basic economics compilation.docx
TRANSCRIPT
(with Taxation and Agrarian Reform) COMPILATION
INTRODUCTION
MEANING OF ECONOMICS
Adam Smith the forefather of the economists regarded economics as a science which studies the process of production, Consumption, distribution and exchange of wealth. According to him, Economics inquires into the factors those determine wealth of a country and its growth.
According to Prof. Marshall, economics is the study of mankind in the ordinary business of life. It examines that part of individual social action which is not most closely connected with the attainment and use of material requisites of well being.
Prof. Lionel Robbins gave his definition of economics in his book “ Nature and significance of Economic Science” in the year 1932 .He defined economics as the science that studies human behavior as a relationship between ends and scarce means which have alternative uses.
Economics is the study of how man and society choose, with or without the use of money to employ scarce productive resources, which could have alternative uses, to produce various commodities over time and distribute them for consumption now and in the future among various people and groups of society. Professor Samuelson ’s definition of economics
MANIFESTATION OF ECONOMICS AS A SUBJECT MATTER
The above – mentioned definitions of economics accorded by the well – known economists agreed on all the three important aspects: scarce resources, unlimited wants, and
maximum satisfaction.
Scarcity is the fundamental economic problem of having seemingly unlimited human wants in a world of limited resources. It states that society has insufficient productive resources to fulfill all human wants and needs. A common misconception on scarcity is that an item has to be important for it to be scarce. However, this is not true, for something to be scarce, it has to be hard to obtain, hard to create, or both. Simply, the production cost of something determines if it is scarce or not. For example, although air is more important to us than
diamonds, the former is cheaper because the production cost is zero. Diamonds on the other hand have a high production cost. They have to be found and processed, both which require a lot of money. Additionally, scarcity implies that not all of society's goals can be pursued at the same time.
The idea of want can be examined from many perspectives. In secular societies, want might be considered similar to the emotion desire, which can be studied scientifically through the disciplines of psychology or sociology. Want might also be examined in economics as a necessary ingredient in sustaining and perpetuating capitalist societies that are organized around principles like consumerism. Alternatively, want can be studied in a non-secular, spiritual, moralistic or religious way.
In economics, a want is something that is desired. It is said that every person has unlimited wants, but limited resources (economics is based on the assumption that only limited resources are available to us from the infinite universe). Thus, people cannot have everything they want and must look for the most affordable alternatives.
Wants are often distinguished from needs. A need is something that is necessary for survival such as food and shelter, whereas want is simply something that a person would like to have. Some economists have rejected this distinction and maintain that all of these are simply wants, with varying levels of importance. By this viewpoint, wants and needs can be understood as examples of the overall concept of demand.
SIGNIFICANCE OF ECONOMICS
As we mentioned earlier that economics is concerned with the satisfaction of human wants. Economics is related to production, consumption and distribution of resources in the economy among individuals. Nowadays, economics touches every one, whether you are a worker, a business owner, a teacher, a lawyer, a banker or a student. The study of economics point out two important advantages: theoretical and practical advantages.
As theoretical advantages, it helps us to understand the concept of national income, employment, consumption, savings, capital formation, investment, price mechanism, demand and supply and so forth. In addition, it also enables us to create and develop logical thinking towards various economic problems.
As practical advantages, economics provides a vital role for the following sections of our society such as:
Significance for the consumers Significance for the producers Significance for workers Significance for politicians Significance for academicians Significance for administrators Effective manpower planning Helpful in fixing price Solving distribution problems
BASIC ECONOMIC PROBLEMS
The basic economic problem is one of the fundamental economic theoretical principles in the operation of an economy. It asserts that there is scarcity; that is, that the finite resources available are insufficient to satisfy all human wants and needs. As such, the following questions must be considered:
What goods and services must be produced? How to produce the goods and services? For whom to produce?
What to produce is a question of the types of goods society desires. Will a country produce rice, coconuts, and corn or manufacture bags and ready to wear clothing? Or if a country is preparing for war, should it concentrate on the manufacture of ammunitions? Since resources are scarce, no economy can produce every product desired by the members of the society.
How to produce is a question on the technique of production and the manner of combining resources to come up with the desired output. Since a good can be produced with different factor combination and different techniques, the problem is which of these to use. The economy that had decided on the production of bags will also have to come up with the decision on how the bags will be manufactured. What materials will be used? Will production involve the use of more
labor or the use of more machinery? How will the available resources be combined to come up with most efficient output of bags?
For whom to produce refers to the market to which the producers will sell their products. It refers to how much of the wants of each consumer are to be satisfied. Will the bags be sold to high income earners or to low income earners? Will the target market be males, females, or children? Will the bags manufactured be exported or strictly to be sold within Philippines? This is a problem since resources and goods are scarce and no society can satisfy all the wants of its entire people.
Hence, an economic system, in answering 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.
Lastly, it must determine how these goods and services should be shared among the members of the society.
TYPES OF ECONOMIC SYSTEM
The economic systems are classified as follows:
1. Traditional is an economic system in which each new generation retains the economic position of its parents and grandparents. Traditional economies rely on the historic success of social customs.
2. Capitalism is an economic system in which trade, industry, and the means of production are largely or entirely privately owned and operated for profit. It is also known as market economy, free enterprise economy, or laissez faire economy.
Capitalism consists of two forms: pure capitalism and modified capitalism. The former means that all economic decisions are made without government intervention while the latter means that the government intervenes and regulates business to a certain extent.
The essential characteristics of capitalism are the following:
Private property Profit Economic freedom Free competition
3. Communism is an economic system in which the government owns all the nation’s resources. It is exactly the opposite of capitalism. It is also known as command economy.
The essential characteristics of communism are as follows:
No private property No free competition No economic freedoms No profit motive Presence of central planning
4. Socialism is an economic system where the major and strategic industries are owned and managed by the government. Examples are telecommunication, transportation, water services, and banking and selected manufacturing businesses. Private individuals are allowed, however to own and operate small businesses. Socialism is a combination of capitalism and communism. Therefore, it contains the characteristics of both capitalism and communism.
THE MIXED ECONOMY
A mixed economy is an economic system in which economic activity is directed by a mixture of private firms and the government.
In a mixed economy, some parts of the economy – known as the private sectors – are left to private firms and individuals, whereas other parts, such as education and the military, are controlled by the government. The activity controlled by the government is known as the public sector.
Mixed economies are the most common form of economic system used around the world, with most developed countries dividing economic activity between the private and public sectors.
It is seldom that an economic system exists in its pure form. While the economy of the United States of America is basically market – oriented, there exists some form of government regulation and control. On the other hand, the People’s Republic of China’s economy is command in nature, yet it cannot use the price system at all.
The Philippine economy is a mixture of three forms of economic systems. In the mountains and isolated barrios, most farmers are still traditional in their production methods. 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. The existence of price control, strict government regulations, government support, and subsidy programs are proofs of the importance of government participation in decision- making in the country’s production activities. In a mixed economy like ours, the question of what to produce and how to produce, answered predominantly through the price mechanism, is modified through government intervention in the form of direct controls, taxes, and subsidies.
The problem of for whom to produce is also solved by the price – mechanism coupled with different forms of government regulation. The economy will produce those commodities that will satisfy the wants of those people who have the money to pay for them. Predominantly, the Philippine economy is a free enterprise in nature, but the best way to describe our economic system is a mixed economy.
ECONOMIC GOALS
Economic growth Employment Economic efficiency Price level stability Economic freedom Equitable distribution of income Economic security Balance of trade
THE ECONOMIC RESOURCES
Economic resources are the goods or services available to individuals and businesses used to produce valuable consumer products. It includes land, labor, capital, and entrepreneurship.
Land is the economic resource encompassing natural resources found within a nation’s economy. This resource includes timber, land, fisheries, farms and other similar natural resources. Land is usually a limited resource for many economies. Although some natural resources, such as timber, food and animals, are renewable, the physical land is usually a fixed resource. Nations must carefully use their land resource by creating a mix of natural and industrial uses. Using land for industrial purposes allows nations to improve the production processes for turning natural resources into consumer goods.
Labor represents the human capital available to transform raw or national resources into consumer goods. Human capital includes all able-bodied individuals capable of working in the nation’s economy and providing various services to other individuals or businesses. This factor of production is a flexible resource as workers can be allocated to different areas of the economy for producing consumer goods or services. Human capital can also be improved through training or educating workers to complete technical functions or business tasks when working with other economic resources.
Capital has two economic definitions as a factor of production. Capital can represent the monetary resources companies use to purchase natural resources, land and other capital goods. Monetary resources flows through a nation’s economy as individuals buy and sell resources to individuals and businesses
.Capital also represents the major physical assets individuals and companies use when producing goods or services. These assets include buildings, production facilities, equipment, vehicles and other similar items. Individuals may create their own capital production resources, purchase them from another individual or business or lease them for a specific amount of time from individuals or other businesses.
Entrepreneurship is also considered an economic resource because individuals are responsible for creating businesses and moving economic resources in the business environment. These economic resources are also called the factors of production. The factors of production describe the function that each resource performs in the business environment.
DIVISION OF ECONOMICS
Macroeconomics (from the Greek word makro- meaning "large" and economics) is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole, rather than individual markets. This includes national, regional, and global economies.
Macroeconomists study aggregated indicators such as GDP, unemployment rates, and price indices to understand how the whole economy functions.
Macroeconomists develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, international trade and international finance.
Microeconomics (from Greek word mikro- meaning "small" and economics) is a branch of economics that studies the behavior of individuals and small organizations in making decisions on the allocation of limited resources. Typically, it applies to markets where goods or services are bought and sold. Microeconomics examines how these decisions and behaviors affect the supply and demand for goods and services, which determines prices, and how prices, in turn, determine the quantity supplied and quantity demanded of goods and services.
One of the goals of microeconomics is to analyze market mechanisms that establish relative prices amongst goods and services and allocation of limited resources amongst many alternative uses. Microeconomics analyzes market failure, where markets fail to produce efficient results, and describes the theoretical conditions needed for perfect competition. Significant fields of study in microeconomics include general equilibrium, markets under asymmetric information, choice under uncertainty and economic applications of game theory. Also considered is the elasticity of products within the market system.
CIRCULAR FLOW OF ECONOMIC ACTIVITY
In economics, the term circular flow refers to a simple economic model which describes the reciprocal circulation of income between producers and consumers. In the circular flow model, the inter-dependent entities of producer and consumer are referred to as firms and households respectively and provide each other with factors in order to facilitate the flow of income. Firms provide consumers with goods and services in exchange for consumer expenditure and factors of production from households.
BASIC ECONOMIC ACTIVITIES
Production is the use of economic resources in the creation of the goods and services for the satisfaction of human wants.
Consumption in economics, the use of goods and services by households.
TWO ECONOMIC UNITS
Household is the basic consuming unit. Firm is the basic producing unit.
STOCK AND FLOW CONCEPTS
Stock refers to the measure of quantity at a point of time. Flow refers to the measure of movement of quantity over a period of time.
Illustration:
If you deposit Ᵽ1,000 at the end of every month into your bank account, you would have a balance of Ᵽ12,000 (Ᵽ1,000 x 12 months) at the end of the year. The monthly deposits are flows and the year-end balance is a stock which accumulates the flows. We can call the monthly deposits saving as flows and the year-end balance savings as stocks.
Flows: GDP, consumption, investment, saving, trade deficit and surplus, budget deficit and surplus, aggregate demand and supply.
Stocks: Debt, infrastructure, buildings, wardrobes, memories, library, circulating currency, computer software and hardware, databases, cars in your garages, antiques.
THE CIRCULAR FLOW OF GOODS, SERVICES, AND INCOME
FIGURE 1
PRODUCTION PROCESS
The process of producing goods and services. Involves households and firms. Economic resources such as: land, labor, and capital are provided by the households. Economic resources are processed and produced by firms. Produced goods and services are delivered to households for consumption.
THE FLOW OF OUTPUT BETWEEN FIRMS AND HOUSEHOLDS
ECONOMIC RESOURCES
HOUSEHOLDS FIRMS
GOODS AND SERVICES
FIGURE 2
The above – mentioned illustration provides us and idea about the flow of raw materials, intermediate goods and final goods. Raw materials are goods which are still unprocessed like wood, sand and gravel, and iron ore. These goods are produced by raw materials producers. Intermediate goods are partially processed goods like steel bars used for construction and flour used in baking. These goods are produced by intermediate goods producers. Final goods are processed goods that are ready for final consumption like ready to wear clothing, appliances, and gadgets. These goods are produced by final goods producers.
THE CIRCULAR FLOW OF GOODS AND INCOME AMONG PRODUCERS AND HOUSEHOLDS
RAW MATERIAL PRODUCERS
INTERMEDIATEGOODS PRODUCERS
FINAL GOODS PRODUCERSHOUSEHOLDS
FIGURE 3
The circular flow of goods and income among producers and households describes the distribution of economic resources made by the households among the various types of producers or firms. In return, the respective producers (raw materials firms, intermediate firms, and final goods firms) will provide payments to households for the use of the economic resources.
In relation thereto, once the goods are finally processed, these goods are delivered to the households for consumption. In this case, the households will give payments to the respective producers.
(See Figure 3)
THE CIRCULAR FLOW OF INCOME BETWEEN HOUSEHOLDS AND FIRMS
HOUSEHOLDS
RAW MATERIALS FIRMS
INTERMEDIATE GOODS FIRMS
FINAL GOODS FIRMS
RESOURCES
RESOURCES
RESOURCES
FIGURE 4
FIGURE 5
The circular flow of income between households and firms is a theory that describes the movement of expenditure and income.
HOUSEHOLDS FIRMS
INCOME FLOW (e.g. purchase
of goods and services)
INCOME FLOW (e.g. salaries,
rentals, and interests)
For example, households provide factors of production such as land, labor, and capital to firms. Firms use these factors to produce goods and services which they sell to the households.
The households then spend money on the goods and services produced by local firms. This money is then used by firms to pay the households for their land, labor, and capital. The households in this case will earned rental income, salaries, and interest income. This process repeats itself and forms the circular flow of income.
However, not all income generated will be spent. In reality, some of the income is being saved, used to pay government taxes, and or used to purchase imported goods from other countries. Therefore savings, taxation and imports are leakages in the circular flow of income. Leakages are the non-consumption uses of income, including saving, taxes, and imports.
Likewise, sometimes there is extra spending in the economy, from investment, government expenditures and payments for exports, which will be added to the circular flow of income. These are called injections. Injections come from investment, government spending and export sales.
THE CONCEPT OF EQUILIBRIUM
The economy will be in equilibrium if the amount received by firms from households is equal to the amount received by households from firms. Disequilibrium happens when either households or firms do not spend all their incomes. If households, for one reason or another, reduce their purchases, firms will receive a reduced amount of income resulting to their inability to maintain current levels of purchases from households. When firms actually reduce their purchases of economic resources, some laborers will lose their jobs, and some land and physical capital will become idle. The result is a corresponding reduction in the income of households.
BASIC ELEMENTS OF DEMAND AND SUPPLY
This chapter discusses the interaction between buyers and sellers in a market economy. Properly framed, almost any economic question can be approached from a supply and demand perspective; because resources are limited but wants are unlimited, the magic of the market is to direct signals between people who are looking to consume and people who are looking to produce. Our implicit assumption is that prices carry this information between buyers and sellers, and hence prices are discussed as the most important factor determining behavior on both sides of the market.
THE MARKET
A market is one of the many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services (including labor) in exchange for money from buyers. It can be said that a market is the process by which the prices of goods and services are established.
For a market to be competitive there must be more than a single buyer or seller. It has been suggested that two people may trade, but it takes at least three persons to have a market, so that there is competition in at least one of its two sides.
MARKET DEMAND
Market demand refers to the buyers’ willingness and ability to pay a sum of money for some amount of a particular good or service. However, the quantity demanded of goods or services will depend on factors such as needs, preferences, income level, and expectation about the future, the prices of related commodities, the buyer’s situation and so forth. The most important consideration, however, is the price. The relationship between price and quantity demanded is the subject of the law of demand.
The law of demand states that other factors being constant (ceteris paribus), price and quantity demand of any good and service are inversely related to each other. When the price of a product increases, the demand for the same product will fall.
Other factors that can influence demand:
1. Income - Generally, as income increases, we are able to buy more of most goods. Demand for a good increases, when incomes increase, we call that good a normal good. When demand for good decreases when incomes increase, then that good is called inferior goods.
.2. Price of related products - Related goods come in two types, the first of which are
substitutes. Substitutes are similar products that can be used as alternatives. Examples of substitute goods are Close Up and Colgate, and Safeguard soap and Bioderm soap. Usually, people substitute away to the less expensive good. Other related products are classified as complements. Complements are products that are used in conjunction with each other. Examples of complements are pencil and eraser, left and right sandals, and coffee and sugar.
3. Tastes and preferences - Tastes are a major determinant of the demand for products. People of different cultures vary in taste and preferences. A large ethnic group, for instance, has a taste for mixing their food with strong dose of spices. Some group of people prefers to spend a large part of their incomes on luxuries even if basic necessities are not satisfied.
4. Size of the market – The demand curve is affected by the number of people living in a given area. A market with a big population like Metro Manila tends to buy more appliances and electricity than a less populated region like Cagayan Valley.
5. Special Influences – There are certain developments that influence demand for certain goods and services. Heat and humidity, for instance, contribute to the demand for air conditioning equipment and light clothing.
6. Expectations about future economic conditions - When you expect the price of a good to go up in the future, you tend to increase your demand today. This is another example of the rule of substitution, since you are substituting away from the expected relatively more expensive future consumption. E.g. expectations about a forthcoming war or typhoon.
DEMAND SCHEDULE AND DEMAND CURVE
Demand schedule shows the quantity of the product demanded by a consumer or an aggregate of consumers at any given price. From our daily experience of buying and selling, we know that the higher prices influence people to buy less. Therefore, the demand function shows how the quantity demanded of a particular good responds to price change. In addition, the demand schedule must specify the time period during which the quantities will be bought. This is best illustrated in Table 1.
Table 1
Price of X(per kilo)
Quantity Demanded( in kilos)
Ᵽ454035302520
100150200250300350
The quantity demanded values are rates of purchases at alternative prices. It can be seen from Table 1 that at lower prices of X, people get attracted to buy more.
The demand curve is a graphical presentation of the demand schedule and therefore, contains the same prices and quantities presented in the demand schedule. Plotting the data from Table 1, we now arrive at figure 6.
The normal demand curve slopes downward from left to right. Any point on the demand curve reflects the quantity that will be bought at the given price. The price per unit is represented in the vertical axis, while the quantity demanded for each price level is indicated in the horizontal axis.
Ᵽ 45
40
Price 35
30
25
20
100 150 200 250 300 350
Quantity demanded (in kilos)
FIGURE 6
CHANGES IN DEMAND vs. CHANGE IN QUANTITY DEMANDED
Changes in demand refer to changes in the determinants of demand like income, population, price expectation, and so forth. For instance, an increase in population also increases demand for goods and services, or a decrease in income also reduces demand. In a graph, an increase in demand shifts the demand curve to the right while a decrease in demand shifts the demand curve to the left as shown in figure 7.
PRICE D3 D1 D2
QUANTITY
Changes in quantity demanded indicate the movement from one point to another point (from price- quantity combination to another price- quantity combination on a fixed demand curve). This means the demand curve does not change its position like that of the demand curve
in the changes in demand. The change in quantity demanded is brought about by changes in price. Whenever there is a change in price (increase or decrease), there is corresponding change in quantity demanded. For example, lower price results to more units of goods. In the case of change in demand, it caused by changes in the determinants of demand. Change in quantity demanded is graphically illustrated in Figure 8.
P Demand
Quantity
MARKET SUPPLY
Supply is the quantity of a good or service that a producer is willing and able to supply onto the market at a given price in a given time period.
The law of supply states that as the price increases, the quantity supplied also increases, and as the price decreases, the quantity supplied also decreases.
SOME FACTORS AFFECTING SUPPLY:
1. Costs of production
A fall in the costs of production leads to an increase in the supply of a good because the supply curve shifts downwards and to the right. Lower costs mean that a business can supply more at each price. For example a firm might benefit from a reduction in the cost of imported raw materials.
If production costs increase, a business will not be able to supply as much at the same price - this will cause an inward shift of the supply curve. An example of this would be an inward shift of supply due to an increase in wage costs.
2. Changes in production technology
Technology can change very quickly and in industries where the pace of technological change is rapid we expect to see increases in supply (and therefore lower prices for the consumer)
3. Government taxes and subsidies
Government intervention in a market can have a major effect on supply. A tax on producers causes an increase in costs and will cause the supply curve to shift upwards. Less will be supplied after the tax is introduced.
A subsidy has the opposite effect as a tax cut. A subsidy will increase supply because a guaranteed payment from the Government reduces a firm's costs allowing them to produce more output at a given price. The supply curve shifts downwards and to the right depending on the size of the subsidy.
4. Climatic conditions
For agricultural commodities such as coffee, fruit and wheat the climate can exert a great influence on supply. Favorable weather will produce a bumper harvest and will increase supply. Unfavorable weather conditions such as a drought will lead to a poor harvest and decrease supply. These unpredictable changes in climate can have a dramatic effect on market prices for many agricultural goods.
5. Change in the price of a substitute
A substitute in production is a product that could have been produced using the same resources. Take the example of barley. An increase in the price of wheat makes wheat growing more attractive. This may cause farmers to use land to grow wheat and less to grow barley. The supply of barley will shift to the left.
6. The number of producers in the market
The number of sellers in a market will affect total market supply. When new firms enter a market, supply increases and causes downward pressure on the market price. Sometimes producers may decide to deliberately limit supply by controlling production through the use of quotas. This is designed to reduce market supply and force the price upwards.
The entry of new firms into a market causes an increase in market supply and normally leads to a fall in the market price paid by consumers. More firms increase market supply and expand the range of choice available.
SUPPLY SCHEDULE AND SUPPLY CURVE
The supply schedule is the relationship between the quantity of a good supplied and its price. If the quantities offered are only of one seller, then it is an individual supply schedule. The aggregate supply quantities of a group of sellers are presented as a market supply schedule.
Let us look at following market supply schedule:
TABLE 2Price (per kilo) Quantity Supplied (per kilo)
Ᵽ454035302520
350300250200150100
From the given schedule, we can see that higher prices serve as incentives for the sellers to offer more X for sale, while low prices discourage them from offering more quantities to sell.
The supply schedule can be depicted as a supply curve. The supply curve contains the exact prices and quantities in the supply schedule. In effect, it is the graphical representation of the supply schedule.
The supply curve is upward sloping from the left to right. Any point on the supply curve reflects the quantity that will be supplied at that given price.
After analyzing the above relationship, we can now state that as price increases, the quantity supplied of a product tends to increase and as price decreases, quantity supplied instead decreases.
Figure 9 Ᵽ 45
40
Price 35
30
25
20
100 150 200 250 300 350
CHANGES IN SUPPLY vs. CHANGES IN QUANTITY SUPPLIED
Changes in supply pertain to changes in the determinants of supply. For example, a decrease in the cost of production increases supply. More subsidies result to more supply. Through graphical presentation, an increase in supply shifts the supply curve to the right while a decrease in supply shifts the supply curve to the left. Figure 10 illustrates changes in supply:
PRICE S3 S1 S2
QUANTITY
Changes in supply show the shifting of the supply curve to the right if there is an increase in supply and to the left if there is a decrease in supply. Such changes are caused by changes in the determinants of supply.
Changes in quantity supplied show the movements from one point to another point on a constant supply curve. Change in quantity supplied is brought about by change in price. For example, if the price increases from P3 to P4, there is a corresponding increase in quantity supplied as shown in Figure 11.
P Demand
Quantity
Change in quantity supplied show an increase in price also increases quantity supplied. This supply curve has not changed its position. Only the points on the same supply curve move.
MARKET EQUILIBRIUM
Market equilibrium is a market state where the supply in the market is equal to the demand in the market. The equilibrium price is the price of a good or service when the supply of it is equal to the demand for it in the market. If a market is at equilibrium, the price will not change unless an external factor changes the supply or demand, which results in a disruption of the equilibrium.
If the market price is above the equilibrium value, there is an excess supply in the market a surplus, which means there is more supply than demand. In this situation, sellers will tend to reduce the price of their good or service to clear their inventories. They probably will also slow down their production or stop ordering new inventory. The lower price entices more people to buy, which will reduce the supply further. This process will result in demand increasing and supply decreasing until the market price equals the equilibrium price.
If the market price is below the equilibrium value, then there is excess in demand supply shortage. In this case, buyers will bid up the price of the good or service in order to obtain the good or service in short supply. As the price goes up, some buyers will quit trying because they don't want to, or can't, pay, the higher price. In addition, sellers, more than happy to see the demand, will start to supply more of it. Eventually, the upward pressure on price and supply will stabilize at market equilibrium. Figure 12 illustrates the law of demand and supply through graph:
THEORY OF CONSUMER BEHAVIOR
Consumer behavior is the study of individuals, groups, or organizations and the processes they use to select, secure, use, and dispose of products, services, experiences, or ideas to satisfy needs and the impacts that these processes have on the consumer and society.
Consumer behavior focuses on how individuals make decisions to spend their available resources (time, money, effort) on consumption-related items that includes what they buy, why they buy, when they buy it, where they buy it, how often they buy it, how often they use it, how they evaluate it after the purchase and the impact of such evaluations on future purchases, and how they dispose of it.
Who is a consumer?
Person or group of people, such as a household, who are the final users of products or services.
One who pays to consume the goods and services produced. The consumer forms part of the chain of distribution.
Consumer considered as a king in a market economic system.
GOODS AND SERVICES
Good is something that you can use or consume. Like for instance, food, car, books, ready to wear, etc.
Service is something that someone does for you. Like for instance, haircutting, food catering, banking transaction, telecommunication services, etc.
NECESSITY GOODS vs. LUXURY GOODS
NECESSITY GOODS LUXURY GOODSType of normal goods Type of superior goodsGoods that are necessary in our daily existence Goods that are may or may not necessary to
our daily existence as human being.e.g. food, water, shelter, clothing, medicine, etc.
e.g. luxury cars, jewels, expensive gadgets, etc.
ECONOMIC GOODS vs. FREE GOODS
ECONOMIC GOODS FREE GOODSGoods that have an opportunity cost. Zero opportunity costRelatively scarce and have a price. Unlimited supply and for free.e.g. water distributed by ORWASA and electricity distributed by LEYECO V
e.g. air that we breathe and sunlight coming from the sun.
CONCEPT OF UTILITY
Utility may be defined as the satisfaction derived from the consumption of a commodity which determines consumption and demand behavior.
Total Utility refers to the total amount of satisfaction one obtains from the consumption of goods and services
THREE CHARACTERISTICS OF THE CONCEPT OF UTILITY
Utility and Usefulness are not synonymous. Utility is subjective. Utility is difficult to quantify.
TWO WAYS IN MEASURING UTILITY
Cardinal Utility Approach refers to the measurement of utility by assigning numerical values, referred to as utils. E.g. 1 util , 140 utils, and -70 utils.
Ordinal Utility Approach measures utility in terms of ranks, such as those indicating levels from most satisfying to least satisfying, best to worst, and highest to lowest.
CONCEPT OF MARGINAL UTILITY
The satisfaction provided by a certain good or service is the main purpose of using the same. By this reason, consumers obtain satisfaction at increasing levels as they continuously consume good or service. It simply means that the total satisfaction of the good or service increases as more units are being consumed. In economics, this increase is called marginal utility. Marginal Utility refers to the additional satisfaction obtained from the consumption of an additional unit of goods and services.
To better explain the concept, here is an example, a chocolate bar. Let's say that after eating one chocolate bar your sweet tooth has been satisfied. Your marginal utility (and total utility) after eating one chocolate bar will be quite high. But if you eat more chocolate bars, the pleasure of each additional chocolate bar will be less than the pleasure you received from eating the one before. Probably because you are starting to feel full or you have had too many sweets for one day. To provide a numerical example, refer to Table 3:
Chocolate bars Total Utility (in utils) Marginal Utility (in utils)1 40 402 70 303 90 204 100 105 80 -206 50 -307 10 -40
This table shows that total utility will increase as marginal utility diminishes with each additional bar. The first chocolate bar gave you a total utility of 40 utils. The second chocolate bar, on the other hand provides an additional satisfaction of 30 utils thereby making your total utility of 70 utils. The third chocolate bar adds 20 utils of utility, hence the total utility is already 90 utils. The fourth chocolate bar gave you a total utility 100 utils but with additional utility of 10 utils. Notice that when you had your fifth up to seventh chocolate bars, your total utility declined resulted to negative marginal utility. It is important to take note that the marginal utility decreases as more bars of chocolate are consumed. This is an illustration of the law of diminishing marginal utility. The graphical illustrations of the law of diminishing marginal utility are presented in figures 13 and 14 respectively.
Figure 13TOTAL UTILITY CURVE
100 TU 90 80 70 60 50 40 30 20 10 0 1 2 3 4 5 6 7
Quantity
Figure 14 MARGINAL UTILITY CURVE
MU 40 30 20 10 0 -10 -20 -30 -40 1 2 3 4 5 6 7
Quantity
CONSUMER EQUILIBRIUM
When consumer makes decisions on the basis of choosing the quantity of goods or services
to consume, the presumption is that the consumer’s objective is to maximize total satisfaction. In maximizing total satisfaction, the consumer is faced with the following realities:
Consumer’s limited income or his purchasing power, and The prices of the goods and services that the consumer wishes to consume.
The consumer’s effort to maximize total satisfaction, subject to the following realities, is referred to as the consumer’s problem and the solution to the said problem which entails about how much the consumer will consume of a number of goods or services, is referred to us consumer equilibrium.
UTILITY MAXIMIZATION
A theory used in economics that holds the belief that when individuals purchase a good or a service, they strive to obtain the most amount of value possible, while at the same time spending the least amount of money possible. When combined, the consumer is attempting to derive the greatest amount of value from their available funds.
To better explain the theory here is an example: Let us assume that Mr. Jose is determining what combination of two goods, hamburger and special siopao, must he purchase for him to obtain maximum satisfaction with his limited fund of one hundred pesos. Jose is confronted with the price of hamburger and special siopao at P20 and P15 respectively. From Jose’s point of view, the utility of the two goods in various quantities are shown in Table 4.
THE UTILITY OF TWO GOODSTable 4
Amount of Utility (in utils)Quantity
ConsumedFrom Hamburger From Siopao
Total Marginal Total Marginal0 0 0 0 01 14 14 9 92 22 8 17 83 24 2 24 74 24 0 27 35 21 -3 29 26 10 -11 30 1
From Mr. Jose’s point of view, the total utility of the 1 hamburger, 2 hamburgers, and 3 hamburgers are 14, 22, and 24 utils respectively. The illustration provides that the TU goes up as
more hamburgers are consumed until it reaches the highest TU. In addition, Mr. Jose’s TU declines when he consumed 5 up to 6 hamburgers. This is so, because his need is fully satisfied. The marginal utility for consuming 1 hamburger is 14 utils which is the highest and it declines with the 2 and 3 hamburgers. However, by consuming 5 and 6 hamburgers, the MU goes down as it registers negative figures. This means that Mr. Jose is only willing to consume up to the point of maximum satisfaction from where an additional unit of consumption no longer yields additional satisfaction. Beyond this point, the additional dissatisfaction begins to incur simply decreases total satisfaction.
Note: The highest TU for siopao is with 6 pieces but the lowest MU is also derived from 6 pieces of siopao.
With the budget constraint of P100, only 6 combinations of hamburgers and siopao are possible. Shown in Table 5 are the various combinations.
SCHEDULE OF COMBINATIONS FOR JOSE’S UTILITY MAXIMIZATIONFigure 5
Combination QuantityHamburgers + Siopao
Total Price Total Utils
1 1 5 P95 432 2 4 100 493 3 2 90 414 4 1 95 335 5 0 100 216 0 6 90 30
INDIFFERENCE ANALYSIS
The word “indifference” means showing no bias or neutral. Supposing there are five combinations of two products (like ice cream and chocolate) the first combination constitutes 5 cones of ice cream and 1 bar of chocolate, and so on. Since all combinations provide the same level of satisfaction, the consumer would be indifferent as to which combination he receives. This means any combination would be desirable for him. He has no particular choice. Table 6 illustrates an indifference schedule showing the various combinations of ice cream and chocolate.
Table 6Combinations Cones of ice cream Bars of chocolate
A 5 1B 4 2C 3 3D 2 4E 1 5
Figure 15A consumer’s indifference curve shows different combinations of two goods which yield the same level of satisfaction.
Ice cream
5 A
4 B
3 C
2 D
1 E
0 1 2 3 4 5 Chocolate
SUBSTITUTION
Most often, consumers use substitute goods to satisfy their wants or needs. Commodities which can be used or consumed in place of other goods are referred to as substitute goods. The substitution option is exercised by the consumer when there are available goods and services which yield the same level of satisfaction but at lower costs. A consumer, for instance, may prefer to consume mangoes. However, if he is confronted by the high price of mangoes, he will consider looking for a substitute. Let say, he finds the bananas as the only lower- priced fruit,
then he may decide to consider the same as a substitute for mangoes. As a result of his action, the demand for bananas will increase.
TYPES OF SUBSTITUTE GOODS
Close substitutes Weak substitutes
A close substitute provides almost or equal level of satisfaction as that of the substituted good or service. Like for instance, mango may be considered as a close substitute for banana.
A weak substitute provides a lower level of satisfaction than the substituted good or service. Like for instance, a weak substitute for mango is a rice cake when used as a dessert during meals.
BUDGET LINE
A budget line or consumption – possibility line indicates the various combinations of two products which can be purchased by the consumer with his income, given the prices of the products. A consumer has a fixed budget, and he has to spend his money wisely to be able to maximize his satisfaction. He has several combinations of two products to choose. However, his choice is confined within the limits of his budget.
As an example, unit price of both products A and B is P25. The budget of the consumer is P150. It is possible for him to buy 5 units of product A and 1 unit of product B, or 5 units of B and 1 unit of A. He can also choose 4 units of B and 2 units of A. Any of these combinations is worth P150.
Table 7 shows a budget line schedule showing the various combinations of two products with a fixed budget of P150 and the unit price of both products at P25.
Product A (in units) Product B (in units) Total expenditures5 1 P125 + P25 = P1504 2 P100 + P50 = P1503 3 P 75 + P 75 = P1502 4 P50 + P100 = P1501 5 P25 + P125 = P150
Figure 16
Graphical illustration of budget line
A
5
4
3
2
1
0 1 2 3 4 5 B
REVIEW QUESTIONS
1. What is meant by the term utility?2. Is there any difference between total utility and marginal utility?3. How is utility measured? Why is measuring utility an important exercise?4. Explain the concept of consumer equilibrium.5. Explain the theory of utility maximization.6. What is meant by indifference analysis?7. What is meant by substitute goods? 8. What are two types of substitute goods? Give an example. 9. Explain the concept of substitution.10. Explain the concept of budget line.
CONCEPT OF ELASTICITY
Based on the law of demand, buyers are willing and able to purchase more goods and services at lower prices than at higher prices. These are natural reactions of buyers. However, such reactions vary depending on the importance and availability of the goods and services. These varying reactions are known as demand elasticity.
In the case of sellers, they tend to sell more goods and services when prices are higher. Their reactions also vary depending on their ability to produce in a given time. For instance, they cannot take advantage of higher prices if they cannot produce the goods and services. Such varying reactions of producers are known as supply elasticity.
DEMAND ELASTICITY
Demand elasticity refers to the reaction or response of the buyers to changes in price of goods and services.
Classification of Demand Elasticity: Price elasticity of demand Income elasticity of demand Cross elasticity of demand
Price Elasticity of Demand
Price elasticity is used to determine the responsiveness of demand to changes in the price of the commodity. It may be calculated with the use of the formula below:
Ep = percentage change in quantity demanded percentage change in price
= (QD2-QD1)/QD1 / (P2-P1)/P1
Where: Ep = Coefficient of arc price elasticity Q2 = New quantity demanded Q1 = Original quantity demanded P2 = New price P1 = Original price
Example: Year Quantity demanded Price
2012 10,000 kg. P5/kilo 2013 16,000 kg. P4/kilo
Solution: = (16,000-10,000)/ 10,000 (4-5) / 5 = 0.6 / -0.2
Ep = -3
Analysis:
-3 means that for every one percent decrease in the price of a commodity, the quantity demanded will increase by 3 percent. The consumer is said to be highly responsive (elastic) to changes in the price of the commodity.
As you may have observed, 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 demand: if price increases, less quantity of good is demanded therefore quantity change is negative, leading to a negative price of elasticity of demand. Conversely, if price falls, this negative value will lead to a negative price elasticity of demand value.
Note: If elasticity coefficient (answer) is: More than 1 = elastic demand Less than 1 = inelastic demand Equal to 1 = unitary demand
FIVE TYPES OF DEMAND ELASTICITY
1. Elastic demand. A change in price results to a greater change in quantity demanded. For example, a 20% change in price (decrease or increase) creates a 60% change in quantity demanded (increase or decrease). This shows buyers are very sensitive to price change. They are easily discouraged to buy the products if their prices increase. However, they are easily encouraged to buy the same products if their prices decrease. Such products are not very important to them, but they provide comforts and pleasures to the consumers. These are the luxury goods like stereo, radio, camera, television set, etc.
2. Inelastic demand. A change in price results to a lesser change in quantity demanded. For example, a 50% change in price creates only a 5% change in quantity demanded. This means buyers are not sensitive to price change. Products under this category are very essential to buyers. They cannot live without them; it is hard to live without such products like rice, medicine, or shelter. People have to buy said products even if there is a big increase in their prices. However, a big decrease in the prices of the aforementioned goods has a very little increase in quantity demanded. For example, a great decline in the prices of rice and medicine does not encourage people to eat more rice or take more medicine. They only buy as much as the requirement of their normal consumption. But if the price of rice is very high and many people cannot afford such price, they are forced to eat only twice a day, or mix rice with corn. Many extremely poor people are doing this.
3. Unitary demand. A change in price results to an equal change in quantity demanded. For example, a 25% change in price produces a 25% change in quantity demanded. Goods or services under this category are considered semi-luxury or semi-essential goods. Examples are the branded ready to wear apparels like Jag, Lee, Guess, Levis, and Penshoppe.
4. Perfectly elastic demand. Without change in price, there is an infinite change in quantity demanded. Such demand applies to a company which sells in a purely competitive market.
5. Perfectly inelastic demand. A change in price creates no change in quantity demanded. This is an extreme situation which involves life or death of an individual. Regardless of price, he has to buy the product like medicine with no substitute.
Figure 17: Types of demand elasticity showing the various degrees of reactions of buyers brought about by price change.
P P D
D ---------- ------------------ ------------------------- -----------------------
0 Q 0 Q
Elastic demand Inelastic demand
P D
--------
-------------
0 Q
Unitary demand
P P D
--------------------------------D
0 Q 0 Q
Perfectly elastic demand Perfectly inelastic demand
Income elasticity of demand
Income elasticity of demand refers to the determination of the responsiveness of demand to a change in consumer income.
FORMULA: Ey = Percentage change in quantity demanded Percentage change in income
= (QD2- QD1) / QD1 / (Y2-Y1) Y1
Where Ey = Income elasticity of demand Y2 = New income Y1 = Original income
When elasticity is greater than 1, demand is said to be income elastic. When it is less than 1, it is income inelastic. When it is equal to 1, it is unitary elastic.
Cross elasticity of demand
The demand for a certain good may be affected a change in the price of another good. From the economic standpoint, it is very useful for a person to know this relationship between goods.
The responsiveness of the quality demanded of a particular good to changes in the price of another good is referred to as cross elasticity of demand. It is measured by computing the percentage change in the quantity demanded of the first good and dividing it by the percentage change in the price of the second good. The mathematical representation of this relationship is as follows:
Ec = Percentage change in quantity demanded for product X Percentage change in the price of related commodity
= (QA2 – QA1) / QA1 / (PB1 – PB2) / PB1
Where Ec = Cross elasticity of demand QA2 = New demand for product X QA1 = Original demand for product X PB2 = New price of related commodity PB1 = Original price of related commodityAnalysis:
If cross elasticity is positive, the goods are substitutes. For example, the 2% increase in the price of rice causes a 0.66% increase in the demand for pan de sal.
If cross elasticity is negative, the goods are complements. For example, if tuition fee increases results to a decrease in the demand for dormitories.
DETERMINANTS OF DEMAND ELASTICITY
The demand elasticity of goods and services are not similar; some are elastic and some are inelastic. This is so because of certain factors or determinants.
1. The price of goods in relation to the consumer’s budget. Consumers are more sensitive to price changes of goods that take a big amount of their budget. For instance, a change in the price of cars drives consumers to think seriously about buying. However, a change in the price of toothpicks; let say, from 50 centavos per box to 75 centavos per box are taken in stride.
2. The availability of substitutes. The demand elasticity of a good is affected by the
availability of substitute. The more and the closer substitutes are, the more people will switch to substitutes, when the price of the good rises.
3. The type of a good. The demand elasticity of a good is affected by its type, whether it is luxury or a necessity. For instance, the demand for rice is inelastic since consumers can scarcely avoid buying them. On the other hand, magazines and comics are luxuries and their demand is elastic because people can avoid them when their price rises.
4. The time under consideration. The demand for a good becomes more elastic over a longer period of time. For instance, if the price of rice rises, people may consider switching to bread, corn, or other cereals. Switching will be slow; however, can be achieved when a longer period is considered.
ELASTICITY OF SUPPLY
Supply elasticity refers to the reaction or response of the sellers or producers to price change of goods. Based on the law of supply, producers are willing and able to offer more goods at a higher price, and fewer goods at a lower price. However, such responses of producers vary in accordance with the kind of goods they produce. For instance, there are goods which are impossible to produce in a short time in order to take advantage of increasing prices. These are the farm products which cannot be increased in just a month. In fact, some crops take several
years to bear fruits like coconut. In the case of industrial goods, it takes a shorter period to increase their supply. Factories can respond to price increases by an overtime schedule of their workers. The mathematical formula for determining elasticity of supply is:
Es = Percentage change in quantity supplied Percentage change in price
= (QS2 – QS1) / QS1 / (P2- P1)/ P1
Where Es = Price elasticity of supply QS2 = New quantity of supplied QS1 = Original quantity supplied P2 = New price P1 = Original price
Example:
Year Quantity supplied Price 2012 10,000 P5 / kilo 2013 18,000 P6 / kilo
Solution: Es = (18,000- 10,000) / 10,000 / (6-5)/ 5
= .80 / .20
Es = 4
Analysis: Supply price elasticity = 4 means that for every one percent increase in the price of commodity X, the quantity supplied will increase by 4 percent. The seller is said to be highly responsive (elastic) to changes in the price of the commodity.
Note: Elastic supply is where the quantity supplied is affected greatly by changes in the price. The change is greater than the elasticity coefficient of 1. When the quantity supplied is not affected greatly by changes in the price, supply is said to be inelastic. The elasticity coefficient is less than 1. When the percentage change in the quantity supplied is equal to the percentage change in price, supply is unitary elastic. The elasticity coefficient is equal 1.
FIVE TYPES OF ELASTICITY SUPPLY
1. Elastic supply. A change in price results to a greater change in quantity supplied. This means producers are very responsive to price change. For instance, with a 10 % increase in price, they increase their quantity supplied by 20 %. Such reaction similarly applies if there is a decrease in price, quantity supplied is expected to decrease even bigger. Examples are those goods which can be produced immediately or in a short period of time. Such as products produced by manufacturing firms.
2. Inelastic supply. A change in price results to a lesser change in quantity supplied. This shows that producers have a very weak response to price change. With a high price, they like to increase their quantity supplied, but they cannot do it at once. For instance, if the price of coconut increases, producers cannot respond immediately in a short period of time. It takes about 5 years or more to produce the same. By that time, price of coconuts would be most likely different.
3. Unitary supply. A change in price results to an equal change in quantity supplied. For instance, a 15% change in price creates a 15% change in quantity supplied. This is a borderline case between elastic and inelastic supply. Example of these goods is semi- industrial or semi- agricultural products.
4. Perfectly elastic supply. Without change in price, there is an infinite (without limit) change in quantity supplied. For instance, in a poor country where massive unemployment prevails, an unlimited number of jobless individuals are willing to work at a fixed wage – even if such wage is very low, which is the general situation in the rural areas of the less developed countries.
5. Perfectly inelastic supply. A change in price has no effect on quantity supplied. An example of this is land in a community. Land area is fixed regardless of price. The big increase in population has tremendously increased the price of land. There are products which cannot be increased immediately or in a short –run period for lack of machinery, raw materials, or money.
Figure 18. Types of supply elasticity showing the various degrees of reactions of sellers or producers brought about by price change. S
P P S
------------------
---------------- -------------
-------- 0 Q 0 Q Elastic supply Inelastic supply
P S P
----------------- -----------------------------S
----------
0 Q 0 Q
Unitary supply Perfectly elastic supply
P S
0 Q
Perfectly inelastic supply
DETERMINANTS OF SUPPLY ELASTICITY
1. The feasibility and cost of storage. Regardless of price, perishable goods like vegetables must be brought to the market. If storage cost is high, even if it is available, the sellers have no choice but to sell at prevailing prices. Supply in this case is inelastic.
2. The ability of producers to respond to price changes. If the producers can easily increase or decrease output when prices fall, supply is elastic.
3. Time. With the passage of time, especially for long periods, supply tends to be elastic. If there is a rise in prices, the producers may not be able to make adjustments quickly, but given sufficient time, they may be able to produce more.
REVIEW QUESTIONS
1. What is meant by elasticity?2. Enumerate the classifications of elasticity of demand. 3. Discuss the implications of price elasticity of demand.4. What are determinants of demand elasticity?5. When is supply said to be elastic?6. How do substitutes affect demand elasticity?7. What products or services may be considered with inelastic demand?8. What products or services may be considered with elastic demand?9. Differentiate unitary elastic demand and unitary elastic supply.10. Explain the determinants of supply elasticity.
PRODUCTION AND COST
Production is the transformation of inputs into outputs. The factors of production are called the inputs of production. On the other hand, outputs are the goods and services that have been created using the production inputs.
Factors of production are classified into:
Fixed factors – these are those remain constant regardless of the volume or quantity of production. This means that whether you produce or not, the factors of production is unchanged.
Variable factors – these are those that vary in accordance to the volume or quantity of production. If there is no production, then there is no variable.
The various inputs consist of the following:
Capital – it includes raw materials, supplies, tools, machinery, equipments, etc. Labor – combines and process the various materials. Land – where the space allotted for processing is located. Entrepreneurial or managerial talent – This performs functions like supervision,
planning, controlling, coordinating, and leadership.
CATEGORIES OF PRODUCTION ACTIVITIES
1. Unique – product production. This type of production activity has its output “made to order” goods and services. A business production strategy that typically allows consumers to purchase products that are customized to their specifications. The made to order (MTO) strategy only manufactures the end product once the customer places the order. This creates additional wait time for the consumer to receive the product, but allows for more flexible customization compared to purchasing from retailers' shelves. Examples are those tailored – made dress, customized gadgets, services of public relations firm, custom-built homes, charter flight airlines, etc.
2. Rigid mass production. This production activity involves the manufacture of uniform products in large quantity using well- defined, proven, and inflexible technology. The tools, materials, and parts used are standardized which make movements and outcomes highly economical.
3. Flexible mass production. This type of production activity is done in two stages. The first stage involves mass production of standardized components. In the second stage, the components are assembled into final products that appear different from one another. For example, in the manufacture of refrigerators, a company produces standardized parts and
assembles them into different sizes and models that will suit different consumer requirements. Flexible mass production clearly has the cost efficiency advantage in addition to its ability to cater consumers’ needs.
4. Flow Production. A continuous flow of outputs is the feature of process or flow production. Integrated technology is employed to move a continuous flow of raw material inputs through the system. This production activity is highly automated and mechanized, resulting to high production efficiency when operated at high capacity. Let say, 24 hours continuous process of production.
PRODUCTION FUNCTIONS
The output of a production process will depend on the quality and quantity of inputs used. Various combinations of inputs will result to different quantities and qualities of output. For instance, to produce 200 sacks of rice, the following must be considered: the use of a farming technology on a given hectare of land with certain characteristics, the use of a certain quantity and quality of seeds and a given number of bags of fertilizer, the use of specified tools and machinery, and the application of a certain amount of labor will all be part of the requirements. The relationship between the amount of inputs required and the amount of output that can be obtained is referred to as the production function.
Another example of production function is the number of college graduates a school can produce. It has been said that the quantity and quality of college graduates will depend on the quality and quantity of teachers and students, the number and types of buildings, classrooms, availability of library, laboratory facilities, etc.
Production function is a schedule (a table or mathematical equation) showing the maximum amount of outputs that can be produced from any specified set of inputs given the existing technology. The production function, in effect, is a catalog of output possibilities.
ANALYSIS OF THE PRODUCTION PROCESS
In the analysis of the process of production, the following must be considered:
1. The classes of inputs, and2. The time frame references.
Inputs are classified as either fixed or variable. A fixed input is one whose quantity cannot be readily changed when market conditions indicate that a change in output is desirable. Examples of fixed inputs are buildings, machineries, and managerial personnel. These inputs cannot be readily increased or decreased. On the other hand, variable input is one whose quantity can be readily changed when a change in output is desired. Examples are direct labor, raw materials, and supplies.
The time frame references consist of the short – run and the long – run production analysis.
The production function relates the quantity of factor inputs used by a business to the amount of output that result. We use three measures of production and productivity.
Total product (or total output). In manufacturing industries such as motor vehicles and DVD players, it is straightforward to measure how much output is being produced. But in service or knowledge industries, where output is less “tangible” it is harder to measure productivity.
Average product measures output per-worker-employed or output-per-unit of capital. Marginal product is the change in output from increasing the number of workers used by
one person, or by adding one more machine to the production process in the short run.
Short Run Production Function
The short run is a time period where at least one factor of production is in fixed supply. A business has chosen it’s scale of production and must stick with this in the short run
We assume that the quantity of plant and machinery is fixed and that production can be altered by changing variable inputs such as labor, raw materials and energy.
The time periods used differ from one industry to another; for example, the short-run in the electricity generation industry differs from local sandwich bars. If you are starting out in business with a new venture selling sandwiches and coffees to office workers, how long is your long run? It could be as short as a few days – enough time to lease a new van and a sandwich-making machine.
Diminishing Returns
In the short run, the law of diminishing returns states that as we add more units of a variable input to fixed amounts of land and capital, the change in total output will at first rise and then fall.
Diminishing returns to labor occurs when marginal product of labor starts to fall. This means that total output will be increasing at a decreasing rate.
What might cause marginal product to fall? One explanation is that, beyond a certain point, new workers will not have as much capital equipment to work with so it becomes diluted among a larger workforce. In the following numerical example, we assume that there is a fixed supply of capital (20 units) to which extra units of labor are added.
Initially, marginal product is rising – e.g. the 4th worker adds 26 to output and the 5th worker adds 28 and the 6th worker increases output by 29.
Marginal product then starts to fall. The 7th worker supplies 26 units and the 8th worker just 20 added units. At this point production demonstrates diminishing returns.
Total output will continue to rise as long as marginal product is positive. Average product will rise if marginal product > average product.
Table 8
The Law of Diminishing ReturnsCapital Input Labor Input Total Output Marginal Product Average Product of Labor
20 1 5 520 2 16 11 820 3 30 14 1020 4 56 26 1420 5 85 28 1720 6 114 29 1920 7 140 26 2020 8 160 20 2020 9 171 11 1920 10 180 9 18
Figure 19
Average product rises as long as marginal product is greater than the average – e.g. when the seventh worker is added the marginal gain in output is 26 and this drags the average up from 19 to 20 units. Once marginal product is below the average as it is with the ninth worker employed then the average must decline.
Terms to remember:
Total output refers to the amount of output produced in physical units.
Average product refers to the total output divided by the quantity of the variable inputs under consideration.
Marginal product is the additional output attributed to the increase in the quantity of the variable inputs under consideration.
Long Run Production Function
In terms of the microeconomic analysis of production and supply, a period of time in which all inputs under the control of a firm used in the production process are variable. In the long run, labor and capital are variable inputs. The long-run analysis of production reveals the key role played by returns to scale. This is one of four production time periods used in the study of microeconomics. The other three are short run, very long run, and very short run (or market period). The long run is also a time period designation used in the macroeconomic analysis of economic growth and full employment.
In microeconomic analysis, the long run is concerned with the adjustment of factory or plant size and is often termed the planning period. In the long run, a firm is able to change the
quantities of all resource inputs such as labor, capital, land, and entrepreneurship. Nothing under the control of the firm is fixed. If the current factory is too small, then a larger one can be built in the long run. If the existing retail store has excess space, then a smaller building can be acquired in the long run.
RETURN TO SCALE
The guiding principle in the microeconomic analysis of the long run is returns to scale. This concept indicates how production changes relative to equal proportional changes in all inputs. A doubling of all inputs might, for example, also lead to an exact doubling of production. Or production might increase by more or less than an exact doubling.
This suggests three alternative returns to scale:
Constant Returns to Scale: This results in the long run if a proportional increase in all inputs under the control a firm leads to an equal proportional increase in production. That is, a ten percent increase in labor, capital, land, and entrepreneurship also generates a ten percent increase in production.
Increasing Returns to Scale: This results in the long run if a proportional increase in all inputs under the control a firm leads to a greater than proportional increase in production. That is, a ten percent increase in labor, capital, land, and entrepreneurship generates more than a ten percent increase in production.
Decreasing Returns to Scale: This results in the long run if a proportional increase in all inputs under the control a firm leads to a less than proportional increase in production. That is, a ten percent increase in labor, capital, land, and entrepreneurship generates less than a ten percent increase in production.
In the long run, all factors of production are variable. How the output of a business responds to a change in factor inputs is called returns to scale. Table 9
Numerical example of long run returns to scale
Units of Capital
Units of Labor
Total Output
% Change in Inputs
% Change in Output
Returns to Scale
20 150 3000
40 300 7500 100 150 Increasing
60 450 12000 50 60 Increasing
80 600 16000 33 33 Constant
100 750 18000 25 13 Decreasing
When we double the factor inputs from (150L + 20K) to (300L + 40K) then the percentage change in output is 150% - there are increasing returns to scale.
When the scale of production is changed from (600L + 80K0 to (750L + 100K) then the percentage change in output (13%) is less than the change in inputs (25%) implying a situation of decreasing returns to scale.
Increasing returns to scale occur when the % change in output > % change in inputs. Decreasing returns to scale occur when the % change in output < % change in inputs. Constant returns to scale occur when the % change in output = % change in inputs
In the long run businesses will be looking to find an output that combines labor and capital in a way that maximizes productivity and therefore reduces unit costs towards their lowest level. This may involve a process of capital-labor substitution where capital machinery and new technology replaces some of the labor input.
In many industries over the years we have seen a rise in the capital intensity of production - good examples include farming, banking and retailing.
THE COSTS OF PRODUCTION
Since the general goal of companies is to maximize profit, it's important to understand the components of profit. On one side, firms have revenue, which is the amount of money that it brings in from sales. On the other side, firms have the costs of production. Let's examine different measures of production cost.
Total cost (TC) = the sum of total fixed costs and total variable costs. Formula: TC = TFC + TVC
Total cost, not surprisingly, is just the all-inclusive cost of producing a given quantity of output. Mathematically speaking, total cost is a function of quantity.
One assumption that economists make when calculating total cost is that production is being carried out in the most cost-effective way possible, even though it may be possible to produce a given quantity of output with various combinations of inputs (factors of production).
Total fixed costs and total variable costs
Fixed costs are upfront costs that don't change depending on the quantity of output produced. For example, once a particular plant size is decided upon, the lease on the factory is a fixed cost since the rent doesn't change depending on how much output the firm produces. In fact, fixed costs are incurred as soon as a firm decides to get into an industry and are present even if the
firm's production quantity is zero. Therefore, total fixed cost is represented by a constant number.
Variable costs, on the other hand, are costs that do change depending on how much output the firm produces. Variable costs include items such as labor and materials, since more of these inputs are needed in order to increase output quantity. Therefore, total variable cost is written as a function of output quantity.
Sometimes it's helpful to think about per-unit costs rather than total costs. To convert a total cost into an average or per-unit cost, we can simply divide the relevant total cost by the quantity of output being produced. Therefore,
Average Total Cost, sometimes referred to as Average Cost, is Total Cost divided by quantity.Formula: ATC = TC/Q or AFC + AVC
Average Fixed Cost is Total Fixed Cost divided by quantity.Formula: AFC = TFC/Q
Average Variable Cost is Total Variable Cost divided by quantity.Formula: AVC = TVC/Q
Marginal cost is the cost associated with producing one more unit of output. Mathematically speaking, marginal cost is equal to the change in total cost divided by the change in quantity.
Marginal cost can either be thought of as the cost of producing the last unit of output or the cost of producing the next unit of output. Because of this, it's sometimes helpful to think of marginal cost as the cost associated with going from one quantity of output to another, as shown by q1 and q2 in the equation above. To get a true reading on marginal cost, q2 should be just one unit larger than q1.
For example, if the total cost of producing 3 units of output is P15 and the total cost of producing 4 units of output is P17, the marginal cost of the 4th unit (or the marginal cost associated with going from 3 to 4 units) is just (P17-P15)/(4-3) = P2.
Formula: MC = TC / Q
ACCOUNTING COSTS vs. ECONOMIC COSTS
The fundamental concept that should be learned is the difference between economic cost and accounting cost. Economic costs are forward – looking costs, meaning economists are in tune with future costs because these costs have major impact on the potential profitability of the firm. Economists are also giving emphasis on the so- called opportunity cost, or costs that are incurred by not putting the resources to optimum use.
If opportunity costs are measurable, it should be included in the decision – making process, even though it is expensive to do so. But there some costs that should not be used in decision- making such as sunk costs, because these are costs that are irretrievable due to the fact that these are already incurred and do not affect a firm’s decision.
Accounting costs tend to be retrospective; they recognize costs only when these are made and properly recorded. They do not adjust these costs even if opportunity costs change. Therefore, the difference between economic costs and accounting costs is opportunity cost.
EXPLICIT COSTS vs. IMPLICIT COSTS
Explicit costs refer to the actual expenses of the firm in purchasing or hiring the inputs it need, such as, when a firm purchases a machine worth one million pesos or rents a building worth one hundred thousand pesos per month.
Implicit costs refer to the value of inputs being owned by the firm and used in its own production process. Example, the owner of the business is an accountant; if he will work for another company he could earn thirty thousand pesos. However, he chose to be the accountant of his business. His thirty thousand peso salary that he could earn for another company is his implicit cost. These two costs are included in economic cost.
BUSINESS PROFIT vs. ECONOMIC PROFIT
Business profit refers to the difference between total revenue and explicit costs, while economic profit is the difference between total revenue and both the explicit and implicit costs. For example, suppose a firm gives an account on its business profit of one million pesos during a calendar year. The owner could have earned three hundred thousand pesos if he managed another firm, and earned one hundred thousand pesos if he loaned his capital to other firms with corresponding interest. For an economist, his profit is only six hundred thousand pesos taking his opportunity costs (implicit costs) of three hundred thousand pesos for his salary and one hundred thousand pesos for his unearned interest in his capital.
REVIEW QUESTIONS
1. What is meant by production?2. What do you mean by inputs of production?3. Explain the two classifications of inputs of production.4. What are the four categories of production activities? How is unique – product
production undertaken?5. Differentiate rigid mass production from flexible mass production.6. What important concept is pointed out by the law of diminishing returns?7. What is total cost? How may it be derived?8. Differentiate fixed costs from variable costs.9. What examples of variable cost may be provided?10. Differentiate accounting costs from economic costs.11. Is there any difference between explicit cost and implicit cost? Explain your
answer.12. What is business profit? How about economic profit?13. How to derived average cost?14. What is marginal cost? How may it be derived?15. Explain the concept of production function.
MARKET STRUCTURES
Market structure is defined by economists as the characteristics of the market. It can be organizational characteristics or competitive characteristics or any other features that can best describe a goods and services market. The major characteristics that economist have focused on in describing the market structures are the nature of competition and the mode of pricing in that market. Market structures can also be described as the number of firms in the market that produce identical goods and services. The market structure has great influence on the behavior of individuals firms in the market and will affect how firm price their products and services.
KINDS OF MARKET STRUCTURES
1. Pure or perfect competition – is a market situation where there is a large number of independent sellers offering identical products.
Characteristics:
1. Many sellers: there are enough so that a single seller’s decision has no impact on market price.2. Homogenous or standardized products: each seller’s product is identical to its competitors.3. Firms are price takers: individual firms must accept the market price and can exert no influence on price.4. Free entry and exit: no significant barriers prevent firms from entering or leaving the industry.
2. Pure or perfect monopoly. It exists when a single firm is the sole producer of a product for which there are no close substitutes. Examples are public utilities and professional sports leagues.
Characteristics:
1. A single seller: the firm and industry are synonymous.2. Unique product: no close substitutes for the firm’s product.3. The firm is the price maker: the firm has considerable control over the price because it can control the quantity supplied.4. Entry or exit is blocked.
3. Monopolistic competition. It refers to a market situation with a relatively large number of sellers offering similar but not identical products. Examples are fast food restaurants and clothing stores.
Characteristics:
1. Lot of firms: each has a small percentage of the total market.2. Differentiated products: variety of the product makes this model different from pure competition model. Product differentiated in style, brand name, location, advertisement, packaging, pricing strategies, etc.3. Easy entry or exit.
4. Oligopoly. It exists where few large firms producing a homogeneous or differentiated product dominate a market. Examples are automobile and gasoline industries.
Characteristics:
1. Few large firms: each must consider its rivals’ reactions in response to its decisions about prices, output, and advertising.2. Standardized or differentiated products.3. Entry is hard: economies of scale, huge capital investment may be the barriers to enter.
CONSTITUTIONAL PROVISION
The State shall regulate or prohibit monopolies when the public interest so requires. No combinations in restraint of trade or unfair competition shall be allowed. Sec. 19, article XII, Philippine Constitution
MEANING OF MONOPOLY
Monopoly refers to a market condition whereby an individual or a group controls prices regardless of the normal economic pressures of supply and demand.
REGULATIONS OR PROHIBITION OF PRIVATE MONOPOLIES
The government may either regulate or prohibit private monopolies when required by public interest. In the first case, they are not prohibited if properly regulated. Certain monopolies are beneficial to the public as in the case of business enterprises providing essential services to the public. Examples of these are Meralco, PLDT, and transportation companies. The
Constitution recognizes that unregulated competition among them may, in the long run, harm public interest. Under existing laws, the government determines the amounts they can charge for their services.
MEANING OF RESTRAINT TRADE
The phrase “restraint of trade” refers to practices which interfere with normal production and supply of commodities by restraining competition. It includes the restriction, by means of an agreement, of the right of a person to engage in business or profession.
MEANING OF COMPETITION
Competition refers to independent efforts of rival parties to get the business patronage of a third person (or buying public) by offering more beneficial terms as incentive to such patronage.
MEANING OF UNFAIR COMPETITION
Unfair competition refers to practices which injure the goodwill or business reputation of a business rival through various methods, particularly the use by a person of the name, symbols, or devices employed by such rival so as to induce the purchase of the goods of such person under a false belief that they are the goods of the rival.
COMBINATIONS IN RESTRAINT OF TRADE OR UNFAIR COMPETITION PROHIBITED
In prohibiting such evil trade practices, Section 19 seeks to preserve and maintain competition in a free atmosphere so that there will be no monopoly through unfair, unjust, or oppressive means.
Note that what the Constitution prohibits is not mere competition but unfair competition. Rival manufacturers may lawfully compete for the patronage of the public through the quality and pricing of their goods, advertising, employment of agents, etc.
OUTPUT AND PRICE UNDER PURE COMPETITION
The price of the product in a pure competition cannot be influenced by any seller or buyer. This is so because the quantity held by any individual seller is only a small fraction of the total quantity produced. Changing the price will not be a cause for retaliation from competitors. If a seller lowers his price, buyers will probably flock to his store. But since his stock is limited, he can only serve a few buyers. Those buyers that are not served by the said seller will be forced to buy from the other sellers at a prevailing retail price. In this case, the said “renegade” seller will be the sole loser because his total revenue is reduced.
To illustrate, assume that there are 200,000 farmers producing rice at an average production of 300 sacks per farmer. If the prevailing market price of rice is P1, 500 per sack and a farmer lowers his price from P1, 500 to P1, 200, the said farmer will be able to dispose all his 300 sacks of rice. In this case, many buyers will be attracted to his offered price however he can only sell limited quantity of rice. This will hardly affect the market price of remaining 59,999,700 sacks of rice. He must realize that even if he does not reduce his price, he will still be able to sell his output at the prevailing market price.
On the other hand, if the farmer raises his price to P1, 600 per sack, he may not be able to dispose even a single sack of rice because the buyers still have an alternative of 199,999 sellers. In pure competition, the actual market price is determined by a combination of the independent actions of the sellers and buyers. No individual buyer or seller can set the market price, it is the interaction between total demand and total supply.
A sample demand schedule of an individual seller is shown in Table 10. This is graphically depicted in Figure 20.
Table 10
DEMAND SCHEDULE OF A FARMER IN PURE COMPETITIONPRICE QUANTITY DEMANDED (PER SACK)
P1,000 Infinite1,100 Infinite1,200 Infinite1,300 Infinite1,400 Infinite1,500 Infinite1,600 01,700 01,800 01,900 02,000 0
Figure 20DEMAND CURVE FACING THE FARMER IN PURE COMPETITION
Price
P1, 500 ----------------------------------------------------- D
Quantity
PRICE AND OUTPUT DETERMINATION UNDER MONOPOLY
Since the monopolist is the sole seller in the market, his demand curve is also the industry’s curve. When he raises his price, the quantity he disposes will be reduced. When he lowers his price, the reverse happens. This relationship is illustrated in a hypothetical demand schedule (Table 11). This is graphically depicted in Figure 21.
Table 11DEMAND SCHEDULE OF A HYPOTHETICAL MONOPOLIST
PRICE QUANTITY SOLD (in unit)P10 100
9 2008 3007 4006 5005 6004 7003 8002 9001 1000
Figure 21DEMAND CURVE OF A MONOPOLIST
Price10 ●
9
8
7
6
5
4
3
2 ●1 100 200 300 400 500 600 700 800 900 1000 QuantityFIXING THE MONOPOLY PRICE
The monopolist will naturally seek the price and quantity combination that will bring him the greatest amount of profits. In pursuing this objective, he faces three possible cost situations:
1. Constant costs2. Increasing costs3. Decreasing costs
The constant costs behavior indicates that per unit cost of the monopolist remains unchanged even if the quantity sold is increased or decreased. Table 12 shows that monopolist will earn maximum profit if he sells his products at P 5.00 per unit.
Table 12PRICE AND PROFITS IN A MONOPOLY WITH CONSTANT COSTS
Price per unit Quantity sold Total receipts Cost per unit Total cost Monopoly profits
P1.00 900 P900 0.75 P675 P2252.00 800 1,600 0.75 600 1,0003.00 700 2,100 0.75 525 1,5754.00 600 2,400 0.75 450 1,9505.00 500 3,000 0.75 375 2,1256.00 400 2,400 0.75 300 2,1007.00 300 2,100 0.75 225 1,8758.00 100 800 0.75 75 7259.00 50 450 0.75 37.50 412.5010.00 0 0 0.75 0 0
Increasing costs mean that the cost of production increases as quantity produced is increased. Table 13 shows an example of such relationship. Maximum profit is realized when price is set at P5.00 per unit. Lowering his price will cause an increase in sales volume, but it will not improve his profits. Raising his price will drive away buyers and will not result into great changes of profit to be earned.
Table 13PRICE AND PROFITS IN A MONOPOLY WITH INCREASING COSTS
Price per unit Quantity sold Total receipt Cost per unit Total cost Monopoly profits
P10 0 0 P0.50 0 09 50 450 0.55 P27.50 P422.508 100 800 0.60 60 7407 300 2,100 0.65 195 1,9056 400 2,400 0.70 280 2,1205 500 2,500 0.75 375 2,1254 600 2,400 0.80 480 1,9203 700 2,100 0.85 595 1,5052 800 1,600 0.90 720 8801 900 900 0.95 855 45
In a decreasing costs situation, the monopolist’s cost of production decreases as the quantity produced is increased. Table 14 indicates that the monopolist maximizes his profits when price is set at P6.00 per unit. Profits decline when price is set above or below P6.00 per unit.
Table 14PRICE AND PROFITS IN A MONOPOLY WITH DECREASING COSTS
Price per unit Quantity sold Total receipt Cost per unit Total cost Monopoly profits
P10 0 0 P1.00 0 09 50 P450 0.95 P47.50 P402.508 100 800 0.90 90 7107 300 2,100 0.85 255 1,8456 500 3,000 0.80 400 2,6005 600 3,000 0.75 450 2,5504 700 2,800 0.70 490 2,3103 800 2,400 0.65 520 1,8802 900 1,800 0.60 540 1,2601 1000 1,000 0.55 550 450
PRICE AND OUTPUT DETERMINATION UNDER OLIGOPOLY
In setting the price of products, the seller under oligopoly faced the following situations:
1. If he reduces his price, competitors will retaliate and will not gain anything, but short- term profits from his initial move. His long run profit (and that of his competitors) will be reduced.
2. If he raises his price, his customers will move to his competitors. His sales volume and revenue will decline.
Table 15 shows demand schedule under oligopoly and a graphical illustration in Figure 22.
Table 15DEMAND SCHEDULE UNDER OLIGOPOLY (When seller raises or lowers his price)
Price per unit Quantity sold (in units) Total receiptsP9.00 100 P9008.00 200 1,6007.00 300 2,1006.00 400 2,400
5.00 prevailing price 500 2,5004.00 550 2,2003.00 600 1,8002.00 650 1,3001.00 700 700
Figure 22
Price 10
9 ● D
8
7
6
5 -----------------------● E
4
3
2
1 ●F
100 200 300 400 500 600 700 800 900 1000 Quantity
Point E is the prevailing price and it appears as “kink” in the demand curve DF.Line DE denotes low sales when seller under oligopoly raises price.Line EF indicates limited sales gain when seller under oligopoly lowers price.
PRICE DETERMINATION UNDER MONOPOLISTIC COMPETITION
The firm in a monopolistic competition strives to differentiate its products from that of its competitors. If it is successful in maintaining a sizable group of loyal customers, it will attempt to maximize profits, observing the law of supply and demand. If the profits generated by the firm are big enough, it will invite competitors. The ensuing moves by the competing firms will wipe out profits caused by price cutting and additional promotional expenses.
REVIEW QUESTIONS
1. What are the characteristics of pure monopoly?2. What are the characteristics of pure competition?3. What are the characteristics of monopolistic competition?4. What are the characteristics of oligopoly?5. Is there a need to advertise products under pure competition? Explain your answer.6. Explain section 19, article XII, Philippine Constitution.7. Can a monopolist set a high price for his product and still enjoy a high level of demand?