CHAPTER 1 INTRODUCTION TO ECONOMIC THEORY

Terms to Remember
Basic needs-man's needs required for his survival Luxury goods-goods that man can do without
Economic resources-inputs used in the pro duction of goods and services
Land-natural-resources, not man-made, covering anything found on or under land, including water, forests,
minerals, and animals
Labor-human- effort expended in product ion regarding basic economic problems
Entrepreneur - organizes all other factors of production to be used in the creation of goods and services
Capital-materials used in the production of goods and services includials money
Theory/Hypothesia- an unproven propo sition tentatively accepted to explain certain facts or to provide a
basis f further investigation
Variable- a factor that is subject to change or variations
Macroeconomics - the branch of Economics that studies the economy as a whole, also known as National
Income Analysis
Microeconomics - the branch of Economics that deals with parts of the economy such as the household and
the business firm. It is also known as Price Theory.
Normative economics-an analysis of econo mics which deals with what should be
Positive economics- an analysis of econo mies which deals with what actually is
Empirical validation -the use of statistical evidence to prove the validity of the hypothesis
Economic system - the means by which an economy reaches decisions

Introduction to Economic Theory

Free enterprise system-a aystem in which all economic resources are privately owned. Individuals are free to
engage in a business of their choice.
Right to private property- the right of pri vate individuals and enterprises to own things of value
Market - context in which buyers and sell era buy and sell goods, services, and resources
Economic system -the framework in which a society decides on its economic problem
Wants-the various desires and needs of consumers that have to be satisfied through the use of goods and
services
Function-depicts the relationship between two or more variables. It shows how Ins one variable, called the
dependent var iable, depends on another variabile or variables, called the independent var iables. For
example, the demand fune. tion shows how demand, the dependent the variable, varies according to a change
the in price, the independent variable.

The study of the economic has widend to encompass a wider scope of topics
1. Economics studies how prices of land, labor, and capital are determined, and how these prices are used to
allocate scarce resources
2. Economics looks into the behavior of financial market and how they allocated capital to the rest of the
economy.
3.Economics looks into the distribution of income and into ways of helping the poor without causing harm to
the coun try's economic performance.
4.Economics studies the impact on growth of government spending, taxes, and budget deficits.
5.Economics examines the movements in income and eployment during the different stages of the business
cycle with the goal of developing govern ment policies that will improve econo mic growth.
6. Economics looks at trade patterns among nations and analyzes the impact of trade barriers, Flumin
7.Economics examines growth in deve loping countries and suggests ways to encourage the efficient use of resources.

ECONOMIC ACTIVITY
Man's Best Economic Activity
Man's basic economic activity consists of efforts to satisfy human wants with the the of goods and services.
The first is human wants. The best description that can be made of wants is that they are unlimited. Human
wants vary, from the needs for survival otherwise known as basic needs (e.g. food, clothing, and shelter), to
higher needs for a comfortable and more meaningful life. In addition, man is subject to created wants,
developed due to the effects of advertising and demonstrative effects of consumption. Economics is
concerned with the satisfaction of many of these human wants especially the basic ones.

The second element is the use of resources. The basic economic resources of a nation consists of land, labor,
capital, and entre preneurship. Since these items are available in limited amounts, man has to learn to allocate
them properly in order to maximize the number of wants that can be satisfied. The economy should pay the
owners of these basic factor of production for the use of their resources such as rent for the land, wage or
salary for labor, interest for capital, and e profit for entrepreneurship.

The last element is the technique of production which shows how resources are used and combined in
production. Thus, production is described as capital intensive or labor-intensive depending on what factor is
predominantly used.

CONSUMPTION
The household is the basic consuming unit in the economy, Since human wants are unlimited, it maximizes its
satisfaction through the proper allocation or mix of expenditures within the context of budget limitations. The
opportunity foregone is called opportunity cost, defined as the value of a foregone alter native of a specific
resource. This oppor tunity cost may also be exemplified in the earning value of a university ground had it
been used as a commercial center instead of educational institution.

The business firm serves as the eco nomy's producing unit to satisfy human wants with goods and services.
The use of resources generates income for the resource-owners. The owners of a land on which a factory is
constructed charges rent for the use of his property.

Some Economic Problems

1 Unemployment of labor or other re sources:
2. Economic instability that causes high and lows in production and investment levels;
3. Low levels of growth and development, which make it more difficult for under developed and developing
nations rise from their low levels of income and employment:
4. Inequality in income distribution resull ing in the concentration of the nation wealth in the hands of a few;
and
5.Determination of the type of economic systems to adopt to fit the country's peca liar conditions and needs.

Unemployment is a problem because leads to the existence of idle resources. The means that income is
foregone on resou ces which would generate earnings to thi owner if used.
Make accurato forecasts on demand and consumption levels. This would cause fluc tuations in their
production and supply of goods and services resulting in surpluses or shortages of the goods, countries
especially suffer from low levels of economic growth and development. They get caught in the vicious cycle of
poverty making it dif ficult to get started on their development take-off. Their low levels of income deter them
to channel funds to investments in order to propel economic growth, On the other hand, the problem of un
equal income distribution exists when too many people in the nation belong to the low income group causing
a pyramidal struct ure in the economy. The base which is made up of the majority of the population are the
low income earners who may only to satisfy their basic needs. The wealth of the nation is concentrated in a
small number of families who control the bulk of the count purchasing power and who can afford to ride in
gasoline-guzzling limousines, travel to Europe when they want to take a break, and 20 = their wardrobes with
the most expensive creation of the world's most famous countries

Economic Analysis and Economic Policy

Economic analysis is the process of dir ecting economic relationships by examining economic behavior and
events, and deter mining the causal relationships among the data and activities observed.
On the other hand, the economic analyst must statistics to quantitatively describe economic behavior and
therefore serves as a basis in hypothesis testing. A hypothesis becomes a principle or theory when empirically
validated.The third tool of economics is mathe mustics which enables the analyst to concep tualize and
quantify a hypothesis for empi rical validation.

Purposes Of Economic Purposes

1. Economic analysis is an ald in understanding how economy operates because it explains how economic
variables are related to one another
2. It permits predictions of the results of changes in the economic variables
3. It serves as basis of policy formulation

Economic Policy
Economic policy consists of intervention or courses of action taken by the government or other private
institutions to manipulate the results of economic activity. The econo mic policy adopted by the government
may be monetary, fiscal, or trade for the purpose of achieving economic welfare.

The Construction of Economic Theory

Any set of principles, or theory, must have a bedrock starting points consisting of propositions or conditions
that are taken as given that is, as being so without fur ther investigation. These we call the pre- mises or
postulates upon which the theory is erected. In aero- dynamics the farces gravity, the operation of centrifugal
force, and air resistance may be among the pos-gether, tulates of a theory involving lift, thrust, and drug. In
economics we may build a theory of consumer behavior on the postulate of consumer rationality, defined as
the gen eral desire of consumers to secure as much satisfaction as they can in spending their incomes. The
first step, then in the cons truction of a thonry in the specification and definition of its postulates.
The second step is the observation of "facts" concerning the activity about which we want to theorize.
As facts emerge from continued and repeated observation, it will become apparent that some are rele- vant
and can be discarded while others are obviously significant.
In the grocery exchange case, the hair color of consumer is not likely to matter, but the weekly amounts of
money that consumers have to spend, the number of supermarkets available to them, and the weekly
quantities of groceries available to be purchased will most certainly be impor- tant.
The third step- and this one will fre quently be taken concurrently with the second is the application of the
rules of logic to the observed facts in an attempt to establish causal relationship among them insignificant
facts as possible. Deductive chains of logic may believe that certain effects follow certain causes in a regular
manner. We may reason that because con sumers with larger incomes are willing to pay higher prices for
specific goods, an increase in consumer incomes is likely to lead to higher prices. Or, on the other hand, we
may reason inductively. Repeated observations may indicate that increases in consumer incomes and
increases in con f sumer incomes and increases in prices occur simultaneously. So, putting two and two
together, we reach the tentative conclusion that higher incomes cause prices to rise. Such tentative
statements of cause and effect relationships are called hypotheses.
 The fourth step in the process of estab lishing a set of principles is a crucial one. Once hypotheses have been
formulated, they must be thoroughly tested to determine the extent of which they are valid, that is, the extent
to which they yield good explanations and predictions. The tools of statistics and econometrics are of
particular value in this respect. Some hypotheses will not withstand the rigors of repeated testing, and conse
quently, must be rejected. Others may look promising with modifications then, the modi fied hypotheses must
be tested. Still other hypotheses may be found to hold up most of the time in most of the circumstances to
which they are relevant. These we usually refer to as principle.
It would be foolish to regard a set of principles or a theory as absolute truth. The testing process in economics
and in other sciences never ends.

The Functions of Economic Theory

The principal functions of economic theory fall into two categories: (1) to explain the nature of economic
activity and (2) to predict what will happen to the economy as facts change. The explanation of the nature of
economic activity enables us to under stand the economic environment in which we live - how one part
relates to others.

Economists distinguish between positive and normative economics. Positive economics is supposed to be
completely objective, limited in to cause-and-effect relationships of economic activity. But if economic policy-
making is to be effective it must obviously be rooted in sound positive analysis. Policymakers should be
cognizant of the full range of consequences of policies they recommend.
PRICE THEORY AND ECONOMIC THEORY
Theory of the economy as a whole (macro economic theory) and microeconomic theory are essential to a
thorough understanding of economic activity. Principles of both are applied to special subject areas such as
monetary economics, international finance, public finance, agricultural econo mics, regional economics.

Microeconomics is concerned with the impact of economic activities on individual economic units such as
consumers, re source owners, and business firms. It is con cerned with the flow of goods and services from
business firms to consumers, the composition of the flow, and the process for establishing relative prices.

Macroeconomics treats the economic system as a whole rather than the individual economic units of which it
is composed. Value of the overall flow of goods and services (net national product) receive the focus of
attention in macroeconomics, but are not integral part of the analysis.
Price theory is abstract because it does not and cannot encompass all the economic data of the real world.
Price index numbers or general price level concepts in macroeconomics replace the relative-price concepts for
individual goods used in microeconomics. In elimi nating less important data and in building up logical
theoretical structure, we lose some contact with reality.
Price theory is an attempt to explain why economic units tend to move in the direction they do. The
abstraction and precision of theory are essential to clear thinking and to policy making in the real world. But
we should guard against the notion that it provides an unqualified description of reality.

Characteristics Of Microeconomics
Microecono mies is concerned the with the process of resource allocation by individual decision units or
markets. It is also concerned with efficiency with which these resources are allocated. From this definition,
some charac teristics can be deduced, among them are:.
1. Microeconomics looks at the decisions of individual units. It focuses on the choices made by individual
decision units such as households, producers,and firms. Resource allocation decisions are made by these
individual entities in a market economy. It is necessary to understand their decisions in order to understand
our economic system.
2. Microeconomics looks at how prices are determined. It is concerned with how prices are determined in
various types of market structures such as pure com petition, monopoly, monopolistic com petition, and
oligopoly. Micro-econo mics is often called, "price theory".
3. Microeconomics is concerned with social welfare. It also examines the efficiency, relative desirability, and
choice of alternative methods by which resources are utilized to alleviate scarcity. This branch of
microeconomics is termed "welfare economics".
4. Microeconomics is just a part of the economics discipline. It does not exam ine the processes or efficiency of
allo cation in alternative types of economics systems. Neither does microeconomics focus on other economic
issues, such as aggregate level of emplement of resources.
5. Microeconomics develops skills. The study of microeconomics helps to deve lop a set of useful and
marketable skills
a. Microeconomics helps you develop your logical reasoning.
b. Microeconomics will help you dev elop skill in the construction and use of models. This is one of the major
skills economists offer to the business community.
C. Microeconomics employs optimi zing techniques that are useful for making decisions in a variety of
situations.
d. The concepts studied in microeco nomics are applicable to personal resource allocation decisions, such as
your career choices or financial investments.

Economic Models
Economic models are composed of a series of statements of assumptions or given and statement of
implications or deductions. The statement described the essential features of an item or process and the inter-
relationships between factors or variables model. Microeconomics makes extensive use of modeling,
comparative statics, and ma thematics.
The supply and demand relationships could be expressed in three different forms: verbal (or logical),
mathematical, and gra phical. The above-described law of supply can be expressed succinctly in an equation.
Prices and quantity offered for sale are directly related; the higher the price, the more supply, the lower the
price.

General equilibrium analysis 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. This attempt to include
all possible varis bles that would affect demand would fall under the general equilibrium analysis.

The economy is the sum of the activities of production, consumption, employment, and income generation.
The house hold is the product of the interrelationship existing between the B basic consuming unit, the house
hold and the basic producing unit, which is the firm.

Partial vs. General Equilibrium

Partial equilibrium analysis compared equilibrium changes for one decision unit or one market independent of
related changes in the economic system. General equilibrium analysis recognizes the interdependence of all
decision units and all markets in the economy. All variables are allowed to adjust in response to the initial
change.

The circular flow shows the flow of economic resources from the household to the firm. The financial flow,
which is the money flow, is depicted in the money payment by the firm to the household. The goods flow, or
goods and services flow, shows the physical exchange of goods and materials.

Basic Economic Problems

All nations, big or small, developed and underdeveloped
What to produce is a question of the types of goods society desires. Will a country produce rice, coconuts,
bananas or manu facture bags, shoes and garments? Or if a country is preparing for war, should it concentrate
on the manufacture of ammu nitions, rocketships, nuclear weapons, etc? Since resources are scarce, no
economy can produce every product desired by the mem bers of society. What materials will be used? Will
production involve the use of more labor or machinery? How will the available resources be combined to
come up with the most efficient output of shoes?

For whom to produce refers to the mar ket to which the producers will sell their products
Hence, an economic system, in answer ing the needs of the society, has the function of determining what
goods and services to produce as well as the order of their importance. This will naturally depend on the
needs of the economy as well as its goals and objectives.In addition, the economic system has to perform the
task of organizing productive efforts to produce the selected goods and services in the proper quantities.
Economic System
Economic systems may be classified as traditional, command, or market systems.
the answers to the basic comic problems are dictated hy the government through the head of the nation or a
group of men designated by the head to ake the decisions.
In such a case, the consumers freedom of chole is curtailed and does not coable him to partiopate in the
decision making process with regard to the answers to society's basic coonopie problems Furs thermare,
decisions regarding the distri bation of goods te in the hands of the ger erament, and hence individual
preferences are not considered at all.
The indicators are consumers desiand in the market as reflected in the prices of goods and services.
The market prices serve as signals to the producers about what goods to produce and how much of these
goods should be produced High prices indicate that goods are in demand and serve as go signals for
production.
The problem of production is, therefore, solved by the prize mechanism.
The Market System and the Enterprise
The market aystem is the best described as characterized by free enterprise where individuals enjoy the right
of private .
The economy operates on a systemat dveluntary exchange and cooperation among e private individuals and
organizations It =places a high value on individual freedom and allows self-interest to be the motivi ting force.

Under the free enterprise system, the f individual is free to do any of the following
1. Purchase goods and services of his choice within the limits of his income
2. Offer for sale his economic resources t exchange for a financial remuneration,
3. Establish a business enterprise of his choice for the production and sale of desired product.

Under the market economy, the con sumer is free to buy goods of his choice as long as he has the purchasing
power to de so.He may buy any quantity of a good with his income as long as there is an unlimited supply of
that good in the market.The individual is also free to offer his resources for use by other people in order ta
earn income. Any individual with sufficient capital, proper motives, and entrepreneurial skills is also free to set
up a business of his own to provide consumers with goods and services of their choice. Briefly described, the
market economy is an economy where individuals exercise free enterprise.

The Mixed Economy

The Philippine economy is a mixture of the three forms of economic systems discus sed. While most buyers
and sellers are influenced by the price system, it cannot be denied that the government plays a significant role
in decision-making with regard to production, business, and industry. Predominantly, the Philippine eco nomy
is free enterprise in nature, but the best way to describe our economic system is a mixed economy.
CHAPTER 2 DEMAND AND SUPPLY
Terms to Remember
Market- a place were buyers and sellers in teract and engage in exchange
Demand-reflects the consumer’s desire for a commodity
Supply-the amount of a commodity available for sale
Aggregate demand-the totality of a group of consumer’s demand
Aggregate supply-the tota;ity of a group of producer;s supply
Demand schedule-the quantities consumers are willing to buy a good at various prices
Supply schedule-the quantites producers are willing to offer for sale at various prices
Movement along the curve-a change from one point to another on the same curve
Shift of the curve-a change in the entire curve caused by a change in the entire demand or supply schedule
Nonprice factors-also known as parameters, are factors other than price that also affect demand or supply
Demand function-show how quantity demanded is dependent on its determinants
Supply function-shows how quantity supplied is dependent on its determinants
Equilibrium-condition of balance or equality
Price ceiling- is the maximum limit at which the price of a commodity is set
Price floor- a minimum limit beyond which the price of a commodity is not allowed to fall
Surplus-an exess of supply over the demand and for so good

The Market Mechanism

A market is a mechanism through which buyers and sellers interact in order to determine the price and
quantity of a good or a service. In the market system, prices serve as signals to both the producers and the
consumers. Rising prices encourage producers to increase the supply of the good. High prices are therefore a
green light to producers since these normally mean rising profit margins.

If a good is overstocked, sup pliers of this good will lower their prices so they can dispose of their excess
supply. What will ensue is the restoration of equi librium between the buyers and sellers.

Demand Schedule and Demand Curve

The demand for a product is defined as the quantity that buyers are willing to buy. The demand schedule
shows the quantity of the product demanded by a consumer or an aggregate of consumers at any given price.
Higher prices influence people to buy less so the demand function shows how the quantity demande of a
particular good responds to price change.

Demand and Supply

The normal demand curve slopes down ward from left to right, and any point on the demand curve reflects
the quantity that will be bought at the given price. The demand curve is a graphical presen tation of the
demand schedule and there fore, contains the same prices and quantities.

THE LAW OF DEMAND

After analyzing the above relationship, we can now state that as price increases, the quantity demanded of the
product dec reases, but as price decreases, the quantity purchased will instead increase.

Ceteris Paribus Assumption

The Law of Demand states that there are factors other than price which also influence the quantity of
demand, namely: tastes and preferences, income, expectation on future prices, and the size of the population.
The functional rela tionship between price and quantity demanded is essential since these nonprice factors are
assumed as constant. Price and quantity deman ded are inversely proportional.

THE LAW OF SUPPLY

In the theory of demand there are nonprice determinants that influence supply, these include cost of
production, availability of economic resources, number of firms in the market, and technology applied. Under
the ceteris paribus assumption, these factors are again assumed constant to enable us to analyze the effect of
a change in price on quantity supplied. The law of supply now states, "order things assumed as constant, price
and quantity supplied are directly proportional".

Market Equilibrium
Demand and supply should eventually be analyzed as one since the market ope rates within the forces of both
demand and supply. This is exactly what a British eco nomist, Alfred Marshall, has in mind when t he he
combined the Law of Demand and Supply into one law. There is only one point in the graph where demand is
exactly equal to supply. This point of equality is the equilibrium Curves point. A low price will attract the
buyers to bid for more while a high price will discourage sellers from offering more goods at the same price.

Shifts to Both the Demand and Supply

The equilibrium price is the difference between the demand and supply curves for a given commodity. Shifts in
either the demand cura or the supply curve alone can cause a change in the equilibrium price. For example, a
rightward shift of the supply. curve with the original demand curve maintained, will result in a decrease in the
equilibrium price.

Hypothetical Shift in the Market Demand and Market Supply Curves

The equilibrium price is maintained at P3 per kilo. However, the new equilibrium point corres- ponds to a
bigger quantity which is now called beef, a rightward shift of the Shifts in Demand curve, with the supply curve
main, has caused the equilibrium price to.

The Dynamics of Demand and Supply

A price of P75 is equal to the quantity that consumers are willing to buy which is 1,500 kilos. A rightward shift
of the demand curve is shown in the preceding graph. This ref lects an increase in demand which resulted
from the increased wages.

Shift of Demand to the Right

shows the above reflects higher quantities demanded of beef at the price schedule ranging from P60 to P90 in
the graph. Since the price of a substitute good is nonprice determinant of demand, this will cause a shift of the
entire demand curve.

Shift of Demand to the Left

The downward shift of the demand curve has resulted in a new equi- librium price of P70 and a lower
equilibrium quantity of 1,250 kilos of beef. This new demand curve reflects lower quantities of beef purchased
at the various prices for meat.

Shift in Supply
A breakthrough in cow breeding technology results in an increased. supply of cows and more beef is now avail
able for sale in Manila. Figure 13 shows that the entire sup ply curve shifts to the right resulting in a new
equilibrium position: a lower equilib rium price of P65 and a higher equilibrium quantity of 2,000 kilos. A cow
pestilence in Mindanao results in a death of a considerable number of cattle and less beef is now available for
sale in Manila. This will result in a down ward shift of the supply curve as seen in Figure 15. Figure 15:
Equilibrium price of 580 kilos of beef is higher than the current equilibrium quantity of 1,000 kilos.

Simultaneous Shifts in Demand and Supply

Demand and supply curves undergo shifts simultaneously. As a result of the change in the nonprice
determinant, the supply curve has shifted to the left. This new supply curve S, ref- lects smaller quantities of
beef supplied at various prices. The above change has resulted in a new equilibrium position at a price of P75.

Violations of the Law of Supply and Demand

Law of Supply and Demand has been violated on several occasions by governments. In the black market,
consumers pay higher prices to enable them to buy extra bars of detergent.

CHAPTER 3 ELASTICITY OF DEMAND AND SUPPLY

Terms to Remember

Elasticity- the responsiveness of demand supply to a change in irs determinant

Price Elasticity-the percentage change in quantity compared between to a percentage change in price
Arc Elastisity-the coefficient of price elasticity demand between two points along the demand curves
Point Elasticity-the coefficient of orice elasticity of demand at one point along the demand curve
Coefficient of Elasticity-absolute value of elasticity
Income Elasticity of Demand-percentage change in quantity demanded compared to the percentage change
in income
Cross Elasticity of Demand-percentage change in quantity demanded of the good compared to the percentage
change in the price of a related good
Total Revenue-price multiplied by quantity
Inferior goods-good which are bought when income levels are low,the demand for which tends to decrease
when increases
Substitute Goods-goods used in a place of each other.
Complementary Goods-goods that supplement each other and are therefore used together.
Engel Curve-a curve depiciting the quantities of a good the consumer is willing to buy at all income
levels,assuming ceteris paribus
Inferior Goods-goods for which demand increases when income levels are low
Normal Goods-goods for which demand increases when income increases
Prestige Goods-are goods bought for the status and prestige they give to the concumer, and are bought when
the prices are high
Arc and Point Elasticity