand remains constant for any value of price.
Perfectly inelastic demand is a theoretical concept and cannot be
applied in a practical situation. However, in case of essential goods,
such as salt, the demand does not change with change in price.
Therefore, the demand for essential goods is perfectly inelastic.
. The figure

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above are the two extreme types of demand elasticity. Figure 3.3a illustrates a perfectly

inelastic demand curve while Figure 3.3.b shows a perfectly elastic demand curve.

Income Elasticity of Demand

Income elasticity of demand measures the degree to which consumers

respond to a change in their incomes buy purchasing more or less of a particular

good. The coefficient of income elasticity of demand E1 is determined with formula:

E1 = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑

𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒

In discussing income elasticity of demand, we have to distinguish a normal

good from an inferior good.

A good is considered a normal good if a rise in income brings an increase in

demand and a fall in income brings a decrease in demand. For most goods, the

income elasticity coefficient E1 is positive, meaning that more of them are

demanded as income rise. However, the value of E1 varies greatly among normal

goods. For example, if you buy more bottled water when your income increases,

then bottled water is a normal good. Most good are considered normal goods. In

addition, if your income rises by 10 percent and it resulted to a 15 percent increase

in your demand for movies, your income elasticity of demand for movies is 1.50

(equal to 15 percent ÷ 10 percent). We can therefore say that a good is a normal

good if the income elasticity is positive – indicating a positive relationship between

income and demand. New cars, new techno gadgets, new clothes are some of the

products that have positive income elasticities and are thus considered normal

goods.

In the other hand, a good is an inferior good if a rise in income brings a

decrease in demand and a fall in income brings an increase in demand. In other

words, the consumption of other products decreases (increases) as income

increases (decreases). For these goods, the income elasticity is negative –

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revealing a negative relationship between income and demand. Hence, a negative

income elasticity coefficient designates an inferior good. Used clothing, home

cooked food, riding a jeepney are some examples of goods that have negative

income elasticity. Consumers of these goods decreases their purchases as their

income rise.

Cross price elasticity of demand

We already noted in our previous discussions that the demand for a

particular product also depends in part on the prices of related goods – substitutes

and complements. The cross price elasticity of demand measures the

responsiveness of demand to changes in the prices of other goods, indicating how

much more or less of a particular product is purchased as other prices change. The

cross elasticity is defined as the percentage change in quantity demand of one

good (X) divided by the percentage change in the price of a related good (Y). Thus,

the formula for cross price elasticity of demand is:

Exy

As we have already noted, two goods are considered substitute if there is a

positive relationship between the quantity demanded of one good and the price of

the other good. For example, an increase in the price of bananas increases the

demand for mangoes as consumers substitute mangoes for bananas. For a more

specific example, suppose the price of a burger falls by 10 percent and the demand

for pizza decreases by 5 percent, the cross price elasticity of demand for pizza with

respect to the price of burger is:

Exy = -5 percent ÷ 10 percent = 0.50

The cross price elasticity of demand for a substitute is positive. A fall in the

price of a substitute good brings forth a decrease in the quantity demanded of the

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good. In other words, the quantity demanded of a good and the price of one of its

substitute change in the same direction.

Supposed that when the price of Coke falls by 10 percent and the quantity of

pizza you demanded increased by 2 percent. The cross elasticity of demand for

pizza with respect to the price of Coke is:

Exy = +2 percent ÷ -10 percent = -0.20

Two goods are considered complements if there is a negative relationship

between the quantity demanded of one good and the price of the other good.

Hence, the cross price elasticity of demand for a complement is negative: a fall in

the price of a complement brings forth as increase in the quantity demanded of the

other good. In other words, the quantity demanded of a good and the price of one of

its complements change in opposite directions.

Estimates of cross elasticity of demand are useful to retailers in their pricing

decisions. For example, when a grocery store cuts the price of bread, the store will

sell more bread but will also sell more complementary goods such as jelly, peanut

butter, cheese, ham, etc. If the cross elasticity of demand for jelly is 0.5. a 10

percent decrease in the price of bread will increase the demand for jelly by 5

percent. Retailers use coupons for one product to promote the sales of that good as

well as its complementary goods. Armed with the relevant cross elasticities,

retailers can predict just how much more of a complementary goods consumer will

buy.

Elasticity of Supply

Supply elasticity refers to the reaction or response of the sellers or producers

to price changes of goods sold. In other words, it is a measure of the degree of

responsiveness of supply to a given change in price. Moreover, it is the percentage

change in quantity supplied given a percentage change in price.

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Thus, Es

Supposed the price of rice increases from P20.00 to P22.00, the quantity supplied

increases from 100 million metric tons to 120 million metric tons. In other words, a

10 percent increase in the price of rice increased the quantity supplied by 20

percent using the formula for the supply elasticity.

If a percentage change in price results in a more than proportionate change

in quantity supplied, then quantity supplied is said to be price elastic.

(See Figure 3.4). take note that an increase in the price of good A from P1.00 to

P3.00 represented by the broken line ba results in a larger increase in quantity

supplied from 5 units to 25 units represented by the broken line cb. This simply

indicates that the response of suppliers to a small change in price is to increase the

quantity of goods supplied in the market more than the increase in price. Just like

an elastic demand curve. In fact, the more the supply curve tends to be horizontal

the more that it becomes highly elastic.

Figure 3.4 Supply Elastic

The figure illustrates an elastic supply curve. An elastic supply curve is flatter

than a normal supply curve. This is because a smaller change in price (broken line)

calls for a greater change in quantity supplied (broken line cb).

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 Conversely, if a change in price produces a less than proportionate change

in the quantity supplied then supply is considered price inelastic (See Figure 3.5).

Observe in the figure that an increase in the price from P1.00 to P3.00 represented

by the broken line ba resulted in a small increase in quantity supplied from 5 units

to 10 units represented by the broken line cb. The small change in quantity supplied

simply tells us that suppliers are not that responsive to price changes under an

inelastic supply condition. We can also see that inelastic supply curve is more

vertical than a normal supply curve. In fact, the more vertical the supply curve is the

more it becomes a highly inelastic.

At the extremes, supply can be perfectly price inelastic, that is, price

changes have no effect at all on quantity supplied. A perfectly inelastic supply curve

is illustrated by a straight vertical line ( See Figure 3.6a). On the other hand, supply

can be perfectly price elastic, that is, any amount will be supplied at the prevailing

price. A perfectly elastic supply curve is a straight horizontal line (See Figure 3.5).

Figure 3.5 Supply inelastic

This figure illustrates an inelastic supply curve. An inelastic supply curve is

more vertical than a normal supply curve. This is because any change in price

(broken line ba) calls forth a smaller change in quantity supplied (broken line cb)

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 Just like demand elasticity, what determines supply elasticity? Two

important factors can be identified: (a) time; and (b) time horizon involved with

which production can be increased.

Time is a determinant of supply elasticity as producers respond to changes in prices

from time to time, given a certain period. Some producers change the number of

supply of their commodities depending on the movements of prices which shifts

from time to time.

Also, the degree of responsiveness of supply to changes in price is affected by the

time horizon involved in the production process. In the short run, supply can only be

increased in response to an increase in demand or price by working on the firms’

existing plant more intensively, but this usually adds only marginally to total market

supply. Hence, in the short run, the supply curve tends to be price inelastic. Why?

Because when the price of a particular in their existing production facilities (for

example, in their factories, stores, offices, etc.). Although higher price will certainly

induce firms’ production facilities. In the long run, firms are able to enlarge their

supply capacities by building additional plants and by extending existing ones so

that supply conditions in the long run tend to be more price elastic. Moreover, new

firms can enter the market so there will be a larger response in the long – run. As

time passes, supply becomes more elastic as more and more new firms have the

time to build production facilities and produce more output.

Figure 3.6 Extreme types of Supply Elasticity

The figures above the two extreme types of supply elasticity. Figure 3.6 illustrates a

perfectly inelastic supply curve shows a perfectly elastic supply curve.

Now that you have clear idea why some goods that you purchase are more (less)

than the price changes, it is now time for you to apply the concept that you have

learned in your everyday activity as a consumer. It is expected that this concept will

help you in your decision making as a consumer (and may be later on as a

producer).
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There are three extreme cases of PES. Perfectly elastic,where supply is infinite at

any one price. Perfectly inelastic, where only one quantity can be supplied. Unit

elasticity, which graphically is shown as a linear supply curve coming from the

origin.

Figure 3.6 Extreme types of Supply Elasticity

LESSON 4: CONSUMER BEHAVIOR AND UTILITY MAXIMIZATION

TOPICS: Goods and Services

Consumer Goods

Essential or Necessity Good Vs. Luxury Goods

Economic and Free Good

Tastes and Preferences

Maslow’s Hierarchy of Needs

The Economics of Satisfaction

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 The Utility Theory

Marginal Utility Total Utility

Duration: 6 hours

CONSUMER BEHAVIOR AND UTILITY MAXIMIZATION

We, as a consumer, are unique in many ways. We have different needs, wants and

demands. We differ in likes and dislikes, standards, reactions, lifestyles, traditions,

etc. However, our behavior as a consumer is hard to identify and measure. From an

economic stand point, our objective as consumers is to maximize our satisfaction

given our limited budget (or income). With this in mind, economics seeks to explain

why consumers behave differently and in a particular manner.

In this chapter, you will learn how we as consumers behave in order to maximize

our satisfaction on the goods and services that we consume given our limited

income.

Consumer

Before we proceed with our discussion of consumer behavior, let us first define

who is a consumer. Simply defined, a consumer is one who demands and

consumes goods and services. Without, consumption (mainly by households),

there is no need for production made by firms. The consumer is the king in a

capitalists or free-market economy. Producers, for their own interests, have to

satisfy the needs and wants of consumers in order to earn profits. In this

perspective, all of us are consumers because as we live our daily lives we demand

goods and services the moment we wake up in the morning until we

retire to our bed at night.

As consumers, our power is to determine what are to be since we are the ultimate

purchasers of goods and services. This is referred to as consumer sovereignty. In

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general terms if we, as consumers, demand more of a good or service then more of

it will be supplied or vice versa. The producers simply obey the wishes and desires,

and the needs and wants of consumers. This therefore implies that producers are’

passive agents’ (Pass and Lowes 1993) in the price system because they simply

respond to what we want. However, in certain kinds of market (notably oligopoly

and monopoly), producers are so powerful vis-à-vis consumers that it is they who

effectively determine the range of choice open to us consumers. Nevertheless, our

freedom to satisfy our human wants is not completely unlimited. For the good of

society and the individual consumers, the government restricts consumer

sovereignty. For example, the government prohibits the use of dangerous drugs

and substances and regulates the use of products that are health hazards like

alcoholic beverages and cigarettes. It also regulates products that are destructive to

the environment like the use of leaded gasoline.

Goods and Services

It is also important to clarify first what are goods and services. Goods refer to

anything that provides satisfaction to the needs, wants, and desires of the

consumer. They can be any tangible economic products9 like cars, books,

clothes, cell phones, iPods, etc.) that contribute directly (final goods) or indirectly

(intermediate goods) to the satisfaction of human needs and wants. Services, on

the other hand, are any intangible economic activities (such as hairdressing,

catering, insurance, banking, telecommunications, etc.), that likewise contribute

directly or indirectly to the satisfaction of human wants.

Tangible goods can be classified according to, but not limited to, the following:

Consumer goods

These are the goods that yield satisfaction directly to any consumer. These goods

are primarily sold for consumption, and not to be used for further processing or as

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an input or raw material needed in producing another good. Usually, these are the

goods that are easily accessible to consumers (for example, soft drinks, bread,

crackers, cellular phone loads, clothes etc.).

Essential or necessity good vs. luxury goods

Essential or necessity goods are goods that satisfy the basic needs of man. In other

words, these are goods that are necessary in our daily existence as human beings.

These are also goods that we cannot live without such as food, water, shelter,

clothing, electricity, medicine, etc.

Conversely, luxury goods are those which men do without, but which are used to

contribute to his comfort and well-being. Examples of luxury goods are private jet,

yacht, luxury cars, perfumes, jewelry, etc.

Economic and free good

An economic good is that which is both useful and scarce. It has value attached to it

and a price has to be paid for its use. If a good is so abundant that there is enough

of it to satisfy everyone’s need without anybody paying for it, that goods is free.

Water from our faucet is an economic good, because we are not utilizing it for free,

we have to pay to its distributor. The air that we breath and the sunlight coming

from the sun are examples of free good.

Tastes and Preferences

Consumes have various tastes and preferences. Generally, tastes and preferences

are determined by age, income, education, gender, occupation, customs and

traditions as well as culture. Preferences are the choices made by us consumers as

to which products or services to consume. The strength of our preferences will

determine which products to buy given our limited disposable income and thus the

demand of products as well as which product to buy. We as consumers also

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express preferences as to which particular brand of a product to purchase. Even in

the choice of food, clothing and shelter, for instance, we differ in our choices and

preferences. Some prefer bread than rice, others like fish and vegetables than

meat. In fact, we can generalize that no two consumers have exactly the same likes

and dislikes. Some individuals have simple taste and few preferences; others are

sophisticated and extravagant.

Before we leave this discussion, it is also important to understand what brand is.

Simply defined, a brand is the name, term or symbol given to a product by a

supplier in order to distinguish his offering from that of similar products supplied by

competitors. Brand names are used as a focal point of product differentiation

between suppliers. Examples of brand names include Coca cola for the soft drink

products; Guess, Levi’s, and Lacoste for RTW products, etc. Now, you can identify

other brands that you usually buy or consume?

Maslow’s Hierarchy of Needs

Maslow’s hierarchy of needs identifies the basic priorities of every consumer.

Maslow saw human needs in the form of a hierarchy, ascending from the lowest to

the highest. He concluded that when one set of needs is satisfied, this kind of need

ceases. The basic human needs placed by Maslow in an ascending order of

importance (like a pyramid) are: (a) social needs; (b) security, or safety needs; (c)

social needs; (d) social needs; and (e) self-actualization needs.

Physiological needs

These are the basic needs for sustaining human life itself, such as food, water,

warmth, shelter, sex and sleep. According to Maslow, until these needs are satisfied

to the degree necessary to maintain life, other higher order needs will not stimulate

people.

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 Safety needs

These are the needs to be free of physical danger and the fear of losing one’s work

property, food, or shelter.

Social needs

These needs cover the value of the sense of belongingness, love, care, acceptance

and understanding of family, relatives and friends, and to be accepted by others.

Esteem needs

These needs explain the importance of self-esteem, recognition, status of an

individual and the general acceptance of the society to an individual. This kind of

need produces such satisfaction as power, prestige, status, and self-confidence.

Self – Actualization needs

These needs explain the worth of a person’s self – development, growth and

realization and achievement. According to Maslow, this is the highest need in the

hierarchy. It is the desire to become what is capable of becoming – to maximize

one’s potential and accomplish something.

The Economics of Satisfaction

You might be wondering by now how economics can explain the behavior of

consumers in order to attain maximum level of satisfaction on the goods and

services that they generally consume. In this section we try to explain how

consumers attain maximum satisfaction level on the many goods and services

available to them for consumption. However, we have to remember at this point that

satisfaction is a relative term. This is because we differ in the way we are satisfied

as well as the degree of our satisfaction. As we said earlier, no two consumers have

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the same likes and dislikes. This section will discuss to you some of the theories

that economists have devised to explain how consumers are able to attain level of

satisfaction when consuming a particular good or service.

The utility theory

Utility, in economics, refers to the satisfaction or pleasure that an individual or

consumer gets from the consumption of a good or service that (s)he purchases. For

purposes of economic analysis, utility is also measured by how much a consumer is

willing to pay for a good/service.

Table 4.1 presents a hypothetical demand schedule for siopao. You will notice in

the table that the amount of money that you are willing to buy for an additional unit

of siopao declines. What is the reason for this? As you might have experienced the

more siopao you can eat, the more you become satiated so that you are not willing

to spend more for the next siopao that you wish to consume. In other words, the

satisfaction or utility that you derive in the consumption of an additional siopao

declines as you consume more and more of it.

The hypothetical example that we just illustrated is what the utility theory is all

about. It simply tries to explain how our satisfaction or utility as consumer’s decline

when we try to consume more and more of the same good at a particular point in

time.

Two important concepts need to be explained before we totally understand the

utility theory. These are: the marginal utility and total utility concepts.

Marginal utility is defined as the additional satisfaction that an individual derives

from consuming an extra unit of a good or service. Marginal; means’ additional’ or

‘extra’. In economics, we use marginal analysis in the examination of the effects of

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adding one extra unit to, or taking away one unit from, some economic variable. For

this purpose, we are interested in the incremental or additional utility derived from

an additional consumption of a commodity. Thus, the marginal utility of a commodity

is the increase in total utility or satisfaction derived from the consumption of an

additional or extra unit of such commodity; is the loss of utility or satisfaction if one

unit less is consumed. In other words, it is the change in the total utility that results

from a one-unit increase in the quantity of a good consumed.

Table 4.1

Hypothetical Demand Schedule for Siopao

Price Quantity Demanded

(P) (QD)
15.00 1
12.75 2
10.50 3
8.25 4

The table shows that as you continue to buy siopao, your willingness to pay for it

continuously declines because your satisfaction from the good declines as you

consume more of it.

Total utility, on the other hand, is the total satisfaction that a consumer service

derives from the consumption of a given quantity of a good or service in a particular

time period. We can also say that utility is the total benefit that a person gets from

the consumption of a good or service. Total utility depends on the quantity of the

good consumed – more consumption generally gives more total utility. Hence, our

total utility usually increases as we consume more and more of a good or service,

but generally the increase is at a slower or declining rate. This implies that each

extra unit consumed adds less and less marginal utility than the previous units

consumed as we become satiated with the good or service we are consuming.

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Let us illustrate this using the hypothetical utility schedule presented in Table 4.2

Assume that the end of our class, you are too hungry so that you went directly to

the cafeteria. In the cafeteria, you bought and consumed one siopao for your

merienda. In this case, your total and marginal utilities are 40 utils. Assume further

that you consumed another siopao because you are too hungry after the class. Your

total utility now increases to 90 utils so that marginal utility increases by 50 utils. Let

us now assume that you have consumed five siopaos. Take note in that table that

your total utility for the fifth unit is 350 utils. However, what is more important is the

marginal utility. As we can observe, marginal utility has declined to 80 utils. Why is

this so? This is because of the Law of Diminishing Marginal Utility.

GLOSSARY

Allocation - A description of who does what, the consequences of their actions,

and who gets what as a result (for example in a game, the strategies adopted by

each player and their resulting payoffs).

Allocation rate - The percentage of the money you pay into a pension scheme or

life insurance policy that is actually invested.

Asset - Anything of value that is owned. See also: balance sheet, liability.

Ceteris paribus - Economists often simplify analysis by setting aside things that

are thought to be of less importance to the question of interest. The literal meaning

of the expression is ‘other things equal’. In an economic model it means an analysis

‘holds other things constant’

Commodities - Physical goods traded in a manner similar to shares. They include

metals such as gold and silver, and agricultural products such as coffee and sugar,

oil and gas. Sometimes more generally used to mean anything produced for sale

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Consumer sovereignty - is the idea that it is consumers who influence production

decisions. The spending power of consumers means effectively they ‘vote’ for

goods.

Economics - The study of how people interact with each other and with their

natural surroundings in providing their livelihoods, and how this changes over time.

Economic goods – cover goods, services, products and the like that have price

and are sold in a market

Economic Resources- inputs used in the production of goods and services

Employment rate - The ratio of the number of employed to the population of

working age.

Entrepreneur - A person who creates or is an early adopter of new technologies,

organizational forms, and other opportunities.

Equilibrium - A model outcome that does not change unless an outside or

external force is introduced that alters the model’s description of the situation.

Equity - An individual’s own investment in a project. This is recorded in an

individual’s or firm’s balance sheet as net worth. See also: net worth. An entirely

different use of the term is synonymous with fairness.

Excess demand - A situation in which the quantity of a good demanded is greater

than the quantity supplied at the current price.

Excess supply - A situation in which the quantity of a good supplied is greater than

the quantity demanded at the current price.

Exchange – this is the process of trading goods and/or services for money and/or

its equivalent.

Goods – anything that yields satisfaction to someone

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Income - The amount of labour earnings, dividends, interest, rent, and other

payments (including transfers from the government) received by an economic actor,

net of taxes paid, measured over a period of time, such as a year.

Investment (I) - Expenditure on newly produced capital goods (machinery and

equipment) and buildings, including new housing.

Invisible hand game - A game in which there is a single Nash equilibrium and

where there is no other outcome in which both players would be better off or at

least one better off and the other not worse off.

Marginal utility - The additional utility resulting from a one-unit increase of a given

variable.

Market - A way that people exchange goods and services by means of directly

reciprocated transfers (unlike gifts), voluntarily entered into for mutual benefit

(unlike theft, taxation), that is often impersonal (unlike transfers among friends,

family).

Monopoly - A firm that is the only seller of a product without close substitutes.

Also refers to a market with only one seller.

Needs - the things that we need for survival

Oligopoly - A market with a small number of sellers of the same good, giving each

seller some market power.

Opportunity cost - The opportunity cost of some action A is the foregone benefit

that you would have enjoyed if instead you had taken some other action B. This is

called an opportunity cost because by choosing A you give up the opportunity of

choosing B. It is called a cost because the choice of A costs you the benefit you

would have experienced had you chosen B. The opportunity cost of some action A

is the foregone benefit that you would have enjoyed if instead you had taken some

other action B.

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Product market = refers to a place where goods and services are bought and sold

Resource market - is a place, either physical or virtual, where materials, assets

and other elements are exchanged between parties. In other words, supply and

demand interact with each other to trade different kinds of items.

Scarcity – it is a commodity or service being in short supply. A good that is valued,

and for which there is an opportunity cost of acquiring more.

Saving - When consumption expenditure is less than net income, saving takes

place and wealth rises.

Share - A part of the assets of a firm that may be traded. It gives the holder a right

to receive a proportion of a firm’s profit and to benefit when the firm’s assets

become more valuable. Also known as: common stock.

Shock- An exogenous change in some of the fundamental data or variables used in

a model.

Supply curve - The curve that shows the number of units of output that would be

produced at any given price. For a market, it shows the total quantity that all firms

together would produce at any given price.

Wants - the things that we would like to have

Wealth – refers to anything that has a functional value which can be traded for

goods and services. It constitute Stock of things owned or value of that stock. It

includes the market value of a home, car, any land, buildings, machinery, or other

capital goods that a person may own, and any financial assets, such as bank

deposits, shares, bonds, or loans made to others. Debts to others are subtracted

from wealth—for example, the mortgage owed to the bank.

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