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Introduction to Economic Theory

Terms to Remembers

Economics Basic Needs Luxury Goods Economic Resources Land Labor Entrepreneur Capital Theory Market Wants

Variable Macroeconomics

Normative Economics Positive economics Empirical validation

Economic System
Free enterprise system Right to private property Function

Different definitions of economics:

Economics studies how prices of land, labor

and capital are determined, and how these prices are used to allocate scarce resources.

Economics looks into the behavior of financial

market and how they allocated capital to the rest of the economy.

Economics looks into the distribution of income and

into ways of helping the poor without causing harm to the countrys economic performance.

Economics looks into the impact on growth of

government spending, taxes and budget deficits.

Economics examines the movements in income

and employment during the different stages of the business cycle with the goal of developing government policies that will improve economic growth. nations and analyzes the impact of trade barriers.

Economics looks at trade patterns among

Economics examines growth in

developing countries and suggests ways to encourage the efficient use of resources.

Economic activity: Mans economic activity consists of efforts to satisfy human wants with the use of goods and services.

3 elements are involved in this objective of satisfaction: 1. Human wants 2. Use of Resources 3. Technique of production

Human wants
Human wants wants are unlimited. This vary from

the needs for survival (basic needs).




Human Wants
Man is also subject to created wants (caused by advertising).

Use of Resources
The basic economic resources of a nation consist of:
Land Labor Capital Entrepreneurship

These are available in limited amounts, which is why man has to learn how to allocate them properly to maximize the number of wants that can be satisfied.


Land Labor Capital Business

The economy should pay the owners of these basic factors of production for the use of their resources such as rent for the land, wage or salary for labor, interest for capital and profit for entrepreneurship.

Technique of Production
Shows how

resources are used and combined in production. Production may be:

Capital intensive, or Labor intensive

This depends on the

factor that is predominantly used.

Household is the basic consuming unit in

the economy. Since human wants are unlimited, it maximizes its satisfaction through proper allocation or mix of expenditures within the context of budget limitations.

Allowance per week is 500 Budget: Transportation 100 Food 250 Soft drinks 50 Others - 100

Allowance per week is 500 Budget: Transportation 100

Food 125
Soft drinks 30
Others - 100

T-shirt - 145

The student forgoes food and drinks for shirt

Opportunity cost Value of foregone alternative of a specific resource

Business firm the economys producing unit to satisfy human wants with goods and services. They hire employees and use resources to operate and provide goods and services.


Hire employees Use resources

Resource owners
Pay for the use of resources


2. 3. 4. 5.

Unemployment Economic Instability Low levels of growth and development Unequal income distribution Determination of the countrys type of economic system.

this is a problem because it leads to idle

resources. This means that income is foregone in resources which would generate earnings to the owners if used.

Economic Instability
makes it difficult for producers to make accurate

forecasts on demand and consumption levels, causing fluctuations in production and supply of goods and services, which further leads to surpluses or shortages.

Low levels of Growth and Development

makes it difficult for underdeveloped and

developing nations to rise from their low levels of income.

Unequal Income Distribution

this concentrates the wealth of the

nation in the hands of the few.

Determination of the countrys type of economic system

this is vital to any nation because this determines

how goods will be produced, the quantities to be made, and how these goods and services shall be distributed.


Economic analysis
the process of directing economic relationships by

examining economic behavior and events, and determining the causal relationships among the data and activities observed.

Tools in Economics:
Logic 2. Statistics 3. Mathematics

first tool of economics. Used in establishing

relationships among different variable to draw conclusion from particular to general or from general to particular.

used to quantitatively describe economic

behavior and therefore serves as basis for hypothesis testing. Hypothesis becomes a theory when empirically validated.

enables the analyst to conceptualize and quantify

a hypothesis for empirical validation.

Purpose of economic analysis:

It is an aid in understanding how economy

operates because it explains how economic variables are related to one another. It permits prediction of the results of changes in economic variables It serves as basis for policy formulation.

Economic Policy
This consists of interventions or courses of action

taken by the government or other private institutions to manipulate the results of economic activity.

The economic policy adopted by the government

may be monetary, fiscal or trade for the purpose of achieving economic welfare.

One must use economic theory to make a useful

and systematic study of economic activity.

Economic theory consists of causal relationships

among the important facts or variables that surrounded and permeate economic activity. Theories are based on premises or postulates (conditions that are taken as given).

The construction of economic theory:


Specification and definition of its postulates.

Ex. In economics, theory may be build based on consumer behavior.


The observation of facts concerning the activity about which we want to theorize.
Ex. Looking at the exchanges of groceries between supermarket and consumers: What facts are relevant and what facts can be disregarded?


The application of the rules of logic to the observed facts.

This attempts to establish causal relationship among the

facts and to eliminate as many irrelevant and insignificant facts as possible. inductive (particular to general). hypotheses.

Reasons could be deductive (general to particular) or

Reasons will help reach tentative statements called


Testing hypotheses thoroughly after its formulation.

Testing it is crucial to determine the extent of its

validity. Some hypothesis will not stand repeated testing and therefore should be rejected.

Others may be modified and tested. Hypotheses that hold up to most of the time in most

of the circumstances, to which they are relevant may be referred to as principles

Theories should not be regarded as absolute truth

as the testing process is never ending. Economic theories continue to evolve and grow.

Functions of Economic Theory:

To explain the nature of economic activity
To predict what will happen in the economy as

facts change.

Differentiation of how the theory is used

1. Positive Economics
2. Normative Economics


Positive Economics
Supposed to be completely objective Limited to the cause and effect relationships of

economic activity


Normative Economics
Concerned with what ought to be Value judgments must necessarily be made
Ex. Economic policy making conscious intervention in

economic activity with the intent of altering the course that it will take.


The 2 Basic Analytical Tool Kit in Economics are:
Price theory

microeconomics Economic theory macroeconomics

It is primarily concerned with the market

activities on individual economic units such as consumers, resource owners, and business firms.

Microeconomics is concerned with:

1. 2. 3.

5. 6.

the flow of goods and services from business firms to consumers the composition of the flow the process of establishing relative prices of the component parts of the flow the flow of resources from resource owners to business firms the evaluation of resources the allocation of resources among alternative uses

Treats the economic system as a whole rather

than treating the individual economic units of which it is composed.

The value of overall flow of goods (net national

product) and the value of the overall flow of resources (national income) receive the focus of attention.

Macroeconomics Deals with:

Price index and general price level
Concentrates on cause of change in aggregate

money flows, the aggregate movement of goods and services

The general employment level resources

Concerned about the nature of economic growth

The conditions necessary for the expansion of

productive capacity and national income time

Price theory Microeconomics

This is abstract because it does not and cannot

encompass all the economic date of the real world.

The function of the theory is to single out the

most relevant data and to build an overall conceptual framework of the price system in operation from those.

It concentrates on data and principles that are

most important in motivating most economic units. Eliminating less important data, certain contact with reality is lost but we gain understanding on the overall operation of the economy.

Characteristics of Microeconomics

Microeconomics looks at the decisions of individual units (household, producers and firms).
Ex. How efficiently is our resources used?


Microeconomics looks at how prices are determined.

Ex. Should a monopolist increase his price?


Microeconomics is concerned with social welfare.

Ex. Is it prudent to build a new bridge or to buy

additional arms for the army.

4. Microeconomics has a limited focus. It

is just a part of the economics discipline.


Microeconomics develops skills:

Microeconomics helps you develop your logical

reasoning. Microeconomics will help you develop skills in construction and use of models.

Microeconomics employs optimizing techniques

that are useful for making decisions in variety of situations.

Its concepts are applicable to personal resource

allocation decisions (career choice and financial investments).

Microeconomics makes extensive use of

modeling, comparative static and mathematics.

Economic models are composed of a series of:

Assumptions or given Statement of implications

Supply and demand

One of the best known economic model. This is an

example of comparative static analysis (a comparison of two different economic outcomes

Supply and demand relationships can be

expressed in 3 ways:
Verbal or logical 2. Mathematical 3. Graphical

Supply is a schedule of prices and quantities that

a supplier would be willing to offer for sale at each price period of time.

As suppliers, they would be encouraged to sell

more at higher prices and would sell less at lower prices. This is because higher prices, if other things are held constant, means higher profits.

Therefore, higher prices offered for sale are

directly related.

The law of supply can be expressed in an



This means that if the price for commodity is Php 1, quantity supplied would be Php 500.00 (Php 1 x 500 = Php 500.00.

Price Qty.

1 2 3 4 5

10 20 30 40 50

A common feature of models is that they focus

only on the fundamental elements of an object or process. In the example, supply is analyzed based on varying prices. But supply could also be affected by other factors.

Models that consistently predict a broad range of

real-world phenomena are classified as theories. But not all models are theories. The test of the theory is the consistency of its predictions.

3 types of models in Microeconomics:


Models that explain resource allocation or choice decisions of individual household, producers and firms.


Models that explain how prices and quantities exchanged are determined in various types of market structures.


Models that examine the market economy as an interrelated system (general equilibrium model).


Comparative statics focuses on the shift of

equilibrium positions for an individual decision unit, a market or an economic system.

Equilibrium refers to a state in which there is

balance of internal forces and no tendency for the situation to change unless outside forces intervene. A system in such an equilibrium may also be termed static.

Ex. A commodity reaches equilibrium at price Php

20. If demand will go up because of increase in population or extensive advertising effort, price would go up to Php 22. Comparative analysis is applicable here because of the shift in equilibrium.

Dynamic analysis focuses on the pattern and

rate of change for some variable between points in time.

Ex. There is dynamic analysis if the model will state

that the price of commodity would increase in a weeks time.


Partial Equilibrium Analysis
This compares equilibrium changes for one decision

unit or one market, independent of related changes in the economic system.

It assumes that, for the purpose of analysis, other

factors will remain the same (ceteris paribus).

General Equilibrium Analysis

This recognizes the interdependence of all decision

units and all markets in the economic system. All variables are allowed to adjust in response to the initial change.

Here, demand will not only depend on one variable

like price. It will also depend on several other factors like income, population, advertising, promotion and the like.

The Circular Flow of

Economic Activity:
Basic activities: Production Consumption

Income generation

Householdconsuming unit
Firm producing unit

Circular Flow of Economic Activity

The consumers pay for the goods and services

provided by the business firms. The business firms/producers on the other hand, pays the consumers/resource owners for labor, land or capital used for the operation of their business.

Economic issues that a nation should address:

1. What to produce?
2. How much to produce? 3. How to produce?

4. For whom to produce?

What to produce?
The country should identify the type of goods

that the society or the nation desires.

Since the resources are limited, no economy is

able to produce all the product that the people in the nation desires.

This is why a country should identify the goods

that are most useful for the country.

How much to produce?

This would refer to the quantity of each good that

will have to compose the total output. How much of the decided products to be produced will be produced.

How to produce?
This refers to the technique of production and the

manner of combining resources to come up with desired output.

This involves the materials to be used. Will the

process involve more labor or more machinery?

For whom to produce?

This refers to the market of the producers. Who

will buy the products? Will the goods and services be sold to high income groups or to poorer buyers, to women or men?

Types of Economic System:

1. Traditional
2. Command 3. Market Systems

Traditional Economic System

Production decisions are made according to

customs and traditions.

Example: A farmer engaged in the production of

rice does exactly what his father did when he planted rice 20 years ago.

Such system does not allow progress to be

introduced in the production techniques. This is normally practiced in underdeveloped regions, especially in areas where transportation and communication are nonexistent.

Command economies:
The answers to the economic problems are

dictated by the government through the head of the nation or a group of men designated by the head to make decisions.

The government owns and controls the factors of


The system works on the principle that the

interests of the society should prevail over that of the individuals.

Here, the consumers freedom of choice are

curtailed and this does not enable him to participate in the decision-making process. Individual preferences are not considered at all.

Market system:
This deals with economic problems by

considering consumers choices. The indicators are consumers demand in the market, reflected in the prices of goods and services.

The market serves as signals to the producers

about what goods to produce and how much of these goods should be produced.


Market system is best described as characterized

by free enterprise where individuals enjoy the right of private property.

It places high value on individual freedom and

allows self-interest to be the motivating force.

Under the free enterprise, individuals are allowed

to do any of the following:

Purchase goods and services of his choice within

the limits of his income. Offer for sale his economic resources in exchange for financial remuneration. Establish a business enterprise of his choice for the production and sale of a desired product.

The market economy is an economy where

individuals exercise free enterprise.


It is seldom that an economic system exists in its

pure form. While the US exercises market economy, there is a form of government regulation and control.

China is known to exercises command economy

but it may have adopted other economic systems in certain occasions.

Philippines adopts the 3 types of economic system: Traditional a system used in isolated barrios Command although Filipinos exercise the market system, they are also influenced by government decisions, regulations and laws. 3. Market Filipinos exercise the different activities under the free enterprise system.
1. 2.