E11 Lecture Notes

Economics 11
Topic 1
Introduction
U-PRIMO E. RODRIGUEZ
Dept. of Economics
UPLB
WHAT IS ECONOMICS?
Oikonomia (Greek) household
management
Defn: A social science that deals with
the allocation of scarce resources to
satisfies unlimited human wants
Key words
Science
Social science
Scarcity
Economics as a science
Science
Systematic observation of natural events and
conditions in order to formulate laws and principles
Systematic body of knowledge
Methodology of science (and economics!)

Scientific method: seeks to explain events in a
reproducible way, and to use these reproductions to
make useful predictions
Steps
Hypothesis/questions
Procedure: experimentation or observation
Assumptions, models, statistical techniques
Formulate conclusions
Economics as a social science

Fields of science
Natural science focuses on natural
phenomena, including biological life
Social science focuses on human behavior
and societies
Sociology, psychology, political science,

anthropology, history, economics, etc
What differentiates economics from the

other social sciences? Answer: Focus on
scarcity!
Question: What do we mean by scarcity?
Scarcity
Easier to understand scarcity by recognizing
the unlimited human wants
ContScarcity
and human wants evolve over time
Scarcity cont
Scarcity exists because our resources are
not enough to satisfy all human wants
MAIN BRANCHES OF ECONOMICS

Microeconomics
-
studies behavior of individual economic units

households, firms, markets
Macroeconomics
-
Focus is on the whole/aggregate economy
Examples of indicators: GNP, GDP, inflation,

unemployment
POSITIVE vs NORMATIVE ECONOMICS

Positive Economics
Answers the question: What is?
The price of gasoline is about Php 60/liter.
The population growth rate is 2.3%.
11 million Filipinos live on $1 a day.
Normative Economics
Answers the question: What should be?
The price of gasoline should be Php 20.0/liter
The population growth rate must only be at 2 %.
Filipinos ought to live on at least $5 a day
ECONOMICS AND MODELS

Economists use models in conducting
analyses
Models: A model is a simplified
representation of reality
Often represented by mathematical equations
and/or diagrams
Why use models

Allows us to organize our thoughts
Allows us to focus on the essential elements of
an economic relationship
WAKAS
Economics 11
Topic 2
Economic Problem
Dept of Economics
UPLB
Scarcity and choice

Scarcity = problem of choice
I.e. how do we allocate scarce resources?
Examples
Time: How much time should be spent between
studying, watching TV, friends?
Land: What do we plant? Do we even want to plant?
Budget of the national govt: Should it go to education
and health or to national defense?
etc
Basic Economic Questions

3 Questions: What, how and for
whom?
What to produce?
Do we produce everything?
Do we produce a few goods and
import the rest? If so, which goods?
How to produce?
What inputs are used to produce
goods?
What techniques?
ContHow to produce?
Example: In agriculture
or
or
Do we want to use fertilizers and/or pesticides in farms?
For whom to produce?

Who benefits?
Production Possibilities Frontier (PPF)

Useful tool for illustrating the choices
available to society and its constraints
PPF (defn): all the possible
combinations of the maximum
amounts of two goods and services
that can be produced with a given
amount of resources
Assumptions about the PPF

Only two goods are produced: food (F)
and clothing (C)
The society has limited resources (in
fixed supply)
Aside # 1: can assume that the resources
are land, labor, and capital
Aside # 2: capital physical capital like
machinery, buildings, etc.
Example of a PPF for a given technology

Interpretation: If the economy
uses its resources properly and
employs all of its resources,
then it can produce:
0 units of food and 1000
units of clothing
Alternative:
200 units of food and 850
units of clothing
Alternative: ?
Trade-off: To produce
more food, need to
produce less clothing
Option A: Economy
specializing in clothing
Option F: Economy
specializing in food
PPF
B
C
D
Specializing
in clothing
A
Specializing
in food
B
C
D
Negative slope
captures the trade-off
Infeasible
point
A
B
C
D
E
Inefficient use
of resources
and/or
unemployed
resources
Opportunity cost and the PPF

Defn: value of the best foregone
alternative
Applied to the current example:
The opportunity cost (O.C.) of producing
food is the quantity of clothing that needs
to be given up
Question: What is the O.C. of clothing?
OC using the table for the PPF

Preliminary calculations:
Preliminary calculations:
Interpretation
Between points A
and B, the O.C. of
producing an
extra unit of food
is half a unit (0.5)
of clothing
Increasing opportunity costs
OC of producing
food increases as
more food is
produced. Explains
the concave shape
of the PPF
The PPF & the Basic Econ Questions?

What to produce?
Shown by 2 goods on axes of PPF
Location on the PPF how much to
produce
How to produce?
Use technology that will enable
economy to produce goods represented
by points along PPF
For whom to produce?

Not shown by PPF
Shifts in the PPF

Technological improvement
Better production techiques
Changes in resource endowments

More workers, more capital
Improvements in the quality of resources
Water, Land, Forests, etc
The changes above cause an outward shift

in the PPF
Shifts in PPF
C
resources and/or
techno improvements
in the production of F and C
Aside: balanced
Question: Can the PPF shift
inward?
Shifts in PPF
Improvements confined
to clothing only
Improvements
confined to food
only
10
Economic systems & the Basic

Economic Questions
2 extreme economic systems
Complete command economy
Decisions made by authorities
Completely unregulated market economy
Markets determined the answers to the

questions
Actual economies fall somewhere in

between
WAKAS
11
Economics 11
Topic 3
Supply, Demand and Market Equilibrium
Dept. of Economics
UPLB
THE ROAD AHEAD

This lecture discusses the basic concepts
behind supply and demand analysis.
Topics
What is a market?
Demand side of the market
Supply side of the market
Market equilibrium
WHY STUDY SUPPLY & DEMAND?

Helps explain movements in prices and
quantities
A useful tool for analyzing a wide range of
topicsexamples:
How do govt policies affect consumers and
producers?
Price controls
Taxes and subsidies
Oil price increase, appreciation of the peso

Market shortages
Global warming and agricultural prices
WHAT IS A MARKET?
Market = an institution that facilitates
transactions between buyers and sellers
Markets as we know it:
But..
a market does not have to be a place
DEMAND SIDE
Demand - refers to the various quantities of
a good or service that users/consumers are
willing to purchase at alternative prices,
ceteris paribus.
Captures the desire for the commodity and
capacity to pay. Willing and able!
Emphasizes the relationship between quantities
of a good that people want to buy and prices of
that good
Law of demand
Asserts that the quantity demanded
of a good (Qd) is inversely related
to its own price (P)
Why is there a negative relationship?

Substitution effect
When price of a good decreases, the

consumer substitutes the lower priced good
for the more expensive ones.
Income effect
When price decreases, the consumers real

income (or purchasing power) increases, so
he tends to buy more.
3 ways to present the Law

of Demand
Table
Graph
Equation
Table: Demand schedule for Denim pants

Price of Denim Pants
(in pesos)
Quantity Demanded
(No. of pairs)
50
100
150
200
250
300
350
400
Demand curve
Note: Values here

were taken from the
table in the previous
slide
Price (in pesos)
400
300
200
100
D
0
Quantity
Equation
Qd is expressed as a mathematical
function of the price
Qd = a b P
a = horizontal intercept ~ indicates quantity

demanded when price is zero
-b = slope of the function ~ indicates the
change in Qd for a one unit increase in P
Equation for the previous example
Qd = 8 0.02 P
Change in quantity demanded vs change in

demand
Change in quantity demanded is a movement
along the same demand curve, due solely to a
change in price, i.e., all other factors held
constant.
Change in demand is a shift in the entire
demand curve (either to the left or to the right)
as a result of changes in other factors affecting
demand (later).
Change in quantity demanded
Price (in pesos)
P1
P2
D
0
Q1
Q2
Quantity
Change in demand
Increase in demand (rightward shift)
Price (in pesos)
P1
D2
D1
0
Q1
Q2
Change in demand
Decrease in demand (leftward shift)
Price (in pesos)
P1
D1
D2
0
Q2
Q1
The price is not the only factor that affects

demand.
Other factors affecting demand (OFAD)
Prices of related commodities
Consumer incomes
Tastes and preferences
Number of consumers
Price expectations
Changes in these (other) factors cause the

demand curve to shift
OFAD: Income
Normal goods: higher income leads to
higher demand (rightward shift in the
demand curve)
Most goods are normal
Inferior goods: higher income leads to

lower demand (leftward shift in the
demand curve)
Few examples but these exist
OFAD: Prices of related goods

Substitutes = goods which are substitutable for
each other
Eg. Coffee and tea, gin and rum

An increase in the price of a substitute raises the
demand for a good
Complement = goods which are used or

consumed together
Eg. Left and right shoe, coffee and sugar, beer and
sisig, paper and pencil
An increase in the price of a complement reduces the
demand for a good
OFAD: Consumer tastes and preferences

When consumer tastes shift towards (away
from) a good, then the demand for the good
increases (decreases)
E.g. higher preference for small products
Increase in demand for IPods
Lower demand for large stereo systems
E.g. preference for faster communication
Increase in demand for internet services (email)

Decrease in demand for traditional postal services
(snail mail)
10
OFAD: Consumer expectations

Expectations about future prices and income affect our
current demand for goods and services.
Expectation of higher prices increases current demand
queues in gasoline stations in anticipation of higher gas prices
Expectation of lower prices redeuces current demand
Postponing purchases in anticipation of a sale (lower prices)
OFAD: Number of consumers

More consumers/users of the good tends to
raise the demand for a good
Eg. Higher population leads to higher demand
for food, housing, etc
Eg. More health conscious people leads to higher
demand for the facilities provided by gyms
Let us now shift to the other side of the

marketSupply
11
SUPPLY SIDE
Supply refers to the various quantities of a
good or service that producers/firms are
willing to sell at alternative prices, cet. Par
Law of Supply states that quantity sold of
a good or services is positively related to its
own price
Higher price more good/service will be sold
Lower price less good/services will be sold
3 ways to present the Law

of Supply
Table
Graph
Equation
12
Table: Supply Schedule for Denim Pants

Price of Denim Pants
(in pesos)
0
50
100
150
200
250
300
350
400
Quantity Supplied
(No. of pairs)
0
1
2
3
4
5
6
7
8
Graph: Supply Curve

P
S
400
300
200
100
0
13
Equation
Quantity supplied (Qs) is expressed as a
mathematical function of price (P). The supply
function may thus be written as:
Qs = c + d P
c = indicates the value of Qs when P = 0
d = slope of the function
Applied to example: Qs = 0 + 0.02 P
Change in quantity supplied vs change in

supply
Change in quantity supplied is a movement
along the same supply curve, due solely to a
change in price, i.e., all other factors held
constant.
Change in supply is a shift in the entire supply
curve (either to the left or to the right) as a
result of changes in other factors affecting
supply (later).
14
Change in quantity supplied
P
P2
P1
Q1
Q2
Change in supply
Increase in supply (rightward shift)

P
S1
S2
P1
Q1
Q2
15
Change in supply
Decrease in supply (leftward shift)

P
S2
S1
P1
Q
Q2
Q1
The price is not the only factor that affects

supply.
Other factors affecting supply (OFAS):
Prices of resources/inputs
Prices of related commodities
Technology
Number of producers
Price expectations
Changes in these other factors cause the

supply curve to shift.
16
OFAS: resource/input prices

Higher input prices lead to a reduction in
supply (leftward shift in the supply curve)
Reason: Higher input prices make it more
expensive to produce the good or service
Example: Barber shop inputs are labor
(time of the barber), electricity, baby
powder, gel, razor blades, etc
OFAS: Prices of related goods in production

Resources can be used to produce several types
of goods
Example
Agriculture: Land can be used to grow rice, corn, etc.

Higher corn prices may lead to lower supply of rice
Land for housing and farming .
Corn is an input for producing food or biofuel.
Question: What could happen to the supply of food if
the price of biofuels increase?
17
OFAS: Technology
Improved production techniques tend to shift the supply
curve the right
Reason: Lower production costs for each unit of output
OFAS: Producer expectation

Expectations about future output and input prices affect
the supply of a good today.
If firms expect prices to rise in the future, then current
supply might fall.
OFAS: Number of sellers

More sellers in the market tend to raise the supply of a
good
MARKET EQUILIBRIUM
Market equilibrium is a state in which the
quantities that firms want sell is equal to the
quantities that users want to buy.
Equilibrium = state of rest
Equilibrium condition: Qs = Qd
Defines equilibrium price (P*) and equilibrium
quantity (Q*)
Three ways of presenting the concept

Table, Graph, Equations
18
Table: (Uses information provided earlier)

Price
(P)
Quantity
Demanded
(Qd)
Quantity
Supplied
(Qs)
50
100
150
200
250
300
350
400
Equilibrium
P* = 200
Q* = 4
Price above P*
Qs > Qd
Surplus or excess supply
Not equilibrium: There is pressure for the price
to fall.
Price below P*
Qs < Qd
Shortage or excess demand
Not equilibrium: There is pressure for the price
to rise.
19
Shortage and surplus

Price
(P)
Quantity
Demanded
(Qd)
Quantity
Supplied
(Qs)
50
100
150
200
250
300
350
400
Shortage (Qd>Qs)
=4
Surplus
(Qd<Qs) = 6
Graphical treatment
400
300
P*
200
Equilibrium
100
D
0
Q*
20
Surplus
surplus
400
300
P*
200
100
D
0
Q*
Shortage
400
300
P*
200
shortage
100
0
Q*
21
Rice shortage in RP?
Caption : WHAT SHORTAGE? People line up to buy NFAs subsidized rice on Friday
at its central office warehouse along Visayas Avenue in Quezon City. Each person
is allowed Only 3 kilos. A kilo costs P18.85. JOAN BONDOC
Source : Philippine Daily Inquirer, March 28, 2008, front page
Algebraic derivation
Equations
Solution
22
Our example
Equations
Solution
23
Equilibrium and an increase in demand

Possible sources:
Higher income (if good is normal)
Lower income (if good is inferior)
Higher price of a substitute
Lower price of a complement
Increased preference for the good
More consumers
If supply is upward sloping,
Higher equilibrium quantity
Higher equilibrium price
24
P*1
P*0
D1
D0
0
Q*0
Q*1
Do on your own:
Decrease in demand
Increase/decrease in supply
Simultaneous change in the supply and demand curves
WAKAS
25
Economics 11
Topic 4
Supply and Demand: Elasticities and Policy
Department of
Economics
UPLB
THE ROAD AHEAD

Elasticity concepts
Meaning of elasticity
Own price elasticity of demand
Cross price elasticity of demand
Income elasticity of demand
Applications of Supply and Demand

Floor price
Price ceiling
Tax incidence
Welfare measures
Consumer surplus
Producer surplus
MEANING OF ELASTICITY
If Y = f(X), the elasticity measures the
responsiveness of Y to changes in X
Percentage change in Y in response to a
one percent change in X
Formula:
Interpretation: = 0.75 means that a 1%

change in X leads to a 0.75% change in Y
Range of elasticity values (in absolute
value)
OWN PRICE ELASTICITY OF DEMAND

Own price elasticity of demand =
responsiveness of quantity demanded of
a good to its own price
Formula:
Two ways of measuring elasticity

Point elasticity - elasticity is measured
for a single point on the demand curve
More precise since elasticity can be different

at every point on a demand curve
Can be obtained if demand function is known
Arc elasticity computed for two

points along a demand curve
Implemented if there are a limited number of

observations
Point elasticity
P
P1
D
0
Q1
Arc elasticity
P
P1
A
B
P2
D
0
Q1
Q2
With numbers
P
30
A
B
20
D
0
100
200
Elasticity along a linear demand

curve
Linear demand curve = constant
slope
Elasticity = falls as you move down
the demand curve. Hint: examine
the formula for the point elasticity
Elastic
Unit Elastic
P1
P2
Inelastic
D
0
Q1
Q2
Example: Elasticity along a linear demand curve

Price
Quantity
Slope
Elasticity
10
-2
-2
-9.00
-2
-4.00
-2
-2.33
-2
-1.50
10
-2
-1.00
12
-2
-0.67
14
-2
-0.43
16
-2
-0.25
18
-2
-0.11
20
-2
0.00
Uses formula
for the point
elasticity of
demand
Special Case: Perfectly inelastic demand

curve
P
A vertical demand curve

implies that any change in
price will not lead to a
change in quantity
demanded.
Special case: Perfectly elastic demand curve

A horizontal demand
curve implies that a very
small change in price
will lead to an infinitely
large change in quantity
demanded.
Elasticity and total revenue

Total revenue is equal to the quantity sold
multiplied by the price.
TR = P x Q
It is of interest to the seller to see what
happens to TR if there is a change in the
price.
What happens to TR when P increases?

Answer: It depends!
If demand is elastic, higher price leads to
lower TR
If demand is inelastic, higher leads to
higher TR
If demand is unit elastic, higher price does
not affect TR
Elastic:
Q=
TR
Inelastic:
Q=
TR
Unit Elastic:
Q=
no TR
Determinants of the price elasticity

Availability of substitutes
More substitutes, more elastic
Price of the good relative to purchasing power
Larger share of the budget, more elastic
Time frame under consideration
Longer period, more elastic
Location along the demand curve
Recall previous points.
CROSS-PRICE ELASTICITY OF DEMAND

Cross-price elasticity of demand =
responsiveness of quantity demand of a
good to changes in the price of another
good
Formula:
Sign
+ for substitutes
- for complements
INCOME ELASTICITY OF DEMAND

Income elasticity of demand =
responsiveness of quantity demanded of a
to a change in income
Formula:
Values
+ normal
Greater than 1: luxury
Less than 1: necessity
- inferior
FLOOR PRICE
Aka minimum price policy
This is a lower limit on a price.
E.g. Floor price = 10 pesos. Means that the price
at which the good/service is sold cannot go below
10 pesos.
Examples: minimum wages
To be effective, this must be set above the
equilibrium price.
Consequence: surplus
10
Floor Price
P
S
surplus
Price floor
P*
D
0
Q*
PRICE CEILING
Aka maximum price policy
This is an upper limit on a price.
E.g. Price ceiling = 10 pesos. Means that the price
at which the good/service is sold cannot exceed 10
pesos.
Examples: jeepney fares
To be effective, this must be set below the
equilibrium price.
Consequence: shortage
11
Price Ceiling
P
P*
Price
ceiling
shortage
0
Q*
TAX INCIDENCE
Concerned with the effects of government
taxes on consumption and production.
Specific/excise tax vs ad valorem tax
Specific/excise tax = tax per unit of the product
Ad valorem = tax as a percentage of the selling
price
Question: Who pays for such taxes? Is it the

consumer? Or is it the producer?
Answer: likely to be both
Reason: Producers cannot raise the price by the
amount of the tax.
12
Case: Specific Tax (t)

Specific tax shifts the supply curve up by the
S1
amount of the tax
S0
P0+t
P0
Q0
but producers are likely to be unable to

raise prices by the amount of the tax
S1
P0+t
S0
P1
P0
D0
Q1
Q0
13
For each unit of the

good, this is the
component of the tax
that is paid for by the
producer
S1
P0+t
For each unit of the

good, this is the
S0 of the tax
component
that is paid for by the
consumer
P1
P0
D0
Q0
Q1
Numerical example:
Tax = 15 pesos/unit
Original equilibrium price = 10 pesos per unit

New equilibrium price = 14 pesos per unit
Burden:
Consumer pays 4 pesos/unit of the tax
Producer pays 11 pesos/unit of the tax
S1
25
S0
14
10
D0
Q1
Q0
14
Special case: Perfectly inelastic demand

D0
S1
P1 = P0+t
S0
Entire tax is
passed to
consumers
P0
Q0
Special case: Perfectly elastic demand

Entire tax is is
borne by
producers
S1
S0
D0
P1 = P0
Q1
Q0
15
CONSUMER SURPLUS
P
S
Consumer surplus:
difference between
what a consumer is
willing to pay and
what he actually pays
for the good.
P*
D
0
Q*
Decline in the market price raises the consumer

surplus
P
S0
P0
P1
D
0
Q0
Q1
S1
Increase in
consumer
surplus
16
PRODUCER SURPLUS
P
S
Producer surplus:
difference between
what a producer
receives and the
amount that will
motivate him to sell
the product
P*
D
0
Q*
The producer surplus is going to rise if there

is an increase in the price of the product
P
S
P1
Increase in
producer
surplus
P0
D1
D0
0
WAKAS
17
ECONOMICS 11
TOPIC 5
CONSUMER BEHAVIOR
Dept. of Econ., UPLB
THE ROAD AHEAD

Consumer behavior and utility
Utility concepts
Consumer equilibrium
Consumer behavior and utility

Useful for understanding the demand side of
the market.
Eg. Consumer behavior can help explain why
the demand curve is downward sloping
Utility - amount of satisfaction derived from

the consumption of a commodity
measurement units = utils
UTILITY CONCEPTS
Approaches
cardinal utility - assumes that we can
assign values for utility, (Jevons, Walras,
and Marshall). E.g., derive 100 utils from
drinking a bottle of beer
ordinal utility - does not assign values,

instead works with a ranking of
preferences. (Pareto, Hicks, Slutsky)
Example
Q
0
1
2
3
4
5
6
7
TU
0
20
27
32
35
35
34
30
MU
--20
7
5
3
0
-1
-4
TU
0
20
27
32
35
35
34
30
Marginal utility (MU)

MU = TU/ Q
If TU is increasing,
MU > 0
TU, in general, increases

with Q
Example
Q
0
1
2
3
4
5
6
7
Total utility (TU)
MU
--20
7
5
3
0
-1
-4
At some point, TU can start

falling with Q (see Q = 6)
From Q = 1 onwards, MU is
declining principle of
diminishing marginal utility
As more and more of a
good is consumed, the
process of consumption will
(at some point) yield
smaller and smaller
additions to utility
Total utility curve

Total utility(in utils)
TU
35
30
25
20
15
10
5
0
3 4 5
Quantity
Marginal utility curve
Marginal utility (in utils)
MU
20
15
10
5
0
-5
Q
1
Consumer Equilibrium
So far, we have assumed that any amount of
goods and services are always available for
consumption
In reality, consumers face constraints :
Limited consumers income or budget
Goods can be obtained at a price
Simplifying assumptions
Consumers objective: to maximize
his/her utility subject to income
constraint
2 goods (X, Y)
Prices Px, Py are given
Consumers income (I) is given
Definition
Marginal utility per peso = additional utility
derived from spending the next peso on the

good
Optimizing condition (maximizes utility):
Spend more on good X if (not yet optimal)
Example:
Note: PX = 2, PY = 10
Qx
TUX
MUX
QY
TUY
MUY
30
30
15
50
50
39
4.5
105
55
5.5
45
148
43
4.3
50
2.5
178
30
54
198
20
56
213
15
1.5
2 potential optimum positions

Combination A:
X = 3 and Y = 4
TU = TUX + TUY = 45 + 178 = 223
Combination B: X = 5 and Y = 5
TU = TUX + TUY = 54 + 198 = 252
The presence of two optimal conditions

suggests the need to consider income.
Preparatory work: calculate spending with
each combination
Total expenditure = PX X + PY Y
Combination A: 3(2) + 4(10) = 46
Combination B: 5(2) + 5(10) = 60
Scenarios
If the consumers income is 46, then the optimum is

given by combination A. Combination B is simply not
affordable.
If the consumers income is 60, then the optimum is
given by Combination B. Combination A is affordable
but it generates a lower level of total utility.
WAKAS
ECONOMICS 11
TOPIC 6
PRODUCTION AND COST
THE ROAD AHEAD

The focus here is on the behavior of the
firm.
Firm: entity concerned with the employment of
resources in the production of goods/services
Contents
Production function
Production analysis with one variable input
Costs of production and related concepts
Costs: Short run
Costs: Long run
The Production Function

The production function refers to the
physical relationship between the inputs of

a firm and their output of goods and
services at a given period of time, ceteris
paribus.
Purely technological relationship no

economics!
Inputs resources that contribute to the
production of a good/service. E.g. Land, labor,
capital
ContProduction function
Fixed and variable inputs
Fixed inputs resources used at a constant amount

in the production of a commodity
Variable inputs resources that can change in
quantity depending on the level of output being
produced
Fixed and variable inputs over time
Over a longer planning period, the distinction

between fixed and variable inputs disappears
All inputs are variable in the long run
Production Analysis with One Variable Input

Imagine a production function in which there is
only one input, say labor (L), used to produce
output. Alternatively, there are many inputs but
only one input is variable.
Total product (TP or Q) refers to the total amount

of output produced in physical units (may refer to,
kilograms of sugar, sacks of rice produced, etc)
Production Analysis with One Variable Input

The marginal product (MP) refers to the change in
output for a one unit change in the quantity of an
input, holding all other inputs constant.
Production function of a hypothetical

farmer
Quantity of
Labor (L)
Total Product
(QL or TPL)
12
20
26
30
32
32
30
10
26
Total product curve (uses the info in the

previous table)
Q
QL
Integrating marginal product

Quantity of
Labor (L)
Total Product
(QL or TPL)
12
20
26
30
32
32
30
-2
10
26
-4
Marginal Product
(MPL)
Some points
Observe that the marginal product initially
MPL
beyond this point, the marginal product
declines, reaches zero, and subsequently
other inputs fixed), a point will eventually
-2
10
-4
be reached at which the resulting additions
increases, reaches a maximum level, and
becomes negative.
The law of diminishing returns states
that "as the use of an input increases (with
to output decrease"
Graphical presentation
L
MPL
-2
10
-4
MP
L
MPL
MP and the TP curve
For a given level of L, MP is the slope of the line

that is tangent to the TP curve
Slope of this
line is MP at
L0
QL
L0
MP and the TP curve

Q
MP = 0
QL
Inflection point:
MP highest at this
point
L0
MP and the TP curve

MP = 0
MP < 0
MP>0 and falling
QL
Inflection point
MP>0 and rising
L0
Law of Diminishing Marginal Returns

As more and more of an input is added (given a
fixed amount of other inputs), total output may
increase; however, as the additions to total output
will tend to diminish.
Counter-intuitive proof: if the law of diminishing
returns does not hold, the worlds supply of food
can be produced in a hectare of land. Hint: Just
keep on adding more workers or other inputs in
that one hectare of land.
Average Product (AP)

Average product is a concept commonly
associated with efficiency.
The average product measures the total output
per unit of input used.
The "productivity" of an input is usually expressed in
terms of its average product.
The greater the value of average product, the higher
the efficiency in physical terms.
Formula:
Working with our numerical example.

Labor (L)
Total product of
labor (TPL)
Average product of
labor (APL)
0
1
2
3
4
5
6
7
8
9
10
0
2
6
12
20
26
30
32
32
30
26
2
3
4
5
5.2
5
4.5
4
3.3
2.6
Graphical derivation: Generic

The slope of the line from the origin is a measure of
the AVERAGE
Y
L1
Applied to the production function:

AP highest at pt. b
Total
Product
Q
AP at pt. c is less than at pt. a.

AP at pt. d is less than at pt. c.
b
c
d
QL
AP and MP curves
AP,MP
At Max AP,
AP = MP
Max
MPL
Max
APL
APL
L1
L2
L3
MPL
10
TP
TPL
L1
L2
MP>AP
AP increasing
Stage II
Stage I
AP,MP
L3
Stage III
MP<AP
AP decreasing
MP still positive
MP<0
AP decreasing
A
B
0
L1
L2
APL
L3
L
MPL
In Stage I
APL is increasing so MP>AP.
All the product curves are increasing
Stage I stops where APL reaches its maximum
(point A)
MP peaks and then declines at point C and
beyond, so the law of diminishing returns
begins to manifest at this stage
11
Stage II
starts where the APL of the input begins to
decline.
QL still continues to increase, although at a
decreasing rate, and in fact reaches a maximum
Marginal product is continuously declining and
reaches zero at point D, as additional labor
inputs are employed.
Stage III
Starts where MP < 0
All AP and MP product curves are falling
TP curve shows that hiring more inputs actually
reduces output
COSTS OF PRODUCTION
Opportunity Cost Principle - the economic
cost of an input used in a production process
is the value of output sacrificed elsewhere.
The opportunity cost of an input is the value
of foregone income in best alternative
employment.
Implicit vs. Explicit Costs
Explicit costs costs paid in cash
Implicit cost imputed cost of self-owned or self
employed resources based on their opportunity
costs.
12
Short run: 7 Concepts of costs

Total Fixed Cost
(TFC)
Total Variable Cost (TVC)
Total Cost (TC=TVC+TFC)
Average Fixed Cost (AFC=TFC/Q)
Average Variable Cost (AVC=TVC/Q)
Average Total Cost (AC=AFC+AVC)
Marginal Cost
(MC= TC/Q)
Long run: all costs are variable
TFC = AFC = 0
TVC = TC
AVC = AC
Costs: Short run

Total fixed cost (TFC)
Aka sunk cost or overhead cost
Component of cost is independent of the
level of output produced
Examples: include the payment or rent for
land, buildings and machinery.
13
Total variable cost (TVC)

Component of cost that changes with
the level of output
TVC = 0 if Q = 0
TVC increases as Q increases
Examples - purchases of raw

materials, payments to workers,
electricity bills, fuel and power costs
Total cost (TC)
sum of total fixed cost and total

variable cost
TC=TFC+TVC
As the level of output increases,
total cost of the firm also increases.
Numerical example of TFC, TVC

and TC of a hypothetical firm in
the next slide
14
Total
product
TP or Q
Total
Fixed
Cost
Total
Variable
Cost
Total
Cost
TFC
TVC
TC
0
1
2
3
4
5
6
7
8
9
10
Total
product
TP or Q
0
1
2
3
4
5
6
7
8
9
10
10
10
10
10
10
10
10
10
10
10
10
0
30
50
60
65
75
95
125
165
215
275
Total
Fixed
Cost
Total
Variable
Cost
TFC
TVC
10
10
10
10
10
10
10
10
10
10
10
10
40
60
70
75
85
105
135
175
225
285
Total
Cost
TC
0
10
30
40
50
60
Highlights the point
60 incur costs 70
that firms
75
even if 65
nothing is
produced.
75
85
95
105
Value does not change
125 of the firms135
regardless
175
output165
215
225
275
285
15
Total
product
TP or Q
0
1
2
3
4
5
6
7
8
9
10
Total
Fixed
Cost
Total
Variable
Cost
Total
Cost
TFC
TVC
TC
10
10
10
TVC = 0 if firms
produce10
nothing.
10 the
Rises with
firms 10
output
0
30
50
60
65
75
10
95
10
125
TC= TFC10+ TVC
165
TC = TFC if Q=0
10
215
Rises as Q increases
10
275
10
40
60
70
75
85
105
135
175
225
285
Cost curves
Pesos Doyo: relate this to the table
TC
(Total Cost)
TVC
(Total Variable Cos
TFC
(Total Fixed Cost)
16
Average fixed cost

AFC = TFC / Q
Declines as Q
increasesbut
never becomes
zero
Example with our
table
Graphical
derivation
provided in the
recit class
AFC
17
Average variable cost

AVC = TVC / Q
As Q increases, AVC
declines initially and
then rises
AVC falling
as
Q increases
Example with our table

This generates a U
shaped curve (next
slide)
Note: Graphical
derivation provided in
recit class
AVC rising
as
Q increases
AVC
18
Average cost
AC = TC / Q
AC = AFC + AVC
AC falling as
Q increases
Follows a similar pattern

to the AVC curve
Note: Graphical
AC rising as
Q increases
recit class
AC
19
AC and AVC curves

AC > AVC
Reason: AC = AFC +
AVC
Gap between AC and

AVC narrows as Q
increases
Reason: declining AFC
AC
AVC
AFC
20
Marginal cost
Shows the change in
total cost for a unit
change in output
MC falling as
Q increases
Follows a similar pattern

to the AVC curve
Note: Graphical
MC rising as
Q increases
recit class
MC
21
MC, AVC, AC
All 3 curves are U
shaped
MC intersects the AVC
and AC curves at their
lowest points
MC intersects the AVC
curve first (will become
clearer later)
MC
AC
AVC
AC is falling if MC < AC and rising if MC > AC.

AVC is falling if MC < AVC and rising if MC > AVC.
Closer look at intersections: see next slide
22
On closer inspection..
Minimum
point of
AC curve
MC
AC
AVC
Minimum
point of AVC
curve
Q
Costs: Long run

All costs are variablei.e. no fixed costs
PhP
LTC
Long
run
total
cost
cuve
23
Long run average costs (LAC)

ATC = LTC/Q
The LAC curve is an envelop curve of all
possible plant sizes. Also known as planning
curve
It traces the lowest average cost of producing
each level of output.
It is U-shaped because of
Economies of Scale
Diseconomies of Scale
PhP
LAC
SAC1
SAC2
24
Deriving the LAC curve

Let SAC1 correspond to plant size 1. With this plant size the
cost of producing Q0 units of output is C0. In the long run,
the firm can adjust the plant size (corresponds to a new SAC
curve) so that production costs are lower (see next slide)
Php
SAC1
LAC
C0
Q0
Potentially lower costs with plant size 2 (represented by

SAC2). ..can repeat this exercise for all other levels of
output
Php
SAC1
SAC2
LAC
C0
Q0
25
Long run marginal cost (LMC) curve

LMC
Php
LAC
Minimum point
of LAC curve
Q1
Constructing the LMC curve

Php
SMC1 SAC
LAC
First point on LMC

curve
0
Q1
26

Php
SMC1 SAC
LAC
SMC10
SAC10
Another point on
LMC curve
0
Q1
Q10

Another point on
LMC curve
Php
SMC1 SAC
SMC100
SAC100
SMC10
LAC
SAC10
Q1
Q10
Q100
27
Connecting the dots
SMC100
LMC
SMC1
Php
SAC100
SAC1 SMC10
LAC
SAC10
Q1
Q10
Q100
Cleaning-up
LMC
Php
LAC
Q1
Q10
Q100
28
The road ahead

We have just seen the cost side of
production.
But firms do not just look at costs in
making decisions. They also need to
examine the demand side..Abangan!
WAKAS
29
ECONOMICS 11
TOPIC 7
PERFECTLY COMPETITIVE
MARKETS
MARKETS
the market is a system where buyers and
sellers exchange goods or services
allocates goods and services with the help of
prices
Markets for commodities and inputs

Commodities rice, clothes, etc
Inputs labor, land, etc
Markets may have different structures

Number of sellers or buyers
Control in the market
etc
GENERAL TYPES OF MARKETS

Perfect competition [features later]
Imperfect competition
Monopoly one firm
Oligopoly two or more firms. Few firms
Monopolistic competition many firms selling
differentiated products
Note: This topic focuses on perfect

competition. Imperfect competition will be
discussed in the next topic.
FIVE FEATURES OF A PERFECTLY

COMPETITIVE MARKET
1. Smallness of buyers and sellers relative to
the market
2. Homogeneous product
3. Absence of artificial restraints or controls
4. Free entry or exit
5. Perfect information
The Demand Curve Faced by the Firm

In a perfectly competitive market, no
individual firm can influence the market
price.
Implication: the firm in perfect competition
faces a perfectly elastic demand curve
P
d
MARKET vs FIRM DEMAND

Market
Price
D
Price
Firm
P*
0
Equilibrium price is determined
in the market
P*
Once determined, a firm can sell

as much as it wants at that price
Changes in market conditions can affect the

price at which the firm sells its output
Market
Price
Firm
Price
D2
D1
P2
P2
P1
P1
Revenues of the Firm

Total revenue (TR) is the firm's gross income from
the sale of its product
TR =P x Q
Marginal revenue (MR) is the additional revenue
earned from each additional unit of output sold.
MR=TR/Q
Average revenue (AR) is total revenue divided by
output.
AR=TR/Q
NUMERICAL EXAMPLE
Q
TR
MR
AR
200
200
200
200
200
200
400
200
200
200
600
200
200
200
800
200
200
200
1000
200
200
Under perfect competition, P = MR = AR
How the table was constructed

Q
TR
MR
AR
200
200
200
200
200
200
400
200
200
200
600
200
200
200
800
200
200
200
1000
200
200
PxQ
TR/ Q
TR/ Q
Graphical representation
TR
600
400
MR =
AR
P = 200
HOW MUCH OUTPUT WILL THE

FIRM PRODUCE?
Assumption: The objective of the firm
is to maximize profits
Profits () = Total revenue (TR)
Total Cost (TC)
Table in the next slide integrates cost

into the analysis (note: MR and AR
eliminated temporarily)
NUMERICAL EXAMPLE
Output
Price
Total
Revenue
Total
Cost
Profit
(Q)
(P)
(TR)
(TC)
()
200
500
-500
200
200
591
-391
200
400
668
-268
200
600
737
-137
200
800
804
-4
200
1000
875
125
200
1,200
956
244
200
1,400
1,053
347
200
1,600
1,172
428
200
1,800
1,319
481
10
200
2,000
1,519
481
11
200
2,200
1,784
416
12
200
2,400
2,119
281
13
200
2,600
2,529
71
14
200
2,800
3,019
-291
Maximum profits
The firm produces
10 units of output
Graphical representation: details in next slide

TR,TC
TC
Total Revenue, Total

Cost
TR
Maximum
profits
Maximum
profits
Profit
Q0
Q*
Q1
Profit curve
Output
TR,TC
TC

Cost
TR
Highest
profits
0
Q0
Q*
Q1
Profit
Profits or losses are measured by the vertical distance between the

TR and TC curves
Q = Q0 or Q = Q1: TR intersects TC. Means zero profits.
Q0 < Q0 < Q1: TR above TC curve. Firm is making Q
profits
Q0
Q*
Q
Other values of Q, TR below
TC so firm is 1experiencing losses
(negative profits)
Output
TR,TC
TC

Cost
TR
Highest
profits
Q
Q0
Q*
Q1
Profit
Highest profits correspond to point in which the slopes of the TR and

TC curve are equal.
Note:
0
Q
Q0
Q* (MR)
Q1
Slope of TR = Marginal
revenue
Slope of TC = Marginal cost (MC)
Output
Implication: MR = MC
at maximum profits!
Completing the table

Output
Price
Total
Revenue
Marginal
Revenue
Total Cost
Marginal
Cost
(Q)
(P)
(TR)
(MR)
(TC)
(MC)
()
200
500
-500
200
200
200
591
91
-391
200
400
200
668
77
-268
200
600
200
737
69
-137
200
800
200
804
67
-4
200
1000
200
875
71
125
200
1,200
200
956
81
244
200
1,400
200
1,053
97
347
200
1,600
200
1,172
119
428
Profit
200
1,800
200
1,319
147
481
10
200
2,000
200
1,519
200
481
11
200
2,200
200
1,784
265
416
12
200
2,400
200
2,119
335
281
13
200
2,600
200
2,529
410
71
14
200
2,800
200
3,019
490
-291
MC
200
AC
P =MR = AR
AVC
150
100
Q*
Optimizing condition: MC = MR = P
Optimizing position: point A
Profits maximizing level of output: Q*
MC
P = MR = AR
200
AC
AVC
150
100
Q*
Total revenues = PxQ = area 0FAQ*

Total cost = ACxQ = area OCBQ*
Profits = TR-TC = CFAB
What happens to output when price falls

from P0 to P1? Output falls to Q1.
MC
AC
AVC
200
P0= MR0
150
P1 = MR1
100
Q1 Q0
10
Break-even point:
P = MR = MC at the minimum of AC
Zero profits
MC
AC
AVC
P2 = MR
100
Q*
Firm experiencing losses

P = MR = MC below the minimum of AC
MC
AC
AVC
P3 = MR
Q*
11
Firm experiencing losses: Loss = GABC

Will the firm quit? No!
MC
AC
AVC
G
F
P4 = MR
E
Q
Q*
If continue producing, the loss is GABC

If stop producing, the loss is FABE (Fixed cost)
GABC < FABE
MC
AC
AVC
G
F
P4 = MR
Q*
12
When will the firm quit? (Shut down point)

When P = MR = MC at minimum of AVC
MC
AC
AVC
P5 = MR
Q*
Lessons:
The firm maximizes profits at the point
where P = MR = MC.
The firm will continue production even if it
is experiencing losses.
Will not quit the market if the loss from

leaving the market (TFC) is bigger than the
loss from operating
The firm will shut down in P = MR = MC

at the minimum point of the AVC curve
13
Supply curve of the firm

Corresponds to the firms MC curve that
is above the minimum point of the AVC.
The MC curve here indicates how much
the firm will produce at alternative
prices.
See next slide
Supply curve of the firm: MC curve above

the minimum point of the AVC curve
MC
AC
AVC
P1
P2
P3
P4
P5
Q*
14
Cleaning-up
When P = MR = MC at minimum of AVC
MC
AVC
Supply curve
Q*
Long Run Equilibrium

Suppose that the price level
(determined by D-S) is such that it is
profitable for firms to operate.
Positive profits will attract new firms
into the industry.
Supply curve will shift to the right
Price will decline until profit is driven
down to zero.
15
However, it is not profitable to

operate, then
negative profits will make some firms
leave the industry.
Supply curve will shift to the left
Price will increase until profit is no longer
negative.
EQUILIBRIUM AT FIRM & MARKET LEVELS

P
SAC
MC
S0
LAC
P0
MR
P0
Q0
At P0, firms are making profits. This encourages other

firms to enter the market. As this happens, the supply
curve shifts down and pushes the equilibrium price
downwardsee next slide
16
EQUILIBRIUM AT FIRM & MARKET LEVELS

P
MC
D
S0
LMC
S1
LAC
P0
P0
P1
P1
Q1
Q0
The entry or exit of firms will stop only when profit is

reduced to zero. This is at the lowest point of the LAC
curve.
A CLOSER LOOK AT THE INDUSTRY

LMC
COST
LAC
SMC1
SAC1
0
Long Run Equilibrium of the Industry: P = LMC = SMC,
LAC = SAC
MR,
AR
Q
P=
17
THREE TYPES OF INDUSTRIES

Industries differ in their long run
response to a change in demand
Types
Constant cost industry
Increasing cost industry
Decreasing cost industry
Long run effects of an increase in demand

Assumption: initially starting at zero profits
(long run equilibrium)
Increase in demand raises the equilibrium price
(short run)
Positive profits encourages the entry of first and
shifts the supply curve to the right
Rightward shift in the supply curve makes the
effect on the price ambiguous
See diagram in next slide
18
P
P0
D1
P0
D0
Q0
Constant cost industry
Supply curve shifts such that the price is

unaffected
S0
S1
P0
P0
D0
Q0
D1
19
This implies a long run supply curve that is

horizontal
S0
S1
P0
Long
run
supply
curve
P0
D0
D1
Q0
Increasing cost industry
Supply curve shifts such that the price is

higher
S0
S1
P1
P0
D0
Q0
D1
20
This implies a long run supply curve that is

upward sloping
S0
S1
Long
run
supply
curve
P1
P0
D0
Q0
D1
How did this happen? Effectively the entry of firms

Has shifted the LAC schedule up.
COST
LAC1
LAC0
P1
P0
0
MR,
AR
Q
21
Decreasing cost industry
Supply curve shifts such that the price is lower
S0
S1
P0
P1
D0
D1
Q0
Implies a long run supply curve that is

downward sloping
S0
S1
P0
P1
D0
D1
Long
run
supply
curve
22
How did this happen? Effectively the entry of firms

has shifted the LAC schedule down.
LAC0
COST
LAC1
P0
P1
0
Where do we go from here?

In practice, it is hard to find markets
that are perfectly competitive.
imperfect competition
WAKAS
23
ECONOMICS 11
TOPIC 8
IMPERFECT COMPETITION
What is imperfect competition?

Imperfect competition is a situation where
individual firms have a measure of control
over the price of the commodity in an
industry.
a firm that can affect the market price of its
output can be classified as an imperfect
competitor.
arises when an industry's output is supplied
only by one or a relatively small number of
firms.
Important points
While a firm may have some control over
the price, but this power is not absolute!
Why?
It has to consider the demand for its output!
Aside from discretion over price, imperfect

competitors may or may not have product
differentiation/variation.
Demand curve faced by firm

The firm under an imperfect market faces the
market demand curve or part of it.
In either case, the firm faces a downward sloping
demand curve
This implies that if the firm wants to sell more, it should
lower the price; if it wishes a higher price, it should
restrict output.
In contrast, a perfectly competitive firm, since it has no
control over price, faces a horizontal demand curve.
Sources of market imperfection

Imperfect competition often arises when an
industrys output is supplied by one or a small
number of firms.
This may be traced to the existence of barriers to
entry and the existence of significant differences
or advantages in cost conditions.
Barriers to entry natural or artificial constraints

that prevent other firms from entering the
industry
legal restrictions like patents and exclusive franchises;
existence of advantages in cost conditions demand
for commodity may be too small, firms production
function may exhibit increasing returns to scale (LAC
curve shows economies of scale over all profitable
output levels).
MC
AC
Market demand
TYPES OF IMPERFECT MARKETS

Monopoly one seller in the market
e.g., Meralco is sole distributor of electric power in
Metro Manila
Oligopoly market structure with few sellers;
e.g., cement and automobile industries,
firms operating in an oligopolistic market situation
may either collude or act independently
Monopolistic competition occurs when there are many
sellers producing differentiated products
firms have slight control over the price of the
commodity
MONOPOLY
Note: Other forms of imperfect competition will
not be covered in the course
Some points about monopolies
being a monopolist does not ensure the firm instant
profit;
it is not true that the firm can impose any price it
wants; maximum price is dictated by market demand;
and
a monopolist cannot maximize profit at the inelastic
portion of the market demand curve.
Monopoly: Market demand curve and

marginal revenue (MR)
P
MR
Demand for output, P, TR and MR of a monopolist.

Q
TR
MR
200
198
198
198
196
392
194
194
582
190
192
768
186
190
950
182
188
128
178
186
1302
174
184
1472
170
182
1638
166
10
180
1800
162
11
178
1958
158
12
176
2112
154
Note:
MR =
TR/ Q
Also, P>MR
for Q>1
Important points:
Note that P MR, unlike perfect competition.
P is also the AR curve, hence as price drops,
MR is less than price
On a linear demand curve, MR decreases
twice as fast as the demand curve.
Short run profit maximization

Maximum profit is at the largest vertical
difference between total revenue TR and total
cost TC.
At maximum vertical difference, slopes of TR
and TC are equal. Hence, MR=MC.
Firm will produce (at MR=MC) unless price
falls below AVC.
Profit max at MR = MC
Q
TR
MR
TC
MC
200
500
-500
198
198
198
589
89
-391
196
392
194
660
71
-268
182
1638
166
1168
114
470
10
180
1800
162
1330
162
470
11
178
1958
158
1550
220
408
12
176
2112
154
1850
300
262
13
174
2262
150
2262
412
Monopolist sells 10 units and charges

180 pesos/unit
Q
TR
MR
TC
MC
200
500
-500
198
198
198
589
89
-391
196
392
194
660
71
-268
182
1638
166
1168
114
470
10
180
1800
162
1330
162
470
11
178
1958
158
1550
220
408
12
176
2112
154
1850
300
262
13
174
2262
150
2262
412
Profit max at MR = MC (pt A).

Firm produces Q* and
charges P*
MC
AC
P*
A
0
D=AR
Q*
MR
Profits = EP*CB
P
MC
AC
P*
B
E
A
D=AR
Q*
MR
Is the MC curve the supply curve?

No.
The MC curve of the monopolist does not reflect
the short run supply curve since the monopolist
does not produce output at the levels where MC
=P
It produces output at MR=MC to maximize
profit. But MR is generally less than P.
Does a monopolist always make a profit?

P
Loss
MC
P*
AC
No!
D=AR
Q*
MR
Inefficiency of a monopolist
The price set by monopolist is greater
compared to that under competition.
Hence some consumers are unable to
purchase the commodity, implying some
welfare loss.
The level of output under monopoly is
lower compared to that under perfect
competition.
10
Pricing at marginal cost

P
MC
PM
P0
D=AR
QM
Q0
MR
Regulation of a monopoly
Lump sum tax is a fixed amount of tax levied on a
producer
The tax increases the firms fixed cost but not the variable cost
The firms marginal cost is not affected (does not change)
The change in fixed cost however affects total cost and average
cost
Specific tax is a tax proportional to level of output

produced.
Affects the firms variable cost, average cost and marginal cost
Price regulation a set price imposed by the

government to enhance the welfare of the consumers,
a regulatory body can impose a price equal to MC.
11
Monopolist charged a lump-sum tax

(LST): still sell Q* and charge P*
MC
AC w/ LST
P*
AC
A
0
D=AR
Q*
MR
P
MC
P*
F
G
But profits lower:

Old profits = P*EBG
New profits = P*ECF
Tax = FCGB
AC w/ LST
AC
C
B
A
D=AR
Q*
MR
12
Specific tax: higher price and lower

quantity
MC w/ ST
MC
P1
P0
AC w/ ST
AC
A
D=AR
Q1 Q0
MR
Government can force monopolist to

charge a price equal to MC. Tends to
reduce the price and raise output.
MC
PM
P0
D=AR
QM
Q0
MR
13
Where do we go from here?

We will now switch gears and go to
macroeconomics
WAKAS
14
ECONOMICS 11
TOPIC 9
NATIONAL INCOME ACCOUNTING
INTRODUCTION
National income accounting (NIA) refers to the
measurement of indicators of national output or
income; e.g. GDP, GNP
The road ahead
Circular flow diagram
Gross Domestic Product
Measuring GDP
National accounts of the Philippines
Refinements to GDP
Important considerations
Digression: price indices and the inflation rate
CIRCULAR FLOW DIAGRAM

summarizes the transactions between
the different economic agents
agents: households, firms (business),
government, and foreigners (rest of
the world)
Assumption: The economy composed

of households and firms only
Households: own factors of production,
consume goods and service
Firms: hire factors of production to
produce goods and services
payments for goods and services
Goods and services

FIRMS
HOUSEHOLDS
Factor services (labor,
capital, land
factor payments
(wages, interest, rent, profit)
payments for goods and services
Goods and services

FIRMS
HOUSEHOLDS
capital,
land
upper loop
represents
The
the
transactions in the market for
goods and services
The lower loop

represents
transactions in the
market for factors
FIRMS
HOUSEHOLDS
capital, land
factor payments
(wages, interest, rent, profit)
Extension: Accounting for

government and foreign agents
a.
b.
c.
d.
e.
f.
Government purchases of goods and

services.
Government payments for factor
services (wages, rent, interest).
Transfer payments between different
agents (more in the next slide)
Firms and households pay taxes to
government.
Taxes paid on income, property, goods
and services.
Transactions with the foreign sector
(more in the next slide)
Transfer payments
Transaction for which the receiving party is not
obliged to deliver a good/service in return for a
payment
E.g., donations, unemployment benefits, gifts
Transactions with the foreign sector

Sales of goods and services, assets and transfers
between domestic and foreign agents
Exports sales of domestic goods/services to other
countries
Imports domestic purchases of goods/services
produced overseas
GROSS DOMESTIC PRODUCT (GDP)

GDP, along with GNP, is commonly
used as a measure of the output of an
economy.
The GDP measures the market value of
all final goods and services produced
within an economy in a given period.
Some points regarding GDP

Only measures final goods
Goods which are not purchased for the
purpose of producing other goods or resale
Example: Rice
Example: coconut
Final good if bought for the purpose of

consumption
Not a final good (intermediate good) if
purchased for re-sale in a restaurant
Final good if bought for the purpose of
consumption
Intermediate good if used for making buko pie
Helps avoid double counting
Some points regarding GDP
cont.
Usually expressed in the currency

of particular country
Peso for RP
Allows us to add different goods
Market value of good i = Pi Qi
Qi = quantity of final good i produced

Pi = price of good i
Some points regarding GDP cont.

Only measures current production. Does
not include:
Does not include transfer payments
Does not include current sales of goods
produced in other periodse.g. secondhand
goods
MEASURING GDP
Note: There are always two sides to every
transaction (purchase)
Eg. Pedro buy 50 pesos worth of rice from
Juan
1 transaction = 50 pesos
Pedros viewpoint: expenditure = 50 pesos
Juans viewpoint: income = 50 pesos
Lesson: If the 50 pesos worth of rice is to

be included in GDP, then we can measure
it from Pedros (expenditure) or Juans
(income) perspective.
Three equivalent approaches for measuring

GDP:
expenditure
income
value added
Expenditure approach
GDP = sum of expenditures on final goods
Example: 2 final goods ice cream and buko
pie
Numerical example in the next page
Good
Ice Cream
Buko pie
Price per unit
Q sold
Expenditure
100
50
10
5
GDP
1000
250
1250
Income approach
GDP = sum of payments for the different
factors of production
GDP = wages + rent + interest + profits
Value added approach

Value added measures the
contribution of the different
factors of production to the
value of a good
GDP = sum of value added of all
productive activities
Formula: Value added = sales
purchases from other firms
(POF)
Numerical example:
Value added = 1,000 300 =
700
Item
Sales
Value
(Php)
1,000
Costs
Wages
100
Interest 100
Rent
100
POF
300
Profits
400
Equivalence of the approaches

Expenditure and income
Every transaction is an expenditure from the

viewpoint of one party and an income from the
viewpoint of the other party
Income and value added
Value added = Sales purchases from other firms

= wages + rents + interest profits = components of
the income approach
To verify this, see the table in the previous slidethe
textbook also provides an example
NATIONAL ACCOUNTS OF
THE PHILIPPINES
The actual accounts retain the principle
that the three approaches generate the
same value for GDP. However, some
adjustments are made to accommodate
the realities of modern economies.
Strategy:
Values presented are based on the textbook
Will present more recent data later
Expenditure approach
GDP = C + G + I + X M + SD
GDP of the RP, 1998, million pesos
Item
Personal Consumption Expenditure
Symbol
C
Value
1,980,088
Government Consumption Expenditure
354,981
Gross Domestic Capital Formation
541,233
Exports of Goods and Services
1,478,016
Less: Imports of Goods and Services
1,577,727
Statistical Discrepancy
SD
-109,483
GDP
2,667,108
10
Spending of households and private non-profit institutions

on goods & services.
Includes durable and non-durable goods.
Main items: Food, beverages, clothing and footwear, fuel,
light and water, transport/communication, household
furnishings, household operations, miscellaneous
Item
Symbol
Value
1,980,088
Government Consumption Exp.
354,981
541,233
1,478,016
payments
for its
Less: Governments
Imports of Goods
and Services
workforce and purchases of
goods and services
1,577,727
SD
-109,483
GDP
2,667,108
Investment spending of domestic agents. Its

major components are Fixed Capital and
Changes in Stocks
Item
Symbol
C
Value
1,980,088
354,981
541,233
1,478,016
1,577,727
SpendingDiscrepancy
of foreigners on goods and non-SD
Statistical
factor services produced in the Philippines.
Gross
Product because C+I+G
GDP
AddedDomestic
into the calculations
just represents the expenditures of domestic
residents only.
-109,483
2,667,108
11
Philippine purchases of goods and nonfactor services produced in other countries.

Subtracted because C+I+GSymbol
includes
Item
Value
imports
and
these
should
not
beCincluded 1,980,088
in
RP GDP.
G
354,981
541,233
1,478,016
1,577,727
SD
-109,483

GDP
2,667,108
Captures accounting and reporting errors
inserted to ensure that the 3 approaches
generate the same value for GDP
Value added approach

Aka GDP by Industrial Origin
Classified by major sector
Includes crops like palay, corn, coconut, sugarcane,

bananas, livestock, poultry, agri activities and services,
other crops, fishery, forestry
12
Includes mining & quarrying, manufacturing (food

and non-food), construction, electricity-gas-water
Includes: Transport-communication-storage, trade

(wholesale and retail), ownership of dwellings &
real estate, private services, government services
Income approach
GDP = COE + NOS + Depreciation + IBTS
Depreciation and IBTS are adjustment items
ITEMS
SYMBOLS
VALUE
Compensation of Employees
COE
725,261
Net Operating Surplus
NOS
1,468,612
Depreciation
236,845
Indirect Business Taxes less Subsidies
IBTS
236,390
GDP
2,667,108
13
This captures wages in the theoretical

presentation
ITEMS
SYMBOLS
VALUE
Compensation of Employees
COE
725,261
NOS
1,468,612
Depreciation
This
captures
rent,
profits
Indirect
Business
Taxes less
Subsidies
and IBTS
interest
in the theoretical presentation
GDP
236,845
236,390
2,667,108
wear and tear of physical capital

D is treated as a business cost and is not
ITEMS
SYMBOLS
VALUE
included in NOS. Added here
because the
investment
item in the expenditure
accounts
Compensation
of Employees
COE
725,261
includes depreciation.
Depreciation
NOS
1,468,612
236,845
Indirect Business Taxes less Subsidies
IBTS
236,390
GDP
2,667,108
Includes taxes on the use/purchase/production of

goods and services and grants from governments to
firms
Examples: value added tax (VAT), specific taxes
14
Summary
Items
Expenditures
Primary
items
C
I
G
X
(less) M
Adjustments
Total
Value added Income

AFF
Industry
Services
SD
GDP
COE
NOS
IBTS
Depn
GDP
GDP
GDP and GNP

Aside: Gross National Product (GNP) is also
known as Gross National Income (GNI).
Source: Albert, J.R. (2013) Understanding Income as

Measured from GDP, GNI and NDI, National Statistics
Coordination Board, http://www.nscb.gov.ph/
sexystats/2013/SS20130626_incomegdp.asp, posted
on 28 June
GNP = GDP + Net factor income from abroad

(NFIA)
NFIA = earnings of Philippine residents in other
countries earnings of foreigners in the RP
15
GDP and GNP continued

Implication:
GDP = value of output in the Philippines, regardless
of who makes it
GNP = value of the output of Filipinos, regardless of
where it is made
To help you remember the difference:

GDP = Gawa Dito sa Pilipinas
GNP = Gawa Ng Pinoy
Example: 2006, billion pesos
Additional indicators available

Quarterly accounts
Estimates of GDP, GNP and their components for
each quarter the year
Gross Regional Domestic Product

GDP of different regions in the Philippines
16
Possible sources of data:

National Statistics Coordination Board (NSCB): www.nscb.gov.ph
NEDA: www.neda.gov.ph
World Bank (World Development Indicators):
http://data.worldbank.org/data-catalog/world-developmentindicators
ADB (ADB Key Indicators for Asia and the Pacific):
http://www.adb.org/publications/series/key-indicators-for-asiaand-the-pacific
IMF (World Economic Outlook):
http://www.imf.org/external/pubs/ft/weo/2013/01/weodata/index.
aspx
REFINEMENTS TO GDP
(and GNP)
GDP estimates are usually refined (or
adjusted) to enhance their usefulness for
analysis.
Analysis over time
Analysis across economies
Refinements:
Price changes or differences
Population
Note: All adjustments to GDP also apply to

its components and to GNP.
17
Nominal and real GDP

GDP at current prices or nominal GDP = GDP
measured using the prices for the year in
which it is calculated
Example
Incorrect conclusion: Output went up in

Year 2 because GDP is higher.
Why incorrect? Look at the quantities of
buko pie and ice cream!
18
Real GDP or GDP at constant prices= measures

GDP using prices of a pre-selected year (base
year)
Example: Using Year 1 as the base year
REAL GDP
Conclusion based on real GDP: The output of

the country did not change between Years 1
and 2
Lesson: Real GDP eliminates the impacts of

changing prices.
In practice, the formula is
GDP deflator a price index that allows us

to convert nominal GDP into real GDP.
[note: more on the price index later]
19
Some numbers for RP
The nominal GDP in 2006 is about 11 times larger

than its counterpart for 1984. However, Real GDP
(valued at 1985 prices) in 2006 is only about 2 times
larger than its counterpart for 1984. Why? Because
prices have risen.
The GDP deflator shows that prices as a whole are 4.7

times higher in 2006 than in 1985.
GDP per capita

GDP per capita measures how much
output or income was produced or
received, on the average, by an
individual in an economy
Formula
20
Actual data for the Philippines
Population projection
for 2006 (medium
assumption) of the
NSO
GDP for cross-country comparisons

Convert to a common currency using the
exchange rate
GDP domestic currency/Exchange rate
Easier to understand and compare values
Use per capita estimates
Bigger countries (in terms of population)

likely to have bigger GDPs. However, does
not mean that per capita GDP is higher.
21
Example: 2012 data from the IMF, World

Economic Outlook
Brunei:
GDP = US$ 17 B, population = 0.4 M
persons, GDP per capita = US$ 41,703
Ethiopia:
GDP = US$ 42 B (2.5 times larger than
Brunei), population = 86.8 M persons
(217 times larger than Brunei), GDP per
capita = US$ 483 (1% of Brunei)
More examples in Annex 1
PPP adjusted GDP
Adjusts for the fact that one dollar spent in one

country does not buy the same quantity of goods
as in another country
Price of Big Macs in selected countries
Country
Price of a Big Mac (US$)
Price relative to US
Ukraine
1.86
0.4
China
2.45
0.6
Philippines
2.80
0.6
United States
4.33
1.0
Norway
7.06
1.6
Source: The Economist, July 2012
PPP adjusted GDP (see Annex 2)
22
Aside: Growth rates

Growth rate formula:
Applied to many variables: GDP, GNP,

components of GDP/GNP, etc..
Why use growth rates? Gives us a sense
of how fast has a variable is rising or
falling
IMPORTANT CONSIDERATIONS
REGARDING GDP/GNP
Main point: High values of GDP do not always
correspond to high standards of living. At best
GDP is an imperfect measure of output
GDP does not capture
Income distribution, poverty
Costs of achieving high levels of output: pollution,
time for leisure, etc
Transactions to that do not go through
organized/formal markets: e.g. household chores,
helping friends.
Illegal activities
23
Some values in GDP are imputed

Imputing refers to the process of approximating
values of certain activities
E.g. owner-occupied houses
DIGRESSION: PRICE INDEX

A price index indicates the change in the cost of
purchasing a given bundle of goods in one year
relative to another (base year). In other words, it
measures how prices, on the average, differ across
observations.
Interpretation:
Price index for 2007 is 160 and the base year is 2005
This means that prices in 2007 are, on the average,
60% higher than in 2005.
Note: If the base year is 2005, then the price index for
2005 is 100.
24
Consumer price index

One of the most commonly used indicators
of the general price level
Measures changes in the cost of purchasing
a given bundle of goods that are bought by
the average household.
Weights are based on the shares of goods
and services in the spending of the average
household. Example provide in the next
slide for the CPI with 2000 as the base year
25
Inflation rate
measures the rate of change in the general
price level
indicates how fast prices are, on the
average, rising or falling over a given
period.
Formula:
Example:
Let CPI1998 = 137.9 and CPI1997 = 125.1
Interpretation: Prices in 1998 are, on the

average, 10.2% higher than in 1997
Note: A lower inflation rate does not

mean lower prices.
WAKAS
26
Annex 1
GDP and population estimates for 2012
Rank
1
2
3
4
5
181
182
183
184
185
10
20
65
93
113
127
140
144
157
159
11
13
87
Country
GDPpercapita
(US$)
HighestpercapitaGDP
Luxembourg
107,206
Qatar
99,731
Norway
99,462
Switzerland
79,033
Australia
67,723
LowestpercapitaGDP
Liberia
436
Niger
408
Burundi
282
Malawi
253
DRCongo
237
SoutheastAsia
Singapore
51,162
BruneiDarussalam 41,703
Malaysia
10,304
Thailand
5,678
Indonesia
3,592
Philippines
2,614
Vietnam
1,528
LaoP.D.R.
1,446
Cambodia
934
Myanmar
835
Others(selected)
UnitedStates
49,922
Japan
46,736
China
6,076
GDP Population
(BUS$) (mpersons)
57
183
501
632
1,542
0.5
1.8
5.0
8.0
22.8
2
7
2
4
18
4.0
16.1
8.8
16.6
74.7
277
17
304
366
878
250
138
9
14
53
5.4
0.4
29.5
64.4
244.5
95.8
90.4
6.4
15.3
63.7
15,685
5,964
8,227
314.2
127.6
1,354.0
Source of basic data: IMF, World Economic Outlook

Note: GDP estimates at current prices
Annex 2
Per capita GDP of selected countries, 2012
Country
US$
PPPadjusted US$/PPPadjusted
Lowestratios(GDPinUS$/PPPadjustedGDP)
The Gambia
503
1,864
0.3
Kiribati
1,646
5,973
0.3
Malawi
253
858
0.3
Timor-Leste
3,730
9,873
0.4
Tanzania
599
1,567
0.4
Highestratios(GDPinUS$/PPPadjustedGDP)
Zimbabwe
756
559
1.4
Denmark
56,202
37,657
1.5
Australia
67,723
42,640
1.6
Switzerland
79,033
45,418
1.7
Norway
99,462
55,009
1.8
Memo:
Philippines
United States
Global average
2,614
4,430
49,922 49,922
13,431 14,874
Source: IMF, World Economic Outlook Database
0.6
1.0
0.6
ECONOMICS 11
TOPIC 10
DETERMINATION OF NATIONAL INCOME
OBJECTIVE
Explain fluctuations in national income
Helps understand changes in national income
Helps in formulating policy and business
decisions
The road ahead

Basic framework
Consumption and income
Two sector economy
Three sector economy
BASIC FRAMEWORK
Tasks
Define aggregate expenditure and
equilibrium income
Describe how the economy adjusts to
equilibrium
Explain how changes in aggregate
expenditure affect equilibrium income
Aggregate expenditure (AE)

total amount that all economic agents
want/plan to spend on domestic
goods/services
Agents: households, firms, govt, foreigners
Common formulation
AE = C + I + G + X M
C = consumption, I = investment, G = govt
spending, X = exports, M = imports
Note: AE is not the same as GDP.
AE = planned spending
GDP = actual spending/output
AE and National output (Y)

There is no reason to expect that Y and AE are
equal.
Firms formulate production plans armed only with an
estimate of how much economic agents want to buy.
If AE is not equal Y, then firms adjust production
AE > Y, increase production

AE < Y, decrease production
Discrepancies between AE and Y reflected in

unintended inventories
AE > Y, firm inventories fall
AE < Y, firms accumulate inventories
Equilibrium: Y = AE
Why? No longer an incentive to adjust
production
Illustration
Assume AE does not respond to changes in
income
Horizontal line in (Y,AE) space (AE schedule)
Highly unrealistic but sufficient for now
450 line: illustrates all potential equilibrium

positions (Y = AE)
Equilibrium: intersection of the 450 line and AE
schedule
AE
Equilibrium
E0
AE
20
45
20
Y*
AE > Y
raise production
AE
E0
AE
20
45
20
Y*
AE
AE < Y
Reduce production
E0
AE
20
45
20
Y*
Higher AE raises equilibrium income (Y*)

AE
E1
30
AE1
E0
20
AE0
45
0
20
Y0
30
Y1
CONSUMPTION AND INCOME

Keynes (1936)
suggested that
consumption
spending tends to
increase with
income
Higher income leads
to higher
consumption
spending
Low levels of Y
C>Y
Break-even level:
C=Y
High levels of Y
Y>C
Income Consumption
(Y)
0
200
400
600
800
1,000
1,200
1,400
1,600
(C)
200
350
500
650
800
950
1,100
1,250
1,400
Y
0
200
400
600
800
1,000
1,200
1,400
1,600
C
200
350
500
650
800
950
1,100
1,250
1,400
Autonomous
consumption
Marginal propensity
to consume (mpc) =
change in
consumption
spending for a one
peso increase in
income
mpc = C / Y
Example
C = 500 350 = 150
Y = 400 - 200 = 200
mpc = C / Y
= 150/200 = 0.75
a 1 peso increase in
Y leads to 75 centavo
increase in C
Note: 0 < mpc < 1
Y
0
200
400
600
800
1,000
1,200
1,400
1,600
Y
0
200
400
600
800
1,000
1,200
1,400
1,600
C
200
350
500
650
800
950
1,100
1,250
1,400
C
200
350
500
650
800
950
1,100
1,250
1,400
Completing the table

Y
0
200
400
600
800
1,000
1,200
1,400
1,600
C
200
350
500
650
800
950
1,100
1,250
1,400
200
200
200
200
200
200
200
200
150
150
150
150
150
150
150
150
C/Y
_
0.75
0.75
0.75
0.75
0.75
0.75
0.75
0.75
Consumption schedule (based on values

in the previous table)
C
1600
1400
Slope is the
mpc
1200
1000
800
600
Autonomous
consumption
400
200
0
400
800
1200
1600
Drawing a 450 line helps identify some

important regions
450
1600
1400
Y<C
1200
1000
Y>C
800
600
Breakeven
400
200
0
400
800
1200
1600
Mathematical representation:
Consumption function
Autonomous
consumption
Example consistent with the

numbers in the table:
C = 200 + 0.75 Y
TWO-SECTOR MODEL
Two sectors: Households and firms
No govt and no foreign trade
Implication
AE = C + I
Assumption: I is autonomous and equal to

100
Next slide: Integrate to previous table on
consumption and income
AE = C + I
investment
AE
400
500
100
600
600
650
100
750
800
800
100
900
1,000
950
100
1,050
1,200
1,100
100
1,200
1,400
1,250
100
1,350
10
Equilibrium: Y = AE
Example, equilibrium income (Y*) = 1,200
Y
AE
400
500
100
600
600
650
100
750
800
800
100
900
1,000
950
100
1,050
1,200
1,100
100
1,200
1,400
1,250
100
1,350
Graphical treatment: Revised AE
11
Graphical treatment: Equilibrium
Experiment: What
if I investment
rises from 100 to
200? I.e. I =
100
Equilibrium
income rises from
1,200 (our original
value) to 1,600
AE
400
500
200
700
600
650
200
850
800
800
200 1000
1,000
950
200 1150
1,200
1,100 200 1300
1,400
1,250 200 1450
1600
1400
200 1600
1800
1550
200 1750
12
Graphical treatment
Summary: The 100 peso increase in

investment led to a 400 peso
increase in equilibrium income.
Question: Why is the increase in Y
bigger than the increase in I?
The answer lies in the notion of the
multiplier.
13
Multiplier ()
Measures the change in income for a
unit change in an autonomous
component of aggregate expenditure
investment in the previous experiment
Mathematical representation for the

change in investment
How is the multiplier calculated?
Applied to our example:
14
Using the multiplier to infer the

effects of a change in investment:
This explains why a 100 peso increase

in investment led to a 400 peso
(=4*100) increase in Y*
Why is the multiplier greater than 1?

Initial increase in
investment
Round
1
2
0
mpc[100]
100
0
100
mpc100
mpc [mpc100]
mpc2100
mpc[ mpcn-2100]
mpcn-1100
15
Mathematical derivation
Algebraic treatment of income

determination
Key equations
16
Substituting the consumption and

investment equations into the
equilibrium condition:
Solving for Y:
Applied to our example

Key equations
17
Substituting the consumption and

investment equations into the
equilibrium condition:
Solving for Y:
Question: Where in all this is

saving?
Saving represents that component of
income which is not spent on consumption
(i.e. S = Y-C)
The story on how savings fits into the
current topic will be discussed in another
course (Econ 101).
WAKAS
18
ECONOMICS 11
TOPIC 11
GOVERNMENT AND THE
MACROECONOMY
THE ROAD AHEAD

Government Budget
Government and
national output:
The three-sector
model
Fiscal policy
GOVERNMENT BUDGET
Government budget: indicates the public sectors
expenditures and sources of income
Net budgetary position
Budget surplus: revenues > expenditures
Budget deficit: revenues < expenditures
Balanced budget: revenues = expenditures
Some sources of information

Philippine Statistical Yearbook
Bureau of Treasury (www.treasury.gov.ph)
Budget of Expenditures and Sources of Financing
(BESF) of the Department of Budget and Management
(www.dbm.gov.ph) very detailed
Revenues & expenditures of the Phil.

national government (billion Php)
Item
2011 2012
Revenues
1,360
1,535
Expenditures
1,558
1,778
-198
-243
Surplus
(Deficit)
Source: Bureau of Treasury

(http://www.treasury.gov.ph/statdata/yearly/yr_
corsum.pdf), downloaded 22 August 2013
Expenditures by sector of the national

government (2012, % of total)
Economic services (includes agriculture, trade and
natural resources) = 24%
Social services (includes health and education
spending) = 34%
General public services = 18%
Defense = 5%
Debt service interest payments = 18%
Net Lending = 1%
Source of raw data: DBM (2013) Budget of
Expenditures and Sources of Funds
Expenditures by object of the national

government (2012, % of total)
Personal services = 33%
Maintenance and Other Operating Expenses =
52%
Capital outlays = 14%
Net Lending = 1%
Government Revenues 2012

ITEM
Tax Revenues
Taxes on net income and profits
Taxes on property
Taxes on goods and services
Taxes on intl trade & transactions
Non-Tax Revenues
TOTAL
% share
91.5
43.0
0.2
44.1
4.2
8.5
100.0
GOVERNMENT & NATIONAL OUTPUT

How do changes in government
spending and taxation affect
aggregate output?
Revisions to the basic model

Disposable income (YD) - income that households
are free to spend and save.
YD = Y T + Net transfers to households
where: Y = income, T = taxes
Examples of transfers: unemployment benefits

(other countries), conditional cash transfers
(Philippines)
Aside: for convenience, let net transfers = 0.

Implication: YD = Y T
Consumption now depends on disposable

income
Revised consumption function
Implies higher T leads to lower C
Revised AE
AE = C + I + G
Revised equilibrium condition

Y = AE = C + I + G
Numerical example
Y
1,100
1,300
1,500
1,700
1900
2,100
T
100
100
100
100
100
100
YD
1,000
1,200
1,400
1,600
1,800
2,000
C
950
1,100
1,250
1,400
1,550
1,700
I
100
100
100
100
100
100
G
200
200
200
200
200
200
AE
1,250
1,400
1,550
1,700
1,850
2,000
Equilibrium income (Y = AE): 1,700

Y
YD
1,100 100 1,000 950
AE
100
200 1,250
1,300 100 1,200 1,100 100
200 1,400
1,500 100 1,400 1,250 100
200 1,550
1,700 100 1,600 1,400 100
200 1,700
1900
100 1,800 1,550 100
200 1,850
2,100 100 2,000 1,700 100
200 2,000
Algebraic Treatment
Graphical treatment:
Government spending and equilibrium

income
Main point: G AE Y*
How large is the change in income?
If
G = 200
then,
Y* = (4).(200) = 800
Graphical treatment
Income taxes and equilibrium income

Main point: T C AE Y*
How large is the change in income?
Graphical treatment
Balanced budget multiplier

It commonly asserted that the balanced
budget multiplier is 1.
Implication: If the government raises its
spending by the same amount as its taxes,
then equilibrium income will increase by
the same amount as the increase in
government spending.
That is,
10
Using the values in previous slides
Shock
Impact (Y*)
G = 200
800
T = 200
-600
Total effect
200
Algebraic derivation:
11
Fiscal Policy
Fiscal policy - a collective term that refers
to the use of taxation and government
spending to influence the level of income

Expansionary fiscal policy - spending and
taxation aimed at increasing income;
e.g. , G or T
Contractionary fiscal policy - spending and
taxation aimed at decreasing income;
e.g., G or T
Define: Yf = full-employment level of

output
Inflationary gap
Exists when AE >Y at Yf
There is pressure for an increase in the
general price level (inflation) because it
is not possible to produce beyond Yf.
12
Can eliminate the inflationary gap through a

contractionary fiscal policy
13
Deflationary gap
Exists when AE < Y at Yf
There is pressure for a decrease in
output.
Implies unemployment
14
Can eliminate a deflationary gap by an

expansionary fiscal policy
WAKAS
15
ECONOMICS 11
TOPIC 12
OPEN ECONOMY MACROECONOMICS
Meaning of Open Economy

Most modern economies do
not operate in isolation.
Countries rely in varying
degrees on trade with other
countries on goods and
services for their
consumption and production
needs.
The transactions among

countries extend to
transfer payments, sales
and purchases of assets,
borrowing and lending,
etc.
A country that engages in
such transactions is called
an open economy
Balance of Payments
Balance of Payments (BOP) - a summary
of the transactions between residents and
non-residents of a country over a given
period
It records transactions in goods, services,
assets and transfers.
Keeps track of the country's transactions with
the rest of the world.
The information helps in analyses that could
assist in the formulation of economic policies
and decisions.
BOP Acct of the Phil, 2012 (preliminary, million USD)

Item
Values
Sub-totals
Current Account (CA)
7,177
Goods & services

Exports
69,721
Imports
-80,845
Income (net)
Transfers (net)
-871
19,172
Capital Account (KA, net)
181
Financial Account (FA)

Direct Investment (net)
5,520
341
Portfolio Investment (net)
3,523
Others (net)
1,656
Net unclassified items (NUC)

Overall BOP Position (CA + KA + FA + NUC)
Reserves and Related Assets (RRA)
-3,642
9,236
-9,236
Source: Bangko Sentral ng Pilipinas, www.bsp.gov.ph
Current Account
The Current Account
reflects the flow of the country's transactions in
goods and services, investments as well as
current transfer payments.
Inflows = earnings of residents from nonresidents
Outflows = payments of residents to nonresidents
Capital Account
Capital Account
the sum of the Capital Account and Financial
Account
represents capital transfers, changes in the
resident claims on non-residents (changes in
assets), and changes in non-resident claims on
residents (changes in liabilities).
Financial Account
The Financial Account captures transactions
in equity and other financial assets.
It is classified into
Direct Investment represents transactions in
equity capital, reinvested earnings, etc.

Portfolio Investment represents transactions in
equity securities and debt securities (bonds and
notes, money market instruments, etc.).

Other Investment (net) includes trade credits,
short to long term loans, currency and other

deposits
Reserves and Related Assets

Reserves and Related Assets are composed of
Exceptional Financing, Use of Fund Credit and
Loans and Reserve Assets.
Reserve Assets represent changes in the assets of
the monetary authorities that can be used for
balance of payments purposes. It is composed of
Monetary Gold, Special Drawing Rights (SDR),
Foreign Exchange and Other claims.
Net Unclassified Items

Theoretically, the sum of the Current Account, Capital
Account, Financial Account and Reserves and Related
Assets must be zero, i.e.,
CA+KA + FA + RRA = 0.
The myriad of transactions between residents and nonresidents poses difficulties for recording and compiling
entries. These eventually cause the sum of the to be nonzero.
To capture the presence of such a discrepancy, the practice
is to present it as a separate item in the BOP accounts - Net
Errors and Omissions.
ECONOMICS 11
TOPIC 13
MONEY
Significance
Some of the more controversial economic
issues involve the conduct of monetary
policy as it is used to deal with inflation,
budget deficits, unemployment, incomes,
international economic relationships, etc.
Monetary policy has profound effects on our
jobs, incomes, livelihood, and career
choices.
This lesson, therefore, introduces the role
and functions of money in the economic
system
The Road Ahead

evolution of money and modern payment
systems
basic insights as to why people and firms
hold money (demand for money).
money supply
Definition of Money
Economists have not really agreed on a single
definition but they agree that money supply
refers to all things generally acceptable in
payment of debt (store of value) and as payment
for goods and services (medium of exchange)
whatever its legal status may be.
Functions of Money
Money serves a
medium of
exchange.
This means that

money is an
accepted means
of payment for
goods and
services.
Functions of Money (cont)

Money serves as a unit of account
Money represents an item with which the
values of all other goods and services are
expressed or quoted.
Functions of Money (cont..)

Money serves as a store of value (and a
standard of deferred payment).
Money can be kept today (i.e., stored) and spent at a

later period. It also implies that goods can be bought
today and paid for at a later date (deferred payment).
However inflation, may decreases the ability of money to
act as a store of value and deferred payment.
Evolution of Money
Autarky refers to a family or tribal
group, which, in the absence of
trade, produces that level of goods
and services equal to their
consumption. Money is not used.
Barter system involves trading of

goods and services for other goods
and services. Money is not used but
the barter system requires a double
coincidence of wants.
Evolution of Money (cont)
Commodity Money - overcame the inconveniences
that went with barter system by using uncoined metals

like gold, silver or copper.
had the advantage of ease of transport and durability.
new set of problems came up with the use of uncoined metals
such as adulteration (impurities in content) and short weighing
by unscrupulous traders.
Evolution of Money
Coinage solved the
problem of
adulteration and short
weighing, with the
king's seal being
stamped on the metals
for authentication.
However, some more
problems came up like
storage, theft, costly
and risky transport,
and so on.
Evolution of Money
IOU's tend to minimize risk in transport since coins were left to a
reputable person with "vault or safekeeping" means. IOU's ("I owe
you") were simply written on paper/receipt instead of going to the
safekeeper to transact.
Bank note involves the promise to pay a debt (IOU) which is
evidenced by a piece of paper backed by specie.

Specialized Bankers evolved because it was observed that not all
people who "deposited" their money were demanding payment at
the same time. Hence, there was no need to hold all the gold/silver
pieces all the time. The idea of lending out a portion of the
entrusted money for a fee while holding on to the rest for safekeeping paved the way for fractional reserve banking.
Electronic Funds Transfer System (EFTS)- Electronic money
make use of computer terminals for transactions and automated
computer clearing house that does away with a physical medium of
exchange.
Demand for Money Why to

people hold money?
Transactions demand
for money
Precautionary demand
for money
Speculative demand
for money
Transactions Demand for Money -
arises from the need of households and

firms to have money for the regular
payments of goods and services
Precautionary Demand for Money

People want to hold money for unexpected
events
Speculative or Portfolio Allocation

Motive
the speculative demand stems from the
preference of households and firms to hold
other assets that are "perfectly liquid and
perfectly free from risk of depreciation in
terms of money" in order to "take advantage
of market movements."
Demand for Money

Demand for money is primarily determined by
the level of real output or income and the
interest rate.
Other factors:
(a) credit availability and affordability;
(b) expectations on future income;
(c) expectations on prices;
(d) risk and expected returns on alternative assets;
and
(e) financial innovations that allow easy movement
of funds from less liquid to more liquid forms.
Supply of Money
M1 consists of items used as medium of exchange
such as currency or coins in circulation and demand
deposits.
M2 consists of M1, plus savings and small time

deposits.
M2 =M1+
Savings &
small
time
deposits
M3 refers to money supply, peso savings,

negotiable order of withdrawals (NOW accounts),
time deposits and deposit substitutes of moneygenerating banks.
RM or reserve money represents liabilities of the

Bangko Sentral ng Pilipinas (Central Bank) to the
public sector in the form of currency in circulation
and to the banking sector inthe form of cash
reserves.
Adios!!!
WAKAS
10

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Economics 11

Methodology of science (and economics!)

Economics as a social science

Sociology, psychology, political science,

What differentiates economics from the

MAIN BRANCHES OF ECONOMICS

studies behavior of individual economic units

Focus is on the whole/aggregate economy

Examples of indicators: GNP, GDP, inflation,

POSITIVE vs NORMATIVE ECONOMICS

ECONOMICS AND MODELS

Why use models

Scarcity and choice

Basic Economic Questions

Do we want to use fertilizers and/or pesticides in farms?

For whom to produce?

Production Possibilities Frontier (PPF)

Assumptions about the PPF

Example of a PPF for a given technology

Opportunity cost and the PPF

OC using the table for the PPF

Increasing opportunity costs

The PPF & the Basic Econ Questions?

For whom to produce?

Shifts in the PPF

Changes in resource endowments

Water, Land, Forests, etc

The changes above cause an outward shift

Economic systems & the Basic

Decisions made by authorities

Completely unregulated market economy

Markets determined the answers to the

Actual economies fall somewhere in

Supply, Demand and Market Equilibrium

THE ROAD AHEAD

WHY STUDY SUPPLY & DEMAND?

Oil price increase, appreciation of the peso

a market does not have to be a place

Why is there a negative relationship?

When price of a good decreases, the

When price decreases, the consumers real

3 ways to present the Law

Table: Demand schedule for Denim pants

Note: Values here

Price (in pesos)

a = horizontal intercept ~ indicates quantity

Equation for the previous example

Change in quantity demanded vs change in

Change in quantity demanded

Price (in pesos)

Increase in demand (rightward shift)

Price (in pesos)

Decrease in demand (leftward shift)

Price (in pesos)

The price is not the only factor that affects

Changes in these (other) factors cause the

Most goods are normal

Inferior goods: higher income leads to

Few examples but these exist

OFAD: Prices of related goods

Eg. Coffee and tea, gin and rum

Complement = goods which are used or

OFAD: Consumer tastes and preferences

Increase in demand for IPods